On May 13, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with the Republic of Lithuania.

Economic growth suffered a temporary setback from a difficult external environment last year. Private consumption and investment expanded strongly, but exports were stagnant, reflecting sluggish demand from trading partners, particularly Russia. GDP grew by only 1.6 percent, compared to an average of 3.5 percent per year during 2012–14. Wages rose strongly in a tightening labor market, but inflation was nonetheless slightly negative on account of declining energy and food prices. Investment benefitted from high capacity utilization and a revival of credit growth. Weak exports also meant that the current account balance moved from a surplus into a moderate deficit.

Growth should pick up to 2.7 percent this year as the drag from external developments diminishes. Domestic demand is set to remain solid—wage growth continues to be robust and there still is pent-up demand for investment. Demand growth from export partners should be somewhat higher than last year, with Russia’s recession easing and its importance for Lithuanian exports already diminished. That said, risks remain tilted to the downside, reflecting the global risks to which Lithuania’s small open economy is highly exposed.

Executive Board Assessment²

Executive Directors commended the authorities for the recent gains in macroeconomic management, which have helped Lithuania advance income convergence with Western Europe and weather a difficult external environment in 2015. While medium-term growth prospects are favorable, continued economic progress will hinge on structural reforms geared toward productivity enhancement, safeguarding competitiveness in a tightening labor market, and addressing high income inequality while preserving fiscal gains.

Directors welcomed the completion of the multi-year fiscal consolidation effort, with the structural fiscal position reaching balance in 2015. It will be important to preserve these hard-won gains and to build fiscal buffers while supporting growth. In this regard, Directors cautioned against new unfunded spending initiatives or tax cuts. On the revenue side, they called for efforts to strengthen tax administration.

Directors underscored the importance of continued productivity gains for a sustainable improvement in living standards. They welcomed the steps taken to improve the business environment and the authorities’ intention to modernize labor relations in a new labor code. In particular, Directors emphasized the need to improve the employability of labor by boosting training, addressing labor market mismatches, and lowering the tax wedge for low-income earners. Innovation policies, with a key focus on company upgrading, would also be essential to raise long-run growth.

Directors agreed that external competiveness remains intact, but underscored the need for vigilance in view of emerging pressures. While boosting productivity is the priority, containing wage growth until these efforts bear fruit is also critical. In this context, Directors recommended a cautious approach in minimum wage policies given the potential negative impact on competitiveness. The sharp increases since 2012 have significantly narrowed the gap between minimum and average wages, which could harm employment prospects for the low-skilled. Directors also urged close monitoring of non-price competiveness given the recent stagnation in export market shares.

Directors considered high income inequality as weighing on macroeconomic prospects. They urged the authorities to push ahead with measures that serve the dual purposes of boosting growth and helping the disadvantaged, with an emphasis on measures to improve the employability of labor. Redistribution policies, in the form of a more progressive tax system and higher social spending could also be considered, to the extent they are consistent with social preferences. Directors considered the “new social model” to be a step in the right direction, while calling for careful consideration of its social and financial implications.

Directors acknowledged that the financial system is sound and welcomed the nascent credit recovery. They urged the authorities to continue cooperating closely with banks’ home-country authorities, adopt quickly legislation to address weaknesses in the small credit union sector, and continue to support credit to SMEs.