Lithuania’s Economic Development Scenario

2018–2021

September 2018

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The Economic Development Scenario (hereinafter – the scenario) has been developed on the basis of the statistical data published by 31 August 2018 and the information presented by the institutions following Government of the Republic of Lithuania Resolution No 369 On the Approval of the Description of the Procedure for Development and Publishing of the Economic Development Scenario of 13 April 2016. Respective publicly available technical assumptions about the external environment (development of trading partners, oil prices, EUR / USD exchange rate) made by the European Commission and the International Monetary Fund were also taken into consideration.

Taking into consideration Lithuania’s economic development results in the first half of 2018, changes in the external environment and favourable conditions for domestic demand acceleration, we project that Lithuania’s gross domestic product (GDP) in 2018 could grow 3.4 %. This is by 0.2 percentage point higher than it was projected in spring this year. In subsequent medium-term years GDP should grow at the same pace as it was projected in spring this year – 2.8 % in 2019 and 2.5 % both in 2020 and 2021.

International institutions did not change the world economic outlook in summer 2018 – a stable GDP growth of almost 4 % is still expected within next two years, however, it will not be synchronised as in 2017. Economies of some foreign trading partners important to Lithuania will grow at less accelerated pace as it was projected at the beginning of the current year, and a negative risk, as a result of the increased tension in international trade, as compared to spring this year, increased. Due to these circumstances, the development of exports of the Lithuanian goods and services will be more moderate compared to the development projected in spring this year.

Domestic demand in medium-term will be a key driver of Lithuania’s economic activity. It will be stimulated by the Government decisions related to personal income increase and enhanced incentives to invest, direct foreign investments and the implementation of investment projects financed from the European Union (EU) financial assistance as well as the need encouraged by tight labour market for business to invest to operational automation, technological renewal, innovations and other measures enhancing operational efficiency and productivity.

The situation on the labour market will remain favourable during the entire medium term, and the competition between the employers for employees will not decrease. Taking into consideration current trends and administrative solutions increasing wages, we project that the average monthly gross wages in the country in medium-term will grow at an average about 7.2 % per year – this is by 1 percentage point higher than projected in spring this year.

As the effect of one-off factors which led to the average annual inflation jump faded out in 2017, price developments in first 7 months this year were more moderate. Taking into consideration the information disposed during the development of the scenario, we project that the change in inflation estimated on the basis of the harmonised consumer price index will reach 2.7 % − this is by 0.2 percentage point lower than projected in spring 2018. In subsequent years of the medium term price developments should settle at 2.5 % per year.

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The scenario has been developed assuming that it will not be deviated from the fiscal policy laid down in the Stability Programme of Lithuania, i.e. general government financial surpluses will be formed in medium term. General government sector surplus along with the Government measures increasing domestic demand and enhancing public expenditure effectiveness under increased uncertainty in the external environment will play the role in stabilising the economy.

Investments

We project that in 2018 gross fixed capital formation expenditure in the country will grow at a more accelerated pace than it grew during last several years – 9 % – this is by 1.4 percentage point higher than projected in spring 2018. We also upgraded medium-term perspectives: in 2018-2021 expenditure on gross fixed capital formation should grow by an average of 5.8 % each year (in spring 2018 it was projected to grow by 5.4 %).

The need to maintain a competitive advantage both in domestic and foreign markets under limited labour supply conditions encourages the Lithuanian enterprises to search for ways to increase labour productivity through modernisation, automation and making work processes more effective, and provides a strong stimulus for increase of productive investments. Rapidly growing productive investments in 2017 enabled the increase in national labour productivity level by 3 percentage points, as compared to the EU average, − from 72 % in 2016 to 74.9 % in 2017. In the first half of 2018 such investments were further increasing: to machinery, equipment and weapon systems – 10.7 %, intellectual property products – 6.6 %, information and communications technologies equipment – 6.5 %, transport equipment – 2.1 %. Demographic changes taking place in the country dictate that the investments to technological renewal, automation of processes and operational modernisation are necessary to maintain profitability of companies and to attract suitably qualified staff; therefore, the development of this type of investments should not stop through the entire medium term.

The importance of innovations, technological innovations is perceived in the country and the attention paid to this area is evinced. Currently more and more investments are made to intellectual property products: this type of investments in 2017 grew by 16.3 %, in the first half of 2018 – 6.6 %. Tax incentives and one of 6 reforms implemented by the Government of the Republic of Lithuania directed towards the promotion of innovations in medium term should support the development of innovations.

Under improving financial situation of the population in medium term, housing will remain an attractive investment instrument, however, due to prevailing demographic trends, we do not expect a significant growth of residential construction in medium term. The development of construction of infrastructure stimulated by the EU financial assistance should continue. Constantly growing flows of tourists, improved transport infrastructure will foster the enlarged construction of new hotels. For Lithuania becoming more attractive to foreign investors, the international companies that settled down in the country will foster the construction of commercial premises which meets the latest standards.

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The endeavour to meet the EU quality standards and to remain competitive fosters the renewal and development of the transport fleet – the fastest growth pace of acquisition of new heavy goods vehicles (26 %) in the EU was recorded in Lithuania in the first half of 2018. The investments to acquisition of new transport vehicles in short term will remain to be a significant factor of the investment growth in the country.

Under a persistent need to make operational processes more effective, further investments should be made to expand production capacity. Historically high industrial production capacity utilization level recorded in the last several years demonstrates that a part of enterprises are currently operating without having the possibility of expanding production without additional investments, therefore, they are restricted from rapid business expansion.

The impact of the implementation of the Investment Plan for Europe (ESIF) will be also felt in medium term – according to the data for July 2018, the financing volume of transactions approved in Lithuania under ESIF makes up EUR 409 million. It is expected that this will promote investments in the amount of EUR 1.5 billion.

Inflation

Increased economic activity and natural convergence processes to the EU average in medium term will foster price increase in Lithuania, however it will not be as rapid as the one observed in 2017. The development of productive investments projected in medium term will create conditions for narrowing the recent gap between labour productivity and wage growth, and thereby reducing the pressure on price increase. The scenario is based on technical assumptions that starting from the year 2020 global oil prices and EUR / USD exchange rate will stabilise.

Taking into consideration the information disposed of during the development of the scenario, we project that the change in inflation estimated on the basis of the harmonised consumer price index (HICP) will reach 2.7 % − this is by 0.2 percentage point lower than projected in spring 2018. In subsequent years of the medium term price developments should settle at 2.5 % per year.

Since October 2017 annual inflation in Lithuania keeps decreasing and at present is twofold lower than last year. In July 2018 annual inflation estimated on the basis of the HICP represented 2.3 %, average annual inflation – 3.4 %. Annual inflation significantly shrank in March 2018 when the impact of excise duties on alcoholic beverages increased last year faded out. More favourable food commodity prices that reduced prices of dairy products, fruit, vegetables, stable prices of non- energy industrial goods make conditions for falling inflation. In the current year the growth of prices of consumption goods and services will be fostered by higher oil prices and persistent (though more benign) growth of service prices.

Recently observed rising prices of services are mainly due to rapidly growing wages in service sector, where labour costs more than in production sector are passed on to the final price, as well as to more active consumption of services prompted by rapidly growing income of households. In January-July 2018 the growth rate of prices of housing (4.4 %), leisure (4.7 %) and transport (4.3 %) services remained to be rapid, however slower than last year, despite a higher growth rate of 4 wages. Since the last quarter of 2017, the observed slowdown of the growth rate of prices of services should keep also in the second half of 2018.

Prices of foodstuff and non-alcoholic beverages over the first seven months of 2018 grew 2.3 % (in 2017 – 3.4 %). Since November 2017, due to more favourable prices of some raw materials (especially milk), the growth rate of prices of foodstuff slows down. In recent nine months when farm gate milk prices in Lithuania kept decreasing (in July 2018, as compared to October 2017, farm gate milk prices decreased by 24.2 %), prices of dairy products, as compared to their highest price in January, fell slightly. Prices of dairy products, excluding butter, fell by 1.4 %, butter – 2.9 %. As compared to prices of a the corresponding period a year ago, prices of dairy products in July 2018 were higher by 5 %, and butter – 27 %. In the first quarter of 2018 the prices of vegetables and in the second quarter – the prices of fruit slightly decreased. According to the information of the Ministry of Agriculture, due to unfavourable weather conditions – last year rainstorms and recent drought – it is projected that in 2018 the cereal harvest will decrease by a quarter (24.8 %). Unfavourable weather conditions – severe drought and heat – dominate also in other EU countries, therefore, their winter wheat yields are projected to be lower than the average of the last 5 years. The projection of lower cereal harvest in majority of the EU countries, as a result of drought, rises prices of cereals. Taking it into consideration, the scenario makes the presumption that higher prices of cereals will have upward impact on retail prices of bread and meat products both in 2018 and in 2019.

Under escalation of international prices of energy products and the fuel used for heat production (especially biofuel), the rise in heating prices is observed since the autumn 2017. It is projected that with increasing prices of fuel used in heat production, the average price of central heating in the country will be higher in 2018-2019, as compared to the last year. During later years of the medium term when international prices of energy products become stabilised, it is projected that the average heating prices could decrease, if consumers are refunded through the heating price the amount overpaid (EUR 7.54 million) to the company Vilniaus Energija in 2011-2017, and the implementation of CHP projects in Vilnius and Kaunas would ensure more favourable heating prices for the residents in these cities.

Since the beginning of 2018 electricity for household consumers became cheaper at an average by 1 %. Lower electricity tariffs for household consumers are the result of decreased prices of electricity procurement and prices of services meeting public interests. Repairs of the electricity link between Lithuania and Sweden “NordBalt” from 16 August to 28 October 2018 may affect the electricity price for household consumers in 2019 and 2020; however, it will not have any impact this year. In the first half of 2018 the price of gas, as compared to the second half of 2017, decreased by 1.6 %, however, as compared to the first half of 2017, was higher by 5.1 %. Despite rise of prices of natural gas on international markets, in the second half of 2018 gas prices will remain the same as in the first half, due to slightly lower costs of maintenance of the gas infrastructure and lower operational costs of the company Lietuvos Dujų Tiekimas. In medium term gas prices for households will mainly depend on gas prices on international markets. If costs of maintenance of the liquefied natural gas terminal significantly decrease, the benefits could be reaped also by households.

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In January-July 2018, as compared to corresponding period a year ago, the price of Brent oil in euro increased by 25 %, and the price of transport vehicle fuel grew by 6.6 %. In July 2018 the European Commission updated oil price forecasts indicating the expected much more rapid oil price increase as it was projected in spring: in 2018 the oil price in euro will keep increasing by 27.7 %, in 2019 – 0.7 %, accordingly. In February 2018 the European Commission projected that in 2018 the oil price would increase by 15.6 %, and in 2019 it would fall down by 5.9 %. The oil price rising in 2018 increases the prices of transport vehicle fuel, and the latter – operational costs of companies, therefore, there is a risk that a part of increased costs may be passed on to the final price.

Employment and Unemployment

Taking into consideration good employment and migration results in the first half of 2018, labour market projections for 2018 and 2019 have been improved. As compared to the scenario published in spring 2018, a higher number of employed population and a lower unemployment rate are projected. Based on the demographic projections of the statistical office of the European Union (Eurostat), in medium term the country will face demographic challenges leading to the decrease in the number of the working age population, and companies will further compete for suitably qualified staff, the shortage of which will keep increasing in medium term.

In the first half 2018 the unemployment rate in the country constituted 6.6 % (in the second quarter – 5.9 %) and during the year decreased by 0.9 percentage point. The unemployment rate in the country keeps decreasing at the same pace as last year, mainly due to strongly increased employment and diminished unemployment rate in rural areas. In the first half of 2018 the unemployment rate in rural areas represented at an average 9.7 % and, as compared to corresponding period a year ago, it decreased by 2 percentage points.

During the first half of 2018 a number of the employed population in the country grew by 0.4 %, in the cities it remained unchanged, while in rural areas it increased by 1.3 %. According to the data by the Ministry of Agriculture, it is planned to allocate EUR 19.4 million of the EU assistance to companies operating in rural areas for business development. This should increase the incentives for employment and contribute to reduction of the unemployment rate in rural areas. If labour force mobility grows, and regional unemployment rate keeps rapidly decreasing, a higher employment rate and lower unemployment rate of population, as projected in the scenario, in the country in medium term could be expected.

Increased wages in the country and the demand for skilled workers in the first half of 2018 further promoted the employment of foreigners in Lithuania. Under increased immigration and decreased emigration of population, net migration flow in July 2018 for the third successive month was positive. Improving migration trends is a result of increasing number of immigrants from the Ukraine and Belarus. According to the data by the Migration Department, 22.2 thousand visas for foreigners to work for 7 months in Lithuania were issued over 2018, of which about 80 % – to the Ukrainians. As compared to last year, total number of work-based visas issued to foreigners over the year made up slightly more than 23 thousand. Over the next few years the number of the Ukrainian citizens arriving to Lithuania should further increase. In order to improve business 6 environment and to attract to Lithuania more highly skilled experts, in July the Government almost twice – from 27 to 49 – extended a list of occupations in deficit. Almost half of new occupations is related to IT activities. The extended list of occupations with easier employment of foreigners allows to expect further growth of the number of employed foreigners this and next year. More accelerated labour force immigration from non-EU countries will partly compensate labour force and employed population loss (mainly in construction and transport service sectors) and will mitigate the tension in the labour market.

Though the international migration flow since May 2018 for three successive months was positive (the latest data for July available during the development of the scenario), it is still premature to consider it as a long-term trend. The developed scenario was based on statistical information on the number of population in the country and the latest demographic projections of the services of Eurostat, which predicted that in medium term the change patterns of the number of the working age population in Lithuania would remain close to the years 2016 and 2017, i.e. the number of population of 15–74 years of age would decrease at an average by 1.6 %, or by 33 thousand persons each year. The scenario projects that gradually increasing retirement age of population and obvious shortage of labour force offering more favourable opportunities for employment will further promote elderly people to be more actively involved in the labour market. Labour force participation of the group of residents of 55 years of age and older will constantly keep increasing through the entire medium term and will partly compensate the labour force loss as a result of emigration and ageing society.

Wages

The labour force demand in medium term will exceed the supply; therefore, the pressure to increase wages will persist. The demand for skilled labour force, competition between companies for skilled staff, productive investments, growing labour productivity will foster the average monthly gross wage growth rate, especially in private sector.

In the first half of 2018 average monthly gross wages in the country (excluding individualenterprises) increased at the most accelerated pace during the last 10 years − 10 % (in private sector – 10.2 %, public sector – 9.5 %). Such a rapid wage growth demonstrates that the competition between the employers for staff is increasing. Real wages in the national economy increased by 5.9 %: in public sector – 5.5 %, private – 6.1 %.

Under more rapid growth of wages in private sector than in public sector, the average monthly gross wages in private sector for the first time exceeded wages in public sector. In the first half of 2018 average monthly gross wages in the national economy made up EUR 911, in private sector – EUR 911.9, public sector – EUR 909.1.

In the first half of 2018 wages over the year grew in the companies, institutions and organisations of all economic activities from 5.8 % (in electricity, gas, steam and air conditioning activity) to 14.4 % (in information and communication activity). The fastest wage growth was observed in the companies, where the demand for necessary skill labour force was well beyond the supply or which

7 employ highly skilled staff and create high added value. After additional allocation of funds for wages of doctors and nurses starting from 1 May, in the second quarter, as compared to corresponding period a year ago, the average wage growth in human health and social work activity was the most rapid of all activities and reached 16.5 %.

The annual growth rate of wages was also affected by the minimum monthly wage (MMW) increased by 5.3 % up to EUR 400 from 1 January 2018; increased basic salary of state politicians, judges, public officials, civil servants and employees in budgetary institutions; reviewed minimum salary weightings for skilled employees of budgetary institutions.

Minimum social security contributions set since the beginning of 2018 for employees with wages lower than MMW might have an impact on wages of the lowest-income employees. According to the data by “Sodra”, the number of employees with wages lower than MMW decreased by 30 thousand persons during the half of the year.

The wage growth pace in 2018 and 2019 will be fostered by the increased MMW and teachers’ remuneration to be changed from September 2018.

The wage gap for employees of different skills, economic activities and regions will sustain in medium term. More accelerated wage growth will be observed in major regions of the country (in Vilnius, Kaunas, Klaipėda and in their counties), where economic activities will retain to be the most active. Investments to enterprises in manufacturing industry planned in the regions (on-going or planned construction of plants in Marijampolė, Naujoji Akmenė, Šiauliai) will foster employment and wage growth in the regions.

A faster wage growth may be expected in private sector, especially, in manufacturing activities, where the annual increase in vacancies is observed for 6 successive quarters, and under a high production capacity utilisation rate the investments to the development and productivity enhancement are presumable. In the construction and transport services sectors, increasing employment of foreigners from non-EU countries will mitigate the pressure to increase wages.

Implementing the tax reform related to labour taxation, since 2019 social and health insurance contributions (excluding unemployment social insurance and accidents at work and occupational diseases social insurance contributions) will be transferred from the employer to the employee. Social insurance rate of 28.9 % will be transferred to the employee; therefore, gross wages should increase by a relative part. The statistical base (statistical data on the average annual gross wages published by Statistics Lithuania) necessary for projections of wages variables (average monthly gross wages, fund for wages and salaries) available during the development of the scenario still did not reflect the impact of the tax reform on the level of gross wages.

Taking into consideration the growth rate of average monthly gross wages (7.5 %) projected in 2019, calculated according to the current procedure, and after the transfer of the social insurance rate of 28.9 % to the employee, average monthly gross wages in 2019 would make up EUR 1,268.1. Accordingly, the level of wages in 2020–2021 and the level of payroll in 2018–2021 would be higher.

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Consumption

The fastest growth of wages in a decade substantially increased income of residents in the first half of 2018 and resulted in good household consumption expenditure results – consumption expenditure grew 3.8 %. Taking into consideration a favourable situation in labour market, projected faster growth of wages than prices, the Government decisions increasing income of residents, the best consumers’ expectations over several current years and one-off factors stimulating the consumption expenditure growth – Lithuanian Century Song Celebration in 2018, Pope’s visit to Lithuania – it is projected that over the entire year of 2018 household consumption expenditure will grow 4.3 % – by 0.3 percentage point faster than it was projected in spring this year.

Labour taxation fall since 2019, pension indexation and still relatively rapidly growing wages will provide additional stimulus for income growth of residents. This should accelerate household consumption expenditure growth in 2019 up to 4.3 % (3.8 % was projected in spring 2018). In 2020–2021 both due to statistical base effect and decreasing number of consumers, household consumption expenditure will grow at more moderate pace – at an average about 3.6 % per year.

Under prevalence of positive consumers’ expectations during the development of the scenario and after evaluation of labour market developments favourable to employees, in medium term the consumers’ behaviour may be expected to remain mainly unchanged. The Household Budget Survey performed by the Statistics Lithuania every four years demonstrates that under improving financial position of households, residents of Lithuania are inclined to increase consumption expenditure, and in difficult economic times they strictly limit expenditure for non-essential goods and services. In 2016 when wages began to grow almost twice as fast as at an average during the five-year (2010-2015) period following the economic crunch (8.4 %, as compared to 4.4 %), the average household consumption expenditure per person per month, as compared to 2012, increased by 20.3 % (after consideration of the consumption price growth and consumption volumes – 18.9 %). Similar expenses during the five-year period (2008-2012), when for two successive years (2009 and 2010) wages fell (-4.4 % and -3.3 %, accordingly), grew barely 0.5 % (in 2012 as compared to 2008).

Exports

In 2017 after the most rapid growth of the value of exports of goods in six successive years (16.8 %), in the first half of 2018, due to a high comparative base and slightly slower growth of the euro area economy, the growth rate of the value of exports of the Lithuanian goods slowed down to 6.3 %. The value of exports of goods of the Lithuanian origin also grew at a slower pace and increased by 8.3 %. The exports of majority of key commodity products of the Lithuanian origin kept increasing, and, especially, – exports of chemical industry production (fertilisers), mineral products, metals, prepared meals, furniture and plastics. Last year the recovery of Russia’s economic activity continued also in the first half of 2018 (economy grew 1.6 %), however the weakening value of the rouble against the euro negatively affected the growth rate of the re-exports of goods, which in the first half of 2018 grew only 3.3 %. 9

In summer 2018 the international institutions left the global economic development perspectives unchanged – stable global GDP growth of almost 4 % is still expected in the next two years, however, it will not be synchronised as in 2017. The economies of some foreign trading partners of importance to Lithuania will grow at less accelerated pace as it was projected at the beginning this year, and a negative risk due to increased tensions in international trade, as compared to spring this year, has increased. Due to these circumstances, the developments of exports of the Lithuanian goods and services will be more moderate as it was projected in spring this year.

Under increased uncertainty in the external environment, the need to manage the currency risk and to increase productivity-enhancing investments for exporting companies will sustain in the entire medium term.

A successful search for new markets in Asia will offer additional opportunities for the Lithuanian food exporters; however the basic direction of goods of the Lithuanian origin will remain the EU. Sustaining a wide variety of exports (diversification) and productivity-enhancing investments will make presumptions for a sustainable development of national exports in medium term. If exporting companies are reluctant to increase investments to enhance operational efficiency and productivity, rising labour costs and capacity shortage even under sufficient external demand will limit export development in medium term.

Exports of services, whose growth rates from the year 2012 annually exceeded growth rates of exports of goods, regain a more and more important role affecting the economic development. In the first half of 2018 the value of exports of services grew 14.5 % (volumes – 11.2 %), and their share in the structure of exports of goods and services increased up to 25.6 %. Though transport services have a paramount importance in the structure of exports of services, currently telecommunication, computer and information services assume greater importance. Their value in 2017 grew 63.8 % (in the first quarter of 2018 – 16.1 %) and caused the export growth of 2.7 percentage points of all services during this period. In medium term the importance of exports of services on Lithuania’s economy should not diminish.

The Risk for the Economic Development Scenario Fulfilment

There is a positive risk that innovation and tax reforms pursued by the Government will enhance domestic demand more than it is projected in the scenario. Better Lithuanian demographic trends than those currently projected by Eurostat and faded tensions in global trade could also have a positive effect on the development of national economy in medium term.

Due to increased uncertainty in the external environment, a negative risk which may lead to inferior estimates than projected in the scenario is currently increased and is of potential importance to a small open economy of Lithuania.

Exacerbated tension in international trade as a result of manifestations of protectionist tendencies, trade wars; increased geopolitical tensions; potential threats of contamination from the Turkish financial crunch for euro area countries; increased potential cause of hard Brexit; potential global financial market turbulence – risks which when fulfilled would have a negative effect not only on 10

Lithuanian, but also on global economy. Besides, there is a risk that under further increasing uncertainty in the external environment, exceptionally good Lithuanian business and consumers’ expectations prevailing for several last years may worsen, companies may postpone their investment plans, and consumers cut expenses for non-essential goods and services. In drafting the scenario it was known that the Quantitative Easing Programme of the European Central Bank should continue till the end of 2018, and interest rates should remain at current level at least until summer 2019, therefore, there are still uncertainties over the monetary policy stance in later period.

More frequent natural disasters both in foreign countries and in Lithuania may also have a negative effect on Lithuania’s economic development.

The main risk related to projected inflation rates still remains as a result of uncertainty over the developments of international oil prices significantly affecting the prices of consumer goods in Lithuania. Though the investment processes intensified in 2017 and enhanced productivity have significantly diminished the wage and price spiral risk, under weakening labour resources it still remains.

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