Lithuania

Highlights and Key Issues

* Inflation and external deficits remain lower than in other Baltic countries, but less ambitious fiscal tightening - with no clear surplus until 2011 - means a similar prospect of growth slowdown in 2008-11 and euro adoption being delayed until after 2012. Although public debt remains low and banks solvent, there is growing concern about the sustainability of rising private debt.

* The present commitment to an income tax cut and the growth slowdown now under way rule out a tightening of fiscal policy and leave the weight of adjustment on the monetary discipline imposed by the currency board. So far, this has restrained the growth of industrial investment and output more substantially than that of consumer spending.

* Having secured a tighter 2008 budget in December, the minority coalition has said it will support a move to early elections in an effort to create stronger government. The highly proportional system is expected to produce another divided parliament, requiring coalition building that will prevent any acceleration of moves to consolidate the budget more quickly.

* Although a slowdown is unavoidable, it will be cushioned by a turnaround in the trade deficit from this year as imports slow more rapidly than exports. Even with an upside risk from energy and food import prices, the current account deficit is set to peak at a financeable level, preserving the fixed exchange rate and ensuring a return towards EU average inflation by 2011.

Overview

Monetary brakes get sharper...

* After growth of almost 9% in 2007, the economy is set to slow in 2008-10 as the fixed exchange rate offsets the surge in demand that has caused present inflation and current account overshoots. The external deficit, up 44% on the year to LTL9.7bn (US$4.1 bn) in the first ten months of 2007, was previously not a policy priority because it has been financed largely by private borrowing in foreign currency from domestic units of secure Scandinavian banks. However, tighter international credit conditions, although not directly endangering these banks, have restricted their capacity and raised the urgency of containing private external debt.

...but inflation pressures continue...

* Inflation, which climbed to 7.8% in November, has been fuelled by a tight labour market and sharp food and fuel price rises as well as by domestic credit growth. The headline rate is now at its highest for ten years, and contributes to the widening external deficit by raising relative costs and restraining export growth. The central bank expects the annual rate to keep rising through Q1 2008, with an early-year rise in gas and home heating costs passing through into utility bills. While the government has been expecting the imported Russian gas price to rise by around 25%, to US$300 per thousand cubic metres, Gazprom has hinted at a rise to over US$350.

...as private borrowing costs rise

* Higher import prices also continue to widen the trade deficit, which is the main source of external imbalance. Although the current account deficit shrank to 12.3% of GDP in Q3 2007 from 16.1% in Q2, this resulted more from import restraint due to slower production growth than from any improvement in exports. The costs of servicing the external debt are also set to rise. Ratings agency Fitch placed a negative outlook on its A sovereign credit rating on 7 December, citing private sector indebtedness and the widening external deficit. Even if this can be successfully financed, there is a growing likelihood that this will delay euro adoption until 2013, up to three years after the official target. Such rating actions will impede the government's efforts to reduce the cost of its own debt, through a EUR400m (US$270m) eurobond scheduled for Q1.

Early elections expected...

* Although it has kept public debt low, the government has not offset the private sector deficit with fiscal surpluses, and the slowdown in growth will make it harder to achieve these. The present minority coalition lacks the strength to force through measures to tighten the budget, and an imminent phase of new coalition-building may further delay this process.

* Parliamentary elections due by October are to be brought forward to February or March after the ruling Social Democrats indicated they would support opposition calls for an early dissolution. Prime Minister Gediminas Kirkilas needs a positive swing to regain a majority for his four-party coalition, and may attain this on the strength of recent rapid output and wage growth and entry to the EU's borderless Schengen area. But the prospect is for another deeply divided parliament, requiring a multi-party coalition that will not be well placed to implement tighter budgeting or wage control.

...but budget tightening unlikely

* The draft 2008 budget approved in early December still shows an EU-definition deficit of around 1% of GDP. The finance ministry has said more recently that it will close the gap to 0.5%, and finance minister Sadzius has hinted at working for a surplus in 2009, but officially this is not expected until 2010. Current government forecasts, showing GDP growth slowing to 5.3% this year from around 9% in 2007, indicate that it will be hard to avoid renewed loosening of the budget unless there are significant expenditure cuts or a rise in the flat-rate income tax, which no party will wish to propose ahead of the election.