Council opinion of 10 March 2009 on the updated convergence programme of Lithuania, 2008-2011
Date: 2009-03-10
Institutions: Council of the European Union
Subjects: Lithuania, budget estimate, economic convergence, economic forecasting, public finance, stability programme

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COUNCIL OPINION

of 10 March 2009

on the updated convergence programme of Lithuania, 2008-2011

(2009/C 70/02)

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)

(3)

On 10 March 2009, the Council examined the updated convergence programme of Lithuania, which
covers the period 2008 to 2011.

Lithuania's economy started to slow rapidly in 2008 after a sustained boom centred on growth of
domestic demand that started in 2003. In the context of the currency board framework, monetary
and credit conditions tightened in 2008 amid higher country risk perceptions and a continued appre-
ciation of the real effective exchange rate. The period of high recent growth created overheating
pressures: macro-economic imbalances increased, with both inflation and the external deficit peaking
in the first half of 2008. Wage growth exceeded productivity growth by far, thus weakening the
country's competitiveness. Fiscal policy was expansionary throughout the boom period and no
reserves were accumulated to prepare for changing cyclical conditions. Lithuania's large external
imbalances have amplified its vulnerability in view of the tightening global credit conditions and
lower growth in export markets. The global financial crisis and weak external demand are expected to
add to the ongoing fall in domestic demand and contribute to the contraction of the economy. The
immediate economic policy challenge for Lithuania is to manage the economic slowdown so as to
preserve macro-economic stability. Given the need to correct the country's high imbalances the
authorities adopted in December 2008 a fiscal austerity package to facilitate the adjustment process
and help maintain market confidence. This should also limit the worsening of the public deficits
during the downturn.

The macro-economic scenario underlying the programme estimates real GDP to have grown by 3,5 %
in 2008. It projects a sharp contraction by 4,8 % in 2009 and a further small decline by 0,2 % in
2010, before a recovery to growth of 4,5 % in 2011. Assessed against currently available informa-
tion (2), this scenario is based on plausible growth assumptions until 2009 but markedly favourable
ones thereafter. Growth assumptions appear optimistic from 2010 on, considering that worsening
growth prospects in trading partner countries and domestic demand in Lithuania due to constrained
credit are likely to be more pronounced and protracted than assumed in the programme. The esti-
mated potential growth in 2011 is rather on the high side. The programme's projection for inflation
is realistic for 2009 while it could be on the low side for 2010, notably because of the impact on
energy prices from the closure of the Ignalina nuclear power plant scheduled by the end of 2009.
Compared to the Commission services' January 2009 interim forecast, the programme projects a
much faster unwinding of external imbalances in 2009 which is due to the more severe contraction
of the domestic demand and the more favourable developments in export markets envisaged in the
convergence programme.

(1) OJ L 209, 2.8.1997, 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 assessment notably takes into account the Commission services' January 2009 forecast, but also other information

that has since become available.

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(4)

(5)

(6)

(7)

For 2008, the general government deficit is estimated in the Commission services' interim forecast at
2,9 % of GDP, against a deficit target of 0,5 % of GDP set in the previous update of the convergence
programme. This significantly worse-than-expected outturn reflects mainly considerable expenditure
overruns on public sector wages and social transfers for families and pensioners following policy deci-
sions adopted during the year and thus not included in the 2008 budget and to a lesser extent lower
tax revenues than initially projected by the authorities,
in particular because of sharply slowing
economic activity towards the end of the year. Investment expenditure and EU funds absorption were
lower than planned.

The new government that took office on 9 December 2008 adopted a programme of significant
fiscal retrenchment. In line with this, the 2009 budget adopted by Parliament on 22 December 2008
includes a fiscal consolidation package aimed at restoring market confidence and limiting the govern-
ment's financing needs. Fiscal consolidation is based on a comprehensive tax reform and substantial
cuts in budgetary expenditure, both expected to contribute to a similar extent to fiscal consolidation.
The budget targets a general government deficit of 2,1 % of GDP, which in the absence of the consoli-
dation measures would have been substantially higher. Tax changes aim to shift the tax burden from
direct to indirect taxes and from labour to capital and to broaden the tax base by removing exemp-
tions. The main revenue measures include a 1 percentage point increase in VAT and excise duties, a 3
income tax with restricted eligibility to the initial
percentage points cut in the rate of personal
tax-free threshold and a 5 percentage points increase in the rate of corporate income tax as well as
the removal of most VAT and personal income tax exemptions and broadening the tax base, particu-
larly by including more persons into the social security system. The estimated net effect of these tax
changes according to the programme is around 1,8 % of GDP. The budget also plans significant
including public sector wages, other current
expenditure cuts, estimated at around 2 % of GDP,
expenditure and planned investment.

However, some measures underpinning the budget have been rejected by the parliament either in full
or in part and therefore need to be substituted by new measures. The overall fiscal stance in 2009, as
measured by the 3 % of GDP reduction in the structural balance (cyclically-adjusted net of one-off
and other temporary measures), is estimated to be strongly restrictive (1).

The main goal of the medium-term budgetary strategy in the programme is to achieve the MTO of a
general government structural deficit of 1 % of GDP by 2010, and to reach a balanced headline
budget in later years. The general government headline deficit is expected to narrow to 1,0 % of GDP
in 2010 and to be in balance in 2011. The adjustment is foreseen to be achieved by a substantial
increase in the revenue-to-GDP ratio and a modest reduction in the expenditure ratio. The govern-
ment has begun a more detailed review of current expenditure, including public sector employment,
which could lead to further expenditure savings to be proposed in later years. Higher revenue growth
can mainly be explained by the tax changes introduced in the 2009 budget. However, the programme
the budgetary targets presented in the programme
explicitly acknowledges that achievement of
requires additional measures of around 0,5 % of GDP in 2010 and around 1,5 % of GDP in 2011.

The budgetary outcomes are subject to significant downside risks. This concerns all programme years:
in 2009 the main risk is that revenues could be significantly lower than projected in the programme,
mainly related to the risk that discretionary revenue-increasing measures, particularly the indirect tax
increases, will not lead to higher tax revenue to the extent planned in the programme, and that not
all proposed expenditure cuts, especially on subsidies and public sector employee compensation, may
be implemented; in 2010 and 2011 risk arises from the projected fiscal consolidation being based on
markedly favourable growth assumptions and requiring additional measures to underpin the
budgetary targets.

(1) The projected structural consolidation in the programme of around 4 percentage points of GDP is equal to the nominal
value of the consolidation package. However, it differs from the structural balance as recalculated by the Commission
services based on the information in the programme, mainly due to different estimates of potential growth and output gap.

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(8)

(9)

The long-term budgetary impact of ageing is lower than the EU average, as a result of the pension
reform already enacted. However, the budgetary position in 2008, as estimated in the programme,
has worsened considerably compared with the starting position of the previous programme and
compounds the budgetary impact of population ageing on the sustainability gap. Achieving primary
surpluses over the medium term, as foreseen in the programme, would contribute to reducing the
medium risks to the sustainability of public finances.

Lithuania's medium-term budgetary framework has not succeeded in preventing expenditure overruns
in recent years. Buoyant revenue growth has facilitated repeated upward revisions of expenditure
targets and the electoral cycle has put additional pressure on the framework as evidenced by the
recent deterioration of the headline deficit. With a view to strengthening the framework, a Law on
Fiscal Discipline was adopted in November 2007, including notably an expenditure rule. However,
the law focused on the preparation and execution of the annual budget and did not as such introduce
more of the necessary forward-looking medium-term elements. Hence, the current framework is still
rather weak as regards medium-term planning and control of public finances. There is scope for
the medium-term expenditure
enhancing planning and for reinforcing the binding character of
ceilings, which would contribute to restraining expenditure growth. Moreover, the framework needs
to ensure fiscal consolidation in good economic times, by preventing that additional revenues entail
higher spending. Transparency of the whole budgetary process including appropriate reporting of
revenue and expenditure executions also remains weak, including as regards the comparability of the
budgetary indicators on cash and accrual bases.

(10) With a view to stabilising the financial sector, the Lithuanian authorities have increased the guarantee
for deposit insurance from the equivalent of EUR 22 000 to EUR 100 000 in October 2008 and the
deposit guarantee ratio has been extended to 100 %. The programme acknowledges a possible risk
related to deposit guarantees, where the total amount guaranteed at the end of 2008 was around
30 % of GDP.

(11)

(12)

In line with the EERP agreed in December by the European Council, Lithuania, which is facing signifi-
cant external and internal imbalances, adopted a budgetary policy which aims at correcting such
imbalances. Taking into account the need to correct economic imbalances and the difficulty in
securing new financing at acceptable conditions due to market risk aversion, the planned restrictive
fiscal stance from 2009 until 2011 is an appropriate response to the macro-economic and budgetary
situation. A comprehensive tax reform and a wide range of expenditure-saving measures, including
reductions in public wages in 2009, have been taken. Furthermore, the Lithuanian authorities are
planning to adopt a comprehensive package of measures aiming at business support by reducing
administrative burdens, improving access to finance and facilitating export and investment. One of
the priorities includes modernisation of Soviet-type buildings so as to improve energy efficiency. In
this context, Lithuania aims to accelerate (and simplify) the absorption of EU structural funds, where
the possibilities of financing such investments would be considerably enlarged under the Commis-
sion's EERP proposals. These measures are related to the medium-term reform agenda and the
country-specific recommendations proposed by the Commission on 28 January 2009 under the
Lisbon Strategy for Growth and Jobs.

Lithuania has adopted a consolidation programme, which is an adequate response to the need to
correct macro-economic imbalances. However, the budgetary outcomes are subject to significant
downside risks. Moreover, the adjustment should be backed by additional measures, particularly in
the outer years. Although the safety margin against normal cyclical fluctuations appears to be
respected in the programme in all years starting in 2009, this may become insufficient, taking into
account the risks including the severe economic downturn, to prevent breaching the 3 % threshold in
2009 and 2010. The fiscal stance is expected to be restrictive from 2009 until 2011 as measured by
the change in the structural (primary) balance. In the context of Lithuania's ERM II membership and
the need to improve economy's cost competitiveness, correction of previously high wage growth is
warranted.

(13) 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 Lithuania is currently facing a severe contraction in domestic demand
following years of above-potential economic growth. The deepening global financial crisis and weakening
external demand contribute to aggravating the contraction of the economy. For a sustained period wage
growth has exceeded productivity growth by far, thus weakening the country's competitiveness hindering
prospects of export-led economic recovery. The general government balance deteriorated considerably in
2008 mainly reflecting an expansionary fiscal policy. The programme targets a deficit of 2,1 % of GDP in
2009 and a gradual decline in the headline deficit thereafter to a balanced position in 2011. Taking into
account the risks related to the macro-economic scenario and the lack of information on measures needed
to underpin fiscal consolidation after 2009, the budgetary outcomes in the programme are subject to signifi-
cant downside risks, with the headline deficit possibly exceeding the 3 % of GDP threshold in 2009 and
2010, while the debt ratio will remain very comfortably below the 60 % of GDP reference level. The
planned restrictive fiscal stance from 2009 until 2011 is an appropriate response in the light of existing
imbalances. The current budgetary framework is rather weak as regards medium-term planning and control
of public finances, especially in terms of expenditure.

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:

(i) implement measures needed to achieve the budgetary target in 2009 by prioritising expenditures and

continue targeted fiscal consolidation in the medium-term;

(ii) implement public sector wage restraint to facilitate the alignment of whole-economy wages with

productivity and to strengthen cost competitiveness;

(iii) strengthen fiscal governance and transparency, by enhancing the medium-term budgetary framework

and reinforcing expenditure discipline.

Comparison of key macro-economic and budgetary projections

Real GDP
(% change)

CP Jan 2009

8,9

3,5

– 4,8

– 0,2

4,5

2007

2008

2009

2010

2011

COM Jan 2009

8,9

3,4

– 4,0

– 2,6

n.a.

CP Dec 2007

9,8

5,3

4,5

5,2

n.a.

HICP inflation
(%)

CP Jan 2009

5,8

11,2

5,4

3,6

– 0,1

COM Jan 2009

5,8

11,1

5,6

4,8

n.a.

CP Dec 2007

5,8

6,5

5,1

3,6

n.a.

Output gap (1)
(% of potential GDP)

CP Jan 2009

7,1

5,4

– 2,8

– 5,7

– 4,0

COM Jan 2009 (2)

7,7

6,6

– 0,5

– 4,8

n.a.

CP Dec 2007

3,3

1,5

– 0,4

– 1,3

n.a.

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2007

2008

2009

2010

2011

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

General government
revenue
(% of GDP)

General government
expenditure
(% of GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

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

Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

CP Jan 2009

– 12,7

– 10,2

COM Jan 2009

– 13,2

– 10,7

– 1,8

– 4,8

– 4,7

– 4,7

CP Dec 2007

CP Jan 2009

COM Jan 2009

CP Dec 2007

CP Jan 2009

COM Jan 2009

CP Dec 2007

CP Jan 2009

COM Jan 2009

CP Dec 2007

CP Jan 2009

COM Jan 2009

CP Dec 2007

CP Jan 2009

COM Jan 2009

CP Dec 2007

CP Jan 2009

COM Jan 2009

CP Dec 2007

CP Jan 2009

COM Jan 2009

CP Dec 2007

– 12,5

– 12,7

– 14,5

– 15,4

33,9

33,9

35,5

35,2

35,2

36,4

– 1,2

– 1,2

– 0,9

– 0,5

– 0,5

– 0,1

– 3,1

– 3,3

– 1,8

– 2,6

– 2,7

– 1,2

17,0

17,0

17,6

33,8

33,9

37,4

36,7

36,8

37,9

– 2,9

– 2,9

– 0,5

– 2,3

– 2,2

0,3

– 4,4

– 4,6

– 0,9

– 4,9

– 4,6

– 0,9

15,3

17,1

17,2

35,8

34,8

38,6

37,8

37,8

38,5

– 2,1

– 3,0

0,2

– 1,2

– 2,0

0,9

– 1,3

– 2,9

0,3

– 1,8

– 2,9

0,3

16,9

20,0

15,0

37,3

36,0

39,4

38,3

39,4

38,6

– 1,0

– 3,4

0,8

0,0

– 2,3

1,4

0,5

– 2,1

1,1

0,1

– 2,1

1,1

18,1

23,3

14,0

– 5,7

n.a.

n.a.

36,4

n.a.

n.a.

36,4

n.a.

n.a.

0,0

n.a.

n.a.

1,1

n.a.

n.a.

1,1

n.a.

n.a.

1,1

n.a.

n.a.

17,1

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 6,1 %, 4,5 %, 2,8 % and 1,8 % respectively in the period 2007-2010.
(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, 0,5 % in 2008, 0,5 % in 2009 and 0,5 % in 2010; all deficit-reducing according to the most recent
programme and 0,6 % of GDP in 2007; deficit-increasing according to the Commission services' January interim forecast.

Source:
Convergence programme (CP); Commission services' January 2009 interim forecasts (COM); Commission services' calculations.