Council opinion of 4 March 2008 on the updated convergence programme of Lithuania, 2007-2010
Date: 2008-03-04
Institutions: Council of the European Union
Subjects: Lithuania, budget estimate, economic convergence, economic forecasting, public finance, stability programme

20.3.2008

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Official Journal of the European Union

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COUNCIL OPINION

of 4 March 2008

on the updated convergence programme of Lithuania, 2007-2010

(2008/C 74/05)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particular
Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

On 4 March 2008, the Council examined the updated convergence programme of Lithuania, which
covers the period 2007 to 2010 (2).

Over the past several years, Lithuania has been experiencing a period of strong growth primarily
driven by domestic demand. Monetary conditions have been accommodative, given a high degree of
euroisation in the framework of a currency board arrangement within ERM II.

In the absence of sufficient measures to curb excessive domestic lending, rapid credit expansion facili-
tated by financial deepening has boosted private consumption and real estate investment. However,
capacity constraints have emerged as emigration and high economic growth have led to labour
shortages, aggravated by skill mismatches and low participation rates, and increasing costs. Increas-
ingly rapid wage growth outstripping productivity is leading to rapid inflation and declining price
competitiveness. Even though export performance remains robust, the external deficit has widened
rapidly as strong domestic demand has led to high import growth and external vulnerability has
increased. In this context fiscal policy has not responded to the rising macroeconomic imbalances:
the general government balance has remained in deficit and, in the absence of binding medium-term
expenditure ceilings, better-than expected revenues have been systematically spent. Tax incentives and
exemptions have been contributing to the real estate boom and thus added to overheating, though
more recently the ongoing tightening of credit conditions is supportive of the necessary adjustment.
A tighter fiscal stance and structural reforms in the labour market and educational system, further
strengthening the supply-side, will be major contributors to addressing internal and external imbal-
ances and attracting inward investment, thus ensuring a sustainable catching-up process. This is parti-
cularly important given the limited number of policy instruments available to Lithuania in the
context of the constraints implied by its monetary policy regime.

(3)

The macroeconomic scenario underlying the programme envisages real GDP growth reaching 9,8 %
in 2007 and declining relatively sharply thereafter to 5,3 % in 2008 and to 4,8 % per annum on
average over the rest of the programme period. Domestic demand is expected to slow but to remain
the main driver for growth. Assessed against currently available information (3), this scenario appears
cautious. This is particularly so in 2008 given recent momentum. Some discrepancies,
including
between the widening of external imbalances and the strong slowdown of domestic demand, are not
explained in the programme.

(1) OJ L 209, 2.8.1997, p. 1. Regulation as amended by Regulation (EC) No 1055/2005 (OJ L 174, 7.7.2005, p. 1). The

documents referred to in this text can be found at the following website:
http://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) The update was submitted 4 weeks beyond the 1 December deadline set in the code of conduct.
(3) The assessment takes into account notably the Commission services' autumn 2007 forecast and the Commission assess-

ment of the October 2007 implementation report of the national reform programme.

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The programme projects inflation to increase from 5,8 % in 2007 to 6,5 % in 2008 before falling to
5,1 % in 2009 and 3,6 % in 2010 showing very little progress towards convergence. Moreover, in
view of food price trends, planned gas price increases (explicitly recognised in the programme and
estimated at 1,5 % in 2008 but not incorporated into its 2008 inflation projection) and wage
increases far above productivity growth, underlining the danger of exacerbating the wage-price spiral,
serious upside risks to these projections are evident. Widening external imbalances, if materialising as
foreseen by the programme, would increase the economy's external vulnerability. However, recent
price and wage developments pointing to the danger of deteriorating competitiveness could them-
selves result in a worsening external position.

(4)

(5)

For 2007, the general government deficit is estimated at 0,9 % of GDP in the most recent update of
the convergence programme, identical to the target set in the previous update in spite of a much
better-than-expected performance in 2006. The favourable base effect of some 0,6 % of GDP was
offset by a one-off measure of similar magnitude (1). Similarly to the practice of some previous years,
additional revenues on the back of higher-than-anticipated economic growth were spent, in 2007
mainly by the Social Security Fund and for national co-financing of EU-supported projects. Budgetary
implementation in 2007 was not in line with the invitation in the Council opinion of 27 February
2007 on the previous update of the convergence programme (2) as the economic good times and
lower-than-targeted deficit in 2006 did not lead to a more demanding deficit target for the year.
Further, even though the medium-term objective (MTO) of a structural deficit (i.e. cyclically-adjusted
deficit net of one-off and other temporary measures) of 1 % of GDP was just reached in 2006, there
was a small slippage from the MTO in 2007, by about 0,25 % of GDP.

The main goal of the medium-term budgetary strategy is to foster macroeconomic stability via a
tighter fiscal policy. Compared to the previous update, the target year for achieving the MTO has
been postponed by one year from 2008 to 2009 despite a broadly unchanged macroeconomic
scenario. However, applying the common methodology to the information in the programme suggest
the MTO could be reached from 2008. The programme targets a gradual improvement of the head-
line general government balance from a deficit of 0,9 % of GDP in 2007 to a surplus of 0,8 % in
2010. The structural balance calculated according to the commonly agreed methodology is projected
to improve from a deficit of 1,25 % of GDP in 2007 to a surplus of 1 % in 2010, with the main
adjustment effort back-loaded to after 2008. On the back of relatively strong economic growth, the
adjustment is planned to be achieved through a greater increase in the revenue-to-GDP ratio than in
the expenditure-to-GDP ratio (3,9 percentage points compared to 2,2 percentage points respectively).
Despite further direct tax cuts, revenues are expected to increase on the basis of higher EU funds
inflows, increases in excise duties and a further considerable improvement in tax collection. On the
expenditure side, the increase stems from significantly higher social payments and rising public invest-
ment, the latter mainly supported by EU funds. The adoption in November 2007 of the Law on
Fiscal Discipline aimed at providing a firm commitment to fiscal restraint. The law, effective from the
beginning of 2008, states that general government finances should be managed to achieve budgetary
positions close to balance or in surplus and aims to impose expenditure restraint to this end.
However, the law is focused on annual budgetary preparation and execution and does not as such
introduce a forward-looking medium-term budgetary framework, which needs to be enhanced.

(6)

The budgetary outcomes could be worse than projected in the programme. Despite the programme's
particularly cautious projection of real and nominal output growth from 2008 onwards, the projected
revenue increase seems substantial: even with a more favourable macroeconomic growth scenario, the
revenue projection appears on the high side, especially taking into account the impact of further
direct tax reductions and its reliance on improved tax collection. The large increase in the ratio of
non-tax revenues to GDP, partly related to EU funds, is insufficiently articulated in the programme
while the expected results from improved tax collection appear optimistic. Moreover, the numerous
expenditure-increasing measures together with the need to strengthen the medium-term framework

(1) The one-off measure relates to compensation of partly unpaid pensions in 1995-2002 that follows a Constitutional Court
decision and was adopted by the government in November 2007. This operation was decided after the cut-off date of the
Commission services' autumn 2007 forecasts, hence the estimated outturn for 2007 cannot be compared with that in the
programme.

(2) OJ C 71, 28.3.2007, p. 19.

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for the planning and control of public finances imply a risk that expenditure will continue to exceed
previously set ceilings. If the economic slowdown proves to be severe or protracted, producing a
rapid fall in revenue growth, this would exert greater pressure on the budget.

(7)

(8)

(9)

In view of this risk assessment, the budgetary stance in the programme seems insufficient to ensure
that the MTO is achieved by 2009, as envisaged in the programme. In particular, there could be dete-
rioration in the structural balance in 2008, because of the planned revenue-decreasing and expendi-
ture-increasing measures, whereas Lithuania, which currently enjoys strong growth, should pursue an
effort above the 0,5 % of GDP benchmark for the annual structural improvement. The pace of adjust-
ment towards the MTO implied by the programme should thus be strengthened, especially in 2008,
to be in line with the Stability and Growth Pact. After the projected achievement of the MTO, the
fiscal policy stance implied by the programme is in line with the Stability and Growth Pact. However,
given persisting external and domestic pressures, a tighter fiscal policy than currently planned would
be appropriate.

Lithuania appears to be at low risk with regard to the sustainability of public finances. The long-term
budgetary impact of ageing is lower than the EU average, with a limited increase in pension expendi-
ture over the coming decades, influenced by the pension reforms already enacted. The current level
of gross debt is very low and the initial budgetary position in 2007 as estimated in the programme,
which is better than the starting position of the previous programme, would contribute to containing
the risks to the long-term sustainability of public finances.

The convergence programme seems to be consistent to some extent with the October 2007 imple-
mentation report of the national reform programme. The measures in the area of public finances
envisaged in the convergence programme seem to be in line with those foreseen in the national
reform programme. In particular, both programmes cover the ongoing pension, healthcare and tax
reforms. Information provided in both programmes on the direct budgetary costs associated with the
healthcare and education reforms are insufficient, while the convergence programme provides more
detailed information on other reform areas. However, a qualitative assessment of the overall impact of
the national reform programme within the medium-term fiscal strategy is lacking.

(10)

The budgetary strategy in the programme is partly consistent with the country-specific broad
economic policy guidelines included in the integrated guidelines in the area of budgetary policies
issued in the context of the Lisbon strategy. However, the projected fiscal stance does not contribute
adequately to improving macroeconomic stability and containing inflationary pressures.

(11) Upon entry into the ERM II mechanism, Lithuania undertook commitments related to fiscal policy,
the financial sector and structural policies. Concerning progress in implementing these commitments,
the authorities have insufficiently strengthened the fiscal stance and although measures to improve
the quality of lending have been taken, efforts to restrain credit growth have been limited. Despite the
rapid economic growth of recent years, the government has not achieved a balanced budget,
budgetary targets have been unambitious and windfall revenues mainly spent. The medium-term
budgetary strategy needs to be strengthened. To curb credit growth, high reserve requirements have
been maintained, vigilant financial supervision has been continued and the compulsory reserve base
impact has been limited. The anti-inflation initiatives
has been extended; however,
announced by the government in March and December 2007 were steps into the right direction, but
have so far led to few concrete measures and have had a limited impact on inflation. A number of
structural reforms are ongoing, but further efforts are needed in the fields of education,
labour
market and to attract inward investment.

the direct

(12) As regards the data requirements specified in the code of conduct for stability and convergence

programmes, the programme provides all required and most optional data (1).

(1) In particular, the data on the subcomponents of the stock-flow adjustment, estimates of the contributions to potential

growth and some data on long-term sustainability are not provided.

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The overall conclusion is that the programme aims at tackling Lithuania's macroeconomic imbalances by
tightening fiscal policy. However, the budgetary targets seem modest in the light of the current high
economic growth. The programme envisages only a back-loaded adjustment effort so that the MTO is
reached only in 2009. There are risks to the achievement of the budgetary targets as the consolidation is
insufficiently backed by announced measures while there is a need to strengthen the medium-term frame-
work. The revenue projections seem optimistic given the further planned direct tax cuts and a reliance on
improved tax collection and the cautious macroeconomic scenario counterbalances them only partially. A
significantly tighter fiscal policy than foreseen in the programme and further structural policy measures are
needed to address mounting inflationary pressures, maintain competitiveness and tackle remaining bottle-
necks in the labour market, crucial also for sustaining catching-up. As regards the long-term sustainability of
public finances Lithuania remains at low risk.

In view of the above assessment and also given the need to ensure sustainable convergence and a smooth
participation in ERM II, Lithuania is invited to contribute to reducing overheating pressures by:

(i) aiming for significantly better budgetary outturns in 2008 and thereafter

than foreseen in the
programme, notably by restraining expenditure growth, saving windfall revenues and reinforcing the
binding character of the medium-term expenditure ceilings;

(ii) tackling inflationary pressures including by promoting wage setting in line with overall productivity

gains and adopting structural measures to remove labour market bottlenecks.

Lithuania is also invited to improve compliance with the submission deadline for stability and convergence
programmes specified in the code of conduct.

Comparison of key macroeconomic and budgetary projections

Real GDP
(% change)

HICP inflation
(%)

Output gap (1)
(% of potential GDP)

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

General government
balance
(% of GDP)

CP Dec 2007

COM Nov 2007

CP Dec 2006

CP Dec 2007

COM Nov 2007

CP Dec 2006

CP Dec 2007

COM Nov 2007 (2)

CP Dec 2006

2006

2007

2008

2009

2010

7,7

7,7

7,8

3,8

3,8

3,9

1,7

1,0

2,4

9,8

8,5

6,3

5,8

5,6

4,7

3,3

1,0

1,6

5,3

7,5

5,3

6,5

6,5

3,4

1,5

0,4

0,1

4,5

6,3

4,5

5,1

5,2

3,1

5,2

n.a.

n.a.

3,6

n.a.

n.a.

– 0,4

– 1,3

– 0,6

– 1,9

n.a.

n.a.

CP Dec 2007

– 9,5

– 12,5

– 12,7

– 14,5

– 15,4

COM Nov 2007

– 8,9

– 12,5

– 12,9

– 13,0

CP Dec 2006

– 6,6

– 7,5

– 7,0

CP Dec 2007

– 0,6

– 0,9

– 0,5

n.a.

0,2

COM Nov 2007

– 0,6

– 0,9

– 1,4

– 0,8

CP Dec 2006

– 1,2

– 0,9

– 0,5

0,0

n.a.

n.a.

0,8

n.a.

n.a.

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Primary balance
(% of GDP)

Cyclically-adjusted
balance (1)
(% of GDP)

Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

CP Dec 2007

COM Nov 2007

CP Dec 2006

CP Dec 2007

COM Nov 2007

CP Dec 2006

CP Dec 2007

COM Nov 2007

CP Dec 2006

CP Dec 2007

COM Nov 2007

CP Dec 2006

2006

2007

2008

2009

2010

0,2

0,2

– 0,4

– 1,0

– 0,8

– 1,8

– 1,0

– 0,8

– 1,8

18,2

18,2

18,4

– 0,1

0,0

0,0

– 1,8

– 1,2

– 1,3

– 1,2

– 1,2

– 1,3

17,6

17,7

19,2

0,3

– 0,5

0,4

– 0,9

– 1,5

– 0,5

– 0,9

– 1,5

– 0,5

17,2

17,2

19,0

0,9

0,2

0,8

0,3

– 0,6

0,5

0,3

– 0,6

0,5

15,0

16,1

17,7

1,4

n.a.

n.a.

1,1

n.a.

n.a.

1,1

n.a.

n.a.

14,0

n.a.

n.a.

Notes:
(1) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the

information in the programmes.

(2) Based on estimated potential growth of 7,9 %, 8,4 %, 8,2 % and 7,4 % respectively in the period 2006-2009.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. One-off and other temporary measures are 0,6 % of GDP
in 2007 (deficit-increasing) according to the most recent programme. As this transaction was decided after the cut-off date of the
autumn 2007 forecast, it is not reflected in the Commission services' autumn forecast.

Sources:
Convergence programme (CP); Commission services' autumn 2007 economic forecasts (COM); Commission services' calculations.