TRANSITION REPORT 2014 Innovation in Transition

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Highlights

  • Economic growth remains robust. Owing mostly to relatively strong domestic demand, the level of growth is among the strongest in the European Union (EU). However, high exposure to export markets that may be affected by regional political tensions, combined with a decelerating Russian economy and a weak recovery in the eurozone, remain key risks.
  • Eurozone entry is on track for 2015. Lithuania will join the eurozone in January 2015, following its two Baltic peers – Estonia and Latvia. Increased credibility of macroeconomic policy and supervision, and potential support within the banking union should reduce credit and regulatory risks, as domestic banks gain access to the European Central Bank’s (ECB) liquidity facilities and become subject to ECB supervision.
  • Gas import sources are being diversified. For the first time in history, thanks to the new liquefied natural gas (LNG) terminal in Klaipeda, the Baltic states will be able to import gas from sources other than Russia. During the first half of 2014, Lithuania was paying the highest wholesale gas prices in the European Union.

Key priorities for 2015

  • The authorities plan to make Lithuania the leading northern European outsourcing hub. Lithuania boasts a relatively well-developed services sector, which accounts for almost two-thirds of the country’s GDP. By attracting more multinational companies in this sector, services could ultimately contribute up to half of the country’s total exports, primarily through a strong information and communication technology (ICT) infrastructure.
  • Electricity supply will be further diversified. The capacity for electricity flows from the Nordic countries will increase more than one-third thanks to the construction of the NordBalt cable to Sweden, which began in April 2014. A power interconnection between Lithuania and Poland is also being developed, which will play a key role in connecting the Baltic states with the European energy markets.
  • Independence and governance need to be strengthened in state-owned enterprises. The professionalisation of boards still needs to be finalised following changes to the state-owned enterprise (SOE) law, which aims to separate regulatory and ownership functions, as well as commercial and non-commercial functions.

ECONOMIC GROWTH REMAINS ROBUST

EUROZONE ENTRY IS ON TRACK FOR 2015

GAS IMPORT SOURCES ARE BEING DIVERSIFIED

2014 sector transition indicators
Corporate Energy Infrastructure FI

Source: EBRD.
Notes: FI – Financial institution; ICT – Information and communication technology; Water – Water and wastewater; IAOFS – Insurance and other financial services; PE – Private equity.


Main macroeconomic indicators %

  2010 2011 2012 2013 2014
          proj.
GDP growth 1.6 6.1 3.8 3.3 3.0
Inflation (average) 1.2 4.1 3.2 1.2 0.9
Government balance/GDP -7.2 -5.5 -3.3 -2.2 -2.2
Current account balance/GDP 0.0 -3.7 -0.2 1.5 0.9
Net FDI/GDP 2.2 3.2 0.7 0.9 1.2
External debt/GDP 81.5 73.1 73.1 65.7 n.a
Gross reserves/GDP 18.0 19.1 20.1 17.4 n.a
Credit to private sector/GDP 58.4 49.2 45.8 42.7 n.a

Macroeconomic performance

Output growth became more balanced as domestic demand strengthened in 2013. At the beginning of 2013 growth was driven by external factors, but the trade contribution eventually turned negative and domestic demand became a more important driver of growth later in the year. Although banks continued to remain cautious in lending, enterprises and households were able to finance large shares of investments from their own resources, positively contributing to growth. Over the first half of 2014 gross investment expenditures grew by 9.8 per cent in annual terms. This represents an acceleration from the pace observed in 2013.

Lithuania will become the 19th eurozone member in January 2015. In July 2014 the EU Council gave the final green light for Lithuania to join the single currency. Lithuania will follow in the footsteps of its two Baltic neighbours, Estonia and Latvia, which adopted the euro in 2011 and 2014, respectively. This step eliminates remaining currency risk premia in lending, and credit risks resulting from independent currency regime exposures. Domestic banks will gain access to the ECB’s liquidity facilities and become subject to the Single Supervisory Mechanism. Public support for euro adoption continues to increase and reached 50 per cent of the population in June 2014, according to the Eurobarometer. This trend is in line with expectations, as eurozone membership provides an additional safety net.

Export performance has been volatile. In the first half of 2013 export volumes showed a double-digit growth of about 15 per cent in annual terms. However, volumes fell in the first half of 2014 as demand from Russia contracted, and the loss-making Orlen Lietuva refinery, one of the largest exporting companies in the country, saw a reduction in export sales.

Over the next two years, growth is expected to remain well above the regional average at 3 and 3.4 per cent in 2014 and 2015, respectively. In the medium term, a prolonged economic slow-down in Russia combined with European Union trade sanctions and Russian counter-sanctions could constitute a risk to growth, as Lithuania ships approximately 20 per cent of its total exports to Russia, though about 85 per cent consist of re-exports from other countries to Russia.


Major structural reform developments

The reform of state-owned enterprises progressed. The main goals of the amendments to the 2012 SOE law were to separate regulatory and ownership functions, and commercial and non-commercial functions. Also, the legal constraints in hiring independent board members were to be loosened, thus leading to a higher degree of professionalism of boards that would positively impact SOE performance. In December 2013 the government approved a legal act compelling SOEs to deliver separate data for commercial and non-commercial operations in their annual reports. The separation of ownership and regulatory functions has been finalised, while plans to professionalise SOE boards are expected to be completed by the end of 2014.

Lithuania’s labour productivity is highest among the Baltic states, though the R&D investment gap persists. Lithuania has a relatively large manufacturing sector, which generates about 20 per cent of the country’s gross value added, the highest among its Baltic peers. It consists mainly of low and medium-technology sectors, which account for over 80 per cent of exports (for example, mineral fuels, transport and furniture). Exports of high-tech goods, by contrast, remain relatively low at only 5.6 per cent of total exports compared with the EU average of 15.4 per cent. Public and private R&D total expenditures remain at 0.9 per cent of GDP, significantly below the Europe 2020 target of 1.9 per cent. Labour productivity has been growing rapidly in the post-crisis period and currently is the highest in the Baltic region, amounting to almost 75 per cent of the EU average. However, real unit labour costs have been rising at a pace well above productivity.

The government continues to support the development of outsourcing services. Given that the services sector constitutes almost two-thirds of GDP and attracts about half of total foreign direct investments, the Lithuanian government intends to make the country the leading northern European service and outsourcing hub. Ultimately, services are likely to make up half of total exports, supported by Lithuania’s well-developed ICT infrastructure.

Compensation for pensioners will be made by 2016. A new pension law was approved by parliament in May 2014. It stipulates that pensioners whose pensions were reduced in 2010, when the government was struggling with the swelling budget deficit, will be compensated through three tranches by 2016. The programme will affect some 485,000 pensioners and will cost about €130 million. The decision to return pensions to their pre-crisis levels was advocated by the Constitutional Court in February 2012, which ruled that the pension reductions were illegal, as they were disproportionate across pensioners.

Upgraded heat generation facilities should cut heating prices by up to 30 per cent in the country’s two biggest cities. In April 2014 the government approved the plan to upgrade heat generation plants by 2018, which will help reduce heating bills in Kaunas and Vilnius. The projects, worth around €580 million (1.7 per cent of GDP), were recognised as projects of national significance. The task leadership was handed over to the state-controlled energy group Lietuvos Energija (Lithuanian Energy), which will work closely with 10 other European companies that have expertise in the development of such facilities. The European Union and Lithuanian government are expected to fund part of the projects, while private investors would finance up to 25 per cent of the costs. The public sector contribution should not exceed 35 per cent of total investment costs.

Vilnius has been included in the Rail Baltica joint venture. Prime ministers from the three Baltic states have signed an agreement on the Rail Baltica project, which is part of the EU’s Trans-European Transport Network (TEN-T) priorities. It envisages an unbroken rail link from Tallinn (Estonia) to Warsaw (Poland), via Riga (Latvia) and Lithuania by the end of 2020. Under the agreement, Vilnius will now be included in the project, which initially foresaw a shorter route through Kaunas, thereby circumventing the Lithuanian capital. A European Commission feasibility study is expected to show that the project will remain profitable following the expansion of the rail link. The estimated costs amount to €3.7 billion, of which 85 per cent will be financed by the EU. This regional integration project could have significant benefits. Not only will it enable major freight transport to be shifted from road to rail, but it will also create passenger connections, which do not exist at the moment.

Construction of NordBalt, the electricity connection between Lithuania and Sweden, has started. In April 2014 Lithuania launched construction works on a 450 km undersea power cable (NordBalt) between Lithuania’s Klaipeda and Sweden’s Nybro. The link is scheduled to become fully operational in December 2015 and will increase the capacity for electricity imports by the Baltics from other EU countries by more than one-third. Of the estimated project cost of €552 million, about one-third is co-financed by EU funds. The new interconnection is expected to boost the electricity flow between the Baltic states and the Nordic countries, which will strengthen electricity supply on both sides of the Baltic Sea.

In May 2014 Lithuania also announced the start of the construction of a power link between Lithuania and Poland. The LitPol Link will enable Lithuania to achieve one of the country’s top political priorities – to gain energy independence from its eastern neighbours and integrate the Lithuanian energy system into European networks. The construction works are scheduled to be finalised by the end of 2015. NordBalt and LitPol Link interconnections form part of the EU’s initiative for the integration of regional energy markets, which aims to eliminate “energy islands” in the European Union.

The enhancement of a gas pipeline from Klaipeda’s LNG terminal will enable gas flows to Estonia and Latvia. The LNG terminal, which is expected to become fully operational in December 2014, remains the main pillar in the government’s energy strategy. Construction works have already started on the second gas pipeline from Klaipeda (Klaipeda-Kiemenai section), which will enable the supply of gas to Estonia and Latvia. Until now, Lithuania has been paying the highest gas prices in the European Union.