Projections of Lithuanian Economic Indicators (March 2007)

The rapid growth of Lithuanian exports in the first quarter of the year, notwithstanding the temporary decline in exports of oil products, accounted for 31 percent. However, such a buoyant development in export is not sufficient enough to expect unambiguous prospects for economic development. The Lithuanian economy’s dependence on credit gains which has developed in recent years ensures that the change of the cycle phase in Lithuania will depend solely on decisions taken by commercial banks and debtors. It is becoming more and more likely that the phase of the economic cycle will change, but the exact time and scope of such change will depend on whether commercial banks successfully implement their plans for loan supply, and whether the debtors cease to ignore the risks formed in the real estate market. Research carried out on consumer confidence shows that expectations regarding economic development are too optimistic. It would be unreasonable to give rise to legitimate expectations based on the robust growth of recent years. Instead, one should take into consideration more moderate projections for economic development, and warnings about any risks issued by independent institutions. It is hard to explain in terms of long-term motives why credit gains have once again accelerated in the past financial quarters, particularly those for the acquisition of property. Subjective arguments could be employed for such explanations but they would have no relevance to long-term economic tendencies. Hence, economic patterns based on reason cannot unequivocally project the exact time and scope of change of the economic phase.

Data taken from a thorough analysis of the last quarter of 2006 and the first quarter of 2007 reveals that it is unlikely in 2007 that the market will undergo an automatic self-regulation. If not for the disturbances in the activities of “Mažeikių nafta” and the drought, the volume of GDP would have increased by 8 percent in 2006. The last quarters of 2006 were distinctive in the acceleration of consumer credit gains and growth of earnings. After failure to announce the euro as the Lithuanian national currency, prices for real estate underwent minor changes. Therefore, the return of temporary rises in real estate prices will lead to additional acceleration of growth in the volume of GDP in 2007.  The subjective confidence of consumers and their commitment to borrow was prompted by the growth of the volume of GDP by almost 8 percent on average which was registered in the past six years, yet interest rates remained relatively low (even though they have doubled in the past year and a half). Other factors include tax laws favourable for consumption, the increasing growth of earnings, cyclically reduced unemployment, and better job opportunities in other EU member states. The economy demand continues to be stimulated with borrowed funds, employment in the economic activities is still rapidly increasing, and the core capital is still being developed. Therefore, it is expected that in 2007 the volume of GDP will continue to sore and may even well exceed 8 percent, even though an increase of 7.2 percent was projected earlier based on the data gathered in March.  A return of economic activity to the potential volume of production is more likely to happen later rather than sooner. The potential growth of GDP will remain close to 6 percent. However, the formed realisation of risks over the medium term may unexpectedly slow down economic growth; whereas the prospects for economic sectors that have undergone buoyant development in past years will depend on their ability to demonstrate flexibility applicable to common adjustments.

It is worth noting that due to the improved estimations for real GDP carried out by the Department of Statistics in September 2006 for the purpose of implementation of the method of a linked-chain, the term of “the growth of the volume of GDP” is now employed instead of “the growth of real GDP”.

Assumptions for Estimations of Projections for Economic Indicators

Competition fuelled by globalisation, as well as the possible adjustment of real estate prices, will not effect the volume of production and the unemployment rate, assuming that the labour force will be able to flexibly switch from one economic sector to another. The flexibility of the labour market can be achieved through earnings: the intensified competition over the medium term due to the globalisation and fluctuating sequence in the credit cycle in different sectors may not only lead to the slackening of the growth rate of earnings, but also to their reduction. The assumption of labour market flexibility ensures that rapid growth of the average wage is coherent with the possible disparities in the sectors of Lithuanian economic development. If the assumption regarding the flexibility of labour force failed, the employment would decelerate, the unemployment would temporarily increase, and the growth of the volume of GDP would slacken at the end of the medium term.

Forecasts for credit gains that are regularly revised by commercial banks play an important role in the projections of GDP growth. Taking into consideration the experience of recent years, when the forecasts for credit gains provided by commercial banks were too high, and the fact that credit gains for the first quarter of this year exceeded the ones of the previous year by almost one percent of GDP, we can assume that the forecasts prepared by commercial banks will be exceeded by around approximately 6 percent. This year the credit gains are expected to increase because the European Central Bank doubled the basic interest rate in the euro zone and increased it by 4 percent over the past 18 months, which provides sufficient liquidity to stimulate the economy. It is assumed that the credit gains will begin to slacken in 2008–2009, which will prompt the natural deceleration of the cyclic growth of GDP, as well as the formation of pressure for the nominal fiscal deficit to be increased.

A rapid growth in the medium term mainly depends on the assumption that entrepreneurs will be able to meet the expectations of financial markets regarding the spread of robust and sustainable Lithuanian productivity towards the European average, and they will manage to sustain profits under the conditions of rapidly growing earnings and interest rates.   

 Since the credit gains were exceeded by 15 percent of GDP in 2006, the assumptions regarding the volume of absorption of EU funding have become secondary. In the period from 2007–2010 the utilisation of the EU Structural Funds and other EU financial support will not impact the growth of GDP as much as the fluctuation of the volume of credit gains. The departure from plans for the utilisation of EU funding may change the relevant growth of GDP in 2007, but only insignificantly.  

The stability of the average currency rate and oil prices in 2007 forms an important assumption for the estimation of the projections for the economic indicators of 2007–2010: the prices will remain the same as they were during the period of the projection formation. The implementation of the provisions of the Stability and Growth Pact was based on assumptions made by the European Commission in its projections for the economic indicators for the spring term, taking into account the average annual oil price at the level in 2005 and 2006: USD 66.2 per barrel.   

In a medium term perspective, Lithuania will sustain a robust economic growth. The growth in 2007 will not constitute a significant change in the gap between inflationary GDP and potential GDP. We assume that the counter-inflationary policy of increasing the interest rates, carried out by the European Central Bank, will eventually effect not only the euro zone but also Lithuania, thus, leading to a rapid narrowing of the gap between the inflationary and the potential GDP in 2008–2009. The growth rate of GDP in 2008 would account for 5.3 percent, whereas the growth rate in 2009 would account for 4.5 percent. The early and controllable adjustment of the growth rate of GDP would ensure a robust and sustainable average growth of 6 percent in the coming years. The consolidation of fiscal discipline in the legislation can also be incorporated into the risk management of interest supplements and the formation of conditions for continuous and robust economic development.   

If the economic environment does not keep as close as possible to the assumptions, the projections or prospects of the projections for the economic indicators of 2007–2010 will change accordingly. It is expected that the projections for the economic indicators will change if commercial banks change their plans for issuing loans, increase their interest rates more rapidly than the European Central Bank, or apply stricter requirements to their debtors. If the volume of credit gains reduces in the second quarter, such an assumption can be adjusted.

Aspects of Economic Development Risks

There are positive and negative aspects of economic development risks.

It is expected that the potential growth of the volume of GDP may be stimulated by investments in technologies that provide opportunities to utilise oil products, labour force, and other increasingly costly production factors more economically. The implementation of technological solutions will be carried out over the medium term. Hence, it is unlikely that the growth of GDP of individual years will be separately effected.   

The continuous growth in credits has reached such volumes that the utilisation of EU funding cannot remain to be a sufficient means of compensation for the cyclic fluctuations of the economy. Therefore, a significant assumption underlies in the economic risk management regarding the continuity in determining prudent tasks for the fiscal deficit of the general government, and the consistency in their implementation. The consolidation of fiscal discipline in the legislation and its implementation in a medium term perspective would mitigate risks arising from the deficit of the current account and allow unfluctuating development of economic potential with the incorporation of relatively low interests.

The macroeconomic reviews of commercial banks feature topics on overheated economies and two scenarios for its adjustment: “slow cooling down” and “sudden fall”. This shows that economic risks over the medium term depend on the country’s ability to prepare in a timely and reasonable manner for natural economic cycles. It is appropriate to assess the financial indicators of liquidity and solvency in both the private sector, and general government not only according to their nominal but also their structural value: one should take into consideration the temporary gained cyclic income which will eventually fade away together with the slackened credit gains. In the past years an average of around one sixth of the revenue has been gained from credit gains that have been annually increasing and accounted for one sixth of GDP. Sectors that enjoyed a higher revenue than others due to the increase in loans would gain an approximate structured value of the financial indicators which would account for more than one sixth of the cyclic income (sectors of construction, retail, industry, and financial intermediation), whereas sectors with a revenue that was effected by secondary macroeconomic incentives due to increased earnings in the sectors of construction, trade, financial intermediation and industry, would gain structural value of the financial indicators estimated at lower than one sixth of the cyclic income. The approximate structural value of the financial indicators would protect enterprises from unplanned consequences that would arise from the cyclic increase in interest rates.

Commercial banks in the macroeconomic reviews predicted that “2006 would mark a remarkable surge in interest rates. However, it was still too early to tell when the peak of such a surge would be reached”. This shows that entities may supplement their financial strategies with solutions on risk management, arising from the growth in interest rates. On the other hand, if commercial banks raise their interest rates too rapidly and/or too high and/or restrict their credit gains too soon, economic activity may slump. The continuity of development depends on the commercial banks’ ability to produce an optimum reduction of the economy’s dependency on annual loan gains that exceeds the GDP by 15 percent over the previous period.

It is unlikely that – due to increased expectations regarding an increase in prices, accelerated growth in earnings, and changed consumer behaviour – projections for the nominal growth of GDP, which increased by several percentage points in 2007, as well as for the current account deficit of Lithuanian balance of payments, would be applied for the following year. It is more likely that the following year a stricter monetary policy carried out by the European Central Bank and banks in other countries, would restrict opportunities to stimulate economy at a global level, hence, the prospects for the projections for 2008–2010 would remain steady.    

On the other hand, if commercial banks are concerned about the regional economic situation and change the policy on credit supply too rapidly, the growth of the Lithuanian economy in the years of adjustment would decelerate by several percentage points. Later, however, it would once again converge with the high potential growth of GDP.

There still remains a risk that the deceleration of the growth of nominal GDP by several percentage points may be induced by the return of real estate prices to the level of economic rationale. The topicality of such a risk is illustrated by the adjustment of the real estate market in the USA, which began in past financial quarters, and is still ongoing. The adjustment of the real estate market would enable a more accurate assessment of the possible impact on the projections for the medium term, created by the unreasonable decisions of debtors in recent years.

Markets for Goods and Services

The economic growth in past years has been fuelled by domestic demand. One of the major factors leading to an increase of investments in the core capital, household consumption, and Gross Domestic Product was a rapid growth in borrowing.  

In 2007–2010 the strong impact of the domestic demand will continue to stimulate the economic growth, while positive trends of Lithuanian export indicators will be sustained.  The growth of the nominal export will be prompted by a recovered EU market. However, the demand for the modernisation of production of exported goods and increased income of the population will induce developments in import, therefore the balance of goods and services for the forecasted period will remain negative. In 2006 accelerated investments in machinery and equipment were recorded, hence, prompting an increase in imports of investment goods, and also an increase in the current account deficit of the Lithuanian balance of payments. A shortage of raw materials, and equipment break-downs in “Mažeikių nafta” reduced the export of oil products in the last quarter of 2006 and in the first quarter of 2007 by 53 percent, hence the growth of all exported goods misleadingly shows a slump of 3 percent. Export in Lithuanian goods, excluding oil products in the last quarter of 2006 and the first quarter of 2007, increased by 26 percent, whereas the first quarter of 2007 alone marked an increase of up to 31 percent. Not only is the export of all groups of products continuing to grow, but the export of plastic goods has also doubled due to direct foreign investment. Temporary disturbances in the activity of “Mažeikų nafta” have accordingly adjusted the current account deficit of the Lithuanian balance of payments. The reduction in export of oil products by half, due to the temporary disturbances in the activities of “Mažeikių nafta” is not sufficient in itself to evaluate general prospects for the economy. 

Opportunities for domestic credit, as well as EU financial aid will form conditions that stimulate investment processes. Since investors remain to be confident of economic stability, investments will constitute an increasingly larger part of GDP. Part of the total core capital formation will reach approximately 29.4 percent of GDP at the end of the period under examination.   

An extra impetus for consumption over the period under examination will be provided by the accelerated growth in earnings, reduced unemployment and taxation of employment income, opening labour markets in the European Union and the transfer of earned income to Lithuania, along with exceptionally optimistic expectations of consumers regarding economic development. The final value of consumption expenditure in 2007–2010 will rise by approximately 8.9 percent. The majority of the population will have to spend a significant part of their additional income on higher costs for heating. The disposable income of those who received loans with a variable interest will be restricted by the growing interest rate. A rapid growth in expenditure will be related to the increase in prices of services, prompted by a growing demand for services and additional costs for hiring labour force. More costly services will change the structure of the consumer basket: an increasing part of expenditure will be attributed to services. More active consumption will form the conditions for growth of retail and wholesale, however, the growth in this sector will spread towards the growth in other sectors due to the slowing down of the economy at the end of the period.

 Industry producing exported goods will remain the basis for sustainable economic growth.  

Consumer Prices

In 2005–2008 increasingly costly energy sources (by 2008 the imported gas prices will grow more than twice as much as they were in 2005), Lithuanian commitments to the EU regarding the increase in excise, tackling issues of deposits of persons and compensation for real estate, and trends of increased earnings over the medium term will have a significant impact on inflation. In 2006–2007 inflation increased by over 3 percent due to objective international causes. Inflation fuelled by natural gas alone in 2006 accounted for approximately 0.9 percent, and it is expected that in 2007 it will total approximately 1.3 percent. In March, the inflation projections were reduced to 0.4 percent, with regards to the decision of the gas supplier not to increase the gas prices from 1^st January. However, taking into consideration the accelerated annual inflation of the consumer basket (4 percent in recent months), excluding foodstuff and energy commodities, it is likely that the previous projection of 4.7 percent for average annual inflation is more realistic than the projection of 4.3 percent. The increase in annual monthly inflation of the consumer basket, excluding foodstuffs and energy commodities, reveals that risks regarding the demand effect on prices have been realised. If earnings grow faster and stimulate consumption in 2007, inflation will still go beyond 4 percent at the end of 2007 and the beginning of 2008.

According to the principles of the currency board, the fixed exchange rate of the litas against the euro ensures that the average multi-annual inflation will remain close to the inflation of the euro zone. After the acceleration period of inflation, stabilisation of oil and gas prices, the harmonisation of Lithuanian excise according to the European Union norms, the increase of interest rates, and the reduction of credit gains, inflation in Lithuania will head towards the level of the euro zone. Due to increasingly costly fuel and commitments to increase excise, the inflation observed over the period of 2006–2008 does not provide reasonable grounding to form long-term inflation expectations and to create long-term expenditure solutions. Even though a very broad gap between the price level and the convergence rate of the economic equilibrium formed under the conditions of the currency board may prompt the disinflation of GDP deflators or temporary deflation, at the moment there is no reason to consider such a development of events as a basic macroeconomic scenario. The deceleration of the growth of GDP deflators can only be made possible if the adjustments of the real estate prices prompt a drop in prices in the corresponding sectors. The possibility of such a scenario would increase if commercial banks increased their interest rates too high and/or too rapidly, and/or restricted loan gains too soon. The reduction of credit gains, which could begin in the second quarter of the year, would form conditions for inflation to drop to 2.6 percent by the end of 2010. 

The acceleration of inflation is highlighted by groups of consumed goods and services that are less influenced by competition. The demand for foodstuffs and transport services is not related to prices. Therefore, the increase in prices in these sectors is an effective way of improving economic indicators. The acceleration of inflation is fuelled by the sectors of limited and imperfect competition, aiming at improving their financial indicators by means of higher prices and, thus, utilising a part of the increased income of the population. Tendencies for increasingly higher prices in services became more obvious in 2006. In the future, more costly services will constitute a major part of stable inflation, while global competition and rapid progress in goods production will continue to facilitate a decrease in the price of clothes, foot wear and household goods.

Labour Market

The Lithuanian labour market is increasingly integrating into the single EU market, therefore, if any risks related to the projections for the economic indicators are realised, the long-term unemployment indicators will change, but only insignificantly. Essentially, integration into the EU labour market will determine that the Lithuanian labour market develop under any circumstances favourable to the labour force. An increase in unemployment is likely to happen, but only in the short-term, until the disengaged labour force takes advantage of the possibilities offered by the single EU labour market.  

It is expected that emigration will not prevent an increase in the number of employed in Lithuania, and it will improve the current account of the Lithuanian balance of payments. The growth of the labour force demands increased productivity, an increase in the minimum monthly salary, improved expectations of the participants of economic activities, and price convergence – as membership of the EU will have an impact on the changes in earnings.

It is expected that the trends that were first noticed in 2004 and accelerated in the second half of 2006 will continue: the average monthly salary will rapidly grow in 2007–2008. It is predicted that the average gross monthly salary will rise from LTL 1500.2 in 2006 to LTL 2289.1 in 2010. The growth of earnings will eventually enable a refund to the labour force for the labour productivity of the previous period.     

The shift of the labour force from a low productivity sector to a higher one over the medium term will become an important factor for growth of GDP and it will protect the labour force from its shortage.  

The unemployment rate in the country will drop from 5.6 percent in 2006 (according to the data of employment) to less than 4.9 percent in 2009 due to an increase in demand for the labour force.  

Data from the last quarter of 2006 and the first quarter of 2007 reveal that, contrary to Latvia and Estonia, increased earnings in Lithuania have not yet provided sufficient impetus for more active participation of the working-aged population in the labour market, therefore, projections for the labour force announced in March may be reduced by approximately 2.5 percent, while the projection for the growth of the employed may drop by approximately 1 percent. Accordingly, the unemployment projections would be reduced by over 1 percent. The remaining rapid growth in demand in 2007 may increase the projections for growth in earnings in 2007 and 2008 by several percentage points.

Methods Applied for the Preparation of Projections for Economic Indicators

The Ministry of Finance prepares the projections of the macroeconomic indicators, incorporating the principles of simulation, equilibrium and quasi-equilibrium, as well as the principles of national accounting. Projections are based on assumptions regarding the accuracy of early evidence. Methods of regressive analysis and econometric simulations are applied. Techniques suggested by the experts that have worked with the PHARE projects are employed.  The projections are coordinated with the experts of the Bank of Lithuania, relevant line ministries, the Department of Statistics, and research institutions.