Report from the Commission - Convergence report 2006 on lithuania (prepared in accordance with Article 122(2) of the Treaty at the request of Lithuania) {SEC(2006) 614}
Date: 2006-05-16
Institutions: European Commission
Subjects: Economic and Monetary Union, European Commission, Lithuania, convergence criteria, economic convergence, report

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 16.5.2006 
COM(2006) 223 final 

REPORT FROM THE COMMISSION 

CONVERGENCE REPORT 2006 ON LITHUANIA 

(prepared in accordance with Article 122(2) of the Treaty at the request of Lithuania) 

[SEC(2006) 614] 

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1. 

PURPOSE OF THE REPORT 

Article 122(2) of the Treaty requires the Commission  and the ECB to report to the 
Council,  at  least  once  every  two  years,  or  at  the  request  of  a  Member  State  with  a 
derogation,  on  the  progress  made  in  the  fulfilment  by  the  Member  States  of  their 
obligations regarding the achievement of economic and monetary union.  

This  report  has  been  prepared  at  the  request  of  Lithuania,  submitted  on  16  March 
2006.  A  more  detailed  assessment  of  the  state  of  convergence  in  Lithuania  is 
provided in a technical annex to this report (SEC(2006) 614).  

The content of the reports prepared by the Commission and the ECB is governed by 
Article  121(1)  of  the  Treaty.  This  Article  requires  that  the  reports  include  an 
examination of the compatibility of national legislation, including the statutes of its 
national central bank, and Articles 108 and 109 of the Treaty and the Statute of the 
ESCB and of the ECB. The reports also have to examine the achievement of a high 
degree of sustainable convergence in the Member State concerned by reference to the 
fulfilment of the convergence criteria (price stability, government budgetary position, 
exchange  rate  stability,  long-term  interest  rates),  and  take  account  of  several  other 
factors mentioned in the final sub-paragraph of Article 121(1). The four convergence 
criteria are developed further in a Protocol annexed to the Treaty (Protocol No 21 on 
the convergence criteria). 

2. 

LEGAL COMPATIBILITY 

In its 2004 Convergence Report (COM(2004) 690), the Commission concluded that, 
as  regards  central  bank  integration  into  the  ESCB  at  the  time  of  euro  adoption, 
legislation  in  Lithuania,  in  particular  the  Law  on  the  Bank  of  Lithuania  and  the 
Constitution  of  Lithuania,  as  well  as  the  Law  on  Currency  and  the  Law  on  the 
Credibility of the litas, was not fully compatible with Article 109 of the EC Treaty 
and 
the  correction  of  some  residual 
imperfections was recommended, in particular with respect to the Bank’s objectives. 

the  ESCB/ECB  Statute.  In  addition, 

These incompatibilities have been addressed in three laws that were adopted by the 
Seimas on 25 April 2006 and shall enter into force on the day of the abrogation of the 
derogation  of  the  Republic  of  Lithuania  by  the  Council  of  the  European  Union, 
pursuant  to  the  procedure  laid  down  in  Article  122(2)  of  the  Treaty.  The  first  Law 
governs amendments to the Law on the Bank of Lithuania. The second Law repeals 
the  Law  on  Currency  and  the  Law  on  the  Credibility  of  the  litas,  which  also 
contained several incompatibilities. The third Law introduces amendments to Article 
125 of the Constitution of the Republic of Lithuania. 

With respect to the Law on the Bank of Lithuania, the incompatibilities raised in the 
2004  Convergence  Report  have  been  removed.  The  amendments  strengthen 
"personal"  independence  and  take  account  of  EC  Treaty  requirements,  in  particular 
as  regards  the  respective  roles  and  competences  of  the  ECB,  the  ESCB  and  the 
Council in the area of monetary policy, the conduct of foreign exchange operations 
and the definition of foreign exchange policy, the holding and managing of foreign 
reserves  and  the  issuance  of  banknotes  and  coins.  The  need  for  the  ECB’s  prior 

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approval  for  the  participation  of  the  Bank  of  Lithuania  in  international  monetary 
organisations is fully taken into account, while the possibility for the Parliament to 
wind  up  the  Bank  of  Lithuania  has  been  removed.  In  addition,  a  reference  to  the 
ESCB’s  secondary  objective  has  been  inserted,  which  takes  precedence  over  the 
Bank  of  Lithuania’s  additional  objective  of  supporting  the  economic  policy  carried 
out by the national authorities. 

Legislation  in  Lithuania,  in  particular  the  Law  on  the  Bank  of  Lithuania  and 
Lithuania's Constitution, are compatible with the requirements of the EC Treaty and 
the ESCB/ECB Statute. 

3. 

PRICE STABILITY 

Evolution of the reference value 

In the 2004 convergence report Lithuania was found to have fulfilled the criterion on 
price  stability.  The  average  inflation  rate  in  Lithuania  during  the  12  months  to 
August 2004 was -0.2 percent, below the reference value of 2.4 percent.  

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Lithuania
Reference value

Chart 1.  HICP Inflation
 (12-m moving average)

The  12-month  average  inflation, 
which is used  for  the  convergence 
assessment,  declined  in  the  course 
of  2002  and  was  negative  in  2003 
and  most  of  2004.  From 
the 
middle  of  2004  onwards  it  started 
to increase gradually and has been 
above  the  reference  value  since 
April  2005.  In  March  2006,  the 
reference  value  was  2.6  percent, 
calculated as the average of the 12-
month  average  inflation  rates  in 
the  three  best-performing  Member  States  (Sweden,  Finland  and  Poland)  plus  1.5 
percentage points. The corresponding inflation rate in Lithuania was 2.7 percent, just 
above the reference value. 

Source:  Eurostat, Commission services

EC Spring 
2006 Forecast

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Underlying factors and sustainability 

After  independence  Lithuania  experienced  triple-digit  inflation  in  the  first  years  of 
transition.  With  the  introduction  of  the  litas  in  1993,  inflation  was  curbed  and  the 
exchange  rate  stabilised.  Inflation  dropped  to  single-digit  levels  in  1997  and 
decreased further in the next few years. By then, transition-related rapid increases in 
administered  prices  had  subsided  and  in  the  following  years  rapid  productivity 
growth  and  the  steady  appreciation  of  the  nominal  effective  exchange  rate  in 
response to the appreciating trends in the respective anchor currencies (first the US 
dollar, then the euro) also helped to bring inflation down.  

From  April  1999  to  July  2004,  Lithuania  experienced  a  prolonged  period  of  more 
than 5 years where harmonised inflation rates were below 2 percent. From June 2002 
until April 2004 consumer prices were even decreasing year-on-year, helped by the 
change of the peg of the litas to the euro in early 2002, which extended the period of 

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effective  nominal  appreciation  of  the  litas.  Positive  inflation  rates  re-emerged 
subsequently and year-on-year HICP inflation rates increased to around 3 percent in 
the second half of 2004. The return of positive inflation rates reflected a combination 
of  factors  including  a  pick-up  in  wage  costs;  substantial  increases  in  unprocessed 
food prices which were partly linked to price arbitrage as EU accession enabled the 
convergence  of  food  prices;  increases  in  indirect  taxes  and  in  administered  prices; 
and  the  impact  of  higher  energy  prices.  While  a  significant  part  of  the  pick-up  in 
HICP  inflation  from  the  summer  of  2005  onwards  was  accounted  for  by  external 
factors,  such  as  increases  in  energy  prices,  inflation  excluding  administered  and 
energy  prices  also  edged  up,  from  around  1  percent  in  the  summer  of  2005  to  2.7 
percent  in  the  first  quarter  of  2006,  notably  for  food,  transport  and  some  services 
components, such as restaurant services. 

Import  prices  for  natural  gas  rose  markedly  as  of  1  January  2006,  by  around  40 
percent, after a multi-year agreement with a major gas exporter had expired. This led 
to  price  hikes  in  gas  used  for  cooking  and  direct  heating,  adding  around  0.1 
percentage  point  to  inflation  in  January  2006.  The  main  impact  of  higher  import 
prices  for  gas  is  likely  to  occur  with  a  delay,  however,  due  to  the  adjustment  of 
regulated prices for distributed heat. 

Inflation  in  the  remainder  of  2006  is  expected  to  rise  gradually  reflecting  upward 
pressures stemming from higher labour costs (unit labour costs growth picked up in 
2005 to 3.8 percent) and import prices, in particular for energy products, which will 
partly be reflected in consumer prices only with a lag. Average inflation in 2006 is 
expected to increase to 3.5 percent, from 2.7 percent in 2005.  

In  a  longer-term  perspective,  buoyant  domestic  demand  and  increases  in  certain 
excise duties represent risk factors to inflation. The achievement and maintenance of 
a low level of inflation in the medium-term will depend on keeping wage growth in 
line with productivity developments.  

The  12-month  average  inflation  in  Lithuania  has  been  above  the  reference  value 
since April 2005 and is likely to stay above it in the months ahead. Lithuania does 
not fulfil the criterion on price stability. 

4. 

GOVERNMENT BUDGETARY POSITION 

In  the  2004  Convergence  Report,  the  Commission  stated  that  Lithuania  was  not 
subject  to  a  Council  decision  on  the  existence  of  an  excessive  deficit  and  that  it 
fulfilled the criterion on the government budgetary position.  

The  general  government  deficit  declined  from  3.6  percent  of  GDP  in  2000  to  1.2 
percent of GDP in 2003. In 2004 the deficit increased slightly to 1.5 percent of GDP, 
to  which  also  the  introduction  of  a  funded  pension  scheme  contributed.  The  deficit 
decreased  to  0.5  percent  of  GDP  in  2005.  Unlike  in  previous  years,  the  budgetary 
adjustment  in  2005  was  revenue-driven.  Strong  revenue  growth  reflected  buoyant 
economic activity and improvements in tax collection and enforcement. Expenditure 
targets were broadly met, as additional expenditures through supplementary budgets 
in  the  second  half  of  the  year,  which  had  been  the  case  before,  were  avoided. 
Cyclical  conditions  have  become  supportive  of  fiscal  consolidation  since  2003  but 

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the  structural  deficit  deteriorated  in  2003  and  2004  on  the  back  of  a  significant 
worsening  of  the  primary  deficit.  In  2005,  the  primary  deficit  improved,  as  did  the 
structural  deficit.  Lithuania  thus  continues  recording  budgetary  deficit  outcomes 
below  the  3  percent  of  GDP  threshold.  The  deficit  is  expected  to  remain  broadly 
stable in 2006, although there are uncertainties related to the absorption of EU funds 
and the impact of the tax reform that will decrease the personal income tax rate while 
raising the corporate tax. 

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steadily 

Chart 2. Lithuania: Government balance
(in percent of GDP)

ratio  of  general 
The 
government  debt  to  GDP 
declined 
from 
23.6  percent  at  the  end  of 
2000  to  below  19  percent 
in  2005.  The  main  factor 
contributing 
the 
decrease was the impact of 
financial 
transactions  of 
the  government,  reflecting 
privatisation 
mainly 
positive 
receipts 
valuation 
on 
foreign  debt  related  to  the  nominal  appreciation  of  the  litas.  The  debt  ratio  has 
remained  well  below  the  60 percent  of  GDP  threshold,  and  is  expected  to  remain 
stable also in the medium term.  

Government balance
Cyclically adjusted balance
Reference value

Source : Commission services

effects 

(*) Spring Forecast

and 

2006(*)

2004

2000

2001

2002

2003

2005

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According  to  the  December  2005  convergence  programme,  the  headline  general 
government deficit was expected to gradually decrease from 1.5 percent of GDP in 
2005  (the  actual  outcome  in  2005  was  a  lower  deficit  of  0.5  percentage  point  of 
GDP) to 1 percent of GDP in 2008, against the background of robust GDP growth. 
The  foreseen  consolidation  is  expenditure-driven,  mostly  due  to  cuts  in  collective 
consumption and social transfers in percent of GDP, while a significant increase in 
government  investment  is  planned.  The  update  of  the  convergence  programme 
estimates Lithuania’s debt ratio to remain at about 19-20 percent of GDP throughout 
the remainder of the programme horizon. 

The  Council  examined  the  updated  convergence  programme  on  14  March  2006.  It 
regarded  the  programme's  budgetary  strategy  as  plausible  and  saw  the  risks  to  the 
budgetary  projections  in  the  programme  to  be  broadly  balanced.  However,  as  the 
medium-term objective of a cyclically adjusted deficit at or below 1 percent of GDP 
might not be reached during the programme's period, the Council invited Lithuania 
to  strengthen  the  effort  in  the  structural  budgetary  adjustment.  As  regards  the 
sustainability of public finances, Lithuania appears to be at low risk in view of the 
projected budgetary costs of ageing. 

Lithuania is not subject to a Council decision on the existence of an excessive deficit 
and fulfils the criterion on the government budgetary position. 

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5. 

EXCHANGE RATE STABILITY 

In  the  2004  Convergence  Report  Lithuania  was  assessed  not  to  fulfil  the  exchange 
rate criterion. By the time of the examination, the country had been participating in 
ERM II for two months.  

The  two-year  period  relevant  for  the  assessment  of  exchange  rate  stability  extends 
from  May  2004  to  April  2006.  Lithuania  entered  ERM  II  on  28  June  2004, 
maintaining  its  longstanding  currency  board  as  a  unilateral  commitment  within  the 
mechanism, and has so far spent 22 months in ERM II. The litas-euro exchange rate 
in the two months prior to ERM II entry was stable with only minor deviations from 
the  central  rate.  There  has  been  no  deviation  from  the  central  rate  since  the  litas 
started participating in ERM II.  

Public  and  market  confidence  in  ERM  II  participation  and  the  currency  board 
remains  strong,  and  the  development  of  additional  indicators  does  not  reveal  any 
major exchange rate pressures on the litas. The ratio of official reserve assets to the 
monetary  base  has  well  exceeded  100  percent  and  reached  127.5  percent  in  2005. 
Discretionary  facilities  to  influence  liquidity  have  not  been  used  actively  to  a 
significant extent.  

Short-term  interest  rates  have  become  very  closely  aligned  to  the  euro  area, 
suggesting  that  no  appreciable  currency  risk  is  priced  in  by  financial  markets.  The 
spread  of  the  3-month  VILIBOR  to  the  EURIBOR  has  decreased  markedly,  from 
around 65 basis point on average in April 2004 to around 3 basis points on average in 
the period January-March 2006. 

The litas has been at the ERM II central rate for the period of two years covered by 
this assessment. There has been no devaluation of the central parity of the litas inside 
ERM II on the initiative of Lithuania. By the time of a possible Council decision in 
July  2006,  the  litas  will  have  participated  in  ERM  II  for  more  than  24  months. 
Lithuania fulfils the exchange rate criterion. 

6. 

LONG-TERM INTEREST RATES 

In the 2004 Convergence Report Lithuania fulfilled the criterion on the convergence 
of  interest  rates.  The  average  long-term  interest  rate  in  Lithuania  in  the  year  to 
August  2004  was  4.7  percent, 
below  the  reference  value  of  6.4 
percent. 

Chart 3.  Long-term interest rates
 (12-month moving averages)

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The  spread  vis-à-vis  euro  area 
average  long-term  interest  rates 
had been declining markedly in the 
run-up  to  ERM  II  entry  in  June 
2004.  Subsequently,  the  spreads 
have  fallen  further  from  around 
55 basis  points  around  the  time  of 
ERM  II  entry  to  around  25  basis 
points in March 2006, indicative of 

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Lithuania

Reference value

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Source:  ECB, Eurostat, Commission services

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– among other factors – the credibility of Lithuanian macro-economic policies. Since 
long-term  interest  rates  for  Lithuania  reflect  primary  market  rates,  the  short-term 
fluctuations  in  the  spread  mostly  mirrored  the  volatility  of  euro  area  long-term 
interest rates.  

The twelve-month moving average long-term interest rate relevant for the assessment 
of the Treaty criterion has continued to decline over the whole assessment period. In 
March 2006, the latest date for which data are available, the reference value, given 
by  the  average  of  long-term  interest  rates  in  Sweden,  Finland  and  Poland  plus  2 
percentage  points  stood  at  5.9  percent.  The  twelve-month  moving  average  of  the 
yield  on  ten-year  Lithuanian  benchmark  bond  stood  at  3.7  percent,  below  the 
reference value. Lithuania fulfils the criterion on long-term interest rate convergence. 

7. 

ADDITIONAL FACTORS 

Lithuania has made encouraging progress with respect to the integration of financial 
and  product  markets  in  several  areas.  Lithuania's  financial  system  has  substantially 
integrated  into  the  broader  EU  financial  system.  The  main  channels  of  integration 
have been a high degree of foreign ownership of financial intermediaries associated 
with substantial foreign currency borrowing. The size of the financial system remains 
relatively small compared to GDP, but financial deepening is progressing rapidly in 
line  with  economic  development.  High  concentration  and  foreign  ownership 
highlights the importance of cross-border cooperation to ensure adequate supervisory 
structure and safeguard financial stability. 

Similar to other new EU Member States, Lithuania experienced important changes in 
the  structure  of  its  economy  in  the  past  15  years.  Data  on  trade  and  foreign  direct 
investment  show  that  Lithuania  has  become  increasingly  integrated  in  the  EU 
economy.  The  presence  of  foreign  firms  has  been  instrumental  in  promoting 
technology  transfer,  boosting  organisational  and  managerial  skills,  and  fostering 
competition.  Differences  in  the  sectoral  composition  of  production  and  exports  in 
comparison with the euro area remain considerable, while consumer price levels in 
Lithuania  are  still  considerably  lower  than  the  EU  average  (54.6  percent  in  2004). 
Important progress has been made with respect to the adoption and application of the 
Internal Market acquis and improvement of the business environment.  

Lithuania  has  had  rather  high  current  account  deficits  for  many  years,  reflecting 
substantial  deficits  in  goods  trade  partly  compensated  by  a  positive  balance  on 
services and current transfers. The current account deficit in Lithuania widened from 
4.7  percent  of  GDP  in  2003  to  7.7  percent  of  GDP  in  2004,  mainly  on  account  of 
strong domestic demand. This trend was halted in 2005 as the current account deficit 
slightly decreased to 7.0 percent of GDP. The slight reduction in the current account 
deficit was due to improvements in the services and transfers balances (with the rise 
in  the  latter  in  the  last  two  years  mainly  due  to  inflows  of  EU  funds),  while  the 
deficit  in  goods  trade  widened  and  reached  11.2  percent  of  GDP  as  imports  were 
buoyed  by  rapid  real  GDP  growth.  The  balance  on  current  income  was  negative  at 
2.4  percent  of  GDP,  a  similar  figure  as  in  the  previous  two  years,  mainly  due  to  a 
sizeable  repatriation  of  profits  by  foreign  companies  (underlining  the  healthy 
profitability of past foreign direct investment).  

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The  pattern  of  high  real  GDP  growth  rates  with  relatively  high  current  account 
deficits is consistent with the rapid catch-up path of the economy, whereby foreign 
savings  are  mobilised  via  external  financing  to  finance  investment.  So  far,  the 
financing  of  the  current  account  deficit  has  been  unproblematic,  but  the  external 
position reflects substantial financing needs in the medium term. A key challenge for 
Lithuania will be to ensure that there is no substantial widening of the external deficit 
and that growth rates can be sustained in the future without negatively impacting on 
competitiveness. Looking forward, a substantial contribution to domestic investment 
is  expected  to  come  from  EU  funds,  which  will  help  external  financing  without 
increasing external indebtedness. 

*** 

Lithuania  has  made  significant  progress  towards  reaching  a  high  degree  of 
sustainable  convergence  by  meeting  the  criteria  on  public  finances,  exchange  rate 
stability and long-term interest rates. Lithuania does not, as yet, meet the criterion on 
price stability. 

In  the  light  of  this  assessment  the  Commission  concludes  that  there  should  be  no 
change in the status of Lithuania as a Member State with a derogation. 

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