Country Report Lithuania
Six months ahead of its euro area accession, Lithuania’s economy performs strongly. While reciprocal EU and Russian sanctions are unlikely to derail growth this year, tensions with Russia may result in further boycotts of Lithuanian products.
Strengths (+) and weaknesses (-)
(+) Proven track record of ability for swift economic rebalancing
Following several pre-crisis years of sizeable macroeconomic imbalances, Lithuania has shown its ability to rebalance its economy and regain competitiveness by means of internal devaluation.
(+) Ongoing commitment to fiscal prudence
Given the overarching goal of euro area accession in 2015, Lithuania’s political elite is strongly committed to prudent macroeconomic policies and ongoing fiscal consolidation
(-) Strong exposure to external economic shocks
Lithuania’s small and very open economy is exposed to external demand shocks, particularly from the euro area and Russia. Given frequent current account deficits, an increase in global risk aversion could reduce the availability of needed external financing.
(-) High external debt levels and financing needs
Lithuania’s external debt, mainly parent bank loans and foreign-held government bonds, remains at elevated levels and burdens the economy with considerable debt servicing costs.
1. Impact of tensions with Russia on the so far solid economic recovery are limited
The recent reciprocal imposition of sanctions by the European Union and Russia amid the conflict in Ukraine is unlikely to derail Lithuania’s so far robust economic recovery. Having expanded by 3.3% last year, Lithuania’s real GDP increased by 3.1% yoy in both Q1 and Q2 of this year. Domestic demand remained solid even as tensions with Russia started to weigh on confidence indicators. Having replaced net exports as the main growth driver in 13Q2, domestic demand has been boosted by marked nominal wage increases, low inflation and declining unemployment. Meanwhile, high capacity utilization rates have spurred private investment. External demand for Lithuanian products is suffering from refining overcapacities in Europe that undermine refined oil exports of the Orlen Lietuva refinery, as well as a Russian ban on EU food imports. Even though about 20% of Lithuania’s total exports are destined for Russia, the direct impact of EU and Russian sanctions on overall growth will likely remain limited. Given the importance of re-exports, Lithuanian-made exports to Russia only account for about 2.5% of total exports (see figure 2), which limits the impact of recent tensions on Lithuania’s economy, even as the transportation sector will likely be hit hard.
Barring a major decline in confidence, which should benefit from recent NATO promises to protect the Baltic states against Russia, the currently imposed sanctions are expected to slow GDP growth by 0.2 percentage points this year to a still solid 3%.
2. Lithuania to join the euro area on January 1st, 2015
Following in the footsteps of its two Baltic peers, Lithuania will become the 19th member of the euro area on January 1st, 2015, as the European Council admitted the country to the single currency area in late July 2014. While earlier attempts at joining the euro area had failed because of too high inflation and fiscal deficits, the successful implementation in recent years of an internal devaluation strategy ensured that the country now complies with all accession criteria comfortably. Given a budget deficit of 2.2% of GDP and public debt of 40%, Lithuania’s public finances rank among the strongest within the euro area, while inflation of 0.6% in the reference period (May 2013-April 2014) came in well below the reference value of 1.7%. The remaining criteria regarding the stability of the exchange rate of the local currency vis-à-vis the euro and the level of long-term interest rates were also met without problems. Even though in July only half of Lithuania’s public supported euro area accession, the country is expected to benefit from joining the single currency area in various ways. Exchange rate risks related to the country’s large euro-denominated external debt burden will be eliminated, while local banks will get access to the ECB’s liquidity facilities. Even though Lithuania will have to contribute up to EUR 290m to the ESM rescue fund in the upcoming five years, public finances should also benefit from the changeover. Besides gaining access to emergency ESM funds, if needed, the public sector will be able to issue debt in euros without exchange rate risks, which could translate into declining risk premia. Since the local currency, the litas, is not overvalued at the set conversion rate, euro introduction should not undermine Lithuania’s regained price competitiveness. In spite of the advantages of euro area accession, a repetition of Lithuania’s pre-crisis credit boom remains unlikely. The country’s mainly Scandinavian banks have adopted a more cautious approach in recent years, which also entails bringing credit provision in line with local funding possibilities. Notwithstanding, euro introduction is not completely risk-free, as Lithuanian policymakers will have to ensure that inflation, likely boosted by the country’s catch-up process, does not undermine price competitiveness.
3. Lithuania’s ‘Iron Lady’ re-elected amid concerns about Russian foreign policy
Lithuania’s incumbent president Dalia Grybauskaite was re-elected in May, following her decision to forego a position in Brussels and remain in Lithuania in light of Russia’s annexation of Crimea and its military manoeuvres on its border with the Baltic states. Besides reflecting her current popularity, her re-election also illustrates Lithuanians heightened concerns about Russian aggression given Lithuania’s Soviet past and the presence of a small Russian minority (6% of the population). Lithuania has been a staunch proponent of permanent deployment of NATO troops in the Baltics and a harsh Western response to Russian foreign policies. In line with her reputation as an outspoken critic of Russian president Putin, Ms Grybauskaite will push for an improvement of the country’s defence capacities and a further reduction of Lithuania’s energy dependency on Russia. Bilateral relations between the two countries are consequently likely to remain very tense. While the actual threat of Russian military aggression against Lithuania is limited, the country remains exposed to additional Russian sanctions or boycotts. Pending the completion of a floating LNG terminal in Klapeida next year that can meet two-third of Lithuania’s domestic gas consumption, this holds in particular for Russian energy exports, on which the country is currently heavily dependent.
Lithuania, the southern-most of the three Baltic countries, is a small and very open economy with a nominal GDP of USD 46bn (2013). Given a total population of 3 million inhabitants, GDP per capita amounts to a comparatively low USD 15,470 (or USD 25,352 in PPP terms), which suggests considerable catch-up potential vis-à-vis the country’s western EU peers. While agriculture still contributes about 3% of GDP, the country is relatively industrialized, whereby the PKN Orlen Lietuva refinery has a dominant position within the sector. Besides refined oil products, machinery and transport equipment, as well as chemicals constitute important export products. Reflecting the importance of the refinery, imports are dominated by mainly Russian oil imports. In spite of Lithuania’s close economic ties with its eastern neighbour, bilateral relations between the two former Soviet republics remain tense. Similar to its Baltic peers, Lithuania opted for strong Euro-Atlantic ties following its independence from the Soviet Union, which is reflected in its strong commitment to NATO membership and a general political consensus on swift accession to the euro area. In spite of a very deep recession in 2009 and an ensuing strict fiscal consolidation course pursued by the previous and the current government, Lithuania’s political and social situation is quite stable. Lithuania’s population seems to have accepted the need for internal devaluation and preferred emigration over protesting. Thanks to the successful implementation of these policies, Lithuania succeeded in reining in large current account and budget deficits and restored its export competitiveness.