2015 JUNE

2015

LITHUANIAN ECONOMICREVIEW

ISSN 2029-8471 (online)

Lithuanian Economic Review analyses the developments of the real sector, prices, public finance and credit in Lithuania, as well as the projected development of the domestic economy. The material presented in the Review is the result of statistical data analysis, modelling and expert assessment. The Review is prepared by the Bank of Lithuania.

© Lietuvos bankas, 2015

Reprinting is allowed only for education and non-commercial purposes, if the source is indicated.

During the preparation of the Lithuanian Economic Review, the data of the Bank of Lithuania, Statistics Lithuania, the European Central Bank, Eurostat, the International Monetary Fund, Bloomberg and other data published up to 20 May 2015 were used.

Contents

ECONOMIC OUTLOOK ........................................................................................................................................................................... 3

I. INTERNATIONAL ENVIRONMENT....................................................................................................................................................... 5

II. REAL SECTOR .................................................................................................................................................................................. 13

III. LABOUR MARKET............................................................................................................................................................................ 15

IV. EXTERNAL SECTOR ....................................................................................................................................................................... 16

V. PRICES AND COSTS ........................................................................................................................................................................ 18

VI. FINANCING OF THE ECONOMY ..................................................................................................................................................... 20

VII. GENERAL GOVERNMENT FINANCE ............................................................................................................................................. 22

ANNEXES .............................................................................................................................................................................................. 24

ANNEX 1. Estimation of household disposable income and the saving ratio at quarterly frequency .................................................. 24

ANNEX 2. Fiscal rules in the European Union and Lithuania ............................................................................................................ 27

Box

Eurosystem’s monetary policy instruments and their application in Lithuania………………………………………………………………………………………8

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List of tables and charts

Table

GDP and inflation developments in selected advanced and emerging market economies ......................................................... Error! Bookmark not defined.

Charts

Chart 1. Ten-year government bond yields for selected euro area countries................................................................................................................................ 5 Chart 2. US labour market development ........................................................................................................................................................................................ 5 Chart 3. Developments of euro-area purchasing managers’ indexes ........................................................................................................................................... 6 Chart 4. Russia’s real GDP development ...................................................................................................................................................................................... 6 Chart 5. Development of real GDP of Lithuania’s important export partners — Poland, Latvia, Estonia and Germany .............................................................. 6 Chart 6. Contributions to the development of real GDP by expenditure approach ..................................................................................................................... 13 Chart 7. Contributions to the development of domestic investment (at constant prices) ............................................................................................................ 13 Chart 8. Contribution of real net exports of goods and services to annual GDP growth ............................................................................................................. 14 Chart 9. Contributions to labour force change ............................................................................................................................................................................. 15 Chart 10. Hiring indicators ............................................................................................................................................................................................................ 15 Chart 11. Wages ........................................................................................................................................................................................................................... 15 Chart 12. Contributions to the exports of goods of Lithuanian origin (three-month moving sum) ............................................................................................... 16 Chart 13. Developments in the exports of Lithuania’s products broken down by geographical market (not including mineral products) .................................. 16 Chart 14. Exports of dairy products of Lithuanian origin broken down by country or region (seasonally adjusted data) ........................................................... 16 Chart 15. Exports of meat products of Lithuanian origin broken down by country or region (seasonally adjusted data) ........................................................... 17 Chart 16. Contributions to annual HICP inflation ......................................................................................................................................................................... 18 Chart 17. Global oil price and fuel prices in Lithuania .................................................................................................................................................................. 18 Chart 18. Developments in unit labour costs, import prices and producer prices ...................................................................................................................... 18 Chart 19. Drivers of net lending/borrowing ................................................................................................................................................................................... 20 Chart 20. Contributions to annual changes in MFIs’ loan portfolio .............................................................................................................................................. 20 Chart 21. Annual changes in currency in circulation and deposits .............................................................................................................................................. 20 Chart 22. Contributions to the development of general government balance ............................................................................................................................. 22 Chart 23. Contributions to the development of general government revenue ............................................................................................................................. 22 Chart 24. VAT revenue target of state budget vs actual VAT revenue ........................................................................................................................................ 22 Chart 25. Contributions to the development of general government expenditure ....................................................................................................................... 23 Chart 26. General government debt ............................................................................................................................................................................................. 23

Abbreviations

% per cent

CIS Commonwealth of Independent States

EC European Commission

ECB European Central Bank

ERM II The Exchange Rate Mechanism

EU European Union

Eurostat statistical office of the European Union

GDP gross domestic product

HICP harmonised index of consumer prices

ICT information and communication technologies

IMF International Monetary Fund

LTL Lithuanian litas

MFI monetary financial institutions

NCB National Central Bank

OPEC Organization of the Petroleum Exporting Countries

p.p. percentage point

US United States of America

USD United States dollar

VAT value added tax

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ECONOMIC OUTLOOK

The growth of the domestic economy has decelerated due to the challenging external environment. Lithuania’s exports to Russia fell by

approximately one-fourth in the first months of this year as a result of economic deterioration in that country. As compared to late 2014, the decline

in exports to Russia became more pronounced due to a substantial depreciation of the Russian rouble. Real disposable household income in that

country continued to decrease, dragging down the retail sector and, in contrast to previous periods, private consumption. Although a substantial

economic deterioration in Russia was anticipated, its imports have been falling much faster than expected, acting as a drag on exports performance

in Lithuania and in other countries involved in trade with Russia. As a result, the outlook for exports has become gloomier not just in Lithuania, but

also in its important trade partner countries, such as the Baltic States.

The fall of exports to Russia have substantial negative repercussions for the transport sector. Recently, re-exports, i.e. goods produced

outside Lithuania, have accounted for more than 90 per cent of goods’ exports to Russia. Most of the negative effects from the decrease of re-

exports are experienced by transportation services providers, merchants and warehousing services suppliers. Freight transportation to Russia

accounts for a substantial proportion (of more than one tenth) of transport services provided in Lithuania. Hence the recession in Russia has a

noticeable impact on transport economic activity.

Another segment of the tradable sector, i.e. industry, appears healthier as the country’s manufacturers export the bulk of their output to the

European Union’s (EU) markets. A gradual pickup of economic development in these countries fuels continued growth of exports of the Lithuanian

corporates to these markets and, simultaneously, the growth of export market share in the EU. Manufacturing performance is also supported by

domestic demand. For more than a year, the expanding domestic market has been contributing about half of the growth observed in manufacturing,

excluding petroleum products.

Domestic demand remains the key factor of economic growth in the country, with the biggest contribution coming from private consump-

tion, which has been growing amid gradual increase in household income and non-increasing saving as household expectations remain robust.

Private consumption is expected to continue strengthening consistently as the growth of wages and employment will augment household income.

Consumption possibilities will also be enhanced by the fall in prices, in particular for fuel, which leaves the consumers with more money to spend on

other goods or services. At the same time, it cannot be ruled out that the consumers may be reluctant to spend the money saved due to cheaper

fuel as they may expect the prices to rise again after recent slumps.

Up till now, economic activity has also been driven by investment projects. Changes in the real estate market and corporate development

have thus far fuelled the construction of residential and non-residential properties. In addition, the public sector has been developing a range of

infrastructure projects. Investment is expected to continue growing in the nearest future, to some extent due to the take-up of funds from the

previous EU’s financial framework. However, the outlook for investment is clouded by high uncertainty. The worsened international environment

may force many companies to put off their investment projects. Negative effects for investment may stem both from the weakened state of economy

in Eastern European countries and from the uncertainty over the sustainability of economic growth in the developed markets as the assessment of

the economic outlook in some of these countries has become more cautious.

Growing domestic demand will continue as the biggest contributor to overall economic growth in the nearest future. The outlook for

domestic demand remains unchanged as compared to previous macroeconomic forecasts. However, the forecast of this year’s economic growth is

nevertheless revised down to 2.0 per cent against the backdrop of worse-than-expected exports performance. The growth of exports is only

expected to resume in the second half of the year with the recovery of the growth of imports by Lithuania’s foreign trade partners. Gradual economic

improvements in these countries should contribute to the acceleration of Lithuania’s economic growth. Hence Lithuania’s real GDP is forecast to

grow by 3.4 per cent in 2016.

The consumer price level remains below the one observed a year-earlier, mainly due to a slump in prices for energy commodities. Global oil

prices have increased somewhat in recent months, but not enough to offset the fall recorded in the second half of last year. Oil prices are kept lower

by both weak demand for this energy commodity and by a supply glut. Hence this fall in crude oil prices is likely to be longer-lived. Stripping out

energy costs, the growth of consumer prices has been marginal. For example, the growth of food prices has slowed down dramatically against the

backdrop of a downward trend in world food commodity prices, which has been observed for a while, and a decline in food producer prices in the

domestic market. At the same time, however, prices for services have been on an upward path due to sustained growth of domestic demand. The

outlook for price developments remains unchanged as compared to previous macroeconomic forecasts. Prices related to energy commodities are

expected to stay depressed and act as a drag on annual inflation in the near time while the growth of other prices will remain broadly stable. The

average annual inflation rate in Lithuania is projected to be –0.3 per cent this year. Next year, it is forecasted to increase as no further falls in energy

prices are envisaged.

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Outlook of Lithuania’s economy in 2015–2016

June 2015 projectiona March 2015 projection

2014 2015b 2016b 2014b 2015b 2016b

Price and cost developments (annual percentage changes)

Average annual inflation, as measured by the HICP 0.2 –0.3 1.6 0.2 –0.3 1.6

GDP deflatorc 0.9 0.1 1.4 0.8 0.1 1.5

Wages 4.7 4.9 4.9 4.9 4.9 4.9

Import deflatorc –2.9 –3.8 0.9 –2.8 –4.0 0.8

Export deflatorc –2.4 –2.5 0.2 –2.8 –3.6 0.2

Economic activity (constant prices; annual percentage changes)

Gross domestic productc 3.0 2.0 3.4 2.9 2.7 3.5

Private consumption expenditurec 4.6 3.4 4.0 4.7 3.4 4.0

General government consumption expenditurec 1.4 1.3 1.2 1.2 1.2 1.2

Gross fixed capital formationc 7.8 3.0 4.0 8.1 3.0 4.0

Exports of goods and servicesc 3.3 0.1 4.3 3.7 3.8 5.0

Imports of goods and servicesc 5.4 1.5 4.5 4.9 4.0 5.3

Labour market

Unemployment rate (annual average as a percentage of labour force)

10.7 10.0 9.2 10.7 9.9 9.2

Employmentd (annual percentage change) 2.0 0.6 0.5 2.0 0.6 0.5

External sector (as a percentage of GDP)

Balance of goods and services 0.0 0.0 –0.7 0.2 0.2 –0.5

Current account balance 0.2 0.0 –1.8 0.0 0.0 –1.4

Current and capital account balance 2.9 2.8 0.1 2.9 3.1 0.4 a These projections of macroeconomic indicators are based on information made available by 20 May 2015.

b Projection

c Adjusted for seasonal and workday effects

d National accounts data; employment in domestic concept

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I. INTERNATIONAL ENVIRONMENT

The global economy continues to expand at an uneven pace with

economic growth accelerating in some regions and countries and

decelerating in others. The growth of the emerging market economies,

such as China, CIS and Latin American countries, has been losing steam

for a while. Meanwhile, the growth of UK and US economies remains on a

sustainable path and the outlook for economic growth in the euro area and

Japan is brightening. As estimated by the IMF, the global real GDP will

grow by 3.5 per cent in 2015 and will exceed the growth rate recorded in

2014 by 0.1 p.p. Global commodity prices continued to slide early in 2015,

which supported the real disposable income and the real consumption

level in commodity-importing countries but put downward pressure on

inflation.

World central banks continue to maintain their accommodative

monetary policy stances. A number of central banks cut their bench-

mark interest rates early in 2015 and some of them introduced additional

monetary policy stimuli to support the economy in the context of sliding

inflation and cautious expectations about the pace of global economic

growth. An expanded asset purchase programme (APP) was launched in

the euro area in March. The Eurosystem’s purchases of bonds issued by

the euro area’s sovereigns, agencies and European institutions fuelled

demand for debt securities, brought down their yields and drove up Euro-

pean stock indexes. The bank lending survey conducted by the ECB in

the first quarter has shown that additional liquidity from the APP was used

by banks for granting loans. The programme led to improvements in credit

availability and in credit standards, in particular for corporates.1 The US

Federal Reserve unwinded its quantitative easing programme altogether

in the autumn of 2014 and plans to raise interest rates once the economic

conditions are ripe (this will depend on the levels of unemployment rate

and inflation).

The US economy slowed down in the first quarter of 2015, but the

slowdown is likely to be temporary and the growth outlook remains

positive. Retail sales decreased early this year, industrial production lost

momentum and housing starts fell. In addition, inflation remained low and

the appreciating US dollar weighed on US exports. At the same time,

other indicators paint a bright outlook for the US economy amid strong

domestic demand and improvements in the labour market. In March, the

unemployment rate decreased to 5.5 per cent, getting a notch closer to

the long-term average of approximately 5.0 per cent. This is coupled with

the growth of wages and employment as well as the acceleration of job

creation (early in 2015, the biggest increases in employment were record-

ed in the professional and business services sectors). As estimated by the

IMF, the US GDP will expand by 3.1 per cent in 2015.

The first euro area’s economic data for 2015 indicates that the re-

covery in the euro area is progressing. The purchasing managers’

indexes (PMI) — the leading indicators of economic activity — have been

improving since the autumn of 2014 and signalling the recovery of the

services and manufacturing sectors. Consumer confidence indexes have

also been rising, reflecting improvements in consumer expectations. The

weakening of the euro bolsters the competitiveness of the euro area’s

merchandise exports in external markets. In addition, the beginning of

2015 saw an increase in the current account surplus. Nevertheless, the

recovery remains fragile as the growth of retail sales and industrial pro-

duction remains weak. Moreover, the inflation rates recorded in the first

months of 2015 were way below the level targeted by the ECB. The

unemployment rate in the region remains high (of 11.3% in February) and

_________________________________ 1 For details about the APP see the box on Eurosystem’s monetary policy instruments and their

application in Lithuania.

The growth of the global economy remains uneven: accelerating in advanced economies and decelerat-ing in emerging economies.

GDP and inflation developments in selected advanced and emerging market economies

2014 2015* 2016*

Real GDP change, per cent

Global 3.4 3.5 3.8

Advanced economies 1.8 2.4 2.4

US 2.4 3.1 3.1

Euro area 0.9 1.5 1.6

Emerging market econo-mies

4.6 4.3 4.7

China 7.4 6.8 6.3

Russia 0.6 –3.8 –1.1

Inflation, per cent

Advanced economies 1.4 0.4 1.4

US 1.6 0.1 1.5

Euro area 0.4 0.1 1.0

Emerging market econo-mies 5.1 5.4 4.8

China 2.0 1.2 1.5

Russia 7.8 17.9 9.8

Source: IMF.

* Forecasts.

The yields on euro-area sovereign bonds (not including Greece) drifted further down as the ECB embarked on the expanded asset purchase programme.

Chart 1. Ten-year government bond yields for selected euro area countries

The US labour market continues to improve. In particular, the unemployment rate fell to 5.5 per cent in March 2015.

Chart 2. US labour market development

0

4

8

12

16

20

24

28

2012 2012 2013 2013 2014 2014 2015

ItalyFranceSpainGreeceGermany

Source: Eurostat.

Per cent

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

30

80

130

180

230

280

330

380

430

480

2012 2013 2014 2015

Unemployment rate (right-hand scale)

Monthly changes in non-farm employment

Sources: U.S. Bureau of Labour statistics and Bank of Lithuania calculations..

Thous. Per cent

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the implementation of structural reforms, which are necessary to address

employment challenges, remains still sluggish and sporadic. Downside risks

to economic growth in the euro area include the ongoing conflict in Ukraine

and financial troubles in Greece, which is battered by the debt crisis.

The growth of investment in the EU remains weak and dampens

the recovery of the region’s economy. Hence the European Commis-

sion plans to step up investment promotion through the EUR 315 billion

worth2 Investment Plan for Europe, which was launched by the Commission

in 2014 with the aim to drive investment, the region’s competitiveness and

economic growth. The plan envisages provision of financing to projects

focused on infrastructure development, research, IT, innovations, energy

sector development and other important sectors. The Investment Plan

should be endorsed by the European Parliament in June. Early in 2015, the

Commission also came forward with proposals on the EU Energy Union, the

Capital Market Union and the Digital Single Market. In addition, it seeks to

finalise negotiations with the United States on the Transatlantic Trade and

Investment Partnership (TTIP) agreement by the end of 2015.

Russia’s economy, which is hugely dependent on oil prices, re-

mains in the doldrums. In 2014, Russia’s real GDP eked out a meagre

0.6 per cent gain and is poised to contract by 3 to 4 per cent in 2015, based

on the estimates from various Russia’s and international institutions. All of

the “Big Three” rating agencies, i.e. Fitch, Moody’s and Standard & Poor's,

downgraded Russia’s credit rating early in 2015. The weak rouble and high

inflation are eroding purchasing power of Russia’s households, which leads

to a decrease in consumption spending and imports. Although the unem-

ployment rate remains relatively low, real wages and real disposable income

are plummeting. With the general government revenue falling, Russia’s

Finance Ministry now expects the budget deficit to GDP ratio to widen to

3.8 per cent in 2015 (instead of previously planned 0.6%). With the conflict

in Ukraine showing no signs of abating, the EU leaders agreed to extend

and maintain economic sanctions against Russia until full implementation of

the Minsk Agreement. This means that external capital markets will remain

shut for a number of Russia’s banks and undertakings, hence external

borrowing will continue to be limited. Despite these negative developments,

the Russian rouble has appreciated against the US dollar and the euro since

the beginning of the year and Russia’s central bank has started cutting its

benchmark interest rates in small increments. The cost of Russian credit

default swaps returned to a downward path in March while the Russian

stocks and stock indexes recorded gains.

Although exports to Russia have been decreasing, economic

growth outlooks for Lithuania’s important trade partners, i.e. Poland,

Latvia, Estonia and Germany, still appear favourable. GDP growth in

Latvia, Estonia and Poland is underpinned by the recovery of domestic

demand, the decrease of unemployment level, the growth of wages and

improvements in the euro area. Germany’s real GDP grew by 1.6 per cent in

2014 and the growth is expected to accelerate in 2015 amid improvements

in the labour market, consumption spending and exports. The Stability

Programme adopted by the German government aims to maintain a bal-

anced budget and to reduce the sovereign debt to GDP ratio. Also, it targets

a substantial increase in public investment.

Growth trends observed in Scandinavian economies are uneven.

Denmark’s economy returned to growth after two years of recession in 2014

and the national central bank expects the GDP to grow by 2 per cent in

2015 in the environment of low oil prices, low interest rates and depreciated

_________________________________ 2 The plan will use EUR 5 billion committed by the European Investment Bank and a guarantee of

EUR 16 billion from the EU budget to raise fifteen times as much in private funds.

The growth of euro area’s PMIs signals potential acceleration of economic growth in 2015.

Chart 3. Developments of euro-area purchasing managers’ indexes

The growth of Russia’s GDP decelerated in the past year and the country is tipped to fall into recession in 2015.

Chart 4. Russia’s real GDP development

Russia’s economic weakness and its sanctions have an adverse effect on the growth of European economies; however, that effect is limited as Lithuania’s important export partners have all managed to avoid a major slowdown.

Chart 5. Development of real GDP of Lithuania’s important export partners — Poland, Latvia, Estonia and Germany

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45

47

49

51

53

55

2012 2013 2014 2015

Euro area's PMI

Euro area's Manufacturing PMI

Euro area's Services PMI

Source: Bloomberg.

–6

–4

–2

0

2

4

6

2010 2011 2012 2013 2014 2015

Actual data

IMF forecast (April 2015)

Consensus Economics forecast (March 2015)

World Bank forecast (March 2015)

Sources: Russian Federation Federal State Statistics, IMF, World Bank, Consensus Economics.

–9

–6

–3

0

3

6

9

2010 2011 2012 2013 2014 2015

EstoniaLatviaPolandGermany

Per cent

Source: Eurostat.

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effective exchange rate. At the same time, low oil prices are dragging down

Norway’s economic performance, hit by a fall of oil and gas investment and

slowdown of wage growth. However, the Norwegian central bank left its key

interest rate of 1.25 per cent unchanged early in 2015 in view of surging

house prices. The central bank of Sweden cut its repo rate to –0.25 per cent,

from –0.1 per cent, and increased its quantitative easing programme in

March, mainly due to the appreciation of the krona and low inflation. Other

economic indicators show improvements in this economy, in particular the

growth of employment, household consumptions and exports.

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Eurosystem’s monetary policy instruments and their application in Lithuania

On 1 January 2015, Lithuania joined the euro area and the Bank of Lithuania, accordingly, joined the Eurosys-

tem, which primary objective is to maintain price stability in the euro area.1 This objective of the Eurosystem is

forward-looking and in fact implies the management of mid-term2 inflation expectations to keep them close to the level

defining the stability of prices.

This box provides an overview of monetary policy instruments, which are used by the Eurosystem in pursuit

of its primary objective. It also describes cooperation between the ECB and NCBs in this context and specifies

the Eurosystem’s instruments that are applied by the Bank of Lithuania. First, it presents the standard monetary

policy measures, which the Eurosystem used to pursue its primary objective until 2007. In future, when the euro area’s

economic growth returns to a sustainable path, these instruments may once again become the key or the only tools of

monetary policy. Next, it discusses the Eurosystem’s non-standard monetary policy measures and the reasons behind

their choice as well as the factors, which have led to the current combination of standard and non-standard tools. Finally,

it reviews the use of the Eurosystem’s monetary policy instruments by the Bank of Lithuania.

Standard monetary policy measures

Until August 2007, the Eurosystem pursued its primary objective through the setting of interest rates on monetary pol-

icy operations and through the steering of short-term interest rates of the euro money market (see Chart A) and the

management of liquidity of the banking system (i.e. credit institutions established in the euro area) by way of standard

monetary policy instruments (see Table 1).

Standard monetary policy instruments used by the Eurosystem in the past and/or at present

Monetary policy instru-ment

Maturi-ty/frequency

Purpose

Main refinancing operations (MRO)

1 week/Weekly The Eurosystem uses MROs to lend and refinance funds to the euro area’s credit institutions. The MRO interest rate is the key rate signalling the Eurosystem’s monetary policy stance. Until August 2007, MROs used to be the main monetary policy instrument and used to account for about two-thirds of the total volume of the full set of monetary policy operations.

Longer-term refinanc-ing operations (LTRO)

3 months/Monthly

LTROs are used to provide credit institutions with necessary liquidity, which needs to be refinanced less frequently than MRO loans. Until August 2007, LTROs used to account for about one-third of the total volume of the full set of monetary policy operations.

Fine-tuning operations From 1 to several days/on demand

Fine-tuning operations are executed with the aim of eliminating or smoothing unexpected fluctuations in short-term interest rates, which may appear in periods between regular monetary policy operations. Fine-tuning operations are executed through quick tenders and may be used to either supply or absorb liquidity from the banking system. Fine-tuning operations were occasionally executed up till the end of 2010 and accounted for a minor share of the total set of monetary policy operations.

Standing facilities: overnight marginal lending facility and overnight deposit facility

Overnight/access at the discretion of credit institu-tions

Standing facilities are used to restrict short-term volatility of market interest rates within the interest rate corridor set by the ECB, which has the marginal lending interest rate as its ceiling and the deposit interest rate as its floor. Credit institutions have the discretion to decide when to borrow funds from, or to place funds with the NCB. Until 2008, recourse to the standing facilities was negligible; this was followed by a surge in deposits as the Eurosystem provided boost liquidity to the banking system’s.

Minimum reserve requirements

One month and a half

The purposes of minimum reserves are to stabilise money market interest rates in periods between regular monetary policy operations as well as to support or prop up the banking system’s demand for the Eurosystem’s refinancing operations and, thus, to enhance the Eu-rosystem’s ability to steer market interest rates.

The minimum reserve maintenance period starts on the date of coming into force of a decision on the ECB’s interest rates adopted at a meeting of the Governing Council and ends on the date immediately prior to the coming into force of a decision adopted at the subsequent meeting of the Council. In this way, the ECB’s interest rates usually remain un-changed during the minimum reserve maintenance period.

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Since 2012, the minimum reserve ratio has been 1 per cent (previously, 2%). The minimum reserve requirements are applied to deposits raised by the credit institutions operating in the euro area and to their debt securities issued with an original maturity of up to 2 years. These liabilities of credit institutions account for the bulk of the monetary aggregate M3, which is monitored by the Eurosystem because of its long-term link with inflation.

When using standard and non-standard monetary policy measures, the Eurosystem combines centralised

decision-making and coordination with decentralised implementation. Decisions on the features of instruments and

their combination as well as on the interest rates are drafted by the ECB in cooperation with NCBs through various

committees and working groups. They are adopted by the Governing Council, which comprises the members of the

ECB’s Executive Board and the governors of the euro area’s NCBs. The Governing Council also sets the minimum

reserve requirements and each NCB supervises credit institutions established in its respective country for compliance

with these requirements. The Eurosystem’s lending to credit institutions shall be fully covered by eligible collateral, which

shall comply with the general criteria adopted by the Governing Council. The ECB sets the volumes of particular open

market operations (MROs, LTROs and fine-tuning operations) for the entire euro area, which are then allotted to credit

institutions that choose to participate in centralised tenders. Open market operations are executed by NCBs, which enter

into transactions with the domestic credit institutions that are deemed the winning bidders. The volume of standing

facilities is not restricted at the central level, however, in a normal context, their use by credit institutions is very limited as

a result of interest rates set by the Governing Council: to have access to these facilities, they enter into transactions with

the NCB of their home country. Decentralised execution of the Eurosystem’s monetary policy operations makes them

available to credit institutions in each euro area country, which became especially relevant after the big shock, which the

euro area’s interbank market suffered back in 2008 and has not fully overcome ever since.

Chart A. ECB interest rates and 3-month EURIBOR Chart B. ECB’s key (MRO) interest rate and inflation

Non-standard monetary policy measures used by the Eurosystem until 2015

Since 2007, a period of tensions in the financial sector, the Eurosystem has been coupling its conventional

monetary policy instruments with non-standard measures, which acquired prime importance soon. The Eurosys-

tem played a vital role in stabilising the financial markets and the economy of the euro area in this period full of challeng-

es for the central banks. It gave market participants and public authorities the necessary time to shore up the banking

system and allowed time for governments to embark on the required structural reforms and consolidation of public

finances.

The Eurosystem, in tandem with other major global central banks, rolled out non-standard monetary policy

measures in August 2007, to counter the rise of tensions in the global financial markets and the spread of subprime

crisis. As mutual confidence among credit institutions started crumbling, the central banks, first and foremost, moved to

enhance lending to credit institutions, to lengthen the maturity of loans and to provide access to funding in major foreign

currencies so as to offset the collapse of the interbank market. The Eurosystem, in its turn, increased the volume of

LTROs (which became predominant) and opened up access to borrowing in US dollars to the euro area’s credit institu-

tions. Despite the provision of enhanced liquidity support to the banking system, the Eurosystem continued its interest

tightening cycle until July 2008 as it sought to harness inflation that shot above the 2 per cent threshold (see Chart B).

–1

0

1

2

3

4

5

6

1999 2001 2003 2005 2007 2009 2011 2013 2015

The minimum bid rate in an MRO tender

Deposit facility

Marginal lending facility

3-month EURIBOR

Sources: ECB Statistical Data Warehouse and Bloomberg.

Per cent

–1

0

1

2

3

4

5

6

1999 2001 2003 2005 2007 2009 2011 2013 2015

The minimum bid rate in an MRO tender

Annual HICP developments

Sources: ECB Statistical Data Warehouse and Thomson Reuters Eikon.

Per cent

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The use of non-standard monetary policy measures by the Eurosystem was further intensified in September

2008, when the period of tensions in the financial sector turned into a banking crisis, sparked by the collapse of

Lehman Brothers, an international investment bank headquartered in the United States. The crisis in the banking

sector eventually led to a severe recession, which erupted in 2009. The first necessary step towards restarting the

economy was to restore confidence in the banking system, which plays a vital (and pivotal in the euro area) role in

transmitting accommodative monetary policy signals to the economy. The Eurosystem responded with a standard

measures, which involved rapid lowering of its benchmark interest rates, as well as with a package of unconventional

instruments. In particular, it stopped limiting liquidity provision via MROs and LTROs, introduced a full allotment at a fixed

rate and additional longer-term (6–12 months) LTROs, which quickly became the dominant instrument, and expanded the

range of foreign currencies, provided through loans or swaps, to include Swiss francs, Danish krones and Swedish

kronas as well as British pounds sterling, in addition to US dollars. Between July 2009 and June 2010, the Eurosystem

implemented its first (albeit limited in scale) securities purchase programme, which involved purchasing of covered bonds

issued by credit institutions, as it sought to shore up the supply of credit to the economy. In the first half of 2010, the

banking crisis abated leading to a temporary respite in demand for non-standard measures. However, the Eurosystem

kept the full allotment via MROs and LTROs as the interbank market remained shallow and fragmented (this instrument is

necessary until now).

In May 2010, the Eurosystem had to further broaden the scope of its non-standard measures in response to a

sovereign debt crisis which hit certain euro area countries. The Eurosystem resumed purchase of covered bonds

and initiated limited purchase of government securities of distressed member states in the secondary market through the

Securities Markets Programme in response to an increase in yield spreads for government securities of those crisis-hit

euro area countries relative to respective Germany’s papers and to disruptions in the single monetary policy transmission

mechanism. Based on volumes, the key operations of the Eurosystem in that period included 3-year LTROs conducted in

December 2011 and February 2012, which saw active participation from credit institutions and fully met their total de-

mand of slightly more than EUR 1 trillion. This helped mitigate the crisis, yet the actual breakthrough came in July 2012

with the announcement of outright monetary transactions programme by the ECB President. Those transactions were to

involve unlimited purchases of government securities of crisis-hit euro area’s countries by the Eurosystem on condition

that those countries undertook to implement an economic adjustment programme agreed with the European Stability

Mechanism.3 Tensions in markets for government securities abated before entering into any outright monetary transac-

tions and the Eurosystem wrapped up its purchases of covered bonds and government securities. The outstanding

volume of 3-year LTROs started to decrease rapidly (it fell by 60% by mid-2014) as credit institutions exercised the option

to repay, starting from 2013 and before LTRO maturity, any portions of the amounts obtained through these operations.

In 2013, as the euro area’s economy continued to contract and actual inflation fell below the target, the Eu-

rosystem stepped up its forward guidance in July. This instrument is used to convey a message to the market that

the ECB intends to keep its interest rates at an unusually low level for an extended period of time, given the subdued

outlook for inflation extending into the medium term and economic slowdown.

After cutting its interest rates to record lows, the Eurosystem introduced a new package of non-standard

measures in the second half of 2014, as both the annual inflation in the euro area and its medium-term expecta-

tions fell below the Eurosystem’s primary objective. The decline in inflation and its shift towards the negative territory

was driven by the slump in oil prices, the euro’s appreciation in 2013 and the first half of 2014 and sluggish recovery of

the euro area’s economy. Although cheaper energy resources brought down production costs and encouraged consump-

tion, they also ratcheted up fears of negative side-effects of low inflation as higher real interest rates (in particular in the

euro area’s periphery countries) and weaker chances for the public and private sectors to reduce their debt burden

undermined expectations for growth of the economy and demand and depressed investment.

In 2014, the Eurosystem cut its interest rates by two steps (in June and October), bringing them down to the

levels described as a technical floor. The interest rate on MROs was reduced to 0.05 per cent, and the interest rate on

the marginal lending facility — to 0.30 per cent. The interest rate on the deposit facility was taken into the unconventional,

i.e. negative, territory as it was cut to minus 0.10 per cent in June and brought further down to minus 0.20 per cent in

October. The negative interest rate was charged on both overnight deposits made by credit institutions with NCBs and on

the entire excess reserves held by credit institutions on settlement accounts with NCBs (i.e. the reserves in excess of

minimum reserve requirements).

The Eurosystem established the negative deposit facility interest rate in order to maintain a fairly wide

(0.50 p.p.) interest rate corridor of its standing facilities to support the cross-border euro interbank market.

Moreover, it was a tool to reduce fragmentation of this market, which developed after the banking and sovereign debt

crises, as it encouraged credit institutions from Germany and other euro area “safe havens” to step up lending and

investing of their existing excess reserves, inter alia, in other euro area countries, and, therefore, to narrow interest

spreads between the euro area’s periphery and its core. Although the exchange rate of the euro is not regulated by the

Eurosystem, the exchange rate of the single currency started a downward slide in the second half of 2014 as a result of

divergence in the monetary policy cycles of the euro area and the United States and increasing spreads between rates of

interest on respective financial instruments denominated in US dollars and euros.

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After cutting its interest rates to the technical floor, in 2014 the Eurosystem deployed additional non-standard

measures, which included targeted LTROs (TLTROs), a new (the third) covered bond purchase programme and the first

asset-backed securities purchase programme.

TLTROs, as the key tool of the 2014 package, are intended to support lending to the real economy. The covered

bond and asset-backed securities purchase programmes are aimed at enhancing the effect of TLTROs and supporting

the growth of markets for these securities. However, these programmes are just auxiliary tools, given the limited scale of

these markets and their role in lending in the euro area. The Eurosystem provided credit institutions with access to

TLTROs, which came with an attractive fixed interest rate4 and were subject to borrowing limits based on the portfolios of

loans issued by credit institutions to non-financial corporations and households (excluding loans to households for house

purchase) and outstanding as of April 2014 as well as on the trends displayed by those portfolio in the twelve months to

April 2014 and on their future developments. The Eurosystem plans to conduct eight TLTROs on a quarterly basis from

September 2014 to June 2016. The TLTRO programme will end in September 2018. However, credit institutions will have

to repay the funds raised through these operations under the mandatory early repayment procedure if they fail to reach

the loan portfolio target. The Eurosystem has already conducted the first three TLTROs, worth a total of EUR 310 billion.

In late March 2015, this amount accounted for one-third of the total balance of all liquidity-providing monetary policy

operations conducted by the Eurosystem.

Expanded asset purchase programme (2015)

In January 2015, the Governing Council announced an expanded asset purchase programme (EAPP) as it

sought to reinforce the existing kit of stimulus tools. This programme was introduced in response to the results of the

final quarter of 2014 and forecasts, which showed that the effects generated by the existing package of non-standard

measures would be insufficient to reach the turning point for inflation and its expectations. As participation in the first

TLTROs by credit institutions was rather low, the Governing Council decided to choose pro-active interventions in debt

securities markets as the dominant instrument. The Eurosystem launched purchases of the euro area’s public sector

bonds in the secondary market under the Public Sector Purchase Programme (PSPP) as it sought to enhance the extent

of this tool. The outstanding volumes of these bonds in the market way exceed the respective volumes for covered bonds

or asset-backed securities. The EAPP added the purchase programme for public sector bonds to the existing purchase

programmes for covered bonds and asset-backed securities of the private sector. The EAPP is often referred to as

quantitative easing of the Eurosystem. On top of that, the Eurosystem continues to conduct TLTROs, which are regarded

as a good alternative for credit institutions to raise long-term credit resources.

The securities eligible for the public sector purchase programme include euro-denominated bonds issued by

the euro area’s governments, certain agencies and European institutions and having the residual maturity of 2 to

30 years. Sovereign bonds issued by Greece and Cyprus will remain non-eligible for the EAPP until the countries get

positive assessments for their macroeconomic stabilisation programmes from the institutional providers of international

financial aid. The Eurosystem will limit its purchases to 25 per cent of any single eligible issue of public sector bond,

which will help it avoid obtaining a blocking minority, and to 33 per cent of an issuer’s outstanding securities (this limit

applies to the combined holdings of bonds purchased for monetary policy or investment purposes) in order to avoid

dominance in the market.

The ECB announced that, together with the NCBs participating in the Eurosystem, it intends to purchase

EUR 60 billion a month of securities under the EAPP until September 2016 or beyond that if needed. The end date

of the EAPP will depend on success in achieving the goal of this instrument, which is to get inflation back on a sustaina-

ble path consistent with the primary monetary policy objective. The total scale of the EAPP over the specified period of

19 months will amount to EUR 1.14 trillion, which would swell the Eurosystem’s balance sheet by approximately 50 per

cent.

Purchases under the EAPP will be split between the NCBs and the ECB. The ECB will buy 8 per cent of the pub-

lic sector bond while the remaining 92 per cent will be purchased by the NCBs. Each NCB will purchase bonds issued by

its respective domestic public sector. Purchases of securities by the NCBs will be divided on the basis of the NCBs’

capital key in the Eurosystem’s paid ECB’s capital (the capital key of the Bank of Lithuania is 0.587%). Moreover, 80 per

cent of the total purchases which will be conducted by NCBs under the EAPP will be allocated to bonds issued by central

governments and national agencies and the remaining 12 per cent — to bonds issued by European institutions, which will

be purchased by NCBs and ECB. If the market is in short supply of bonds issued by the national government and agen-

cies as a result of abovementioned issue and issuer limits, the respective NCB will have to attain its target defined by the

capital key through the purchase of bonds issued by European institutions. Purchases of covered bonds and asset-

backed securities are split between the members of the Eurosystem based on the scale of the markets for these securi-

ties in individual countries and the NCBs’ competence therein.

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1 As laid down in Article 127 of the Treaty on the Functioning of the European Union and in Article 2 of the Protocol No 4 to the TFEU on the Statute of the

European System of Central Banks and of the ECB, the primary objective of the ECB and the NCBs of the EU is to maintain price stability. The Eurosystem is made up of the ECB and the NCBs of the EU Member States whose currency is the euro. On 8 May 2003, the Governing Council of the ECB refined the definition of the price stability objective pursued by the Eurosystem as “an annual increase in the HICP for the euro area of close to but below 2 per cent in the medium term”. 2 In macroeconomics, “medium term” defines a period, which it takes for production and employment as well as prices to respond to changes and which is

insufficient for the level of investment and labour to reach new equilibrium (which is a feature of “long term”). The medium term usually means three to five years. 3 The European Stability Mechanism is an intergovernmental institution established in 2012 by the euro area countries as a permanent euro area crisis

management mechanism for the provision of financial assistance to the euro area countries. 4 The interest rate on TLTROs conducted in September and December 2014 equalled the interest rate on MROs plus 0.10 p. p. The Governing Council of the

ECB reduced the interest rate on subsequent TLTROs to match the level of MRO interest rate.

Purchases under the EAPP were launched on 9 March 2015. Public sector bonds purchased in March and

April 2015 accounted for 78 per cent of the total amount of EUR 121 billion, covered bonds — for 20 per cent, and asset-

backed securities — for 2 per cent.

The effects of the EAPP became evident as early as in November 2014 with a considerable build-up of market

expectations related to this programme. They further intensified in January 2015 with the adoption of the pro-

gramme’s guidelines by the Governing Council. Those effects included a substantial decrease in yields on public and

private sector’s bonds, in particular long-term, improved access to bank loans and their demand as well as a decrease in

costs involved in tapping other financial resources. Inflation expectations started to increase after bottoming out in Janu-

ary 2015. Meanwhile, professional forecasters from public authorities and the private sector moved to revise up substan-

tially their forecasts for the growth of the euro area’s economy.

Eurosystem’s monetary policy instruments applied by the Bank of Lithuania

The Bank of Lithuania, which has been part of the Eurosystem since early 2015, is implementing both stand-

ard and non-standard monetary policy instruments. Starting from early January, the Bank of Lithuania enforces the

minimum reserve requirement of the ECB, which the credit institutions operating in the country must comply with. It also

offers access to MROs, LTROs, TLTROs and standing facilities. Lithuania has no markets for asset-backed securities or

covered bonds hence the Bank of Lithuania is not involved in these securities purchase programmes. However, it has

joined the Public sector purchase programme. Based on current estimates, the Bank of Lithuania will purchase EUR 1.2

billion worth of the Republic of Lithuania government securities within the framework of this programme. As the market for

the Republic of Lithuania government securities is too shallow for the Bank of Lithuania to be able to purchase the entire

volume assigned by the capital key rule, it also purchases the EAPP-compliant bonds issued by European institutions.

The EAPP has both direct and indirect effects on the Lithuanian economy and its full effect will unravel in the

longer term during its implementation and some time thereafter. Direct effects feed through to the economy via low

interest rates and the weakening of the euro, while indirect effects, as expected, manifest themselves through the eco-

nomic uptick in the euro area countries, which are Lithuania’s main export markets. With the EAPP still being in its initial

implementation stages, it will take time before it becomes possible to measure more precisely the total impact of the

programme on the economy of Lithuania and the entire euro area.

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–15

–10

–5

0

5

10

15

–15

–10

–5

0

5

10

15

2010 2011 2012 2013 2014 2015

Final consumption expenditure

Domestic investment (excl. inventory changes)

Net exports

Changes in inventories

GDP (rh scale)

Percentage points

Sources: Statistics Lithuania and Bank of Lithuania calculations.

Per cent, annual change

–40

–20

0

20

40

60

–40

–20

0

20

40

60

2010 2011 2012 2013 2014

Housing

Other buildings and structures

Transport equipment

Machinery and other equipment

Other investment and statistical discrepancies

ICT equipment

Gross fixed capital formation (rh scale)

Percentage points

Sources: Statistics Lithuania and Bank of Lithuania calculations.

Per cent, annual change

II. REAL SECTOR

The rate of economic expansion has slackened somewhat against

the backdrop of weaker growth of external demand and the embargo

imposed by Russia in August 2014. These factors put downward

pressure on the growth of exports of goods and services whereas domes-

tic demand, albeit robust, is insufficient to fully compensate for a lower

contribution from exports to Lithuania’s economic growth. More subdued

expansion of Lithuania’s economy implies a slowdown in the narrowing of

the negative output gap, which built up during the downturn. In spite of

that, Lithuania’s economic fundamentals remain strong. In particular, the

tradable sector has maintained the competitiveness which it has managed

to claw back while the effects from factors, which used to suppress do-

mestic demand during the downturn, are waning.

Household consumption, which is driven by a favourable mix of

market conditions, plays the role of the main engine of economic

growth. The main factors fuelling the growth of household disposable

income and the gains in household financial health include improvements

in the labour market (with both wages and employment being on the rise),

ultra-low inflation, which does not eat into household purchasing power,

and record-low interest rates on loans, which provide relief from the

burden of financial liabilities. This enables the households to be less

cautious with their spending plans. Recent growth of household consump-

tion has also been boosted by the residential property market, which saw

a pickup of activity last year that provided yet another incentive to con-

sume as the households, which purchased housing, also bought other

consumer goods to furnish their new homes. Caution triggered by the

currency changeover supressed incentives to consume and put the brakes

on the growth of household consumption early in 2015. However, with this

caution fading away, these incentives should regain their strength once

again in the near time.

Economic activity is also driven by domestic investment, which,

however, has been cooling off lately, mostly due to a fall in invest-

ment in transport equipment, which, for the record, has not come

unexpected. This type of investment surged in 2013 as businesses rushed

to purchase vehicles ahead of the implementation of a more stringent new

auto pollution standard, known as Euro 6 (in force since early 2014). The

behaviour of other main types of investment, which perform better than the

long-term average, has been more favourable as a result of an advanta-

geous mix of market conditions and the projects implemented by the

public sector. These projects are mainly focused on engineering facilities

and include the implementation of the Rail Baltica project, the construction

of a liquefied natural gas terminal, the development and upgrade of

electricity grids, to mention just a few. Rather high capacity utilisation rates

recently observed in the private sector and the availability of resources in

companies are one of the main factors providing the impetus for business

investment in the upgrade and expansion of production capacity. Hence

the year 2014 saw growth in investment in the construction of industrial

premises and warehouses, as well as the acquisition of manufacturing

equipment. The impact of ultra-low interest rates, albeit positive, appears

still insufficient to convince businesses to finance most of their investment

projects with debt. Housing investment has by far been the only type of

investment to show an increase in financing via bank loans. Favourable

lending standards and the appetite for real estate amongst households

created a dynamic housing market environment in the first half of 2014.

This encouraged investment in new projects from residential property

developers. The outlook for investment is clouded by high uncertainty.

Despite the demand for more investment, which continues to be observed

in some economic activities, the ongoing geopolitical tensions may have

an adverse impact on corporate investment decisions.

The rate of Lithuania’s economic expansion has slackened somewhat against the backdrop of weaker growth of external demand and the embargo imposed by Russia in August 2014.

Chart 6. Contributions to the development of real GDP by expenditure approach

Domestic investment has been cooling off lately, mainly due to a fall in investment in transport equipment.

Chart 7. Contributions to the development of domestic investment (at constant prices)

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5

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20

2010 2011 2012 2013 2014

Exports of goods

Exports of services

Imports of goods

Imports of services

Net exports

Percentage points

Sources: Eurostat and Bank of Lithuania calculations.

The development of net exports has recently been influ-

enced strongly by other than market factors, including the

embargo imposed by Russia and the delivery of a floating

storage vessel for the LNG facility. As a result, the growth path of

net exports and their effect on GDP have been highly erratic. The

floating LNG storage vessel had a negative effect on net exports in

2014 as it led to a surge in the value of imports. At the same time,

the effect of Russia’s embargo was two-fold. On the one hand, the

restrictions triggered a decline in exports. On the other hand,

streamlining of existing business inventories led to a decrease of

imports. The factors arising from market conditions, such as strong

domestic and subdued external demand, unfavourable develop-

ments in exports of petroleum products, continue to be a drag on net

exports. The trends observed with respect to these factors will

remain largely unchanged in the short term hence net exports are

likely to contribute negatively to GDP growth in the medium term.

The main factors affecting the development of net exports include the embargo imposed by Russia, the delivery of a floating storage vessel for the LNG facility

and subdued growth of external demand.

Chart 8. Contribution of real net exports of goods and services to annual GDP growth

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–8

–6

–4

–2

0

2

4

6

8

10

2010 2011 2012 2013 2014

Overall economy

Private sector

Public sector

Per cent, annual change

Source: Statistics Lithuania.

III. LABOUR MARKET

The reforms implemented in recent years contribute to the more ac-

tive participation in the labour market and the growth of the labour force.

The latter, which consists of job-seekers and job-holders, rose by an annual

0.7 per cent in the second half of 2014. The participation rate might have

increased due to the delegation of social support provision for low-income

residents to municipalities in January 2014. This helped better target the

support, which should have strengthened the incentives to participate in the

labour market more actively. Other contributors to the growth of participation

rate might have included new possibilities to arrange agricultural work more

flexibly by using service vouchers and the gradual increase in the retirement

age since 2012. Nonetheless, the data for the first quarter of 2015 shows that

the participation rate is levelling out.

The growth in participation rate leads to a noticeable growth of em-

ployment, which might be even more robust if the economic develop-

ment were somewhat more favourable. Employment increased by 2.5 per

cent year-on-year in the second half of 2014. The data of the Labour Force

Survey attributes this solid growth to the surge in the number of employees.

However, other data sources do not corroborate this finding: on the contrary,

they show that the new hiring weakened slightly in the second half of the year.

The data of the Salary Survey3 suggests that the growth of jobs decelerated in

the second half of 2014. Business surveys reveal similar trends and show in

particular that businesses became more pessimistic about future hiring in the

middle of last year, which possibly contributed to the decrease of vacancies in

the second half of the year. These labour market developments might have

resulted from slower growth of economic activity and the uncertainty height-

ened by geopolitical factors.

The unemployment rate hovers at around 10 per cent and is close to

the estimates of the natural unemployment rate. This means that structural

unemployment now accounts for a large share of total unemployment, which

is therefore expected to decrease at a slower pace in the future. Structural

problems of the labour market are also signalled by developments in the

number of the lower-skilled unemployed. Since the economy moved into

recovery mode, the number of such persons out of job has been decreasing at

a much slower pace than the number of jobless people with higher skills. The

pool of unemployed persons with no skills at all remains similar to the level

recorded in 2010, i.e. in the period of record unemployment. This implies that

the number of unskilled unemployed may not necessarily decrease in the

future, even if the economy grows at a rather robust pace.

Continuing improvements in the labour market promote relatively rap-

id wage growth. In the second half of 2014, annual wage growth accelerated

by 0.7 p.p. from the first half of that year to reach 4.9 per cent. The minimum

wage hike of 3.5 per cent implemented in October 2014 also contributed to

the uptick of wage growth. Still, the acceleration of wage growth at the end of

the year was too high to be driven by the increase in minimum wage alone. In

all probability, rather solid wage growth is also supported by improvements in

the labour market, in particular by a gradual decrease in the number of

unemployed per job vacancy, i.e. the ratio indicating wage pressures. Moreo-

ver, the proportion of companies complaining that worker shortage is hurting

their businesses has increased by 2.3 p.p. since the onset of economic

recovery, to one-tenth of the total number of non-construction companies.4

These developments signal slightly increased difficulties in finding suitable

staff, which adds to the incentives for employers to raise wages.

_________________________________ 3 The data of the Salary Survey is not directly comparable to the data of the Labour Force Survey.

The latter measures the number of employees (persons), while the Salary Survey measures the number of job positions. The difference arises when the same person has several jobs. 4 Not including the construction sector’s executives. This proportion is not substantial as approximate-

ly one-third of non-construction employers complained of a short supply of workers during the eco-nomic upswing in 2007 and 2008.

The labour force participation rate and the labour force are growing, inter alia, due to the reforms implemented in recent years.

Chart 9. Contributions to labour force change

The hiring decelerated slightly due to slower economic growth and heightened uncertainty.

Chart 10. Hiring indicators

Improvements in the labour market encourage fairly noticeable wage growth.

Chart 11. Wages

–6

–5

–4

–3

–2

–1

0

1

2

3

–6

–5

–4

–3

–2

–1

0

1

2

3

2010 2011 2012 2013 2014 2015

Labour force participation rate

Population

Labour force

Sources: Statistics Lithuania and Bank of Lithuania calculations.

Percentage points Per cent, annual change

0

3

6

9

12

15

0

1

2

3

4

5

2011 2012 2013 2014 2015

Number of jobs*

Employment expectations (rh scale)**

Per cent, annual change

Sources: Salary (*) and Business (**) surveys by Statistics Lithuania and Bank of Lithuania calculations.

Percentage points, balance

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40

50

60

2012 2013 2014 2015EU

Russia

Other countries

Export of diary products

Sources: Statistics Lithuania and Bank of Lithuania calculations.

EUR million

-20

-10

0

10

20

30

40

50

60

–20

–10

0

10

20

30

40

50

60

2011 2012 2013 2014 2015

Russia

Other countries

Export, excl. mineral products (rh scale)

Sources: Statistics Lithuania and Bank of Lithuania calculations.

Percentage points Percent, annual change

–15

0

15

30

45

–15

0

15

30

45

2010 2011 2012 2013 2014 2015

Agricultural products and foodChemical products and plasticsWood and articles of woodMetalsMachinery and appliancesVehiclesOtherExports of goods produced in Lithuania (rh scale)Exports of goods, produced in Lithuania (excl. mineral products(rh scale)

Sources: Statistics Lithuania and Bank of Lithuania calculations.

Percentage points Percent, annual change

IV. EXTERNAL SECTOR5

The recent decrease in the nominal exports of goods of

Lithuanian origin has mainly been driven by the lowering

prices of exported goods. The plunge in oil prices in the final

quarter of 2014 eroded the nominal value of exports of mineral

products. At the same time, the recent increase in refining margins

has enabled AB ORLEN Lietuva to increase the output and,

simultaneously, the exports of mineral products. The deceleration

in the growth of wood product exports observed at the end of last

year was followed by a fall in the exports of these goods early this

year. Nevertheless, these developments were mainly driven by

price factors and changes in the export market shares in the EU

countries suggest that the exporters of wood products have re-

mained competitive. The environment for fertilizer exporters has

been more favourable as the exports of these products have been

accelerating for approximately half a year. Although the global

fertilizer prices have shown a slight decline in several recent

months, this has not affected acceleration in nominal growth of

fertilizer exports.

The growth of re-exports came to a standstill in late 2014

and was followed by a nearly 10 per cent fall early this year,

due to a deterioration in trade with Russia. Re-exports of

machinery and appliances to Russia got stalled at the end of 2014

after a short-lived increase in the middle of the year and have

approached the year-before level by now. Re-exports of fruit and

vegetables, which were sent tumbling by the sanctions adopted by

Russia, continue to hover around the level observed since the

introduction of the embargo. The declining trend seen in re-exports

of vehicles all through 2014 remains in place. More specifically, re-

exports of vehicles fell by one-third in January through February

year-on-year, presumably due to, inter alia, a slump in purchasing

power in the main re-export partners (Russia, Belarus and Ka-

zakhstan), which was eroded by currency depreciation, and a

slowdown in their economic growth. These factors also contributed

substantially to a fall of one-fourth in re-exports of textiles early this

year.

The exporters of dairy and meat products, which have

been significantly affected by Russia’s embargo, continue to

struggle to refocus their exports towards other economies.

Exports of dairy and meat products of Lithuanian origin have fallen

substantially as a result of trade restrictions announced by Russia

in August 2014. Exports of dairy products fell by one-third early this

year from a year ago. This decrease can partly be attributed to a

decline in prices for dairy products. However, the data stripped out

of this effect suggests that the dairy producers continue to face

difficulties in reaching out to new markets. Although meat product

exporters are doing somewhat better, exports of these goods still

contracted by nearly 3 per cent early in 2015 from a year ago.

Continued growth in meat product exports to countries other than

Russia helped stave off a larger fall in the total exports of these

goods. The key countries providing new markets to the exporters

of dairy products include the United States and Uzbekistan. The

exporters of meat products, in their turn, have recently stepped up

exports to the Netherlands, Poland and Ukraine.

In the near term, the main risks to the Lithuanian exports

may stem from economic growth in CIS countries, in particu-

lar Russia. These risks, however, are partly offset by the

_________________________________ 5 This section reviews nominal data of foreign trade in goods.

The decrease of exports of goods of Lithuanian origin predominantly reflects lowering prices for exported goods.

Chart 12. Contributions to the exports of goods of Lithuanian

origin (three-month moving sum)

The deterioration in exports is mainly driven by a slump in trade with Russia. Chart 13. Developments in the exports of Lithuania’s products broken down by geographical market (not including mineral products)

Efforts to refocus dairy product exports towards other economies have not yet borne fruit.

Chart 14. Exports of dairy products of Lithuanian origin broken down by country or region (seasonally adjusted data)

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/

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20

15

0

5

10

15

20

25

30

35

2012 2013 2014 2015

EU

Russia

Other countries

Meat exports

Sources: Statistics Lithuania and Bank of Lithuania calculations.

EUR million

expected recovery in the euro area. This year, the developments

of Lithuania’s exports will primarily be affected by economic deterio-

ration in Russia as the rouble’s slump and high inflation will continue

to erode real household income and demand for imports in that

country. The downfall forecast for Russia’s economy will also have

repercussions for other CIS countries with close commercial and

financial ties to Russia and will therefore indirectly further dampen

the demand for Lithuania’s exports. Nonetheless, there are certain

positive factors that may offset the effects of abovementioned

adverse factors for the growth of Lithuania’s exports. Economic

recovery in the euro area, which is still frail but gaining momentum,

should support Lithuania’s exports to this region, which now ac-

counts for more than one-third of the total merchandise exported by

Lithuania. The euro’s slide versus the US dollar will continue to drive

exports from the euro area’s countries, which, as a result, will

generate more revenue. This, in turn, will promote consumption and

investment and, simultaneously, fuel demand for the Lithuanian

goods.

Meat product exporters score well in their quest for new markets, in particular in the EU.

Chart 15. Exports of meat products of Lithuanian origin broken down by country or region (seasonally adjusted data)

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–3

–2

–1

0

1

2

3

4

5

6

–3

–2

–1

0

1

2

3

4

5

6

2011 2012 2013 2014 2015

Administered pricesPrices of food incl. beverages and tobaccoPrices of fuels and lubricantsPrices of servicesPrices of industrial goodsAnnual core inflation* (rh scale)Annual inflation (rh scale)

Percentage points Per cent

Sources: Statistics Lithuania and Bank of Lithuania calculations. * Change in HICP excl. food, fuels and lubricants, and administered prices.

–20

–15

–10

–5

0

5

10

15

20

2010 2011 2012 2013 2014 2015

Unit labour costs

Import prices

Producer prices in Lithuanian market

Per cent, annual change

Sources: Statistics Lithuania and Bank of Lithuania calculations.

V. PRICES AND COSTS

In 2014, the average annual inflation rate, as measured by the

HICP, amounted to only 0.2 per cent — much lower than in previous

several years and way below the long-term inflation average (of

3.2%). Annual inflation was low (of no more than 0.5%) and stable

(within the range of minus 0.1 to 0.5%) in all months of 2014 and,

therefore, was close to the average annual inflation rate. Changes

recorded in all groups of prices last year were more consumer-friendly

than in 2013. In particular, prices for food (including beverages and

tobacco), services and industrial goods followed a more moderate

growth path while prices for fuel showed a steeper decline. Administered

prices fell last year and thereby reversed the trend of rising prices

observed in 2013.

At the end of 2014, annual inflation, which stayed at positive low

levels in previous months, turned negative (but close to zero). In

2015, the slump in prices gathered speed: annual inflation reached

an average of minus 1.1 per cent in January through April. However,

this decline was mostly due to a single group with a noticeable weight in

the CPI basket (of more than 7%), i.e. fuel. As compared to late 2014,

fuel prices contracted at a much steeper (of approximately 17%) annual

pace between January and April 2015. The developments in fuel prices

closely follow changes in oil prices, which fell dramatically in a short

space of time. In September 2014, Brent crude dipped below USD 100

per barrel for the first time since mid-2012 (to USD 97 per barrel). The

slide continued, with particularly steep falls recorded at the turn of the

year. In January 2015, Brent traded as low as USD 48 per barrel.

Although later it pared some losses (recovered to approx. USD 58 in

February through April), the annual decrease remained impressive (of

approx. 45%). The oil price collapse was blamed on a glut of supply and

slow growth in demand. The International Energy Agency stated In

December 2014 that the root cause of this situation was induced by

several years of record high prices, which led to a surge in non-OPEC

supply growth and a slowdown in demand growth. In another major

event for the oil market, OPEC decided in November 2014 to keep its

output target unchanged and thus amplified the collapse of prices.

Leaving the fuel component aside, other components of the

consumer basket also contributed to the downward slide in infla-

tion from the end of last year. For example, changes recorded in

prices for many food groups worked in consumers’ favour. Those devel-

opments were presumably driven, inter alia, by decisions to cut prices

for major goods made by large supermarket chains, said to be a re-

sponse to the growth of competition observed in the retail trade market

in recent years. The increase in excise duties on cigarettes (in order to

reach, in increments, the minimum EU rate in the course of several

years) and alcoholic beverages in March had a marginal effect on prices.

Aside from food prices, disinflationary pressures stemmed from prices

for industrial goods and, to some extent, from administered prices.

Prices for industrial goods recorded substantial losses in 2015, driven

down by a slump in solid fuel prices that previously followed an upward

trend. Compared to late 2014, the fall in administered prices accelerated

somewhat as the energy prices in this group, i.e. heating energy, gas

and electricity, all showed year-on-year decreases. In contrast to

abovementioned components, the developments in prices for services,

in particular for telephony and accommodation, had an upward effect on

inflation.

Low (and negative) inflation is the outcome of various consum-

er-friendly circumstances. Aside from the slump in global prices for

commodities, in particular for crude oil, another factor that is worth

mentioning is low inflation in the euro area, which is passed through into

Annual inflation in Lithuania stuck in negative territory following the plunge in fuel prices.

Chart 16. Contributions to annual HICP inflation

The fall of fuel prices was triggered by the slide in oil prices.

Chart 17. Global oil price and fuel prices in Lithuania

Consumer-friendly changes in inflation are induced by various circumstances, including declines in import and producer prices and a rather moderate pace of

growth in unit labour costs.

Chart 18. Developments in unit labour costs, import prices and producer prices

0

30

60

90

120

150

–60

–30

0

30

60

90

2011 2012 2013 2014 2015

Oil price, USD (rh scale)

Oil price, EUR

Fuel prices in Lithuania

Per cent, annual change

Sources: Bloomberg, Statistics Lithuania and Bank of Lithuania calculations.

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Lithuanian prices through imports. Import prices and producer prices in

the domestic market followed a downward trend leaving no room for

inflationary pressures stemming from abroad and from the production

chain, respectively. Pressure from labour costs, which has the biggest

impact on services inflation, was fairly moderate: although nominal

gross wages advanced at a rather rapid pace, labour productivity gains

had a dampening effect on unit labour costs.

Given the current and forecasted developments in the indica-

tors related to consumer prices, there are no reasons to expect the

average inflation in Lithuania to be positive in 2015. The forecasts of

negative inflation build on three elements: the expected low inflation in

the euro area, the slump in commodity prices and limited domestic

demand pressure in Lithuania.

Firstly, as shown by euro area inflation forecasts published in 2015,

various institutions expect the inflation rate to be close to zero in 2015.

Forecasts published by the IMF in April, as well as the European Com-

mission’s forecasts announced in May tip a 0.1 per cent increase in

prices. The latest results of the ECB’s professional forecasters’ survey,

which were published in the second quarter, show similar expectations.

In March ECB predicted zero inflation for 2015.

Secondly, global commodity prices are projected to fall substantially

in 2015. According to May forecasts published by the Economist Intelli-

gence Unit, prices for food, feedstuffs and beverages in US dollars; will

decrease by 16 per cent while the price of Brent crude will plunge by

approximately 40 per cent. Commodity prices are usually expressed in

US dollars, therefore, their prices in euros also depend on the exchange

rate. The US dollar has been strengthening vis-à-vis the euro since the

spring of 2014, which partly offsets the fall in commodity prices ex-

pressed in US dollar terms. Hence the appreciation of the US dollar has

an upward effect on inflation in both the euro area and Lithuania.

And thirdly, domestic factors should not stoke any major inflationary

pressures. In 2015, the growth of unit labour costs is expected to be

moderate and slower than in 2014 and the output gap is expected to

remain negative.

Based on current evidence, households’ fears of a spike in con-

consumer prices following the adoption of the euro have proved to

be unfounded. Price developments in the first months of 2015 suggest

that the euro changeover effect on inflation in Lithuania was not larger

than in other countries that adopted the single currency in earlier years

i.e. the effect did not exceed 0.2–0.3 p.p. (in Latvia, which was the last

country assessed by Eurostat, the impact was even smaller, of mere

0.1–0.2 p.p.). Negative rates of annual inflation recorded early in 2015

should not be understood as meaning that the euro changeover was

entirely free of inflationary effect. However, that marginal effect, given

the favourable context, was more than offset by strong price-dampening

factors, in particular the fall of fuel prices. Fuel and other energy bills

have decreased this year hence the households are in a position to

increase spending on other goods and services.

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–4

–2

0

2

4

–4

–2

0

2

4

2012 2013 2014 2015

Percentage points

Financial intermediariesGovermentNon-financial corporate sectorHouseholdsTotal (right-hand scale)

Source: Bank of Lithuania calculations.

Per cent

VI. FINANCING OF THE ECONOMY6

The Lithuanian economy has been a net lender in the past sev-

eral years and continues to augment its net financial assets. The

gap between disposable income and consumption spending has been

growing in Lithuania since the economic downturn, which enabled the

economy to build up savings. Growing savings and net capital transfers

from abroad exceeded net capital formation and turned the economy

into a net lender. The main consequence was the alteration in the

behaviour of the private sector, which sought to reduce its net financial

liabilities.

The pace of decrease in the portfolio of loans issued by the

MFIs accelerated early in 2015. In February, the portfolio shrank by

3.1 per cent at the same time last year. Stepped-up use of financing

options offered as an alternative to bank credit also contributed to this

decrease of loan portfolio. Just as in the previous periods, portfolio

changes were mostly driven by the repayment of loans granted by

banks to non-financial corporations. At the same time, the growth of

lending to households helped to partly mitigate the loan portfolio’s

decline.

Non-financial corporations tend to tap alternatives to bank cred-

it to raise financing for their operations. In 2014, non-financial

corporations recorded growth in both sales revenue and profit; hence

businesses were better placed to use in-house resources to finance

their activities (bank loans were used to finance 17.5% of tangible

business investment, down from 18.6% a year before). Moreover, the

growth of the economy fuelled the use of trade credits and led to a

gradual increase in borrowing from non-banking financial institutions

(e.g. from leasing companies). In February 2015, the portfolio of MFI

loans to non-financial corporations contracted by 5.5 per cent in year-

on-year terms.

Lending to different economic activities varies greatly. The port-

folio of loans issued to real estate companies, which have the largest

liabilities vis-à-vis banks, showed the biggest decrease in the reporting

period. Meanwhile, the amount of loans issued to energy supply (this

sector implemented a number of large-scale projects in that period) as

well as transport and storage activities increased by nearly one-tenth

over the year. Banks appear way more willing to lend to companies

related to the public sector as well as to undertakings from more trada-

ble sectors (e.g. transport undertakings).

Households stepped up borrowing from MFIs gradually in the

period under review. The growth of employment, wages and transfers

from abroad leads to improvements in household financial health. The

consumer confidence index fell in the middle of last year, to some extent

due to geopolitical turmoil, but then returned to the growth track at the

end of last year and this year. This was coupled with an increase in the

percentage of households anticipating the purchase of durable goods.

Recently, households have started using borrowed money to finance

some of these purchases (the portfolio of MFI loans to households has

increased) and natural persons have stepped up borrowing from leasing

companies.

_________________________________ 6 The data used in this section to evaluate loans and deposits includes the data for the MFIs,

as provided by the Statistics Department of the Economics and Financial Stability Service of the Bank of Lithuania and adjusted to take account of recent bankruptcies and mergers in the sector concerned (for more details see Annex 2 of the Lithuanian Economic Review, December 2014). This data may differ from the data collected from banks for supervisory purposes.

The Lithuanian economy has been saving more than investing thus far and, a result, remains a net lender.

Chart 19. Drivers of net lending/borrowing

The decrease of loan portfolio was mostly driven by rapid repayment of corporate loans.

Chart 20. Contributions to annual changes in MFIs’ loan portfolio

Currency in circulation was converted into deposits with banks as the adoption of the euro drew nearer.

Chart 21. Annual changes in currency in circulation and deposits

–8

–6

–4

–2

0

2

4

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Net capital formation*

Net capital transfers

Net saving

Net lending, borrowing (–)

EUR billion

Sources: Statistics Lithuania and Bank of Lithuania calculations * Gross fixed capital formation less consumption of fixed capital; negative value represents that formation of capital is greater than consumption.

–2.0

–1.5

–1.0

–0.5

0.0

0.5

1.0

1.5

2.0

2.5

2012 2013 2014

Currency in circulation

Deposits

EUR billion

Source: Bank of Lithuania calculations.

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The growth of deposits with banks in 2014 was much fuelled by

the approaching euro adoption. The amount of overnight deposits

(money in current accounts) soared by EUR 1.2 billion between January

and November of 2014 and by EUR 1.3 billion in December alone.

Nearly all economic sectors replenished their accounts with banks in

December 2014 as they sought to get ready for the currency changeo-

ver. The growth of deposits with banks was also fuelled by the general

government borrowing and the growth of income from abroad. In Febru-

ary 2015, the deposits of Lithuania’s residents with the MFIs amounted

to EUR 16.2 billion and were 17.2 per cent above the year-earlier level.

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-4.4 -3.0

-1.1 -0.8 -0.7

-3.7

-0.6

1.2

-0.7

-2.6

-1.8

-1.7 -1.0 -0.6

–10

–8

–6

–4

–2

0

2

–10

–8

–6

–4

–2

0

2

2010 2011 2012 2013 2014

Balance of social security funds

Local government balance

Pension compensation effect*

IID balance*

Central government balance

General government balance (rh scale)

General government balance (excluding IID and pension compensation effect, rh scale)

Percentage points

Sources: Statistics Lithuania and Bank of Lithuania calculations. * Calculated by the Bank of Lithuania on the basis of publicly available information.

Percentage of GDP

VII. GENERAL GOVERNMENT FINANCE

In 2014, the general government deficit was substantially lower

than in the previous year, to some extent due to one-off factors.

The ratio of four-quarter general government deficit to GDP decreased

by 1.9 p.p. versus 2013 to 0.7 per cent. The narrowing of the deficit was

mainly due to the central government surplus, which was recorded for

the first time in the history of data collection and resulted from a nearly

10 per cent annual increase in central government revenue, while the

spending remained broadly unchanged. The growth of revenue was

mainly driven by capital transfers, which soared by nearly 50 per cent

over the due to of higher revenue from sales of assets. The latter was a

result of reclassification of the deposit and investment insurance com-

pany VĮ Indėlių ir Investicijų Draudimas (hereinafter IID) into the general

government sector. The deficit of local governments decreased on a

year-on-year basis in 2014 as the revenue exceeded the target against

the backdrop of improvements in the labour market and administrative

changes (an increase in the proportion of personal income tax revenue

earmarked to municipalities). Social security funds were the only

general government subsector to show a year-on-year increase in

deficit in 2014. This rise was triggered by a one-off factor, i.e. the

expenditure undertaken to compensate some of the reduced retirement

and work incapacity pensions. Excluding the revenue of IID and the

money spent on pension compensations, the ratio between the general

government deficit and GDP in 2014 would have decreased by 0.8 p.p.

from the revised 2013 figure to 1.2 per cent.

Stripping out the one-off factors, the growth of general gov-

ernment revenue was apparently mostly driven by strong domestic

demand in the latter half of 2014. The labour market continued to

improve in the second half of 2014, which fuelled growth of employ-

ment. As a result, the unemployment rate approached its natural level

and the growth of average wages accelerated. All this taken together

provided a framework for the growth of general government revenue

from social contributions in the second half of 2014. The general gov-

ernment also recorded an increase in indirect taxation revenue as

private consumption expenditure continued to grow at the end of the

year. The improvement in that revenue was mainly due to a 6 per cent

rise in VAT revenue as well as an increase in revenue from excise

duties. Although VAT revenue grew at a fairy rapid pace and basically

matched the growth of nominal retail sales in 2014, the actual general

government budget revenue from VAT missed the target by LTL 321

million (0.3% of GDP) in 2014. This trend of revenue collection, which

potentially implies over-optimistic planning of VAT revenue, has been

observed for several years now.7

The growth of expenditure in the second half of the year was

mainly driven by an increase in average wages in the public sector

as a result of restoration of positional salary coefficients of public

officers and their qualification bonuses in October 2013 as well as

by a slight rise in non-regular allowances. Moreover, the second half

of the year saw a year-on-year increase in spending on intermediate

consumption goods and services as well as on social allowances. The

growth of intermediate consumption expenditure was fuelled by in-

creased appropriations for the repair of tangible fixed assets. Growth

factors also included expenditure on military equipment and arms,

which increased as a result of the decision to boost defence spending

adopted by the Parliament of the Republic of Lithuania in July 2014.

The growth of spending on social allowances was mainly driven by

_________________________________ 7 The Bank of Lithuania brought that to notice in its conclusions on the effect on confidence in

the stability of the financial system and prices from the fulfilment of objectives relating to the improvement of the general government balance indicator of the Republic of Lithuania in 2014, 6 November 2013, see http://www3.lrs.lt/pls/inter/w5_show?p_r=8833&p_d=141639&p_k=1.

In 2014, the general government deficit was substantial-ly lower than in the previous year, to some extent due to one-off factors.

Chart 22. Contributions to the development of general government balance

The growth of general government revenue in the second half of the year was mostly driven by increased non-tax revenue and social contributions.

Chart 23. Contributions to the development of general government revenue

VAT revenue planning has been over-optimistic in the past several years.

Chart 24. VAT revenue target of state budget vs actual VAT revenue

–10

–5

0

5

10

15

20

–10

–5

0

5

10

15

20

2011 2012 2013 2014

Indirect taxesSocial contributionsTaxes on income, wealth, etc.Non-tax revenueTotal revenue (rh scale)

Percentage points

Sources: Statistics Lithuania and Bank of Lithuania calculations.

Per cent, annual change

8.3

8.9

9.3

9.8

8.5 8.7

8.9

9.4

6.5

7

7.5

8

8.5

9

9.5

10

–5

0

5

10

15

20

25

2011 2012 2013 2014

Planned growth rate of VAT and actual VAT growth rate differential

VAT revenue, plan (rh scale)

VAT revenue, actual (rh scale)

Percentage points

Source: Ministry of Finance of the Republic of Lithuania, Statistics Lithuania, Bank of Lithuania calculations.

LTL billion

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increases in sickness benefits, maternity/paternity allowances and social

allowances in kind. The latter grew mainly due to increased expenditure

on health goods and services, in line with the 2014 budget of the Com-

pulsory Health Insurance Fund. Worth mentioning is the general gov-

ernment investment, which decreased in year-on-year terms in the

second half of 2014 and was virtually unchanged in full 2014, although

the National Investment Programme 2014 envisaged a more than

20 per cent increase in investment due to stepped-up take-up of the

European Union’s and other international support. The amounts of EU

support used to finance investment in 2014 were possibly much below

the target.

General government debt increased by LTL 4.4 billion in 2014

and its ratio to the aggregate amount of four-quarter GDP edged up

to 40.9 per cent. The debt increased as a result of pre-borrowing: the

authorities issued a EUR 1 billion bond in the second half of 2014 and

used the bulk of proceeds to redeem a maturing issue early in 2015.

This was the key factor which prevented the narrowing of the debt ratio

in 2014, although the macroeconomic context was favourable. In

particular, the primary general government deficit decreased substan-

tially in year-on-year terms and the negative interest rate and growth

differential. The debt of local governments increased by nearly one-

tenth in 2014 yet the debts overdue decreased by more than one-sixth.

The fiscal discipline of both municipal and public finances should

improve further in the nearest year as a result of the Constitutional Law

of the Republic of Lithuania Implementing the Fiscal Compact, which

was adopted in November 2014. This legislative act establishes spend-

ing cap rules for the budgets of large municipalities and authorises the

National Audit Office to supervise compliance with these provisions.

In the second half of 2014, the growth of general government expenditure was mostly driven by increased spending on wages and intermediate consumption.

Chart 25. Contributions to the development of general government expenditure

The ratio of general government debt to GDP increased slightly in the second half of 2014 due to advance build-up of redemption money for the sovereign bond maturing early in 2015.

Chart 26. General government debt

–10

–5

0

5

10

15

–10

–5

0

5

10

15

2011 2012 2013 2014

Social paymentsInterestCompensation of employeesIntermediate consumptionTotal capital expenditureOther consumpionTotal expenditure (rh scale)

Percentage points

Sources: Statistics Lithuania and Bank of Lithuania calculations. * The sum of general government gross capital formation and capital transfers payable. The latter is strongly affected by IID payments, decisions to compensate cuts in social payments, etc.

Per cent, annual change

0

5

10

15

20

25

30

35

40

45

2011 2012 2013 2014

Deposits (including saving notes)

Loans

Securities

General government debt

Percentage of GDP

Sources: Ministry of Finance and Bank of Lithuania calculations.

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ANNEXES

ANNEX 1. Estimation of household disposable income and the saving ratio at quarterly frequency

The Lithuanian Economic Review of December 2014 provided the analysis of the development of household disposable

income in Lithuania during the period from 1996 to 2012. It came to the conclusion that, although the largest impact on the

development of this income is made by the compensation of employees paid by an employer, it is also necessary to

analyse the development of other household disposable income sources. Such a conclusion was made after considering

the fact that the development of compensation of employees often differs from the development of other income sources.

Unfortunately, the currently available Statistics Lithuania data are only sufficient for analysing the annual development of

household disposable income up to 2013. The availability of only annual data and the large delay of their publication limit

their use for monitoring the economy in the current period. This motivates to estimate of household disposable income at

quarterly frequency.

This Annex to the Review describes two methods of estimating the quarterly development of household disposable in-

come. The first method is relatively simple, but less accurate. The second method is more complex, but also more accurate

and provides more information on the development of household disposable income.

When applying the first method, an assumption is made that the development of household disposable income coin-

cides with the development of disposable income of the whole economy8 published on a quarterly basis. This assumption

is based on the fact that all institutional sectors are closely interrelated and their disposable income is highly interdepend-

ent. Chart A shows the annual growth rates of disposable income of both households and the whole domestic economy. As

seen from the chart, the developments of household disposable income and the whole economy’s disposable income are

very similar. Their development trends diverged only during the period from 2007 to 2008.

Chart A. Development of disposable income at current prices Chart B. Disposable income and their estimate at current prices

The main drawback of the first method of estimation of household disposable income is the fact that it does not allow to

explain which type of income determines the development of household disposable income. This problem is solved by the

second method of estimation of disposable income. When applying the second method, the estimate of each income

source9 is made and then these estimates are summed up to obtain the estimate of total household disposable income.

Only those statistical indicators that are published at least quarterly are used for the estimation of the income sources.

When calculating the development of household disposable income in Lithuania, it is useful to calculate these six estimates

(their comparison with the actual data is provided in Chart F):

Compensation of employees. It is calculated as the sum of the compensation of employees estimated using the

GDP income method and net foreign labour income.

Net social benefits. It is calculated as a difference between general government social payments and social contri-

butions. This difference is adjusted by the change of household net equity in pension funds and net foreign social

contributions.

Current taxes on income, wealth, etc. It is calculated as a sum of personal income tax and land tax paid by resi-

dents.

_________________________________ 8 Household disposable income accounted for nearly two thirds of total disposable income of Lithuania's economy in 2013.

9 More information about household disposable income sources is provided in the Lithuanian Economic Review of December 2014.

–20

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–10

–5

0

5

10

15

20

25

2005 2006 2007 2008 2009 2010 2011 2012 2013

Household disposable income

Disposable income of Lithuania’s economy

Sources: Eurostat, Statistics Lithuania and Bank of Lithuania calculations.

Per cent, annual change

–20

–15

–10

–5

0

5

10

15

20

25

2008 2009 2010 2011 2012 2013

Household disposable income

Disposable income of Lithuania’s economy

Household disposable income estimate obtained by summing up component estimates

Sources: Eurostat, Statistics Lithuania and Bank of Lithuania calculations.

Per cent, annual change

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Value added. The adjusted growth rate of added value

generated by the whole economy is used for its calculation.

Net current transfers. It is calculated as a sum of net cur-

rent transfers receivable from abroad and net other current

transfers payable by the general government.

Property income. In calculating this estimate, an assump-

tion is made that corporations10

pay a constant share of

operating surplus to their owners. This share is the long-

term average of the ratio of household property income11

to

operating surplus of corporations.

The estimate of household disposable income is obtained by

summing up the above-mentioned estimates. Its growth rate com-

parison with the actual data and with disposable income of the whole

economy is provided in Chart B.12

As seen from the chart, disposa-

ble income, estimated according to components, represents the

development of household disposable income more accurately than

disposable income of the whole economy. Judging from mean

absolute error and root mean squared error, the disposable income

estimated according to components represented the development of

household disposable income more accurately by almost one fifth.

After confirming that the annual development of the household

disposable income estimate is close to the actual development, it is

also worth calculating and analysing the quarterly estimate of such

income. In order to calculate it, an assumption should be made that

the correlation of the estimate and the actual data inherent in the

annual development is also inherent in the quarterly development.13

The obtained estimate is further adjusted to ensure that the estimat-

ed amount of a certain year corresponds to the actual data. In order

to express household disposable income at constant prices, the

household consumption expenditure deflator is applied to it. The

quarterly estimate of household disposable income annual growth,

calculated using this method, is provided in Chart C, whereas the

household saving ratio calculated on its basis is presented in Chart

D.

The quarterly estimate of household disposable income obtained

by estimating all household disposable income sources not only

helps assess the quarterly development of total disposable income,

but also provides information on the contributions to this income.

The quarterly development of household disposable income and its

contributions are presented in Chart E. As seen from the chart, the

growth of household disposable income subsided in 2014 and its

development was mostly affected by current transfers received by

households. The growth of the latter was fast in the second half of

2013, but slowed down in 2014, whereas at the end of the year

current transfers declined. Such development of income from current

transfers was determined by foreign personal transfers. Household

property income also grew slower in the second half of 2014. Taking

into account the assumption made, it can be stated that such devel-

opment of property income was determined by slower growth of

_________________________________ 10

The European national accounts define corporations as institutional units whose economic and financial activities are different from those of their owners.

Corporations are divided into financial corporations and non-financial corporations. Financial corporations are engaged in financial intermediation and auxiliary

financial activities. Meanwhile, non-financial corporations are involved in the production of goods and non-financial services. 11

The largest share of household property income consists of dividends paid by corporations and the income of quasi-corporations that households withdraw to

satisfy their own needs. Quasi-corporations are entities which keep a complete set of accounts, but have no independent legal status. These corporations are

market producers and their economic and financial activity is different from that of their owners. Due to the latter reason, an assumption is made that quasi-

corporations have autonomy of decision and are considered as distinct institutional units. 12

Only the data of the period from 2008 to 2012 is used for comparison, since the publication of the data required for estimating current income, wealth and

other taxes was started only in 2007. 13

Only those statistical indicators that are published at least quarterly are used for the calculation of the annual estimates of household disposable income.

Chart C. Disposable income and their quarterly estimate* at constant prices (seasonally adjusted)

Chart D. Saving ratio and its quarterly estimate at constant prices (seasonally adjusted)

Chart E. Development of household disposable income at constant prices (seasonally adjusted)

–25

–20

–15

–10

–5

0

5

10

15

20

2008 2009 2010 2011 2012 2013 2014

Actual annual indicator of disposable income of households**

Estimate of household disposable income, calculated as a sum of it'sestimated contributions

Actual quarterly indicator of disposable income of the economy

Sources: Eurostat, Statistics Lithuania and Bank of Lithuania calculations. * Disposable income of Lithuania's economy is deflated by final consumption expenditure deflator. ** Data for 2014 is not published.

Per cent, annual change

–12

–8

–4

0

4

8

12

16

20

24

–6

–4

–2

0

2

4

6

8

10

12

2008 2009 2010 2011 2012 2013 2014

Actual annual indicator of household's saving rate*

Estimate of household saving rate, obtained using household disposableincome, calculated as a sum of it's estimated contributionsActual quarterly indicator of saving rate of the economy (rh scale)

Sources: Eurostat, Statistics Lithuania and Bank of Lithuania calculations. * Data for 2014 is not published.

Share of disposable income Share of disposable income

–9

–6

–3

0

3

6

9

12

–9

–6

–3

0

3

6

9

12

2010 2011 2012 2013 2014

Compensation of employees

Value added

Property income

Current taxes on income, wealth, etc.

Current transfers

Net of social benefits

Subsidies, production and imports taxes

Household disposable income (rh scale)

Sources: Eurostat, Statistics Lithuania and Bank of Lithuania calculations.

Percentage points Per cent, annual change

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operating surplus of corporations. The main factor that boosted household disposable income in 2014 was compensation

of employees. Its fast growth can be explained by employment and wage growth. Owing to the fast growth of household

labour income, net social benefits negatively affected the development of household disposable income. However, such

impact of this household disposable income source could be expected, since net social benefits act as an automatic

stabiliser — the improvement in the labour market situation determines higher social contributions and lower social fund

payments and vice versa.

It can be seen after the analysis that the household disposable income estimate calculated using these two methods

shows that the growth of household disposable income slowed down in 2014. The main factor that determined such

development was the decline of workers’ remittances from abroad.

Chart F. Estimates of household disposable income sources and the actual values at current prices

Compensation of employees received by households

Net social benefits received by households

Current taxes on income, wealth, etc. paid by households

Value added generated by households

Net current transfers received by households

Household property income

Sources: Eurostat, Statistics Lithuania and Bank of Lithuania calculations.

–20

–15

–10

–5

0

5

10

15

20

25

2005 2006 2007 2008 2009 2010 2011 2012 2013

Per cent, annual change

–1000

–800

–600

–400

–200

0

200

400

600

2005 2006 2007 2008 2009 2010 2011 2012 2013

Per cent, annual change

–60

–50

–40

–30

–20

–10

0

10

20

2005 2006 2007 2008 2009 2010 2011 2012 2013

Per cent, annual change

–25

–20

–15

–10

–5

0

5

10

15

20

2005 2006 2007 2008 2009 2010 2011 2012 2013

Per cent, annual change

–100

–50

0

50

100

150

200

2005 2006 2007 2008 2009 2010 2011 2012 2013

Actual indicator Estimate

Per cent, annual change

–25

–20

–15

–10

–5

0

5

10

15

20

25

30

2005 2006 2007 2008 2009 2010 2011 2012 2013

Per cent, annual change

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ANNEX 2. Fiscal rules in the European Union and Lithuania

Introduction

The recent economic, financial and sovereign debt crisis encouraged the review of the EU economic policy manage-

ment. The provisions of the Stability and Growth Pact (SGP) were supplemented by the six-pack and the two-pack legal

acts, as well as by the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (hereinaf-

ter — the Treaty). The fiscal governance system was finalised after the introduction of the European Semester — the

main calendar of the EU economic policy formation. It is expected that this integrated system will ensure clarity of the

rules and create conditions for better coordination of national policies of individual states at the EU level, encourage

closer cooperation of Member States and EU institutions and will faster apply sanctions for non-compliance with the rules.

It is expected that this will help Member States comply with fiscal obligations and implement structural reforms; therefore,

the EMU will become stronger and more resilient to future challenges.

Lithuania was one of 25 Member States that signed the Treaty on 2 March 2012 and committed to transpose its pro-

visions to the national law. The Seimas of the Republic of Lithuania ratified this Treaty on 28 June 2012 and adopted the

Republic of Lithuania Constitutional Law on the Implementation of the Fiscal Treaty (CLIFT) on 6 November 2014, in

order to implement the Treaty. Amendments to the legal acts related to the CLIFT, including the Republic of Lithuania

Law on Fiscal Discipline (LFD) of 2007, were also adopted. Moreover, by adopting the euro in 2015, Lithuania assumed

the obligation to also comply with those EU rules that are applicable only to euro area Member States. Taking into ac-

count the above-mentioned circumstances, this analysis has two main objectives: first, to discuss the main EU fiscal

governance mechanisms and reasons for their creation and development. The second objective is to review the national

fiscal rules of Lithuania and to establish a clear summarised scheme of Lithuania’s fiscal governance.

Stability and Growth Pact: origins and essential provisions

The fall of the communist regime in Eastern Europe and the reunification of Germany were the main reasons that de-

termined the signing of the Maastricht Treaty in 1992. This Treaty was an essential step of the first stage in the creation

of the Economic and Monetary Union (EMU) — it established the EU. When designing the EMU, attention was paid to the

concerns of the US and European economists that effective functioning of the EMU needs not only labour mobility, cross-

border fiscal transfers, coincidence of business cycles and economic shocks, but also adequate fiscal rules (Jonung,

Drea 2009: 28). It was thought that only strong fiscal discipline of national governments will ensure successful functioning

of the EMU and help to avoid deficit bias, which emerges as a result of fragmented political process. Therefore, the

Maastricht Treaty enshrined some basic principles necessary for the sustainability of the EMU: prohibition of financing of

Member State budget deficits by central banks, prohibition of exclusive rights for the public sector to borrow from financial

institutions, “no-bailout” principle, requirement for Member States to avoid excessive budget deficit and debt. The Maas-

tricht Treaty also created two important institutional elements: first, it established convergence criteria to be complied with

by EU Member States wishing to join the EMU; second, EU Member States agreed to sign the SGP, which would facili-

tate the practical implementation of the requirement to avoid excessive budget deficits established by the Maastricht

Treaty (Schuknecht et al. 2011: 8).

The SGP covers four secondary EU legal acts, which implement fiscal monitoring provisions envisaged by Articles

121 and 126 of the Maastricht Treaty: two Regulations adopted by the EU Council in 1997 (EC 1466/97 and EC 1467/97),

Resolution of the EU Council adopted in Amsterdam in 1997 and the Code of Conduct on the Implementation of the SGP.

According to the EU Council Regulations establishing the procedure for the implementation of the said articles of the

Maastricht Treaty, the SGP is divided into preventive arm and corrective arm.

The preventive arm of the SGP coordinates the budget policy of EU Member States and seeks to ensure sustainable

public finances in the medium term. The initial wording (1997) of the preventive arm envisaged that in the medium term

general government balances of EU Member States must be close to balance or in surplus. It was thought that such a

medium-term objective is sufficient to ensure that the national fiscal policy is capable of stabilising the economy of an

particular EU Member State during its cyclical fluctuations without exceeding the limits of 3 per cent and 60 per cent of

GDP, respectively for general government deficit and debt. The first wording of the preventive arm also envisaged the

budget monitoring mechanisms: an obligation was introduced for EU Member States to submit Stability Programmes (for

euro area countries) or Convergence Programmes (for non-euro area countries) to the EC for assessment. Thus, a

possibility was created for the EC and the European Council to assess budget plans of EU Member States and their

compliance with the medium-term objective. The EC and the European Council were granted the right to warn an EU

Member State, if the assessment of its Stability or Convergence Programme ascertained a risk of non-compliance with

the medium-term objective during the period under review. If the country does not take the necessary measures to

manage the situation and the general government deficit of a certain year exceeds the Maastricht criterion in non-

temporary nature in the absence of extraordinary economic circumstances (annual GDP decline of at least 2 per cent),

the corrective arm of the SGP is applied. The corrective arm of the SGP implements the excessive deficit procedure

(EDP), which describes the steps to be taken by the Member State to reduce its excessive general government deficit. It

should be noted that the wording of the corrective arm of 1997 did not provide for the procedure to assess properly

whether general government debt of EU Member States complies with the Maastricht criterion, especially whether the

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debt to GDP ratio above 60% was sufficiently diminishing and approaching the reference value at a satisfactory pace.

Therefore, the debt criterion was essentially in-operational (European Commission 2013a: 7–9).

The Maastricht Treaty and the SGP contributed to the significant progress made by the EU and the euro area states in

the last decade of the 20th

century in reducing general government budget deficits: the general government deficit of the

whole future euro area comprised around 5.5 per cent of GDP in 1993, less than 3 per cent of GDP in 1997 and was close

to zero in 2000. Such decline was affected by the preparation of certain EU Member States to introduce the euro in 1999

and the rapid economic growth period after 1997. However, the events in stock markets in 2000 and a slowdown of the

economic growth demonstrated that the previous improvement of general government balances was not fully sustainable.

Portugal was the first euro area country, whose general government deficit exceeded the 3 per cent threshold in 2001. It

was joined by Germany and France in 2002, the Netherlands and Greece in 2003 and Italy’s general government deficit

exceeded 3 per cent of GDP in 2004. These developments of public finances in the euro area countries revealed that the

SGP provisions were applied ineffectively and there is a need for revision (González-Páramo 2005: 6). The SGP reform of

2005 was also triggered by other factors: first, the decision of the European Council to close the EDP for Germany and

France, despite the EC assessment. Second, ten Central and Eastern European countries joined the EU in 2004 with their

economies significantly different from those of old EU states (European Commission 2013a: 9).

The Stability and Growth Pact reform of 2005

In 2005, the European Council adopted regulations, which supplemented earlier adopted legal acts and created condi-

tions to take into account specific circumstances of the Member States, to assess the macroeconomic situation more

accurately together with more flexible application of the SGP provisions. The main changes of the preventive arm of the

SGP were the following: first, the previous requirement to have balanced or in surplus nominal general government bal-

ance over the medium term was replaced with individual medium-term structural objectives. Structural medium-term

objective of each state must take into account the debt level and population ageing and ensure that the general govern-

ment deficit does not exceed 3 per cent of GDP, with the national fiscal policy performing the macroeconomic stabilisation

function. The lowest limit for the medium-term objective was set at the level of 1 per cent of GDP structural deficit for euro

area countries and the countries that joined the second exchange rate mechanism (ERM II). Second, the benchmark

annual adjustment of 0.5 per cent of GDP, by which a certain country’s structural general government balance should

approach the medium-term objective over the year, was established. Third, Member States performing structural pension

scheme reforms were allowed to temporarily deviate from the selected strategy for reaching the medium-term objectives.

Although in the short term such reforms require additional expenditure, in the long term they help ensuring sustainability of

public finances. When analysing the amendments to the corrective arm of the SGP, the following changes should be

mentioned: first, the list of extraordinary circumstances, which are taken into account when making an assessment whether

the general government deficit is non-temporary higher than the Maastricht criterion, was adjusted. The decline of the

annual GDP of at least 2 per cent was considered as extraordinary circumstances earlier, whereas the corrective arm

reform of 2005 envisaged that a fall in the GDP of any size or a prolonged period of slow economic growth may be consid-

ered as extraordinary circumstances. Second, it was established that the structural deficit must improve by at least 0.5 per

cent of GDP over one year of excessive deficit correction. Third, the conditional compliance concept was introduced. It

provides for the possibility to extend the term of excessive deficit correction, if the country reduces the structural deficit over

the year by the value set in the EDP, but the nominal general government balance still exceeds the Maastricht criterion due

to unforeseen circumstances (European Commission 2013a: 10–11).

Various opinions were expressed when assessing the SGP reform of 2005. There was partial agreement that the

amendments made were necessary, since they clarified the economic sense of this pact without changing its nature,

improved fiscal monitoring within the EU and ensured higher flexibility in the application of the SGP provisions. However,

the European Central Bank (ECB 2005: 59) strongly criticised the SGP reform and stated that the reform reduced clarity

and simplicity of the rules. Generally, it was agreed that the essential condition for a more effective functioning of the SGP

is a strict and accurate application of the envisaged provisions (González-Páramo 2005: 6). The economic recession that

started in 2008 demonstrated that their application in the past wasn’t ambitious enough. When the financial crisis turned

into the sovereign debt crisis in 2009, debt to GDP ratios of some euro area countries became the main source of concern

in financial markets as they significantly exceeded the reference value. It became obvious that the EU and euro area

Member States did not use the upturn of their economies during the period of 2005 to 2007 to reduce their debts to sus-

tainable levels. Sovereign crisis also showed was an existing strong contagion effect among euro area countries.14

This

was an additional factor that triggered an additional review of the SGP and EU fiscal monitoring mechanisms.

Changes to the Stability and Growth Pact from 2011 to 2013

In 2011, the European Council adopted five new regulations and one directive — the so-called six-pack. This pack in-

troduced several important new elements in the EU fiscal governance system: first, it created the European semester,

which linked previously applied EU fiscal monitoring and management procedures into a single framework and established

the chronological order and calendar of their application. Second, it created the macroeconomic imbalance procedure,

_________________________________ 14

Mostly due to the link between the banking sector and sovereign debt. This problem is addressed by creating the Banking Union.

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whose main objective is the advance identification of the emergence of macroeconomic imbalances and a timely reduc-

tion of the risk imposed by them on fiscal indicators. Third, the minimum requirements to national budgetary frameworks

were established and it was agreed that fiscal monitoring at the national level should be performed by independent fiscal

councils. The preventive arm of the SGP was supplemented with the expenditure benchmark rule, which envisaged that

the annual growth of public expenditure may not exceed the long-term average growth of potential GDP. Expenditure

may grow faster than potential GDP only if that difference is covered by additional revenue and the budget deficit does

not increase (European Commission 2013b: 29–33). In addition, the preventive arm was supplemented with the possibil-

ity to impose a fine of 0.2 per cent of GDP, if the country repeatedly breaches the rules. The corrective arm of the SGP

was supplemented with a provision that clearly defines the possibility to start the EDP, if the public debt-to-GDP ratio

exceeds 60 per cent of GDP, although the general government deficit complies with the Maastricht criterion. The concept

of a "sufficiently diminishing" debt level, though a new debt reduction benchmark, was also defined. It was indicated that

the average decline of the debt ratio over three years should account for at least one twentieth of the difference between

the actual debt level and the reference value. Same as in the preventive arm, the six-pack tightened the conditions for the

application of the corrective arm’s sanctions and increased their automatic nature by introducing the reverse qualified

majority voting procedure. It specified that in the case of a country’s non-compliance with certain EDP requirements,

sanctions should be imposed automatically, unless the qualified majority of voting Member States decide against their

application.

After the official announcement of the six-pack in November 2011, on 9 December 2011 the European Council agreed

to transpose some of the most important provisions to the national law. It was a part of the general strategy for overcom-

ing sovereign debt crisis in the euro area. It was decided to transpose the provisions by signing a new EU Treaty on

Stability, Coordination and Governance in the Economic and Monetary Union and naming one of its parts the Fiscal

Compact. All EU Member States approved this Treaty, with the exception of the United Kingdom (UK). The UK Prime

Minister vetoed the signing of the Fiscal Compact on the grounds that the Treaty did not provide for clear guaranties that

the UK financial services sector will not be affected. During further negotiations, the Czech Republic expressed a wish to

join the Treaty later. Therefore, other EU Member States decided to sign the Treaty not as an EU Treaty, but as an

international intergovernmental agreement (Miller 2012: 1). Three new elements were introduced after signing it on 2

March 2012: first, under the Fiscal Compact, Member States committed to transpose fiscal medium-term objectives and

the strategies for reaching them to the national law, preferably, at the constitutional level. Second, Member States com-

mitted to create automatic budget correction mechanisms, which would be activated in the case of deviation from the

planned strategy for reaching the medium-term objective. Third, the role of independent fiscal councils in the monitoring

and control of fiscal indicators was defined. The Member States that signed the agreement committed also to establish

fiscal councils and ensure their effective operation, as defined in the common principles on national fiscal correction

mechanisms published together with the six-pack (European Commission 2013a: 15, 19).

The financial crisis of 2008 demonstrated that fiscal policy coordination in the euro area has shortcomings and the

contagion effect is strong. Therefore, in the beginning of 2012, when the text of the Treaty on Stability, Coordination and

Governance in the Economic and Monetary Union was still negotiated, the EC proposed two additional legal acts to

strengthen fiscal policy coordination among euro area countries. These two legal acts, known as the two-pack, became

effective in May 2013. The first regulation on common provisions for monitoring and assessing draft budgetary plans and

ensuring the correction of excessive deficit of the Member States in the euro area envisaged that Member States must

present to the EC and the Eurogroup their draft budgets for the coming year no later than by 15 October. The drafts must

comply with the general EU economic policy coordination framework, the common guidelines prepared by the EC and the

European Council in the beginning of the annual surveillance cycle — the European Semester, the EC recommendations

to each country and the macroeconomic imbalance procedure. The EC has to present assessments of these draft budg-

ets by 30 November and, if significant violations of the SGP provisions are identified, it may request the revision of the

draft budget. The second regulation on the strengthening of economic and budgetary surveillance of Member States

experiencing or threatened with serious difficulties with respect to their financial stability in the euro area envisaged

stricter monitoring and responsibility of the countries experiencing financial or fiscal difficulties. It is expected that it will

help to timely identify deviations from the adopted EDP or macroeconomic imbalance correction programme and to take

necessary measures.

Fiscal rules of Lithuania: Law on the Fiscal Discipline of 2007

Preconditions for the strengthening of fiscal governance in Lithuania were formed by several factors: first, after Lithu-

ania joined the EU in 2004, it committed to comply with the SGP provisions applicable to EU Member States. Second,

after the adoption of the National Euro Changeover Plan by the Resolution of the Government of the Republic of Lithua-

nia in 2005 (LRV 2005), the objective was raised to join the euro area in 2007 and thus complete the process of Lithua-

nia’s integration in the EMU. Third, during the period of particularly strong economic growth from 2005 to 2007, the

general government balance of Lithuania remained in deficit, therefore, international institutions expressed growing

concerns about sustainability of Lithuania’s public finances: in May 2007, the credit rating agency Standard and Poor’s

reduced Lithuania’s credit outlook to negative and based such decision on the fact that the legal acts did not ensure

confidence of financial markets in compliance with fiscal discipline, as interest risk premia increased strongly in recent

months (Hawkesworth et al. 2009: 9, 11). In its Article IV assessment of 2007, the International Monetary Fund also

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encouraged Lithuania to pursue stricter fiscal policy and introduce the expenditure restriction rule by a legal act (IMF 2007:

11). Due to these factors, the Seimas of the Republic of Lithuania passed the LFD on 8 November 2007. The main objec-

tive of this Law is to manage government finances in such a manner that ensures general government balance being in

surplus or close to balance in the medium term (Article 3.1). For this purpose, the rule restricting expenditure from the state

budget (excluding EU funds), which comprises the largest part of the general government expenditure, was established. It

may be formalised as follows:

(√∏

)

where: SB expenditure — state budget appropriations, excluding EU financial assistance funds, SB revenue — state

budget revenue, excluding EU financial assistance funds. The main objective of the expenditure restricting rule was to

ensure that state budget expenditure does not grow faster over the planned year than a half of the average annual in-

crease of state budget revenue over the last five ended years, if no exceptions envisaged in the LFD are applicable.

Expenditure limiting rule covered the period of five years, since it was thought that this is the average duration of a busi-

ness cycle in Lithuania (LRFM 2007). If the annual increase of state budget revenue of a certain year, calculated in times

(ratio), is lower than one, it is considered to be zero according to this rule.

Transposition of the Fiscal Compact to the Lithuanian law

When the President of the Republic of Lithuania signed the EU intergovernmental Treaty, Lithuania assumed an obliga-

tion to comply with the Fiscal Compact requirements and to transpose its essential provisions to the national law. However,

from 2015, when Lithuania became the euro area member, it also has to comply with the two-pack provisions applicable

only to euro area countries. Due to these circumstances, the Seimas adopted the CLIFT and amendments to the legal acts

related to it, including the LFD, in November 2014.

In order to implement the EC recommendations, the fiscal rules envisaged in the Fiscal Compact were transposed to

the national legislation of Lithuania as a constitutional law, which may be changed only through the majority voting of at

least three fifths of all members of the Seimas. The main objectives of the CLIFT are essentially similar to those of the LFD:

to ensure sustainability of general government sector finances and a stable development of the economy and to implement

the Treaty (Article 1 of the CLIFT). However, contrary to the LFD, the CLIFT seeks to do it by managing the structural

general government balance (instead of the nominal one) and this is the main difference between the CLIFT and the LFD.

The CLIFT envisages that the medium-term objective will be pursued in a purposeful way, i.e. by establishing each year

the annual step towards the medium-term objective — the structural impetus target. The Seimas establishes it for the

current year and for the coming year by 30 June of the current year or no later than by the date of adopting the law on

amending the current year budget, if other conditions listed in Article 6 of the CLIFT are not applicable. According to the

legal act adopted by the Seimas, the medium-term objective will also be established for the three-year period, however, it

may not be higher than the limit envisaged in the Fiscal Compact — the structural deficit of 0.5 per cent of GDP.15

Compared to the first wording of the LFD, the CLIFT introduced the fiscal rule applicable to the whole general govern-

ment sector (not only to the state budget). The rule may be divided into three parts. The first part envisages that each year,

with the exception of the years when extraordinary circumstances defined in Article 2.2 of the CLIFT emerge, at least one

of these four conditions should be satisfied:

1) in year t, the structural general government balance (GGBS) is in surplus:

;

2) in year t, the absolute value of the structural general government balance is lower than the absolute value of the me-

dium-term objective (MTO) and is declining, if in year t the output-gap (OG) is not negative:

| | | | |

| ;

3) in year t, the absolute value of the structural general government balance is lower than the absolute value of the

MTO, if in year t the output-gap is negative: | | | | ;

4) the actual structural impetus towards the medium-term objective in certain year t is not lower than that year’s struc-

tural impetus target (SIT): .

The validity of at least one of these conditions is ensured by planning (or changing) a certain year’s t + 1 budgets of

general government sub-sectors with appropriations higher than 3 per cent of GDP, i.e. by managing the state budget

(SB), Compulsory Health Insurance Fund (CHIF) budget and State Social Insurance Fund (SSIF) budget appropriations as

a whole, with the exclusion of the EU financial assistance funds. This is the second part of the fiscal rule of the CLIFT,

which envisages expenditure restriction, similarly to the LFD. It may be expressed as follows:

_________________________________ 15

Or no higher than 1 per cent of GDP, if the general government debt-to-GDP ratio is lower than 60 per cent and the risk to long-term sustainability of general

government finances of Lithuania is low.

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(

√∏

√∏

)

, (1)

where: GDPPot

is potential GDP at constant prices. The long-term average growth of potential GDP at current prices in

year t + 1 is calculated by multiplying the average change of potential GDP at constant prices over 10 years by the

annual change of the forecasted GDP deflator in year t + 1. The latter is calculated as the geometric average of the two

(therefore k = (1, 2)) latest GDP deflator change forecasts made by the Ministry of Finance of the Republic of Lithuania

for year t + 1. Each GDP deflator change forecast is calculated as a ration of the forecasted nominal GDP (nGDPP) over

the forecasted real GDP (rGDPP). This rule is primarily used to ensure that general government expenditure is increasing

only by a half of potential GDP growth rate when the economic activity is above its potential level. Such restriction en-

sures that the structural general government balance does not deteriorate due to excessively fast growth of general

government expenditure, compared to the expected growth of general government revenue. This rule is not applied,

when at least one of the five conditions below is satisfied:

1) the annual nominal GDP growth in Lithuania in the last four quarters is lower than the long-term EU nominal GDP

change calculated as a geometric average of the EU nominal GDP change of the last five ended calendar years

and increased by 2 percentage points:

(√∏

)

2) the expected improvement of the nominal general government balance, expressed in percentages of GDP, is at

least 1 percentage point: ;

3) the arithmetic average of the general government balance, expressed in percentages of GDP, of no less than five

consecutive years is no lower than the surplus of 0.1:

∑

;

4) the output-gap (OG) in the planned year t + 1, calculated according to the economic forecast scenario published

by the Government of the Republic of Lithuania or its authorised institution, with regard to the adoption of which

the budget policy control institution (BPCI) presented its conclusion, is negative: ; 5) when changing revenue or expenditure of any current year budget attributed to the general government, the

changed general government balance (GGBt*) will not deteriorate, compared to the balance before the change

(GGBt): It should be noted that the monitoring of compliance with the rules envisaged by the CLIFT and implementation of an-

nual structural impetus targets will be performed by the BPCI, whose functions were assigned to the State Audit Office of the Republic of Lithuania. According to the Law of the Republic of Lithuania on the State Audit Office, within 20 business days from the date of submitting the draft national budget to the Seimas, the BPCI shall present to the Seimas its conclu-sion regarding the structural impetus target formed by the draft national budget and additional measures required for reaching this target. At the end of a certain year, the BPCI must present to the Seimas its conclusion on the implementa-tion of the structural impetus target for that year. It shall present it within 30 business days from the date when the Gov-ernment presented to the Seimas its conclusion on the satisfaction of at least one of the previously mentioned four conditions (Article 3 of the CLIFT, Article 4 of the Law on the State Audit Office). If the report submitted to the Seimas states that the structural impetus target was not met in the previous year, the correction mechanism is activated (Articles 8 and 13). The latter envisages that the Government has to submit to the Seimas and the BPCI the report on the reasons why the structural impetus target was missed and the measures to achieve structural impetus target in the coming year. This information is also provided to the Seimas in an oral presentation. After that, the BPCI presents to the Seimas the conclusion on validity of the reasons, which were indicated by the Government, why the structural impetus target was not met and suitability of measures for its implementation. The final step of the correction mechanism is the final conclusion of the Government on the reasons why the structural impetus target was missed and the measures to achieve structural impetus target in the coming year. These conclusions need to be taken into account by the Government, when it submits to the Seimas the draft national budget for the next year.

The third part of the fiscal rule envisaged in the CLIFT covers three rules of the budgets attributed to the general gov-ernment (Articles 4 and 13): first, each budget attributed to the general government (excluding the state budget, the State Social Insurance Fund budget and budgets with planned appropriations not exceeding 0.3 per cent of nominal GDP) should be planned, adopted, changed and implemented in such a way as to ensure the structural budget balance being balanced or in surplus. Taking into account the restrictions, this rule is applicable to the Compulsory Health Insurance Fund budget and budgets of the largest municipalities; however, it will come into effect only from 2018. Second, the State Social Insurance Fund budget should be planned, adopted, changed and implemented in such a way as to ensure its

structural deficit increases only in the year, when output-gap is negative ( ). This rule will be applied from 1

January 2016. Third, the budget attributed to the general government with appropriations not exceeding 0.3 per cent of the nominal GDP should be planned, adopted, changed and implemented in such a way as to ensure this budget’s appropriations do not exceed its revenue, with the exception of the year, when the same condition of negative output-gap

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is valid. In the latter case, appropriations may not exceed revenue by more than 1.5 per cent. Taking into account the restrictions, this rule is applicable to budgets of smaller municipalities and will come into effect in 2016.

Amendments to the Law on Fiscal Discipline

In addition to the CLIFT, the Seimas also amended the LFD adopted in 2007. The state budget expenditure restriction

rule envisaged in it was expanded and adapted to the general government, thus, the newest wording of this rule in the LFD

is the same as the first formula (1) above. Only two exceptions of the application of the rule envisaged in the LFD are

slightly different. The exception indicated in the CLIFT is stricter in the LFD:

p.p. It means that the exception is not applied, if in year t + 1 the planned improvement of the

nominal general government balance indicator (GGB), expressed in percentages of GDP, comprises at least 1 p.p., where-

whereas the expected improvement of the current year t general government balance indicator (GSBE) is lower than the

improvement of the general government balance indicator (GSBP) planned for year t by no more than 0.5 percentage point.

In addition, the wording of the exception was supplemented in the LFD and envisages the possibility of non-

application of the main rule (1) for the planned year t +1, when the expected production gap is negative, whereas the

expected average annual HICP inflation for the year t + 1 does not exceed 3 per cent ( ). The

available information shows that stricter definitions of exceptions will be applied when preparing draft budgets attributed to

the general government and applying the provisions of the CLIFT and the LFD. The fiscal governance mechanism of

Lithuania envisaged in the CLIFT and the LFD is shown in Chart 1.

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Chart 1: Fiscal governance mechanism and fiscal rules of Lithuania

By 15 March of the year t : The Seimas adopts a legal act and establishes the medium-term objective (MTO) for years t + 1, t + 2, t + 3.

By 15 May of the year t : The Government assesses compliance with at least one of 1–4 conditions and presents the report on the (non-)implementation of the structural impetus target (SPT) for year t – 1.

Within 30 business days from the date of submission of the report by the Government: BPCI presents the conclusion on validity of the reasons why the SIT was not implemented in year t – 1 and suitability of measures for its implementation in year t + 1.

Correction mechanism: 1) Together with the report on the SIT non-implementation in year t –1, the

Government presents to the Seimas and the BPCI a written report on the

reasons of the SIT non-implementation and the measures allowing to

implement the SIT in year t +1.

This information is also provided to the Seimas in an oral presentation.

2) The BPCI presents to the Seimas the conclusion on validity of the reasons of

non-implementation of the SPT indicated by the Government and suitability of

measures to implement the SPT in year t + 1.

3) The final conclusion of the Government on the reasons of non-implementation

of the SIT and measures for the implementation of the SIT in year t +1; the

latter are taken into account, when the draft national budget for the year t+1 is

submitted to the Seimas.

Is the SIT implemented? NO

YES

By 30 June of the year t (but no later than by the date of adopting the laws on state budget and municipalities budget of the year t + 1 or amending the laws on state budget and municipalities budget of the year t) : Taking into account the Government proposal and the BPCI conclusion on compliance of the SIT proposed by the Government with 1–4 conditions, the Seimas sets the SIT for the years t + 1, t + 2 ir t + 3.

The preparation of draft budgets attributed to the general government for the year t + 1 is started

2) Validity of five (1–5) conditions is checked:

Is at least one of five (1–5) conditions valid? YES NO

3) When performing steps 1) and 2), validity of at least

one of four (1–4) conditions in the year t + 1 is

ensured

1) The third part of the fiscal rule of the CLIFT is applied:

a. Municipality (with appropriations > 0.3 % of GDP) and

CHIF budgets: planned, adopted, amended and imple-

mented in such a way as to ensure that structural budg-

et balance is close to balance or in surplus.

b. SSIF budget: planned, adopted, amended and imple-

mented in such a way as to ensure that its structural

deficit increases only in the year, when the condition

𝑂𝐺𝑡 is valid.

c. Municipality (with appropriations < 0.3 % of GDP)

budgets: planned, adopted, amended and implemented

in such a way as to ensure that budget's appropriations

do not exceed its revenue. In the year, when the condi-

tion 𝑂𝐺𝑡 is valid, appropriations can not exceed

revenue by more than 1.5 %.

The second part of the fiscal rule of the CLIFT is not applied (formula 1)

The second part of the fiscal rule of the CLIFT is applied (formula 1)

Draft budgets attributable to the general government for the year t + 1 – state, SSIF, CHIF and municipal budgets – drawn up

By 15 October of the year t: the whole of the draft budgets attributed to the general government is submitted for assessment by the EC By 17 October of the year t: draft budgets attributed to the general government are submitted to the Seimas

Within 20 business days from the date of submission of the drafts to the Seimas: The BPCI presents to the Seimas the conclusion on the SIT established by draft budgets and the need of additional measures required

for the implementation of this target.

Within 15 business days from the date of submission of the drafts to the Seimas: The Bank of Lithuania presents to the Seimas the conclusion about the effect of the implementation of the general government balance indicator annual improvement target on confidence in financial system stability and price stability, paying particular attention to the external balance of the economy and long-term sustainability of general government finances.

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Summary

After signing the Treaty in March 2012 and Lithuania becoming a euro area member in 2015, suitable circumstances

formed to strengthen national fiscal governance and improve fiscal rules. By adopting the CLIFT and respectively amend-

ing the LFD, Lithuania transposed the essential requirements and provisions of the Fiscal Compact to the national law.

Following the EC recommendations, the provisions of the Fiscal Compact were transposed to the national legislation of

Lithuania at the constitutional level (a constitutional law), therefore, they will not be easily changed. The main objective of

the CLIFT is to ensure sustainability of general government finances and a stable development of the economy by manag-

ing the structural general government balance (instead of the nominal one, as in the first wording of the LFD). This is an

essential improvement of the fiscal governance mechanism. Moreover, the two-pack provisions that came into effect in

Lithuania after the adoption of the euro in 2015 should also increase fiscal discipline in Lithuania, since stricter EC control

will be applied. These provisions will also help to identify emerging macroeconomic imbalances as early as possible and

take measures to reduce them. Nevertheless, effectiveness of the new fiscal governance mechanisms will largely depend

on the capacity of Lithuanian and European institutions to implement those provisions. Strict and accurate implementation

of the envisaged provisions will be the key factor determining more effective fiscal governance.

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