LIETUVOS RESPUBLIKOS VYRIAUSYBE

LIETUVOS RESPUBLIKOS VYRIAUSYBE Official translation THE GOVERNMENT OF THE REPUBLIC OF LITHUANIA RESOLUTION No 1323 of 12 December 2005 ON THE CONVERGENCE PROGRAMME OF LITHUANIA OF 2005 Vilnius Acting pursuant to Article 7 of Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies, as last amended by Council Regulation (EC) No 1055/2005 of 27 June 2005, which lays down a multilateral surveillance procedure of the European Union Member States carried out in the form of stability and convergence programmes, the Government of the Republic of Lithuania has resolved: 1. To approve the Convergence Programme of Lithuania (appended); 2. To charge the Ministry of Finance with the task of submitting the Convergence Programme of Lithuania as approved hereby, to the European Commission. Prime Minister                                                             Algirdas Brazauskas Minister of Finance                                                                 Zigmantas Balčytis APPROVED by: Resolution No 1323 of 12 December 2005 of the Government of the Republic of Lithuania CONVERGENCE PROGRAMME OF LITHUANIA I. FINANCIAL POLICY OVERVIEW 1. Lithuania’s economic policy serves the goal of ensuring a rapid real convergence and approximation to the high level of productivity and subsistence within the Economic and Monetary Union, with the ultimate goal of a full-fledged participation in the Economic and Monetary Union. Lithuania pursues to introduce the euro on 1 January 2007. The Convergence Programme of Lithuania (hereinafter referred to as this Programme) outlines the Government's economic policy commitments aimed at ensuring that Lithuania's economic performance satisfies, in a sustainable manner, the convergence criteria. 2. The entire set of reforms is geared towards the development of measures aimed at achieving the above-mentioned goal over the medium term. These measures include: 2.1. a rapid and sustainable real convergence and a stable macroeconomic environment; 2.2. favourable conditions for business development and a successful implementation of structural reforms; 2.3. a transparent public administration and a political consensus regarding the reforms to be carried out; 2.4. a stable and predictable legal environment; and 2.5. a deeper economic integration into the EU. 3. Despite the temporary difficulties related to extra tensions on the budget, Lithuania has undertaken in this Programme to pursue the fiscal and monetary policy that ensures the stability of prices and government finances so as to maintain a strong confidence in the continuity of the currency board arrangement in Lithuania and to successfully participate in the Exchange Rate Mechanism II (hereinafter referred to as the ERM II). 4. This Programme gives an overview of recent economic developments in Lithuania, a projection of a medium-term monetary and fiscal policy, an assessment of risks and of the quality of government finances, and a description of Lithuania’s readiness to overcome the effects of ageing population, as well as an outline of major structural reforms underway. 5. This Programme also examines and assesses the preconditions for the achievement of the declared economic policy goals. The economic development projections given herein are based on the assumption that Lithuania’s external economic environment will, in principle, remain stable during the period concerned. Other assumptions used herein are close to those made by the EU Commission. The commitment to maintain a strict fiscal discipline as laid down in this Programme has been enforced by the Council of the European Union which has unanimously tightened, in June 2005, fiscal policy requirements under the Stability and Growth Pact, namely: the states participating in the ERM II have to reduce structural deficit by about 0.5% of the Gross Domestic Product (hereinafter referred to as the GDP) a year, until the medium-term fiscal deficit objective is reached. EU regulations explicitly require pursuing a tight fiscal policy, thus imposing a legally binding obligation to reduce fiscal deficit. Lithuania’s participation in the ERM II marks the stage of a close economic cooperation between Lithuania and the EU, built on coordination of economic policies, which is a necessary precondition for ensuring a sustainable and deeper integration of Lithuania into the EU single market. With the re-pegging of the litas to the euro in 2002 and the enlargement of the European Union in 2004, Lithuania’s export of goods to the EU has grown from 48% in 2001 to 67% in the nine months of 2005. Lithuania is integrated with the low-risk economies of the EU; therefore, the economic development remains on a solid and fast track.  6. As a result of the re-pegging of the national currency to the euro under the currency board arrangement, inflation remained low, i.e. only 0.2% in 2004; however, a growth to 2.7% is projected due to the recent rise of oil prices. A record-high increase in oil prices over 2004–2005, a projected growth of interest rates, and lower growth of credits coupled with an inert absorption of EU support at the start of the new financial perspective (2006–2007) will have an effect on the economic cycle. The rapid economic development will be maintained through the improvement of the quality of general government finances and the balance between capital and labour taxation as well as the adherence to the requirements under the Stability and Growth Pact.  7. Growth of exports and investment remains on a fast track in Lithuania, with unemployment going down at the highest pace among the EU states. Over the past three years, the level of employment has grown by 4%. The orientation of Lithuania’s fiscal policy towards the achievement of the goals under the Stability and Growth Pact has strengthened market expectations about the approaching membership in the Economic and Monetary Union and has reduced the risks associated with investment in Lithuania. A rapid growth of investment will ensure Lithuania’s competitiveness in the long run and increase the import of investment goods and the current account deficit (hereinafter referred to as the CAD) in the short run. 8. The tight fiscal policy pursued since 2001 and the prudent re-pegging of the litas to the euro in 2002 have aroused market expectations about an early membership in the EMU, thus reducing the gap between interest rates on loans in the litas and in the euro and making euro-denominated-loans more popular. With the drop of interest rates, the private demand financed by the rapidly expanding financial intermediation sector has contributed to the development of new production capacities and the improved utilisation of the existing ones. 9. The successful collection of taxes from the shadow economy, the allocation of saved expenditure for the reduction of fiscal deficit, the temporary taxation of capital income with a new social tax, the creation of equal conditions for the persons engaged in commercial-economic activities  to compete in the market (by expanding the real estate tax base), all have helped to implement the provisions of the EU and Lithuania’s economic policy communication regarding Lithuania’s participation in the ERM II. The implementation of measures set out in Convergence Programme of Lithuania for 2004 as approved by Resolution No 568 of 11 May 2004 of the Government of the Republic of Lithuania (Valstybės žinios (Official Gazette) No 79-2793, 2004) has in part helped to prevent the projected jump of demand and its inflationary impact. Inflation projections for 2005 have been lowered by 0.2 percentage points. One of the fiscal policy objectives, to keep the economic impact of fluctuations in the demand under control, laid down in the Convergence Programme of Lithuania for 2004 will be pursued under this Programme, too. A consistent implementation of measures set out in this Programme will help to ease the concerns about sustainability in implementing Maastricht criteria. 10. The rapid growth of demand under the conditions of a fixed exchange rate of the litas has inspired a rapid growth of imports and Lithuania’s current account deficit of the balance of payments. Thus, to ensure the continuity of foreign capital inflows, the government should further improve business and investment environment, give maximum support to investment that is promoted by laws, and create particularly favourable conditions for "green field" investment, as well as maintain market confidence in an early integration of the country into the euro zone. In the coming years, EU support will finance an increasingly larger share of the CAD. Given the need to implement structural reforms aimed at ensuring productivity and a long-term sustainability of government finances, and in the light of the rapid growth of GDP and the current low level of debt, the medium-term fiscal deficit objective is set at around 1% of GDP. For later years, the medium-term fiscal deficit target will be tightened to take note of the Commission’s latest estimates suggesting that general government debt will approach 80% of GDP in 2050, unless fiscal policy is tightened. EU Commission’s estimations for 2005 suggest that in order to implement ambitious social guarantees to pensioners in 2030 to 2050, despite the problem of ageing population, and to secure a long-term stability of government finances which is a requisite in the euro area, Lithuania’s primary structural surplus should reach about 2.6% of GDP over the medium term. Therefore, once major structural reforms have been completed, a cyclically-balanced or surplus budget will again be pursued as a medium-term fiscal policy goal. 11. Currently, Lithuania’s capacity to plan for a fiscal deficit below 1% of GDP is prejudiced by temporary budgetary difficulties associated with payments to the EU Own Resources, increasing co-financing, accelerating pension reform, and a radical tax reform.  Thanks to the strict fiscal discipline, government current expenditure will remain at the lowest level in the EU. The GDP share of government expenditure will slightly grow due to the implementation of the Public Investment Programme and the increasing investment support from the EU. Fiscal discipline will be maintained by holding the GDP share of government current expenditure down over the medium term and by keeping the share of social expenditure at about 9% of GDP. The successful implementation of the pension reform will pave the way for the reduction of the national debt in the long run and will encourage private persons to save funds to supplement their old-age pension. Tax revenues to be allocated in 2008 for the pension reform will account for 0.8 percentage points of GDP. The reduction of the personal income tax which is expected to ensure a better balance between labour and capital taxation will contribute to the successful implementation of Lisbon objectives in the labour market, to increase employment and the potential GDP, and to mitigate the effects of ageing population for government finances. Although the potential GDP will increase as a result of the tax reform, the fulfilment of the Stability and Growth Pact requirements, namely: to prevent negative effects for fiscal deficit and economic cycle, will be possible only on the condition that additional tax revenue is collected as a temporary measure. As a longer-term goal, Lithuania will make efforts to promote housing renovation aimed at saving heating and reducing the dependability of the economy on natural gas prices.  12. The fiscal policy pursued in compliance with the strict regulations of the Stability and Growth Pact will allow to consistently reduce government debt until government finances become capable of fulfilling, in a sustainable manner, the commitments under the Maastricht Treaty, while maintaining the ambitious social guarantees, regardless the projected significant growth of the number of pensioners and the decreasing number of the employed population in the third decade. II. economic outlook Assumptions 13. The projections of Lithuania’s economic indicators are based on the recent economic development trends and assumptions about economic growth.  In the period of 2005 to 2008, an important assumption is the absorption of the EU structural funds and other financial assistance from the EU. The absorption of the EU support will be important for the growth of GDP of a respective year. According to the estimations by the Ministry of Finance based on the data of appropriation managers about the implementation of contracts, the EU support will provide the largest stimulus for economic growth in 2006. In 2006, the EU support will offset the negative effects of oil prices on the demand; therefore, GDP projections for 2006 remain principally unchanged.  As long as no agreement on the EU financial perspective for 2007 to 2013 has been reached, the absorption of the new wave of EU support in 2007 is assumed to reflect the 2004 trends.  Low absorption of the new wave of EU support in the first year (2007) will not have a positive impact on a solvent demand, which leads to the projection of a lower GDP growth in that year. In 2008, EU support will better contribute to GDP growth; therefore, a larger GDP growth is projected. Table 1. Key assumptions 2004 2005 2006 2007 2008 Short-term interest rates 2.3 2.3 2.7 3.0 3.2 Long-term interest rates 4.6 3.6 4.0 4.1 4.2 USD/EUR exchange rate (euro area and ERM II countries) 1.24 1.25 1.21 1.22 1.22 Nominal effective exchange rate 6.1 -0.8 -1.1 0.2 0.2 (for countries not in euro area or ERM II) exchange rate vis-à-vis the € (annual average) N.A. N.A. N.A. N.A. N.A. World (excluding EU-25) GDP growth 5.1 5.1 4.9 4.6 4.6 EU-25 GDP growth 2.4 1.5 2.1 2.4 2.4 Growth of key export markets 2.4 1.5 2.1 2.4 2.4 World import volumes, excluding EU 5.7 8.8 8.8 8.5 8.5 Oil prices (Brent, USD/barrel) 38.0 55.0 61.4 60.3 60.3 Source: Statistic Lithuania, Ministry of Finance, European Commission Fig. 1. EU net* support (in % of GDP) *Payments from the EU budget (less payments to the EU budget) Source: estimates by the Ministry of Finance Fig. 2. Annual increase of EU net support as compared to previous years (% of GDP) Source: estimates by the Ministry of Finance In 2007, EU net support will be slightly lower due to higher payments to the EU budget. The experience in assessing Single Programmes of other EU Member States enables to estimate that EU financial assistance will have increased GDP by over 3% over 2004 to 2008. The rapid growth of lending to private customers in 2003 and 2004 stimulated the growth of consumption and investment.  Estimates lead to the assumption that investors’ and consumers’ loan portfolio will continue to grow fast but its growth in 2005 will be close to that in 2003 and 2004 meaning no additional stimulus to the rapidly increasing demand. In 2006 to 2008, the decreasing impact of credit growth on the demand will be partially offset by the absorption of EU support. The key assumptions about external economic environment in implementing the EU fiscal monitoring procedure and in seeking to ensure the comparability of economic forecasts correspond to the external environment assumptions published by the European Commission. The projection of average oil prices for 2006 has been raised to USD 61.4 per barrel. In 2007, oil prices are projected to drop to USD 60.3 per barrel.  In the medium term, Lithuania will maintain the rapid economic growth: GDP growth may reach 7% in 2005, 6% in 2006, 5.3% in 2007, and 6.8% in 2008. Monetary and exchange rate policy 14. The implementation of the fixed exchange rate mechanism under the currency board arrangement has played an important role in achieving a non-inflationary and stable macroeconomic development, which has stabilised inflationary expectations, lowered country and currency risk premiums, and boosted confidence in the economic policy of the country. From 1 April 1994 to 2 February 2002, the litas was pegged to the U. S. dollar. On 2 February 2002, the litas was re-pegged to the euro, chosen as the anchor currency, at the official exchange rate of 3.4528 litas to 1 euro (calculated by multiplying the U. S. dollar exchange rate vis-à-vis the euro (0.8632 U. S. dollar to 1 euro) announced by the European Central Bank on the date of the re-pegging (1 February 2002) by 4 (the former official litas exchange rate vis-à-vis the U. S. dollar)), which has not changed upon accession to the ERM II on 28 June 2004. 15. Lithuania seeks to be ready for the introduction of the euro in early 2007. A number of economic considerations also spur a changeover to the euro in Lithuania: 15.1. a historical success in maintaining a tight, fixed exchange rate; 15.2. Lithuania has unilaterally re-pegged its national currency to the euro; however, it does not fully enjoy the advantages of the single currency: economic entities suffer exchange losses in converting currencies to/from the euro, and a deeper integration of trade and finances with the EU is precluded. Cyclical developments and a medium-term macroeconomic scenario Goods and services markets 16. In recent years, Lithuania’s economy has been growing at an accelerating pace. In 2003 and 2004, Lithuania was one of the fastest-growing economies of the world, with GDP growth of 10.5% and 7%, respectively. This is a testimony of a successful implementation of structural reforms. In the three quarters of 2005, GDP grew by 6.9%, according to preliminary estimations by the Department of Statistics under the Government of the Republic of Lithuania (hereinafter referred to as the Statistics Lithuania). The economic growth was driven by the growth of the domestic demand surpassing the growth of GDP and by unused capacities that existed in the economy. In recent years, the economic growth was mainly driven by the domestic demand. The rapid growth of borrowing was among the key factors that promoted the growth of investment, household consumption, and thus the GDP. The surplus capacity, rapid investment, growth of employment, efficient competition in the retail sector, all has helped to keep a balance between the growth of the demand, the supply and imports. GDP grew rapidly thanks to low inflation and a moderate growth in wages. The tight fiscal policy coupled with the carry-forward of EU support to cyclically better periods as well as other circumstances has helped to prevent an external and price imbalance. The projected growth of interest rates in 2006 and 2007 will also limit the growth of loans and the demand, thus creating favourable conditions to maintain economic balances. In 2004 and 2005, the growth of loans slowed down, EU fiscal stimulus was carried forward to later periods, and oil prices reached their record high. For these reasons, GDP gap is projected to shrink from 2006 onwards.  In 2003 and 2004, a rapid growth of demand and a lack of supply caused a jump of real estate prices (housing and land). Seeking to create equal opportunities for persons engaged in commercial-economic activities to compete in the market, by discouraging, at the same time, speculations in real estate prices, Lithuania will impose, from 2006 onwards, a real estate tax not only on real estate owned by legal persons, but also on real estate owned and used by natural persons for commercial-economic purposes. Publicity measures aimed at informing the public that income derived from real estate might be subject to VAT and income tax, in accordance with the procedure laid down in legal acts, have also encouraged people to assess long-term real estate price trends with more care. This policy will help to maintain confidence in the economic sustainability. Over the period of 2005 to 2008, a rapid growth of investment and consumption is projected. Lithuania’s export performance will remain on a positive track. Nominal export growth will be promoted by the liberalisation of trade with the EU, which has crated better conditions for trade. The rise of oil prices and the lack of oil production capacities facilitate export trade for Mažeikių nafta (oil refinery company).  Table 2. Macroeconomic prospects 2004 2004 2005 2006 2007 2008 ESA code level rate of change rate of change rate of change rate of change rate of change Real GDP B1*g 61583.9 7.0 7.0 6.0 5.3 6.8 Nominal GDP B1*g 62440.2 10.0 9.7 9.9 8.2 9.6 Components of real GDP Household consumption expenditure + NPISHs P.3 40393.4 9.7 8.6 8.4 6.7 6.9 General government consumption expenditure P.3 11306.3 7.5 9.0 3.0 2.5 2.5 Gross fixed capital formation P.51 13824.3 12.3 13.5 12.2 12.0 7.3 Changes in inventories and net acquisition of valuables (% of GDP) P.52 + P.53 3934.4 6.4 5.1 4.1 4.2 4.4 Exports of goods and services P.6 33025.4 4.2 12.9 7.0 6.0 5.9 Imports of goods and services P.7 40899.9 14.8 13.9 8.9 8.8 5.7 Contributions to real GDP growth Domestic demand 69458.3 13.8 9.4 8.3 8.3 7.6 Changes in inventories and net acquisition of valuables P.52 + P.53 13824.3 3.6 -0.9 -0.7 0.3 0.5 Balance of goods and services B.11 -7874.5 -6.8 -2.4 -2.3 -3.0 -0.9 Source: Statistics Lithuania, Ministry of Finance EU financial assistance will create the conditions for active investment despite the lower credit growth. With stronger investor confidence in the stability of the economy, investment will account for an increasingly larger share of GDP. Although the impact of EU support on the demand has in part been carried forward to cyclically more acceptable periods, the strongest stimulus of EU support on investment is projected in 2005. At the end of the reference period  the share of gross fixed capital formation will account for over 25% of GDP.  A positive impetus to consumption in the reference period will be provided by the accelerating growth of wages resulting from higher productivity, by the decreasing unemployment, by the opening of EU labour markets and positive consumer expectations about economic development. In 2005 to 2008, final consumption expenditure will grow by 6.9% on the average. The increasing pressure exerted by the domestic demand will be eased by the decreasing GDP share of general government consumption expenditure.   In 2004, the degree of utilisation of industrial production capacities stabilised at over 70%; therefore, the increase in the domestic demand projected for the reference period will be largely met through imports and investment. Import of new technologies will strengthen the capacity of the economy to compete in international markets. In later periods, the increased production capacities stimulated by EU support will enable to meet the domestic demand to an increasingly higher extent by supplying domestically produced goods and services.  Year 2005 results of foreign trade evidence that Lithuanian economy remains competitive. The new approach employed in foreign trade makes it difficult to project export growth potential; nevertheless, Lithuania is likely to still have possibilities to access new export markets and compete in the existing ones in the reference period. At the end of the reference period, export growth will be promoted by the realised expectation about the changeover to the euro. A changeover to the euro on 1 January 2007 will spur foreign investment and growth of exports. Based on assessments made by other countries of the impact of the changeover and taking into account the impact of EU support, GDP is projected to grow by 6.8% in 2008.  Productivity should continue to grow rapidly beyond 2008, being the major driver for approximation of the level of living in Lithuania to the EU average  in the period covered by the 2007-2013 financial perspective.  The expectation about a balanced economic development continues. Exporting industries will play an important role in maintaining sustainability of economic growth.  Competitiveness of the services sector is expected to grow further. The continuing rapid growth of consumption will facilitate a stable growth of retail and wholesale trade. Stability of prices 17. After the effects of the one-off price boom in May 2004 have been neutralised, the monthly annual inflation has dropped to 2%. Fluctuations in prices of food and fuel, principal categories of goods and services causing inflation, and in administered prices in August have accounted for 0.6%, 0.9% and 0.7% percentage points of the annual inflation, respectively. The impact of food prices, in particular, has weakened compared to January-April (when the implications of the price boom of May 2004 were still in effect). In this period, changes in food, administered and fuel prices have contributed, respectively, 1.7, 0.9 and 0.5 percentage points of the four-month average inflation on the average. Annual core inflation (annual inflation according to the harmonised index of consumer prices (hereinafter referred to as the HICP), excluding the effects of food, administered and fuel prices) averaged at about zero in the first half of 2005. Fig. 3. Factors of change in the annual inflation by HICP 4 3 2 1 0 -1 -2 -3 -4 -5 4 3 2 1 0 -1 -2 -3 -4 -5 03 07                             04 01                                04 07                             05 01                                05 07 Administered prices Food and alcohol Fuels and lubricants Other HICP (annual growth, in %) Core inflation* (annual growth, in %) * HICP, excluding food, fuel and oil, and administered prices. Sources: Statistics Lithuania, estimates by the Bank of Lithuania. Higher inflation is recorded for those categories of consumption goods and services, which are less affected by competition.  In May-October 2005, the annual inflation was largely influenced by food and transport (including fuel) prices. The dynamics of dairy prices has raised the convergence indicator for inflation by about 0.4 percentage points. A rise of transport prices has further worsened the inflation indicator by about 1 percentage point. Excluding the inflation in food and transport sectors, the overall level of prices would have increased by 1 percentage point only.  If the assumptions underlying the estimates prove true, the average annual inflation rate will be 2.7% in 2005 to 2007. The projected price level in 2006 has been raised by 0.2 percentage points due to changes in assumptions. As actual data suggest, the record-high impact of oil prices on the cost of goods has not raised inflation above the level required under the Maastricht Treaty, which lays down the principles of assessing convergence in terms of inflation. In July, the annual inflation was below 2%, despite the rise of oil prices by almost 50% over the year, and the impact of the transport sector prices on annual inflation reached 0.9 percentage points. The easement of the tax burden on labour scheduled as from 1 July 2006 and from 2008 will ensure that businesses keep confidence in their competitiveness despite the growth of oil prices. A part of the income to be saved through the easement of the tax burden is likely to be used to keep prices down, for competition. Moreover, lower taxes will mean higher net wages; therefore, average nominal wages for general government-financed budgetary organizations in 2007-2008 are projected to remain at approximately the 2006 level. It is expected that segments of the private sector will follow this practice. The reduction of tax rates will help to keep inflation resistant to any pressure from the nominal wages for three years to come. Employers will be less pressed to raise nominal wages, having in mind that their employees will receive higher net income by virtue of lower taxes. The reduction of personal income tax, a more efficient utilisation of the economic potential and the growth of productivity that essentially offset the increasing growth of the average monthly wages will hold down the rise of prices in the future. At the end of the reference period, the stable inflation rate will average at about 2.5% and will meet, in a sustainable manner, the Maastricht criterion for inflation provided that inflation in other EU Member States is not particularly low. Fuel excise policy is unlikely to raise inflation in Lithuania. Lithuania meets the requirements for transitional minimal rates of excises on fuel. For 2008, excises on fuel will have to be raised by 12%. This increase is not likely to cause a higher CPI inflation than 0.2 percentage points (if oil prices fell from 59 to 54 dollars per barrel in 2007-2008, inflation would remain completely unaffected).   The projected rise of GDP deflator in 2004-2006 is owing to the facilitation of trade achieved through the convergence of prices of goods (oil and foodstuffs) and services (construction) with the EU level, i.e. liberalization of trade in foodstuffs and a freer movement of labour after accession. Table 3. Price developments 2004 2004 2005 2006 2007 2008 ESA code level rate of change rate of change rate of change rate of change rate of change 1. GDP deflator 101.4 2.8 2.4 3.6 2.7 2.6 2. Private consumption deflator 74.9 0.7 2.8 2.4 2.2 2.2 3. HICP* 118.2 1.1 2.7 2.7 2.7 2.5 4. General government consumption deflator 74.9 0.7 2.8 2.4 2.2 2.2 5. Investment deflator 84.9 -7.6 -6.4 4.1 4.9 2.9 6. Export price deflator (goods and services) 101.4 7.5 8.0 2.2 1.8 2.5 7. Import price deflator (goods and services) 101.4 -0.5 4.9 1.1 1.8 1.8 Source: Statistics Lithuania, Ministry of Finance It was largely owing to the jump of oil prices that import prices grew at an accelerating pace in the past quarters.  In the second quarter, the annual change in import prices grew by 5.3% (cf. 0.4% in the second quarter of 2004). A rise of prices of imported mineral products was the cause of the annual growth of import prices by 5.9 percentage points. Fig. 4. Dynamics of import prices, oil prices and U. S. dollar exchange rate Annual change, in % 8 4 0 -4 -8 20 10 0 -10 -20 2002                                       2003                                       2004                                          2005 Import unit value index of imports (IUVI) IUVI excl. mineral products U. S. dollar exchange rate vis-à-vis the litas (right-hand scale) Source: Statistics Lithuania, estimates by the Bank of Lithuania, Bloomberg Excluding the impact of oil prices, the annual deflation of import prices slowed down from –1.5% in the second quarter of 2004 to –0.5% in the second quarter of 2005. The lower import deflation may be partly explained by the appreciation of the U. S. dollar vis-à-vis the euro in the past months: the average monthly nominal value of the U. S. dollar was 10.3% higher in June than at the beginning of the year. Like in the previous periods, cheaper means of transport and imported equipment were the key contributors to the annual fall of import prices (excluding mineral products), accountable for 1.1 and 0.7 percentage points, respectively, over 2005. In the eight months of 2005, the producer prices of industrial production sold in the domestic market (hereinafter referred to as domestic producer prices) grew at an average annual rate of 5.2%. A large part of industrial production consists of energy products, the dynamics of which, therefore, has had the largest impact on the rise of domestic producer prices (accounting for 4.3 percentage points of the annual inflation of domestic producer prices in the eight months of 2005 on the average). Ignoring the impact of energy prices, the annual inflation of domestic producer prices averaged at 2.5% in January-April 2005. In May, it dropped to 2% as a result of a weaker impact of prices of non-durable goods (mainly food products) and stayed at around this level in the recent months. As far as labour costs are concerned, the annual wage growth in the recent quarters of 2005 was slightly higher than in the first half of 2004 (in the second half of 2005, the average gross monthly wage, excluding individual enterprises, grew by 9% year-on-year). Acceleration of the wage growth is particularly vigorous in non-tradable sectors (health care, education, construction). In earlier periods, a faster growth was recorded in labour productivity, and now in wages, which demonstrates a cyclical nature of unit labour costs. To illustrate, from 2003 to mid-2004, as labour productivity grew rapidly, unit labour costs were declining, and from mid-2004, the growth of wages started to catch up with labour productivity that grew earlier. Fig. 5. Wages, labour productivity and unit labour cost Annual change, in % 15 10 5 0 -5 -10 -15 15 10 5 0 -5 -10 -15 2001                             2002                                 2003                             2004                              2005 Labour productivity (-) Gross wage/earnings Unit labour costs Source: Statistics Lithuania, estimates by the Bank of Lithuania Labour market 18. Structural reforms have stimulated a rapid growth of labour productivity. The largest rates of growth of productivity and added value were recorded in production and agriculture-related activities. The growth of productivity in recent years exceeded the growth of wages thus enabling to maintain competitiveness in the conditions of appreciation of the nominal exchange rate of the litas: during 2001-2003, wages grew by 9.2%, whereas labour productivity grew by over 20%. By the data of the Statistics Lithuania, real labour productivity and nominal wages grew by 8% and 5.8% in 2003, respectively, and by 7.1% and 7.9% in 2004, respectively. Nominal growth of wages is close to real growth of productivity. Over the past three years, the level of employment has grown by 4%, meaning lower unemployment. According to the data of an employment survey, the average annual level of unemployment has dropped from 17.4% in 2001 to 11.4% in 2004. In the second quarter of 2005, the unemployment figure stood at 8.5%. Table 4. Labour market developments 2004 2004 2005 2006 2007 2008 ESA code level rate of change rate of change rate of change rate of change rate of change 1. Employment, persons 1436.3 thou -0.1 1.7 2.0 1.3 1.0 2. Employment, hours worked 2 608 388.0 1.1 0.0 0.0 0.0 0.0 3. Unemployment rate (%) 184.4 thou 11.4 9.6 8.6 7.9 7.5 4. Labour productivity LTL 40 382.9 6.6 6.6 6.1 5.3 6.7 5. Labour productivity, hours worked - - - - - - 6. Compensation of employees LTL 24 586.2m 10.5 10.2 10.5 9.5 9.9 *ESA – European System of Accounts. Source: Statistics Lithuania, Ministry of Finance Average monthly gross wages are projected to grow from LTL 1 158 in 2004 (by preliminary estimations) to LTL 1 600 in 2008.  Accelerated accumulation of investment will increase productivity and mitigate the impact of the growth of wages. Corporate profits and productivity that have demonstrated a growth in recent years will also have an upward effect on wages, without causing a loss of competitiveness.   In the first and second quarters of 2005, the number of the employed population grew by 2.5% and 2.2%, respectively, compared with the same periods of 2004. The continuing upward trend in employment shows that enterprises have used the available labour force resources in full and will have to hire additional staff to be able to further increase their production volumes. Financial support from the EU will stimulate a further growth of employment. The number of the employed population is projected to grow throughout the reference period, thus increasingly contributing to the growth of production. With a drop of employment in agriculture in 2004, labour productivity in the sector grew by about 13%: those who stayed in agriculture managed to cope with and maintain the previous production volumes. Hence, re-training and re-allocation of labour force from a low-productivity sector to that of a higher productivity in the reference period becomes an important GDP growth factor in that it is capable of preventing a shortage of labour force.  Owing to a growing demand for labour force, unemployment is projected to shrink from 11.4% in 2004 to 7.5% in 2008 (according to the data of an unemployment survey).   Balance of payments of Lithuania 19. In the first half of 2005 compared with the same period of 2004, Lithuania’s CAD fell to 6.5% of GDP (cf. 9% of GDP in the first half of 2004). The reduction of the foreign trade deficit had the main impact on the change in the CAD. Because exports grew faster than imports, the foreign trade deficit fell by 1.3% over the year to 10.1% of GDP in the first half of the year. Due to the inflows from the EU, the positive balance of current transfers grew by 0.2% of GDP, and the income deficit fell slightly (by 0.7% of GDP). The positive balance of services increased to 3.6% of GDP. Analysis of the 4-quarter moving sum of the CAD reveals a downward tendency of this indicator in the second half of 2004. In the third quarter of 2004, the 4-quarter moving sum of the CAD hit the highest level in five years (8.7% of GDP), followed by a downward movement in the second half of 2004 to drop to 6.5% of GDP in the second quarter of 2005. With export growth surpassing the growth of GDP, this downward trend was largely determined by the reduction in the foreign trade deficit. As far as savings and investment are concerned, the downward tendency of CAD was determined by the higher domestic saving rate rather than the slower investment. Fig. 6. Components of the current account balance 4-quarter moving sum, in % of GDP 10 5 0 -5 -10 -15 10 5 0 -5 -10 -15 2001                           2002                              2003                          2004                        2005 Goods Services Revenue Current transfers Current account balance Source: Statistics Lithuania, estimates by the Bank of Lithuania After a slowdown in the fourth quarter of 2004 and the first quarter of 2005, the annual nominal import growth rate accelerated in the second quarter of 2005 and reached 24.1%. This was largely owing to higher volumes of import of oil products. Excluding fuel and petrol, the tendency of the annual growth of imports were the opposite and slowed down to 6.4% in the second quarter. This slowdown of the growth of imports may, to a certain extent, be explained by a slowdown in the growth of domestic demand (final consumption and investment). Fig. 7. Structural factors of the current account deficit 4-quarter moving sum, in % of GDP 26 22 18 14 10 26 22 18 14 10 2001                              2002                                 2003                              2004                                 2005 Gross savings Gross domestic investment Source:  Statistics Lithuania , estimates by the Bank of Lithuania Fig. 8. Contributions to the annual import growth In percentage points 40 30 20 10 0 -10 40 30 20 10 0 -10 2001                              2002                           2003                              2004                              2005 Investment goods Intermediate consumption goods Consumption goods Cars Other Imports excl. fuels (annual change, %) Imports (annual change, %) Source: Statistics Lithuania, estimates by the Bank of Lithuania As a result of a slowdown of import of final consumption goods, the annual growth of imports (excluding fuel and petrol) increased by only 1.4 percentage points in the second quarter of 2005. Apart from the deceleration of the domestic demand, this could also be attributable to the effect of a high comparative base: expecting a rise of import prices after accession, local manufacturers imported particularly many investment and interim consumption goods in the first quarter of 2004. In the second quarter of 2005, the effect of import of intermediate consumption goods on the annual growth fell to 4.4 percentage points. Fig. 9. Contributions to the annual export growth In percentage points 40 30 20 10 0 -10 40 30 20 10 0 -10 2001                              2002                              2003                                 2004                              2005 Investment goods Intermediate consumption goods Consumption goods Cars Other Exports excl. fuels (annual change, %) Exports (annual change, %) Source: Statistics Lithuania, estimates by the Bank of Lithuania In the first half of 2005, like in 2004, nominal exports grew rapidly, by 24.8% year-on-year. Excluding the effect of fuel and petrol, the annual export growth rate was also quite high in the first quarter of 2005, i. e. 17.9%. The rapid growth of exports was mainly driven by access to the EU markets and EU export subsidies for exports of certain agricultural products to non-EU countries. Particularly, the exports growth was due to the increasing impact of export of intermediate consumption (9.9 percentage points) and consumption goods (5.1 percentage points), food in particular. The rapid growth of exports and a stable real effective exchange rate of the litas point at the capability of Lithuanian exporters to compete in prices. In the first half of 2005, the CPI-based real effective exchange rate of the litas in foreign trade with all key partners went down by 2% year-on-year. Mainly owing to the depreciation of the nominal litas exchange rate vis-à-vis the currencies of the new EU Member States and countries of the Commonwealth of Independent States (hereinafter referred to as the CIS), the real effective litas exchange rate dropped by 5.1% over the year. On the other hand, with inflation in Lithuania slightly higher than the EU-15 average, the real effective litas exchange rate grew slightly (by 1.2%) over the year, compared with these states. Fig 10. Real effective exchange rates index of the litas, by country group Annual change, % 15 10 5 0 -5 -10 15 10 5 0 -5 -10 2002                                          2003                                           2004                                       2005 Overall EU-15 New Member States CIS Source: Bank of Lithuania Looking from the medium-term perspective (by analysing 4-quarter moving sums of indicators), the flow of foreign direct investment (hereinafter referred to as FDI) and capital transfers to Lithuania, i.e. foreign debt-neutral capital flows, financed 46.5% of the CAD in the first half of the year. Net inflows of other investment accounted for 2.2% of GDP, and investment portfolio inflows for 0.4% of GDP. A slight drop was recorded in the official foreign reserves (-0.4% of GDP). In the second quarter of 2005, there was a slight change in the international capital flows:  a drop of net flow of FDI to Lithuania, a slight fall of net inflows of investment portfolio, and a growth of other investment. Fig. 11. Financing sources of the current account deficit 4-quarter moving sum, in % of GDP 12 8 4 0 -4 -8 12 8 4 0 -4 -8 2002                                              2003                                          2004                                              2005 Capital account FDI Investment portfolio Other investment Official international reserves Errors and omissions CAD Source: Bank of Lithuania, estimates by the Bank of Lithuania Even though the net flow of FDI (in % of GDP) was down by 1.1 percentage points, it should be noted that recent quarters witnessed not only a growth of FDI flows to Lithuania but also a growth of direct investment of Lithuanian investors to foreign countries. Although a slightly more than a half of all FDI flows to Lithuania are reinvestment, the foreign investment by Lithuanian investors are mainly direct investments into corporate share capital. The sum of reinvestment in Lithuania of the last 4 quarters accounted for 2% of GDP in the first quarter and 1.1% of GDP in the second quarter, whereas investment in the share capital accounted for 1.6% and 1.2% of GDP, respectively. The sum of investment by Lithuanian investors in foreign countries of the last 4 quarters accounted for 1% of GDP in the first quarter and 1.1% of GDP in the second quarter, of which investment in the share capital accounted for 0.7% and 0.6% of GDP, respectively. In 2005, the current account deficit is projected to stand at around 7.5% of GDP. Table 5. Sectoral balances % of GDP ESA code 2004 2005 2006 2007 2008 1. Net borrowing -6.6 -5.5 -4.7 -5.4 -4.8 of which: - Balance of goods and services -7.1 -6.6 -7.0 -8.7 -8.1 - Balance of income and transfers -0.7 -0.9 -2.0 -2.0 -2.1 - Capital account 1.3 2.1 3.8 3.3 3.6 2. Net surplus (+)/deficit (-) of the private sector -5.1 -3.9 -3.3 -4.1 -3.9 of which: 0 0 0 0 0 - corporate sector 0 0 0 0 0 - households and NPISHs 0 0 0 0 0 3. Net surplus (+)/deficit (-) of general government -1.4 -1.5 -1.4 -1.3 -1.0 4. Statistical discrepancy 0 0 0 0 0 As the credit boom gained momentum, the 4-quarter sum of the flow of foreign loans extended to Lithuanian economic entities in the mid-2004, reached the highest historical level (6.1% of GDP). As banks were increasingly borrowing in the domestic market in the recent quarters, the volume of lending by the main banks dropped sharply. In the first half of the year, the 4-quarter sum of the flow of loans to Lithuania was 2.1% of GDP. A successful absorption of EU support funds will facilitate the financing of Lithuania’s current account of the balance of payments and will be equally important as FDI: funds to be transferred by the EU are projected to account for 3.6% of GDP in 2008. Structural reforms that will ensure a more economical use of energy resources will reduce the country’s needs of the import of oil and oil products for domestic use. Higher transfers by Lithuanian residents working abroad are also likely to improve the position of Lithuania’s current account to a larger extent than projected so far. GDP growth implications of major structural reforms 20. In the near future, the dynamics of government finances will be determined by two major structural reforms with a high GDP growth potential. Personal income tax reform 21. Overview. Currently, there is a deep gap between labour and capital taxation in Lithuania: in 2003, the effective tax rate on labour stood at 38.4%, and the effective tax rate on corporate income, at 5%. Moreover, Lithuania currently applies one of the lowest marginal profit tax rates in the European Union, 15%, whereas personal income tax rate is one of the highest in the Baltic States, 33%; labour income is also subject to social insurance contributions at a rate of 34%. A heavier tax burden is on labour, with capital taxation being much lower; therefore, the tax system in principle supports legal personality in business and affects the growth of competitiveness in the region plus causes high labour costs. The high marginal tax rates on labour income also have the effect of poorer tax collection efficiency. 22. Goal. The key goal of the reform is to ensure the implementation of Lisbon strategy in the labour market: to increase participation of population, reduce unemployment, and increase employment. Once the gap between labour and capital taxation is reduced, the overall tax burden will be eased for people, labour emigration to foreign states will be held down, and GDP potential will be increased. Higher economic participation of population in the economy will mitigate the effects of ageing population. 23. Measures. On 7 June 2005, the Seimas of the Republic of Lithuania passed a Law Amending and Supplementing Articles 6, 20, 27 and 37 of the Law of the Republic of Lithuania on Income Tax of Individuals (Valstybės žinios (Official Gazette) No 76-2743, 2005), to provide for a gradual reduction of personal income tax from 33% to 24% over the years 2006 to 2008: to 27% (by 6 percentage points) from 1 July 2006 and to 24% (by 3 percentage points) from 1 January 2008. A Temporary Law of the Republic of Lithuania on Social Tax (Valstybės žinios (Official Gazette) No 76-2739, 2005) comes into effect as from 1 January 2006. The Law aims at ensuring financing for the implementation of social programmes and measures  designated to reduce poverty and social exclusion. The social tax will be payable by legal persons on taxable profits calculated in the manner prescribed in the Law of the Republic of Lithuania on Profit Tax, at the rate of 4% for the taxable year 2006 and 3% for the taxable year 2007. This implies a temporary increase of the marginal tax rate on corporate income to 19% in 2006 and to 18% in 2007. 24. Impact. By preliminary estimations, the personal income tax reform together with partly offsetting measures will bring revenue losses to the general government budget in the amount of around 0.09% of GDP in 2006, around 0.84% of GDP in 2007, and 1.98% of GDP in 2008. The lower personal income tax rate will improve elasticity of this tax, promote the growth of employment and GDP potential and bring higher budgetary revenues in the long run.  The temporary introduction of the social tax enables to take up the reduction of personal income tax earlier, without prejudicing the commitments under the Stability and Growth Pact, and to pursue a cyclically adjusted fiscal policy. The temporary introduced social tax that will be reduced in 2007 and abolished in 2008 will help to mitigate a cyclical slowdown of GDP growth. As pointed out in the World Bank EU-8 Quarterly Economic Report (first quarter), preliminary empirical estimations show that the increase of the tax burden by 1 percentage point means a slowdown of the growth of employment by 0.5 to 0.7 percentage points.  Based on this estimation, we can preliminarily conclude that the cut of personal income tax rate by 1 percentage point would bring the potential GDP up by 0.3 to 0.4%, while the entire reform would bring it up by about 2.7 to 3.6%. At present, marginal rates of factors of production differ significantly. A rapid reduction of these differences will allow to come closer to an optimal utilization of factors of production and thus the GDP potential may increase more than by the linear approach. A significant cut of personal income tax rate will facilitate a faster development of household services and a more efficient fulfilment of household needs. The tax reform will reduce general government structural revenues by 2 percentage points, and GDP potential will grow by about 2.7 to 3.6%, which suggests that the tax reform is economically efficient.  As the increase of the GDP potential would be sufficient to cover about a half of general government structural revenues earmarked for the tax reform, the reform may in the essence be seen as an advance reduction of the tax burden achieved through a set of temporary tax measures. In the future, this reduction would be financed by the overall growth of productivity and the decline of GDP share of general government expenditure. Apartment Houses Modernisation Programme 25. The Apartment Houses Modernisation Programme has been approved by Resolution No 1213 of 23 September 2004 of the Government of the Republic of Lithuania (Valstybės žinios (Official Gazette) No 143-5232, 2004, No 78-2839, 2005). The Programme is in line with the European Union directives directly dealing with improvement of energy efficiency in buildings, such as Council Directive 93/76/EEC of 13 September 1993 to limit carbon dioxide emissions in improving energy efficiency (SAVE) and Directive 2002/91/EC of the European Parliament and the Council of 16 December 2002 on the energy performance of buildings. The Apartment Houses Modernisation Programme implements the goal of Lithuania’s Housing Strategy approved by Resolution No 60 of 21 January 2004 of the Government of the Republic of Lithuania (Valstybės žinios (Official Gazette) No 13-387, 2004), i.e. to ensure efficient use, maintenance, renewal and modernisation of the existing housing stock and a rational use of energy resources. The Programme is scheduled for the period of 2005 to 2020. 26. Overview. The issue of a rational use of energy in residential buildings becomes increasingly painful and cannot be solved by homeowners alone. In Lithuania, more than 60% of apartment houses were built during the last four decades of the last century. The use of energy is not efficient in these buildings (20% to 30% of heating is lost). Their maintenance costs are very high in winter, and their owners, who are often low-income people, cannot pay heating bills.  For low-income families, a part of expenses on heating and hot water is covered by the state. By the data of the Ministry of Social Security and Labour, about 7% of Lithuania’s population are entitled to the reimbursement of expenses on heating. With the rise of energy prices, more budgetary funds would be needed for compensations. A large part of energy resources is imported, which has a negative effect on the balance of payments. 27. Goals. Lithuania’s Housing Strategy provides that the existing apartment houses and, where possible and economically efficient, the engineering and technical installations thereof will be renovated and modernised by 2020. For about 70% of apartment houses, relative consumption of thermal energy will be down by 10% to 30%. The key goal of the Programme is to help owners of apartment houses and low-income families to modernise their homes, by improving energy efficiency and reducing expenses on heating. 28. Measures. State-supported measures aimed at modernising apartment houses include: major repair or reconstruction of heating and hot and cold water supply installations; hermetisation or replacement of windows and outer doors; major repair or reconstruction of roofs through additional thermal insulation, including the construction of new sloping roofs (excluding construction of attic premises); glassing of balconies (loggia); thermal insulation of exterior walls and reinforcement of wall structures; hermetisation of walls and junctures of block houses; thermal insulation of cellar ceilings; major repair or replacement of lifts; replacement or reconstruction of common use electric installations. The Programme provides for the allocation of state support to owners of  apartment houses by reimbursing up to 30% of their investment in the modernisation of such houses, depending on the energy-efficiency of individual modernisation projects. Low-income families (one-person households) will be supported additionally, by reimbursing a larger part of the related costs. 29. Financing. Modernisation of  apartment houses will be financed by the homeowners’ private funds, long-term loans from commercial banks, municipal funds, targeted support by the State, and from other sources. Only houses built before 1993 are eligible to the state support. To take up an investment project under the Apartment Houses Modernisation Programme, homeowners have to pool a down payment of at least 10% of the total estimated value of the investment to be made. Banks, too, contribute to investment projects by granting loans. Such loans are granted for up to 90% of the value of the investment. State support is given in the following manner: by reimbursing a portion of the investment in the modernisation of an  apartment house depending on the energy-efficiency of the project or by reimbursing the costs for low-income families. It has been estimated that the implementation of the Programme will require at least 7 billion litas in the period until 2020 or, for comparison, 7.9% of the GDP of 2008. 30% of this expenditure would be financed from the state budget, through statutory state support. A certain amount of the expenditure would be borne by general government. The state budget of 2006 allocates 6 million litas for this Programme or 0.01% of the GDP of 2006. For 2007 and 2008, budget allocations are expected to amount to 15 million and 25 million litas, respectively. In the future, state budget appropriations for the Programme will be planned by taking into consideration the financial capacity of the state to implement the provisions of the Stability and Growth Pact. 30. Economic Impact. The Apartment Houses Modernisation Programme will improve sustainability of general government finances in the long run and will be beneficial for the following reasons: 30.1. the future requirement for general government funds for heating compensations to socially disadvantaged groups of population will be lower, meaning better utilisation of general government finances; 30.2. small and medium construction business will be promoted; 30.3. expenditure on fuel (purchased during the heating season) will be lower, meaning a lower current account deficit; 30.4. positive social (promotion of reduction of unemployment) and environmental (lower levels of CO2 emissions) aspects. A research into how much GDP productivity will grow as a result of housing renovation projects that will lower the consumption of fuel for heating is planned. III. public finances Financial policies 31. The key Medium-Term Objective of the fiscal policy is the reduction, by implementing economic policy goals, of the structural deficit below or to 1% of GDP. Efforts will be made to balance government finances or run surpluses in the future, when the need for structural reforms is lower. Fiscal policy goals have been adjusted up, to implement the revised Stability and Growth Pact and the Broad Economic Policy Guidelines. 32. The medium-term fiscal policy will aim at implementing the following priorities of the macroeconomic policy: 32.1. to ensure macroeconomic stability by pursuing an anti-cyclic fiscal policy; 32.2. to create favourable conditions for the improvement of labour efficiency, improve competitiveness of the economy, attract more FDI, and successfully implement EU structural policies; 32.3. to continue the tax reform aimed at balancing labour and capital taxation; 32.4. to promote further reforms in energy and agriculture; 32.5 to continue the pension reform ensuring a long-term sustainability of general government finances; 32.6. to match fiscal policies with the priorities of social policy. 33. Seeking to maintain confidence in the currency board arrangement, Lithuania will further improve, as part of its fiscal policy, the conditions for a long-term institutional saving and for a higher labour efficiency, and will ensure a successful completion of structural reforms, improve tax administration, promote investment, create favourable business environment, and ensure an effective use of public funds allocated for investment. Any additional general government revenue or unspent expenditure allocations will be used for the achievement of the fiscal deficit objective and for measures aimed at ensuring a long-term sustainability of government finances.  34. Actions planned for 2006 to 2007. Once a personal income tax reform has been implemented, i.e. a better balance is achieved between capital and labour taxation, there will be better conditions to develop human capital-intensive industries and to implement Lisbon strategy goals in the labour market, by promoting the creation of jobs.  Efforts will be made to make sure that the balance between labo …