ON THE CONVERGENCE PROGRAMME OF LITHUANIA OF 2006

ON THE CONVERGENCE PROGRAMME OF LITHUANIA OF 2006 Official translation 20 December 2006 government of the republic of lithuania Resolution no 1230 of 8 December 2006 ON THE CONVERGENCE PROGRAMME OF LITHUANIA OF 2006 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 (OJ, 2004, Special Edition, Chapter 10, Volume 1, p. 84), as last amended by Council Regulation (EC) No 1055/2005 of 27 June 2005 (OJ L 174, p. 1), 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 h a s r e s o l v e d: 1. To approve the Convergence Programme of Lithuania of 2006 (as appended); 2. To charge the Ministry of Finance with the task of submitting the Convergence Programme of Lithuania of 2006 to the European Commission. Prime Minister                                                                                 Gediminas Kirkilas Minister of Finance                                                                         Zigmantas Balčytis Approved by Resolution No 1230 of 8 December 2006 of the Government of the Republic of Lithuania CONVERGENCE PROGRAMME OF LITHUANIA of 2006 I. FINANCIAL POLICY OVERVIEW 1. Lithuania’s economic policy serves the goal of ensuring a rapid real convergence, i.e. approximation to the high level of productivity and subsistence within the Economic and Monetary Union. The Convergence Programme of Lithuania of 2006 (hereinafter referred to as this Programme) gives projections of the economic policy outlined in the preliminary budgets currently with the Seimas of the Republic of Lithuania. 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. management of the demand pressure on prices. 3. Lithuania has undertaken in this Programme to pursue an economic policy that ensures the stability of prices and general government finances so as to maintain strong confidence in the continuity of the currency board arrangement in Lithuania and to participate successfully 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 economic policy, an assessment of risks and the quality of general government finances, and a description of Lithuania’s readiness to overcome the effects of an ageing population, as well as an outline of structural reforms underway which have a significant financial impact. 5. This Programme examines and assesses the preconditions for the achievement of the declared economic policy goals. The economic development projections given are based on the assumption that Lithuania's external economic environment will, in principle, remain stable during the period concerned and that the demand for loans will be met by prudent solutions based on deep knowledge, which will protect the economy from the risk of “overheating” and the consequent correction. Other assumptions used are those made by the European Commission. The commitment to maintain strict fiscal discipline as laid down in this Programme have been enforced by the Council of the European Union which unanimously tightened, in June 2005, fiscal policy requirements under the Stability and Growth Pact, according to which the states participating in the ERM II have to reduce their structural fiscal deficit by about 0.5% of the Gross Domestic Product (hereinafter referred to as the GDP) a year, until the medium-term fiscal deficit target is reached. EU regulations explicitly require pursuing a tight fiscal policy, thus imposing a legally binding obligation to reduce fiscal deficit. Lithuania is currently discussing the issue of institutionalisation of fiscal discipline provisions of the Stability and Growth Pact, by negotiating for a relevant agreement between parliamentary parties. 6. National currency pegged to the euro under the currency board arrangement ensures that the average multi-annual inflation will remain close to that in the euro area. After the acceleration of inflation in 2006-2007 and with the stabilisation of oil and natural gas prices as well as with the approximation of excises to the EU rates, inflation in Lithuania will, over time, again come close to inflation in the euro area. 7. The 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 five years (from the second quarter of 2001 to the second quarter of 2006), the level of employment has grown by 9.4%. 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. Lithuania will make efforts to join the euro area as soon as possible. According to the available data, the best period for joining the euro area starts in 2010. 9. 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 of 2004 will be pursued under this Programme, too. In future updates of this Programme, specific additional measures aimed at preventing economic “overheating” and managing fiscal risks will be described. 10. The rapid growth of demand under the conditions of a fixed exchange rate for the litas inspires a rapid growth of imports and Lithuania’s CAD. Thus, to ensure the continuity of foreign capital inflows, the government should further improve the 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 the continuity of the goal of an early integration of the country into the euro area. Given the need to implement structural reforms securing productivity and the 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 objective (hereinafter referred to as the MTO) for 2008 is a structural deficit below 1% of GDP. For later periods, the MTO will be tightened to take note of the Commission’s latest estimates suggesting that general government debt will approach to 77% of GDP in 2050, unless fiscal policy is tightened. The EU Commission’s estimations for 2006 suggest that in order to grant reliable social guarantees to pensioners in the period 2030-2050 despite the problem of an ageing population and to secure the long-term stability of general government finances which is a requisite in the euro area, Lithuania’s primary structural surplus should reach about 1.9% of GDP over the medium term. Therefore, once major structural reforms have been completed, the MTO will again be a balanced or a surplus budget, depending on the economic cycle. 11. Currently, Lithuania’s capacity to aim at a fiscal deficit below 1% of GDP is prejudiced by temporary budgetary difficulties associated with tax reduction. Thanks to strict fiscal discipline, government current expenditure will remain at the lowest level in the EU. The GDP share of government expenditure will grow slightly due to the implementation of the Public Investment Programme and increasing investment support from the EU. Fiscal discipline will be maintained over the medium term by holding the GDP share of government current expenditure down and by increasing the share of social expenditure, i.e. by keeping it at above 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 about 0.7% of GDP. The reduction of the rate of personal income tax which is expected to ensure a better balance between labour and capital taxation will contribute to the successful implementation of the Lisbon objectives in the labour market, to increase employment and potential GDP, and to mitigate the effects of an ageing population for government finances. Although 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 the fiscal deficit and the economic cycle, will be possible only on the condition that additional tax revenue is collected on a temporary basis. 12. The fiscal policy pursued in compliance with the strict regulations of the Stability and Growth Pact will make it possible to consistently reduce government debt until government finances become capable of ensuring a sustainable implementation of commitments under the Maastricht Treaty, while maintaining reliable social guarantees, regardless of the projected significant growth in the number of pensioners and the decreasing number of employed people in the third decade as a result of the low birth rate and high emigration. II. economic outlook Assumptions 13. The projections for Lithuania’s economic indicators are based on recent economic development trends and assumptions about economic growth. Economic projections are based on the assumption that the Seimas of the Republic of Lithuania, when passing legal acts regulating general government expenditures and tax rates, will take into account the principal provisions of the Stability and Growth Pact and approve measures aimed at stabilising inflation at below 3% by the end of 2008. This would be achieved if parliamentary parties reached an agreement on fiscal discipline. An assumption is made that preliminary conclusions of consultations with the International Monetary Fund (IMF) about neighbouring economies will help them to implement economic policy measures in time, enabling to prevent an economic “overheating” and create favourable external conditions for sustainable development in Lithuania. The key assumptions about the 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. Table 1. Key assumptions Indicator  2005 2006 2007 2008 2009 Short-term interest rates 2.3 3.7 3.7 3.3 3.5 Long-term interest rates 3.6 4.1 4.1 4.2 4.2 USD/EUR exchange rate (euro area and ERM II countries) 1.24 1.25 1.27 1.27 1.27 Nominal effective exchange rate -0.8 0.0 0.0 0.0 0.0 (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 5.7 5.2 5.2 5.2 EU-25 GDP growth 1.7 2.8 2.4 2.4 2.4 Growth of key export markets 1.7 2.8 2.4 2.4 2.4 World import volumes, excluding EU 8.8 9.1 8.3 7.9 7.9 Oil prices (Brent, USD/barrel) 55.2 65.6 66.3 68.0 68.0 Sources: Ministry of Finance, European Commission GDP growth projections are particularly dependent on frequently and radically changing credit increase projections made by commercial banks. Credit increase assumptions correspond to those made by commercial banks. Credit increase in 2006 will be 2-3 percentage points of GDP higher than in 2005, to be followed by a corresponding drop in 2007. Changes in credit increase assumptions accelerated the GDP growth of 2006, whereas the 2007 growth will hardly exceed the potential growth, given the additional stimulus for growth to be provided by a likely decent harvest in agriculture. A higher deceleration of credit increase is assumed to start in 2008-2009, marking the start of a natural cyclical slow-down of GDP growth and a growth of the nominal fiscal deficit. Globalisation-driven competition and a possible changes in real estate prices will have no effect on real production volumes only if labour force is flexible enough and manage to shift among different sectors of the economy. Labour market flexibility may be achieved at the expense of wages: in the medium term, competition intensified by globalisation and a varying credit change cycle in certain sectors may prompt not only a slow-down of the growth of wages but also their reduction. The assumption about labour market flexibility ensures that the rapid growth of average wages is balanced with potential development divergences among sectors of the economy of Lithuania. If the assumption of labour force flexibility proves false, employment will be lower and real GDP growth will be slower. A rapid medium-term growth is particularly dependant on the assumption that business community will manage to meet financial markets expectations for a rapid and sustainable approximation of Lithuania’s productivity to the EU-average and to generate profits even with a rapid growth of wages. If credit increase of 2006 exceeds 15% of GDP, assumptions about the level of absorption of EU support will become peripheral. In the period 2006-2009, absorption of the EU structural funds and other financial assistance from the EU will have a smaller effect on the growth of GDP than changes in credit increase volumes. A different-than-planned absorption of EU support would only slightly affect the growth of GDP in the corresponding year. In the medium term, Lithuania will maintain rapid economic development: GDP growth may reach 7.8% in 2006 and 6.3% in 2007. Growth in 2006-2007 will in principle have no effect on the inflationary GDP gap. It is assumed that a timely implementation of demand management measures will cause the inflationary GDP gap to start falling rapidly in 2008. If this is the case, GDP growth will account for 5.3% in 2008 and 4.5% in 2009. An early and manageable correction of GDP growth rates would ensure a rapid and sustainable average growth of 6% in later years. If these assumptions prove false as the economy develops, economic projections or the outlook of projections for 2006-2009 will be changed accordingly. Economic projections are likely to change if commercial banks decide to change their lending plans. Monetary and exchange rate policy 14. The application of the fixed exchange rate mechanism under the currency board arrangement has played an important role in achieving stable macroeconomic development, which has stabilised inflationary expectations of market players, lowered country and currency risk premiums, boosted confidence in the economic policy of the country, and accelerated nominal and real convergence. Openness of the economy, exchange rate stability important for the price level, and relative flexibility of prices and wages are those features of Lithuania’s economy that contribute to the successful application of the fixed litas exchange rate strategy. Lithuania has been participating in the ERM II since 28 June 2004, by implementing a unilateral commitment to maintain a fixed exchange rate regime and a fixed national currency exchange rate vis-à-vis the euro. 15. One of the economic policy goals for Lithuania is as early introduction of the euro as possible. Therefore, Lithuania’s monetary and exchange rate policy goals remain unchanged. Lithuania participates in the ERM II, by maintaining a strictly fixed litas exchange rate vis-à-vis the euro, and seeks to join the euro area as soon as economic convergence criteria are met. Table 2. Interest rates, 1996-2006 (%) Indicator 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Aug 2006** Average interest on bank loans in litas 21.3 13.9 12 13 11.9 9.3 6.6 5.8 5.7 5.2 5.0 Average interest on litas deposits with banks * 13.8 8.2 6.7 7.7 7.3 5.3 3.2 2.5 2.3 2.5 2.7 Source: Bank of Lithuania * Average interest on deposits with maturity of over 1 month ** Interest rates according to the new methodology adopted by MFI Table 3. Interpolated yield of euro-denominated euro-bonds of the Republic of Lithuania and the difference between the latter and the basic euro yield* (as of the end of period) Time before redemption 1 year 2 years 3 years 5 years 10 years Yield Difference Yield Difference Yield Difference Yield Difference Yield Difference Dec 2001 – – 5 +1.3 5.3 +1.4 5.6 +1.2 – – Dec 2002 2.9 +0.3 3.2 +0.5 3.5 +0.6 4.2 +0.8 5.1 +0.9 Dec 2003 2.5 +0.3 2.9 +0.3 3.2 +0.4 3.9 +0.3 4.8 +0.5 Dec 2004 2.2 -0.1 2.5 +0.0 2.8 +0.1 3.2 +0.1 4.0 +0.3 Dec 2005 2.8 +0.1 2.9 +0.0 3.0 +0.0 3.2 +0.1 3.5 +0.2 Jun 2006 3.6 +0.2 3.7 +0.1 3.8 +0.1 4.0 +0.1 4.4 +0.3 Sources: Bank of Lithuania, news agency “Bloomberg” *The yield (%) is expressed as the average of buying and selling prices quoted in the secondary market, and the differences in the yield are expressed in percentage points. The yield of euro-bonds of the Republic of Lithuania has been calculated according to actual yield curves. Table 4. Yield of government securities (GS) of the Republic of Lithuania and the difference between the latter and the interpolated yield of euro-denominated euro-bonds of the Republic of Lithuania* (as of the end of period) Time before redemption 1 year 2 years 3 years 5 years 10 years Yield Difference Yield Difference Yield Difference Yield Difference Yield Difference Dec 2001 4.8 – 5.4 +0.4 5.7 +0.4 6 +0.3 – – Dec 2002 3.2 +0.2 3.8 +0.6 4 +0.5 4.7 +0.5 5.2 +0.1 Dec 2003 2.3 -0.2 3.4 +0.5 3.7 +0.5 4.1 +0.3 4.9 +0.1 Dec 2004 2.3 +0.1 2.4 -0.1 2.7 -0.1 3.2 -0.0 4.2 +0.2 Dec 2005 2.7 -0.1 2.9 -0.0 3.0 +0.0 3.2 +0.1 3.5 +0.1 Jun 2006 3.3 -0.3 3.6 -0.1 3.8 +0.0 4.0 -0.0 4.4 +0.0 Sources: Bank of Lithuania, news agency “Bloomberg” *The yield (%) is expressed as the average of buying and selling prices quoted in the secondary market, and the differences in the yield are expressed in percentage points. The yield of euro-bonds of the Republic of Lithuania has been calculated according to actual yield curves. Economic cycle and a medium-term macroeconomic scenario Goods and services markets 16. In recent years, Lithuania’s economy has been growing at a very high pace. Over 2005, real GDP has grown by 7.6%, followed by a growth of as much as over 8% in the first half of 2006. Domestic demand remains the main driver of economic development, promoted by active borrowing and rapidly growing nominal income, while quite positive changes in net exports testify a fairly good external competitiveness of domestic producers. Despite a moderate growth of interest rates and a growing shortage of labour force, economic growth has not decelerated in recent years. A positive gap between the actual and potential GDP raises certain concerns related to a growing tension in the labour market and an increasingly high impact of domestic demand on prices and the CAD. It is expected, however, that a very rapid growth of domestic demand will slow down as the rate of growth of bank loans (which seems to be quite inert) become more responsive to the continued tightening of monetary policies by the European Central Bank (ECB) and to higher real estate prices in Lithuania. GDP growth was driven mainly by the growth of household consumption expenditure. The situation was particularly favourable for this growth: wages grew rapidly (and will grow further despite the reduction of the rate of personal income tax) coupled by a modest growth of employment; consumption loans gained popularity; and consumers cherished particularly optimistic expectations. As the Government of the Republic of Lithuania pursued a more balanced expenditure policy and the number of people employed in the public sector decreased, general government real consumption expenditure grew moderately. Fig 1. Factors of change in real GDP (by expenditure approach) Sources: Statistics Department under the Government of the Republic of Lithuania (hereinafter referred to as Statistics Lithuania) and estimates by the Bank of Lithuania Due to still very low interest rates and an increasing total corporate profitability in the country, investment in gross fixed capital continued to grow rapidly, although the growth rates were lower than several years ago (mainly due to the basis of comparison effect). In the environment of high domestic demand and shortage of labour force, investments play a particularly important role in promoting sustainable economic growth: they are expected to ensure a growth of the economic potential and to avert the danger of economic “overheating”. It must be pointed out, however, that recently investment in buildings and constructions dominated over investment in equipment and other capital goods. Effective investments will be promoted by allocating EU structural funds support. Foreign trade volumes continued to grow rapidly, driven by favourable external environment and high domestic demand. After a long break, the impact of real net exports on real GDP growth became positive in the second quarter of 2006. A rapid growth of nominal exports shows that competitiveness of Lithuanian producers has not dropped despite the growth of prices of raw materials and a higher demand for labour force in the market. On the other hand, a potential drop of competitiveness is partially offset by EU grants for exports outside the EU. Economic growth is quite well balanced, i.e. activity improves in all main sectors of the economy, which is welcomed. Almost all types of economic activity in the private sector continued to be developed in the environment of an exceptionally high domestic demand. Favourable external conditions also contribute to the rapid growth of exporting sectors of the economy. Large budgetary inflows stimulated by an overall economic upswing facilitated the improvement of activity in sectors financed with government funds. Manufacturing industry remained the largest contributor to the economic growth, followed by the chemical industry, production of fertilisers, furniture and food industries, which demonstrated a rapid growth of real sales. In contrast, producers of electric and optic equipment, the textile and extracting industries and agriculture faced difficulties or quite large uncertainties regarding future prospects. Real activity in the construction sector grew at a particularly high pace (cf. real annual growth of value added was 19.1% in the first quarter of 2006). A rapid growth of real activity was also observed in real estate and financial intermediation sectors. Market services and public sector economic activities demonstrated moderate yet robust growth, except for maybe education where real value added was 7% lower in the second quarter of 2006 than in the corresponding period of 2005. Fig. 2. Factors of change in real GDP (by production approach) Sources: Statistics Lithuania, estimates by the Bank of Lithuania Future capacity of producers to satisfy the high domestic demand will largely depend on sufficiency of labour force as one of the most important factors of production. In the past quarters, labour market has been very dynamic, with the overall situation in the market being very tense. Due to the shortage of skilled labour force and emigration, wages grow faster than labour productivity (in the second quarter of 2006, the average monthly gross wages were 14.1% higher, whereas real labour productivity was only 6.3% higher than a year ago). Unemployment has been decreasing very rapidly recently. In the second quarter of 2006, the level of unemployment dropped to its record lows (5.6% compared to 8.5% a year ago). Labour market also underwent certain structural changes, such as an active shift of labour force from less productive sectors of the economy to those which are currently very active yet affected by larger cyclical fluctuations (e.g. construction, real estate, trade). Economic growth can be said to be more or less balanced, i.e. different sectors of the economy grow evenly, although the likelihood of a slowdown is growing. This can be judged from the increasing tension in the labour market, growing CAD, excessive consumption financed, for a considerable part, with future income, high uncertainty in the real estate market, etc. There are certain changes in financial and property markets, namely a continuous tightening of the ECB monetary policy position and changes in real estate prices that will affect real economic activity. The relaxation of tension in the oil market has slightly reduced the risk that changes in oil prices can undermine economic growth in the medium term. Factors injecting optimism about future economic development include the recent recovery of exports which shows domestic producers are quite competitive, also the gradually accelerating absorption of EU structural funds, the increasing business transparency, the decreasing disbalance in the tax system attributable to a tax reform, and the favourable external environment. In the period 2006-2009 and later, domestic demand will continue to be a strong driver of economic growth, and Lithuania’s export performance will remain on a positive track. The growth of nominal exports will be stimulated by the recovery in the EU market. However, both the need to modernise production of export goods and the growing personal income will promote the development of imports, which will mean a negative balance of goods and services in the reference period. Domestic lending opportunities and EU financial assistance will create conditions for more active investments. With stronger investor confidence in the stability of the economy, investments will account for an increasingly large share of GDP. At the end of the reference period, the share of gross fixed capital formation will account for over 23% of GDP. A positive impetus to consumption in the reference period will be provided by the accelerating growth of wages, decreasing unemployment and labour taxation, the opening of EU labour markets, transfer of earnings to Lithuania, and by particularly positive consumer expectations about economic development. The nominal value of final consumption expenditure is projected to grow at about 10.4% on average in the period 2006-2009. A larger part of population will have to spend a large share of their additional income on heating the cost of which is expected to more than double as a result of higher prices of imported gas. But the continued active consumption will facilitate growth of wholesale and retail trade; however, with the “cooling” of the economy projected for the end of the reference period growth in this sector will come close to growth in other sectors. Export-intensive industries will remain the key contributor to sustainability of economic growth. Table 5. Macroeconomic prospects ESA* code Level in 2005 rate of change, % 2005 2006 2007 2008 2009 Real GDP B1*g 66315.4 7.6 7.8 6.3 5.3 4.5 Nominal GDP B1*g 71200.1 13.8 14.4 10.0 8.1 7.0 Components of real GDP Household consumption expenditure + NPISHs P.3 44367.6 9.8 10.5 7.0 6.6 6.3 General government consumption expenditure P.3 11927.5 4.9 6.2 2.5 2.5 2.5 Gross fixed capital formation P.51 15517.8 9.2 15.0 6.5 5.7 6.9 Changes in inventories and net acquisition of valuables (% of GDP) P.52+P.53 11.6 3.9 4.9 4.8 4.4 4.2 Exports of goods and services P.6 37850.5 14.5 13.2 6.8 7.8 7.6 Imports of goods and services P.7 47530.0 16.0 14.9 6.5 7.3 8.7 Contributions to real GDP growth Final domestic demand – 10.2 11.0 7.1 6.3 6.6 Changes in inventories and net acquisition of valuables P.52+P.53 – 3.6 -0.7 0.3 -0.2 0.0 Balance of goods and services B.11 – -6.8 -3.2 -0.9 -0.9 -2.1 Sources: Statistics Lithuania, Ministry of Finance *European System of Accounts. Stability of prices 17. After a short increase in July and August 2006 when inflation measured by the Harmonised Index of Consumer Prices (HICP) reached 4.4-4.3%, annual inflation dropped to 3.3% in September 2006. In the first half of 2006, annual inflation fluctuated at about 3.4-3.7% (except in March when inflation dropped to 3.1% due to the “base effect”). From the beginning of the year, changes in prices of most inflationary goods and services, i.e. prices of food products, fuels and administered prices, were accountable for 2.9 percentage points of annual inflation on average, whereas price changes of the remaining goods and services were accountable for 0.8 percentage points only. Fig 3. Factors of change in the annual inflation by HICP Sources: Statistics Lithuania, estimates by the Bank of Lithuania * HICP, excl. food, fuel and lubricants, and administered prices The accelerating rise of food prices was offset by a slower growth of fuel prices which even fell in September. Since the beginning of the year, the inflationary impact of food prices has almost doubled, to reach 1.9 percentage points in September and account for over 50% of annual inflation. Particularly unfavourable weather conditions in summer 2006 limited food supply both in and outside Lithuania. However, it should be noted that the particularly rapid growth of domestic demand and the growing tension in the labour market (which is a very painful problem for the retail trade) create extremely favourable conditions to raise prices. The decreasing impact of fuel prices is directly associated with oil prices that have been going down for some time (down by about 13.8 USD/barrel in August and September). As administered prices account for quite larger share of the HICP, administrative decisions have a fairly large inflationary impact. (Prices of goods and services which are sensitive to administrative decisions accounted for 17.8% of the consumer goods and services basket in 2005. This includes prices of water supply (0.42%), sanitary and sewage services (0.76%), electricity (2.76%), natural gas (0.6%), heating (3.62%), medical and pharmaceutical goods (3.1%) and services (0.3%), passenger transportation by railways and roads (1.99%), postal services (0.02%), and education services (0.5%)). In the first three quarters of 2006, the impact of administered prices on annual inflation was more or less stable (about 0.9 percentage points), but it is projected to grow in the end of the year. Three important factors played a role in 2006: higher prices of gas, heating and medical services. From 1 January and from 1 July 2006, the Russian company Gazprom raised prices of natural gas sold to Lithuania. Decisions taken by the National Control Commission for Prices and Energy authorising domestic enterprises to raise natural gas prices accordingly has increased annual inflation by 0.4 percentage points in January-September 2006. Seeking to raise wages for medical staff, rates of fees for medical services were further increased in January and May 2006. For this reason, prices of medical services were about 11.7% higher in the first half of 2006 compared to the previous year. The higher prices of medical services were accountable for 0.08 percentage points of annual inflation of January-June 2006. With the growth of natural gas prices in the fourth quarter of 2006, the inflationary impact of administered prices will grow significantly, mainly due to growing heating prices. Pursuant to the decisions already adopted by the National Control Commission for Prices and Energy, heating prices will grow in the second half of 2006 in Vilnius (16.3%), Druskininkai (33%), Akmenė (39.3%), Ukmergė (34.4%), Mažeikiai (18.8%), Šakiai (11.5%), and Panevėžys (11% for private users). These decisions are projected to have the largest impact in the beginning of the heating period. As gas and heating prices account for a fairly large share of the consumer prices basket, they will have quite a large impact on the HICP growth rate (about 0.6-0.7 percentage points). Growing prices of energy resources (prices of imported gas are projected to more than double in the next two years), Lithuania’s commitments to raise excises, solution of the issue of compensations for personal deposits and real estate, upward trends of wages will all accelerate inflation in the medium term. For a large part, inflation grows for objective international reasons, not government decisions. Inflation caused by higher natural gas prices alone will be about 0.9 percentage points in 2006 and 1.7 percentage points in 2007 (of which 1.3 percentage points will be owing to higher heating prices and 0.4 to higher household gas prices). Table 6. Price developments Indicator ESA code Level in 2005 rate of change, % 2005 2006 2007 2008 2009 1. GDP deflator 107.4 5.8 6.0 3.5 2.6 2.5 2. Private consumption deflator 104.8 3.7 4.0 3.8 3.0 2.7 3. HICP (average annual change) 100.0 2.7 3.9 4.7 3.4 3.1 4. General government consumption deflator 99.6 1.0 4.0 3.8 3.0 2.7 5. Investment deflator 92.4 8.9 15.4 6.7 1.0 1.1 6. Export price deflator (goods and services) 109.6 11.0 10.2 4.0 2.5 2.5 7. Import price deflator (goods and services) 97.8 8.1 11.2 5.5 2.5 2.5 Sources: Statistics Lithuania, Ministry of Finance Annual core inflation (annual inflation according to the HICP, excluding the effect of food, administered and fuel prices) has been gradually growing since mid-2005 yet without exceeding 2% and has eventually stabilised in the past months. The largest impact on core inflation was caused by higher prices of market services. This could in part be associated with wages that grew faster than labour productivity in the environment of high domestic demand. On the other hand, growth of unit labour costs varied greatly from sector to sector, with the largest growth recorded in those sectors where goods and services do not form part of consumer basket or have a very low comparative weight (e.g. construction, real estate, education, health-care). For this reason, core inflation is influenced only by indirect growth of unit labour costs with slow and insignificant effect. In 2006, growth of inflation was limited by decreasing prices of many imported goods. Excluding the impact of prices of oil products, import prices were about 1% lower in the second quarter of 2006 than a year ago. Compared to the average price level of the previous year, the largest decrease of prices was recorded for imported clothes, radio and television equipment, and computers. The largest growth of prices (excluding oil products) was recorded for imported agricultural products, tobacco products, and motor vehicles. Fig. 4. Dynamics of imports prices and USD exchange rate Note: IUVI, excl. mineral products, data for the period from the first quarter of 2006 is not absolutely         comparable with the data for the period before 2006 Sources: Statistics Lithuania, estimates by the Bank of Lithuania, news agency “Bloomberg” The growth of producer prices of industrial production sold in the domestic market (hereinafter referred to as domestic producer prices) has slowed down in the past months, to account for 7.4% in August. As in the previous periods, changes in producer prices were caused by changes in oil product prices. However, decreasing oil prices reduced this impact in 2006. Excluding the impact of oil products, annual inflation of domestic producer prices was more or less stable in the first half of 2006 (about 4.3-4.8%), followed by a jump to over 5% in July and August. This jump was mainly owing to higher prices of gas supply from 1 July and more expensive heating services in Vilnius. Tension in the labour market coupled with other factors (such as administrative decisions and the presumed decrease of illegal wages) has inspired a further rapid growth of average wages. In the second quarter of 2006, annual growth of wages was 14.1% (cf. 9% in the same period a year ago). Fig. 5. Wages, labour productivity, and unit labour costs Sources: Statistics Lithuania, estimates by the Bank of Lithuania Growth of wages has been surpassing growth of labour productivity for eight quarters in turn. In the second quarter of 2006, annual growth of unit labour costs was 7.4%. Growth of unit labour costs was caused by the growth gap between wages and productivity in the construction and real estate sectors and in branches of market services: trade, hotels and restaurants. The particularly rapid growth of unit labour costs might start exerting a higher pressure on consumer prices. It should be noted that the growth of wages would also be inspired by a presumed reduction of “envelope wages”. In future periods, a rise of prices of services will have a crucial impact on underlying inflation, because an increasingly expensive labour will account for an increasingly large share of the cost of services, and the global competition and rapid advancement of production will force prices of clothes, footwear and household appliances down. The nature of the current inflation differs in principle from that of the ninth decade. The current inflation may not be prevented by accumulating a reserve, as the value of long-term consumption goods will continue to be subject to international competition. The only way to maintain the current purchasing power of income is to make more prudent investment in productive sectors or in factors of production. Labour market 18. Confidence in macroeconomic stability has promoted private investment and consumption; therefore, over the period from the second quarter of 2001 to the second quarter of 2006, the number of the employed has grown by 9.4%: 12.2% in urban areas and only 3% in rural areas. Over the reference period, unemployment has shrunk by 11.2 percentage points. 68% of this decline is associated with the growth of employment; growth of employment in urban areas alone accounted for 60% of the overall decline of unemployment in the country. 32% of the decline of unemployment is attributable to shrinkage of labour force. Labour force has shrunk by 3.6%; to a certain extent, this shrinkage was probably caused by emigration. In rural areas, labour force shrank twice as fast as in urban areas: by 2.8% in urban areas and by 5.6% in rural areas. Lithuania’s labour market increasingly integrates into the EU single market, which makes it possible to expect positive developments for employees. Table 7. Labour market developments Indicator ESA code Level in 2005 Rate of change, % 2005 2006 2007 2008 2009 1. Employment, persons (thou) 1473.9 2.6 3.2 0.5 0.3 0.3 2. Employment, hours worked 2750419 5.4 - - - - 3. Unemployment rate (%) 8.3 -3.1 5.3 4.9 4.9 4.9 4. Productivity (real GDP per person employed) 43231.6 7.1 8.0 6.3 5.3 4.4 5. Labour productivity (real GDP per hour worked), LTL 35.92 3.4 - - - - 6. Compensation of employees, m LTL D.1 28616.2 13.4 14.7 14.9 12.1 6.9 Sources: Statistics Lithuania, Ministry of Finance It is assumed that emigration will not retard the growth of the number of people employed and will continue to improve the current account of the balance of payments in Lithuania. Growing demand for labour force, increasing productivity, growing minimal monthly wages, improving market expectations and price convergence after accession to the EU will bring changes in wages. Trends that started in 2004 are projected to continue, meaning a further growth of average monthly gross wages from LTL 1276.2 in 2005 to LTL 1991.5 in 2009. Growth of wages will make it possible to reward gradually the employed population for the high labour productivity achieved in previous periods. It is projected that labour productivity and wages will grow at similar rates, by about 100%, from 1999 to 2009. In other words, both indicators will double. Re-training and re-allocation of labour force from low productivity sectors to higher productivity sectors will become an important GDP growth factor capable of preventing a shortfall of labour force in the medium term. Owing to a growing demand for labour force, unemployment is projected to shrink from 8.3% in 2005 (according to the data of an unemployment survey) to 4.9% in 2009. Balance of payments 19. In the first half of 2006, current account deficit (CAD) of Lithuania’s balance of payments accounted for 10.3% of GDP. In the same period of the previous year, CAD accounted for 6.5% of GDP. The current account balance was negatively affected by dynamics of all its key components. Because nominal import of goods grew faster than export, foreign trade deficit has grown by 1.6% of GDP over a year, to reach 12.4% of GDP in the first half of 2006. Deficit of the balance of income grew by 1.3% of GDP, mainly due to higher re-investments by non-residents. The fact that foreign entities opt to re-invest their profits (rather than paying dividends) shows that foreign entities are content with investment returns in Lithuania. In the first half of 2006, the GDP-relative surplus of the balance of services fell by 0.6% of GDP, for several reasons. First, volumes of cargo transportation by railways decreased. Second, higher wages of cargo drivers and a larger shortage of drivers have reduced competitiveness of the Lithuanian carriers, resulting in lower growth rates export of services. Third, a fairly rapid growth of the purchasing power has increased Lithuanians’ spending on travelling abroad. As for the export of services, the main growth factor was export of merchanting and trade-related services associated with penetration of Lithuania’s sales networks into foreign markets. In the first half of 2006, the flow of current transfers fell by 0.3% of GDP, mainly due to lower transfers by natural and legal persons. In the second quarter of 2006, the four-quarter moving sum of the CAD equalled 9% of GDP. The key factors of growth of the four-quarter moving sum of the CAD include the growth of foreign trade deficit and the growth of deficit of income on equity (mainly re-investments). Fig. 6. Components of the current account balance Sources: Statistics Lithuania, Bank of Lithuania, estimates by the Bank of Lithuania Fig. 7. Structural factors of the current account deficit Sources: Statistics Lithuania, Bank of Lithuania, estimates by the Bank of Lithuania Analysis of factors influencing the balance of savings and investments reveals that the growth of the CAD and GDP ratio is determined by decreasing gross savings and increasing gross domestic investments. In the first half of 2006, nominal imports grew at the rate of 31.2% year on year, or 27.4% if mineral products are excluded. With the slowdown of import of mineral products in the second quarter of 2006, imports exclusive of mineral products grew faster than total imports, i.e. 25% and 24% year on year, respectively. In the second quarter of 2006, all imports, excluding mineral products, were equally increased by import of vehicles and equipment (6.1 and 6.2 percentage points, respectively). The key factor causing changes in the import of vehicles was a still growing demand for cars both domestically and in the neighbouring states. In foreign trade statistics, this is reflected as re-exports. The dynamics of import of machinery was caused by growing consumption expenditure and investment. This has contributed to the growth of import of electric devices from Poland and China and industrial equipment from Germany. Import of the above-mentioned goods makes it possible to increase the production potential and competitiveness in the short and medium term. Fig. 8. Factors of change in the annual import growth Fig. 9. Factors of change in the annual export growth Sources: Statistics Lithuania, estimates by the Bank of Lithuania Sources: Statistics Lithuania, estimates by the Bank of Lithuania In the first half of 2006, nominal exports grew at the rate of 30.9% year on year, or 25.2% exclusive of mineral products. In the second quarter of 2006, the annual growth rate of exports was a bit slower than in the first quarter and stood at 29.3%, or 24.3% exclusive of mineral products. In April-June 2006, Lithuania’s export growth was driven by changes in external demand and internal supply. External demand was positively stimulated by the demand for used cars in Russia and the expanding food market. The export boom for cars (in Lithuania, the annual growth rate of export of surface vehicles was 56.6%) was also contributed to by the increased demand for cars in Kazakhstan. In total, export of vehicles has added 2.9 percentage points to the total exports (exclusive of oil). The main factor that has increased internal supply and stimulated export dynamics was a sale of more cattle by farmers (due to bad weather conditions). This has increased export of animal products to Russia and some EU countries. In total, export of food products has added 7.8 percentage points to Lithuania’s total exports (exclusive of oil). In the second quarter of 2006, Lithuania’s producers of plastics were particularly competitive: a historically high annual growth rate of exports grew further to 70.1%, while export of plastic products to Poland, one of the largest producers of plastics in Europe, almost tripled. Growth of export of plastic products was mainly driven by activities of producers operating in Klaipėda free economic zone (FEZ). In the second quarter of 2006, export of chemicals and plastic products added 4.7 percentage points to the total exports exclusive of mineral products. In the first half of 2006, the real effective litas exchange rate vis-à-vis all foreign trade partners fell by 3.2%. Because inflation in Lithuania was larger than in the EU-15, the real effective litas exchange rate vis-à-vis the EU-15 grew by 1.6% year on year. In contrast, the real effective litas exchange rate vis-à-vis the new EU Member States fell by 2.4%, as inflation in Lithuania was lower than in these states. In the first half of 2006, the real effective litas exchange rate vis-à-vis the CIS countries fell by 11.1%. In June 2006, the annual decline of this indicator was only 5.4%, mainly due to the depreciation of the U.S. dollar exchange rate vis-à-vis the euro. Fig. 10. Real effective exchange rates index of the litas, by country group Source: Bank of Lithuania In the first half of 2006, other investments dominated by long-term liabilities of commercial banks to the leading banks were traditionally the main source of CAD financing. Foreign-debt-neutral capital flows, i.e. foreign direct investment (FDI) and capital account, financed 27.5% of the CAD, compared to 77.2% a year ago. Analysis of four-quarter moving sums reveals several tendencies. A fairly stable GDP ratio of capital account is mainly ensured by a generally stable flow of non-repayable transfers of capital from EU support funds. Decreasing GDP share of FDI flows is a result of lower FDI flows to Lithuania and higher investments by Lithuanian entities in foreign countries (mainly in the form of loans to secondary companies). In the first half of 2006, FDI flows in Lithuania fell by 18.4% compared to the corresponding period of the previous year. Over a year, the moving sum of FDI in Lithuania has dropped from 3.6% to 3.4% of GDP. Changes in the structure of FDI in Lithuania, such as stable flows of equity capital and growing re-investments, show that investors are content with investment returns; this notwithstanding, investment in share capital does not grow for certain reasons (e.g. shortage of labour force). In the second quarter of 2006, the four-quarter moving sum of the investment portfolio went down to –1.7% of GDP. A year ago, this indicator stood at 0.5% of GDP. The downward trend of net flows of the investment portfolio was mainly owing to investments by commercial banks in debt securities of foreign states. A rapid growth of lending forced commercial banks to continue borrowing abroad. In the second quarter of 2006, the four-quarter moving sum of long-term and short-term liabilities of commercial banks was 9% and 3.2% of GDP, respectively. As the majority of these loans have been taken from leading institutions, the probability that commercial banks will face liquidity risks is low. Fig. 11. Financing sources of the current account deficit Source: Bank of Lithuania New “green field” investment in Poland and Slovakia and the EU accession of Romania and Bulgaria, countries with large and cheap labour force, prompt the conclusion that Lithuania’s economy will have a competitive advantage over these countries only if new advanced programmes of promotion of investments are implemented. Table 8. Sectoral balances Indicator ESA code % of GDP 2005 2006 2007 2008 1. Net borrowing B.9N -5.8 -6.6 -7.5 -7.0 of which: - balance of goods and services -7.3 -9.4 -10.4 -10.2 - balance of income and transfers 0.2 0.9 0.6 1.0 - capital account* 1.3 1.9 2.2 2.2 2. Net surplus (+)/deficit (-) of the private sector -5.3 -5.4 -6.6 -6.5 of which: - corporate sector - - - - - households and NPISHs - - - - 3. Net surplus (+)/deficit (-) of general government B.9N -0.5 -1.2 -0.9 -0.5 4. Statistical discrepancy - - - - Sources: Ministry of Finance, *Bank of Lithuania The current level of the CAD raises no concerns given the rapid economic growth and the relatively low total external debt. The CAD is projected to account for 8.6-9% of GDP in 2006. Risk-related aspects of economic development 20. In its Financial Stability Review of 2006, the Bank of Lithuania states that “over the medium-term, the risk stems from the existing imbalances in the real estate market, potential correction of asset prices and a significant slowdown in the growth of the national economy”. This statement is a cornerstone of the macroeconomic projections used in the planning of the budget for 2007. The potential GDP growth will remain close to 6%; however, the existing risk factors may significantly retard economic growth in the medium term, and the future of the economic sectors which have recently experienced a boom will depend on their flexibility with regard to real estate prices. The return of real estate prices back to economically justified levels might slow down GDP growth by several percentage points. 21. Cyclical impact of credit increase on the demand has reached such a level that in the light of a change of an economic cycle and a faster slowdown of credit increase, the upward impact of EU support on the demand would be capable of compensating these cyclical slowdowns only in part. Therefore, further consistent implementation of prudent general government fiscal objectives would be very important for economic risk management. 22. The issues of “overheating” and two correction scenarios, “slow cooling” and “sharp decline”, which are discussed in macroeconomic overviews by commercial banks, show that medium-term economic risks depend on the country’s capacity to get prepared for natural economic cycles in time and efficiently. In their macroeconomic overviews, commercial banks project that “this year interest rates clearly started climbing a mountain the top of which is difficult to see yet”, which suggests that economic entities might have to expand their financing strategies with new solutions aimed at managing the risk of growth of interest rates. 23. Inflation may increase in the medium term due to a faster growth of wages prompted by the “heating” of the economy. However, there is a positive risk of reoccurrence and persistence for some time of the downward movement of oil prices as in September 2006. If this is the case, annual inflation of the month in question will be 0.1-0.3% lower than projected. Persistence of expectations for a strong rise of prices and a faster growth of wages could change consumer behaviour and increase nominal GDP growth and the CAD of the balance of payments by several percentage points. Growth of wages and nominal GDP could also be several percentage points higher if credit growth went up, rather than down. 24. If IMF concerns about the likely correction in “heated” neighbouring economies proved true and commercial banks changed their credit supply policies too quickly, Lithuania’s economic growth in the years of correction would be several percentage points slower, but would subsequently come equal to the high potential GDP growth. 25. In recent years, Lithuania’s exports of goods were impressively growing as a result of growth of re-exports and prices of oil products. Re-exports to Eastern markets, which collect more income due to higher oil prices, have improved Lithuania’s foreign trade indicators by about 10 percentage points. Rising prices of oil products consequential on higher oil prices have also improved general export indicators by about 10 percentage points. Therefore, if oil prices go down, Lithuania’s general exports may experience a sudden delusive slowdown, although export of products of Lithuanian origin will maintain its recent stable nominal growth of 6-9%. Risks posed by changes in oil prices should not be viewed as a background in assessing the economic outlook for Lithuania. III. PUBLIC FINANCES Financial policies 26. The medium-term objective is the reduction, by ensuring the implementation of economic policy priorities, of the structural deficit down to 1% or below in 2008 and further down in later years. 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 tightened in the light of faster-than-projected trends of nominal GDP growth. 27. The medium-term fiscal policy (macroeconomic policy) will be further geared towards the implementation of the following priorities: 27.1. to match the fiscal policy with the priorities of social policy; 27.2. to continue the tax reform aimed at balancing labour and capital taxation; 27.3. to promote further reforms in energy and agriculture; 27.4. to continue the pension reform ensuring a long-term sustainability of general government finances; 27.5. to create favourable conditions for the improvement of labour efficiency, improve competitiveness of the economy, attract more FDI, and successfully implement EU structural policies; 27.6. to keep, as far as possible, the impact of demand on prices under control, by pursuing an anti-cyclical fiscal policy. Discussions about possibilities to reform higher education and studies are due in 2007. If higher education and studies reform were approved as a priority in 2007, the impact of these reforms on general government finances would be described in the next update of this Programme. 28. Seeking to maintain confidence in the currency board arrangement, Lithuania will, as part of its fiscal policy, further create favourable conditions for improving labour efficiency, improve tax administration, create favourable investment climate, and ensure 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 long-term sustainability of government finances. 29. Actions planned for 2006 to 2008. Once 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 job creation. Efforts will be made to ensure that the balance between labour and capital taxation is achieved without adding to the fiscal deficit and that it creates conditions to enhance business competitiveness. In 2005-2006, Lithuania successfully mitigated negative effects of the shadow economy on general government finances. In the medium term, tax collection will continue to be further improved; therefore, the revenue plan is expected to increase by about 0.4% of GDP in 2007; any extra revenues will be used to achieve fiscal deficit targets. Further efforts will be made to ensure maximum efficiency of general government expenditure: investments and social transfers and, as far as possible, expenditure on health-care and education (as a percentage of GDP) will be increased. An assumption is made that the agreement between parliamentary parties on fiscal discipline that is currently being discussed will facilitate the negotiations for additional structural measures aimed at managing the inflationary impact of demand and at achieving fiscal deficit targets. The aggregate impact of the additional measures is likely to help reduce fiscal deficit by 0.4% of GDP in 2007 and by about 1% of GDP in 2008 and 2009. Actions planned for the period 2006-2008: 29.1. seeking that a balance between labour and capital taxation facilitates the achievement of fiscal deficit target; 29.2. making further efforts to mitigate the adverse impact of the shadow economy on general government finances and seeking to ensure that these efforts result in the augmentation of the planned income by about 0.4% of GDP in 2007; 29.3. seeking to ensure maximum efficiency of general government expenditure; 29.4. using unspent expenditure allocations for the achievement of fiscal deficit target; The Government of the Republic of Lithuania has submitted to the Seimas of the Republic of Lithuania a draft law on the approval of financial indicators of the state budget and municipal budgets of 2007, which provides that state budget revenue collected in excess of the plan (except unspent funds under special programmes) will be used for the implementation of state budget deficit. Actual balances and implications of the forthcoming budget on medium-term goals 30. The rapid economic development is a proof that the fiscal policy pursued has helped to win confidence of local and foreign investors. In 2001, the direction of fiscal policy was radically changed with a view to achieving fiscal consolidation. In 2000, general government fiscal deficit accounted for 3.2% of GDP, followed by a drop to 2.1% of GDP in 2001. The pension reform launched in 2004 and payments to the EU Own Resources have lessened possibilities to reduce fiscal deficit faster. As a result, general government budget deficit grew slightly (to 1.5% of GDP), and structural deficit grew to 1.8% of GDP in 2004. Despite higher expenditure attributable to successful implementation of the pension reform in 2005, general government structural deficit was reduced to 1% of GDP. The tightening of general government fiscal deficit targets for 2005 was possible thanks to the implementation of measures aimed at improving tax administration. Lower nominal fiscal deficits in 2005 and 2006 were achieved thanks to supply which was financed with large and still accelerating credit increase and thus higher-than-projected growth of employment and wages. In the light of the faster growth of wages, employment and prices and the wo …