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Lithuania - Economy (Notes)

ECONOMY In the second half of the 20th century, the Lithuanian economy underwent fundamental transformations. The Soviet occupation of 1940 brought Lithuania intensive industrialization and economic integration into the U.S.S.R., although the level of technology and state concern for environmental, health, and labor issues lagged far behind Western standards. Urbanization increased from 39% in 1959 to 68% in 1989. From 1949 to 1952 the Soviets abolished private ownership in agriculture, establishing collective and state farms. Production declined and did not reach pre-war levels until the early 1960s. The intensification of agricultural production through intense chemical use and mechanization eventually doubled production but created additional ecological problems. The disadvantages of a centrally planned economy became evident after the collapse of the USSR in 1991, when Lithuania began its transition to a market economy. Owing to the availability of inexpensive natural resources, the industrial sector had become excessively energy intensive, inefficient in its utilization of resources, and incapable of manufacturing internationally competitive products. More than 90% of Lithuania's trade was with the rest of the USSR, which supplied Lithuanian industry with raw materials for production and a market for its outputs. The need to sever these trading links and to reduce the inefficient industrial sector led to serious economic difficulties. The process of privatization and the development of new companies slowly moved Lithuania from a command economy toward a free market. By 1998, the economy had survived the early years of uncertainty and several setbacks, including a banking crisis, and seemed poised for solid growth. However, the collapse of the Russian ruble in August 1998 shocked the economy into negative growth and forced the reorientation of trade from Russia toward the West. In 1997, exports to former Soviet states were 45% of total Lithuanian exports. In 2006, exports to the East (the Commonwealth of Independent States--CIS) were only 21% of the total, while exports to the EU-25 were 63%, and to the United States, 4.3%. At the end of the first quarter of 2007, Lithuania accumulated foreign direct investments (FDI) of $12.7 billion, with U.S. investments amounting to $277 million, or 2.4% of FDI. The current account deficit in the first quarter of 2007 stood at 11.6% of the GDP. Lithuania has privatized nearly all formerly state-owned enterprises. More than 79% of the economy's output is generated by the private sector. The share of employees in the private sector exceeds 72%. The Government of Lithuania completed banking sector privatization in 2001, with 89% of this sector controlled by foreign--mainly Scandinavian--capital. The government has also completed privatization of the national gas and power companies 'Lietuvos Dujos' (Lithuanian Gas) and 'Vakaru skirstomieji tinklai' (Western electricity distributor). The national telecommunications company had a monopoly on the market until the end of 2002, but now several cell phone companies provide competition. 'Rytu skirtomieji tinklai' (Eastern electricity distributor), 'Lietuvos Energija' (Lithuanian Energy), and 'Lithuanian Railways' remain state-owned. The transportation infrastructure inherited from the Soviet period is adequate and has been generally well maintained since independence. Lithuania has one ice-free seaport with ferry services to German, Swedish, and Danish ports. There are operating commercial airports with scheduled international services at Vilnius, Kaunas, and Klaipeda. The road system is good. Border facilities at checkpoints with Poland have been significantly improved, using EU funds. Telecommunications have improved greatly since independence as a result of heavy investment. The last couple of years have been good for the Lithuanian economy. In 2006, Lithuania's GDP increased 7.5%, above expectations, and in the second quarter of 2007 Lithuania's GDP grew by 8%. This economic growth has been largely driven by private consumption. The contribution of domestic market-oriented sectors has also increased. Growth in 2006 was strongest in construction, retail and wholesale trade, and processing and light industries. In 2006, inflation reached 3.7%, and the government's budget deficit stood at approximately 0.3 % of GDP. Greater development is needed in public policy and further progress in structural and agricultural reforms. Lithuania pegged its national currency--the litas--to the euro on February 2, 2002 at the rate of LTL 3.4528 to EUR 1. Lithuanian income levels lag behind those of older EU members. Lower wages and high income taxes may have been factors that contributed to the trend of emigration to the wealthiest EU countries after Lithuania joined the European Union in 2004. In 2006, the flat income tax rate was reduced to 27%, and a further reduction to 24% is expected in 2008. Moreover, in 2007, the minimum wage increased to $277 per month; the average wage now stands at $724 per month, a 20% increase from the previous year. Income tax reduction and wage growth are starting to result in the return of some emigrants; in early 2006 emigration was 30% lower than in 2005. The initial euro adoption target date of January 1, 2007 was postponed due to the high inflation rate of 2006. Achieving the Maastricht inflation criterion necessary to adopt the euro in 2010 will require significant fiscal tightening in Lithuania. In the short-term, increasing energy prices are likely to raise the headline inflation rate above 4% in 2007. While this influence could moderate in 2008, temporary spikes from the necessary excise tax increases and longer-term convergence forces will probably keep inflation above the Maastricht reference value. Rapid credit growth will call for continued proactive supervision and implementation of prudential measures to ensure financial stability.