The Lithuanian Economy - 2010 September


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The Lithuanian Economy - 2010 September

  1. 1. The Lithuanian Economy Monthly newsletter from Swedbank’s Economic Research Department by Nerijus Mačiulis and Ieva Vyšniauskaitė No. 04 • 30 September 2010 Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000 E-mail: Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720 Nerijus Mačiulis + 370 5 258 2237. Lina Vrubliauskienė +370 5 258 2275. Ieva Vyšniauskaitė +370 5 258 2156. Public finances are on the right track, but choosing the right austerity measures for 2011 will be crucial  Consolidation measures totalling about 10% of GDP during 2009-2010 helped to regain market confidence. Through eight months this year, the government budget revenue plan has been exceeded by 8.4%.  Most measures, however, seem temporal and unsustainable. Retaining market confidence and achieving the strategic goal to join the euro zone in 2014 necessitate further fiscal consolidation measures.  Any new taxes or increases of the current ones would further dent business and consumer confidence and postpone investments and consumption; the government will have to focus on sustainable revenue sources – more efficient SOEs and a smaller shadow economy. On the expenditure side, structural reforms and a smaller public sector will have to replace outright spending cuts. Public finances steered to calmer waters after the storm Lithuanian public finances have stabilised and market confidence has improved since the end of last year, thanks to the bold austerity measures to curb the budget deficit, totalling approximately 10% of GDP, adopted for 2009-2010. In the first quarter, the stringent budget consolidation package brought some positive developments, mostly in the recognition of the government’s efforts by international institutions and ratings agencies.1 Over the second quarter of the year, the improvement in public finances was clearly visible amidst better revenues and some reduction in expenditures. Government budget revenue plan in first eight months of the year was exceeded by 8.4%, supported by unexpectedly strong value- added tax (VAT) collections (exceeding the plan by 22.3%, at close to EUR 1.5 billion). Revenues from 1 In February 2010, Standard and Poor’s ratings agency lifted its outlook for Lithuania to stable from negative on its BBB long- term debt rating; in March, Fitch and Moody’s ratings agencies followed by raising their outlooks on BBB and Baa1 ratings, respectively, from negative to stable as well. On 27 Jan, the EU also affirmed that consolidation efforts were sufficient and allowed Lithuania until 2012 to narrow the budget deficit to within 3% of GDP. income and corporate tax were slightly higher than expected as well, while excise tax revenues fell short of expectations by 8.4%. Revenue sources for state government, Jan-Aug 2010 Profit tax, 3.4% Income tax, 6.1% Other, 12.0% Other tax, 3.3% Excise tax, 20.7% VAT, 53.8% Successful collection of revenues this year can largely be attributed to conservative planning. The revenue collection patterns this year, however, raise concerns by indicating signs of a large procyclical shadow economy. First, lower-than-expected excise revenues can be attributed to a jump in smuggling and unaccounted
  2. 2. The Lithuanian Economy Economic Research Department, Swedbank Nr 04 • 30 September 2010 2 (4) cross-border trade. Second, larger-than-expected VAT collections and below-budget revenues from income taxes indicate that the shadow labour market is thriving. VAT collection is less sensitive to the increase in unaccounted income; furthermore, informal incomes are “legalised” when making a purchase. There is a general tendency to avoid breaching VAT regulations as much easier loopholes exist--for instance, paying personal income taxes. To maximise the gains from the completion of tax reforms over the medium term, the government must recognize that strengthening tax compliance is one of the most urgent tasks that it faces. General government expenditure, 1H 2010 1.5% 4.8% 2.1% 7.0% 41.2% 2.3% 27.1% 14.1% Compensation f or employ ees Consumption (goods and serv ices) Consumption of f ixed capital Interest Subsidies Grants Social benefits Other The decision of the government to use excess revenues primarily for reducing debt rather than increasing expenditure is welcome; this partly explains the signs of stabilisation of government debt: at end- July 2010, central government debt, compared with the previous month, decreased by EUR 208 million and accounted for 33.1% of the projected GDP for 2010. Compared with the beginning of the year, the cost of borrowing has also decreased: in the beginning of September, the government launched a seven-year bond issue in the amount of USD 750 million, with the lowest coupon (5.125%) achieved for the Baltic region since October 2007. Some containment in expenditure areas has also been visible. Over the first half of the year, general government2 expenditures overall were down by 4.4% compared with the same period a year ago; wages and social insurance payments fell by 13.2% year on year, while social assistance payments decreased by 5.1% on an annual basis. 2 The general government consolidates state government and municipality budgets (the national budget), and extrabudgetary and social security funds. Unsurprisingly, because of the rapid build-up of government debt, interest payments were up by a staggering 84% over the same period. As Sodra (Lithuanian State Social Insurance Fund) expenditures were continuously larger than expected, the deficit continued to widen, reaching EUR 601.4 million in the first eight months of the year. The 2014 euro goal is ambitious, but not unattainable Despite successful budget consolidation efforts and the commencement of the economic recovery in the second quarter of this year the general government deficit is expected to reach 8% of GDP in 2010 as the recovery was primarily driven by exports and restocking. Higher-than-expected revenues this year will be offset by the increase in debt- servicing costs and the omnipresent compliance problems (regarding income tax and excise collections, for instance). General government finances, 2004 - 2012 (% of GDP) -10% -9% -8% -7% -6% -5% -4% -3% -2% -1% 0% 2004 2005 2006 2007 2008 2009 2010f 2011f 2012f 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Debt (rs) Budget position (ls) Our forecast of a 6% budget deficit for next year assumes further necessary fiscal consolidation measures – export-led economic growth without a sizable rebound in consumption and fixed capital formation will not be enough. In the very unlikely event that no new austerity measures are adopted, the deficit would quickly escalate on the back of substantial debt-service costs and the expiration of temporary measures (for instance, freezes on public wages); as a result, government debt-to-GDP would exceed the Maastricht criterion of 60% in the next few years. It seems that the government is strongly committed to achieving the convergence deficit targets of 6% next year and 3% in 2012, with an ultimate goal of adopting the euro in 2014. Given the rhetoric adopted since the election, which has emphasized
  3. 3. The Lithuanian Economy Economic Research Department, Swedbank Nr 04 • 30 September 2010 3 (4) the importance of the stability of public finances, it is very unlikely that the government will stray from this road now, even considering the municipal and government elections approaching in 2011 and 2012. General government budget, 1Q 2006 – 1Q 2010 -800 -700 -600 -500 -400 -300 -200 -100 0 100 200 300 2006 2007 2008 2009 2010 -30 -15 0 15 30 45 Budget balance, EURm (ls) Rev enues, yoy (rs) Expenditures, yoy (rs) The consolidation package should be broad based, encompassing both expenditure and revenue measures. The primary criteria, however, in adopting these measures, especially on the spending side, should be clear-cut and, above all, should ensure a balance between, on one hand, making short-term savings that can be delivered swiftly and, on the other, ensuring that long-term costs are not increased as a result. Balancing the budget should not come at any cost for society as a whole – long-term competitiveness and the consequent public welfare have to remain the underlying criteria. Possible sources of sustainable income Fiscal consolidation measures that addressed the revenue side (tax increases, concession and exemption eliminations, etc.) were too straightforward and inefficient. Further increases in current taxes or introduction of new ones would further depress the sentiment of business, consumers, and potential foreign investors. Even potentially stabilising real estate taxes should wait for economic recovery and be announced well before their introduction. There are at least two healthy alternative sources of budget revenues – a more efficient management of state-owned enterprises (SOEs) and a smaller shadow economy. SOEs were valued at EUR 5.2 billion, but in 2009 their contribution to the state budget in the form of dividends was only a little more than EUR 10 million, about 0.05% of GDP. By comparison, dividends of Estonian SOEs amount to more than 1% of GDP. The government is working on a strategy to make Lithuanian SOEs more effective by increasing their transparency and depoliticising them. One way to do this is to float a fraction (less than 50%, if they are perceived strategic objects and state ownership is crucial) of each enterprise’s shares on the equity market – the requirement to publish quarterly financial statements would make them more transparent and private capital would keep an eye on obvious acts of corruption and inefficiencies. The requirement would also have the positive secondary effect of increasing the liquidity of the Lithuanian equity market and adding substantial income to the state budget, which would lower debt and its servicing costs. The government should keep moving in the direction of liberalising labour laws and offering incentives to hire unemployed and create new workplaces. Minimising unofficial income has positive effects on both budget income and expenditure – unjustified unemployment benefits are reduced and income tax revenues are increased. Ending the practice of turning a blind eye to cross-border smuggling and enacting clear measures to improve border control (and punish its absence) can substantially increase income from excise duties. Doing more with less The measures that addressed spending – wage, pension, and other social benefit cuts – were easy to implement but are unsustainable, temporary, and sometimes harmful. In particular, the decision to reduce contributions to second-pillar pension funds is a measure that undermines the whole idea of pension reform and addresses today’s problems by transferring them to the future. Furthermore, pension and social benefit cuts have a strong, direct negative impact on household consumption. Universal wage cuts in the public sector are temporary and do not solve the main problem there – inefficiency. A much more agreeable structural reform would address the necessity, relevance, and appropriateness of the size of many public institutions and organizations – there is no doubt that the same amount and quality of public services can be provided with fewer disappointed employees. This would cause a temporary increase in unemployment (as the workforce would have to drift from the public to the private sector) but be beneficial in the long term. Lithuania is among the leaders in Europe in such ratios as the number of hospital beds per capita, school teachers per capita (or has lowest number of pupils per teacher), and policemen per capita,
  4. 4. The Lithuanian Economy Economic Research Department, Swedbank Nr 04 • 30 September 2010 4 (4) which indicates further possibilities for optimising spending in these sectors. Another area with an obviously wasteful approach is public procurement – recent scandals in some SOEs and public institutions show that there is much room for savings there. There are many paths towards welfare and prosperity and larger government spending is not the only one. The main structural reform that must take place in Lithuania is a mental one – the social and political elite must understand that consistent budget deficits are unsustainable (not once since 1995 has Lithuania had a budget surplus). A prudent step towards sustainable public finances would be setting a long term target not of 3% budget deficit, but some surplus – at least during the economic growth periods. This would enable a small country to build up a cushion against future turbulences in international markets, on which Lithuania greatly depends. Fiscal austerity measures enacted now must be seen as first steps on the path towards long-term competitiveness and prosperity, not just temporary measures to calm the markets, convince the European Commission, and allow adoption of the euro. Nerijus Maciulis Ieva Vysniauskaite Swedbank Economic Research Department SE-105 34 Stockholm Phone +46-8-5859 1028 Legally responsible publisher Cecilia Hermansson, +46-8-5859 7720. Nerijus Mačiulis, +370 5 2582237. Lina Vrubliauskienė, +370 5 268 4275. Ieva Vyšniauskaitė, +370 5 268 4156. Swedbank’s monthly newsletter The Lithuanian Economy is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter The Lithuanian Economy.