LITHUANIAN ECONOMIC REVIEW

Transcription

1 LITHUANIAN ECONOMIC REVIEW 7 7 JUNE

2 ISSN 9-87 (online) Lithuanian Economic Review analyses the developments of the real sector, prices, public finance and credit in Lithuania, as well as the projected development of the domestic economy. The material presented in the Review is the result of statistical data analysis, modelling and expert assessment. The Review is prepared by the Bank of Lithuania. During the preparation of the Lithuanian Economic Review, the data of the Bank of Lithuania, Statistics Lithuania, the European Central Bank, Eurostat, the International Monetary Fund and other data published up to 7 May 7 were used. Reprinting is allowed only for education and non-commercial purposes, if the source is indicated. Lietuvos bankas, 7

3 Contents ECONOMIC OUTLOOK... I. INTERNATIONAL ENVIRONMENT... II. MONETARY POLICY OF THE EUROSYSTEM... 8 III. REAL SECTOR... IV. LABOUR MARKET... V. EXTERNAL SECTOR... VI. PRICES AND COSTS... VII. FINANCING OF THE ECONOMY...8 VIII. GENERAL GOVERNMENT FINANCE... ANNEXES... ANNEX. Decomposition of labour productivity in Lithuania based on the dynamics of sectoral hours worked... ANNEX. Population and labour force projections for the long term... 7 ANNEX. Overview of Household Financial Assets... L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

4 List of tables GDP developments and inflation in selected advanced and emerging market economies... List of charts Chart. Development of Purchasing Managers Indices... Chart Variation and projections for real GDP of Lithuanian export partners... Chart. Change in real GDP of Scandinavian countries... Chart. Price index for raw materials... Chart. ECB deposit facility and MRO interest rates and inflation... 8 Chart. Annual yields on euro area government bonds with the maturity of years, issued in national currencies... 8 Chart 7. Average interest rates on new MFI mortgage loans... 8 Chart 8. Average interest rate on new MFI loans to non-financial corporations... 9 Chart 9. The dynamics of MFI loans to households and non-financial corporations in the euro area and Lithuania... 9 Chart. Contributions to real GDP by expenditure approach... Chart. External demand and real exports of goods and services... Chart. Capital transfers to Lithuania... Chart. Productive investment and GDP ratio in Lithuania and the EU... Chart. Spending on research and development in Lithuania and the EU... Chart. Emigration to the United Kingdom, Norway, Ireland, Denmark and Sweden... Chart. Contributions to job dynamics... Chart 7. Wage dynamics... Chart 8. Dynamics of Lithuanian export and foreign demand... Chart 9. Nominal export of Lithuanian goods to Russia, nominal import of Russian goods and rouble exchange rate... Chart. Balance of current account and its component parts... Chart. Contributions to annual HICP inflation... Chart. Dynamics of global oil prices and fuel prices in Lithuania... Chart. Dynamics of food product prices... Chart. Portfolios of MFI loans to the private non-financial sector... 8 Chart. Contributions to changes in the portfolio of MFI loans to the private non-financial sector... 8 Chart. Loans by type of economic activity... 8 Chart 7. General government balance... Chart 8. Contributions to general government revenue... Chart 9. Contributions to general government expenditure... Abbreviations APP CIS DSI ECB EU EURIBOR Eurostat GDP HICP IMF MFI MRO OPEC PSPP R&D TLTRO UK US USD asset purchase programme Commonwealth of Independent States debt securities issued European Central Bank European Union euro inter-bank offered rate Statistical Office of the European Union gross domestic product Harmonised Index of Consumer Prices International Monetary Fund monetary financial institutions main refinancing operation Organization of the Petroleum Exporting Countries Public Sector Purchase Program research and development targeted longer-term refinancing operations United Kingdom United States of America United States Dollar L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

5 ECONOMIC OUTLOOK This year, global economic activity picked up steam. Confidence has reached elevated levels, international trade accelerated, and global production expanded significantly. This is attributable to the improved situation in many regions. Implementation of accommodative economic policy and development of infrastructure and other projects translated into stronger demand of imported goods in China. In the light of growing domestic demand and the reversal of accumulation of inventories, the US saw positive economic shifts, with confidence indicators improving in part due to future changes in general government finance. Higher domestic demand reinforced economic expansion in the euro area as well. With commodity prices no longer edging into negative territory, economic activity in countries exporting commodities began stabilising. Recovery in these countries, such as Russia, remains fragile; nevertheless, the economies have stopped shrinking, exerting a favourable impact on an international level. The improved global economic situation had relatively swift implications for exporters in Lithuania. Having been contracting for several quarters, exports of goods shot up. Merchandise exports to Western and Eastern countries saw an upswing as economic development in various foreign countries enhanced. Exports of services also posted significant gains. Last year, exports of transport services, comprising the sheer bulk of exports of services, kept growing, since the transport sector, having bolstered investment, directed its activities towards the Western markets. This year, activity in the transport sector has continued intensifying. International environment is not the only factor exerting strong pressure on economic activity. Economic development in Lithuania is still largely influenced by domestic demand, especially private consumption, which is driven by strong shifts in the labour market. Last year, wages rose by roughly 8 per cent. Much of the growth no less than a quarter was underpinned by higher minimum wage. With effects of the increase in minimum wage waning, a more moderate rise in wages was to be expected. Nonetheless, latest data shows that their growth rate remains high. In fact, it exceeded projections, attributing also to a stronger-thanexpected growth in private consumption. Robust wage growth is characteristic not only of individual employee groups. Wages of both lower- and higher-income residents recorded significant increases. In other words, wage growth is not strongly dependent on the wage level, reflecting tensions in the entire labour market all employee groups. It is such tensions that drive this rapid wage growth. The resulting situation in the labour market will be hard to overcome. Labour is a major factor behind corporate development, yet increasingly more enterprises indicate that the shortage of employees hinders their activities. The number of job vacancies is on the rise, while the number of unemployed persons per job opening is small and constantly dipping down. Until now, the resident participation rate, which has been rising for quite some time, has had an easing effect on the impact that demographic factors (past fall in birth rate and ongoing emigration) have on the overall population of working age as a result, the labour force in Lithuania has not declined over the past few years. In the near future, however, the participation rate dynamics will fail to offset unfavourable demographic trends. Even if the resident participation rate follows a strong upward climb, labour force is expected to contract. This will put further pressure on possibilities to spur total employment, increasing tensions currently observed in the labour market. An employee-conducive labour market will continue to bolster labour income; hence, private consumption will remain an important driver of economic growth. Nevertheless, it is expected that labour income will not rise as much as it has until now, since wage growth, which outpaces labour productivity, restrains corporate competitiveness. Such a large gap between wage and productivity dynamics is only possible in the shorter-term. Decelerating labour income should also put the brakes on the growth of household expenditure. Investment will be the mainstay of economic development. Having been subdued last year, in the projection horizon (7 8) it should see positive shifts, driven by rising demand both in the exporting and domestic demand-oriented sectors. Investment will also be spurred by recovering flows from the EU funds. It is projected that Lithuania s real GDP will expand by. per cent in 7, and another.8 per cent in 8. Over the last few years, inflation in Lithuania has been rather low, partly on the back of international economic environment, which weighted on commodity prices. The rise in the latter triggered an increase in inflation, which was also pushed up by higher excise duties. At the beginning of the year, food prices saw significant increases. Excise duties on alcohol and tobacco, which have hiked up since March, exerted strong upward pressure on the general food price level. Growth in prices of food, excl. alcoholic beverages and tobacco, stabilised, even losing some of its momentum. Global oil price dynamics also have a significant impact on price developments: increases recorded last year determine not only higher fuel prices but also non-oil commodity import prices, which once again are following an upward trajectory. This might also propel consumer prices, e.g. industrial goods prices, which have remained basically unchanged for the past few years. Prices of services a price group most related to domestic demand also have L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

6 a visible impact on headline inflation. This year prices of services are increasing more than expected, partly due to short-term drivers, e.g. changed developments in prices influenced by seasonal factors. Eliminating the most fluctuating prices of services, the overall rise in prices of services is rather stable yet relatively large. This is supported by increasing labour costs and strong domestic demand. The only price group that continues to weigh on headline inflation is administered prices. So far, heat energy, gas, and electricity prices have been lower on a year-on-year basis. In the near future, however, administered prices will boost headline inflation, partly as a result of the value added tax on heat energy which increased in June 7. Such a ramp-up was not taken into account when making previous projections, to some extent attributing to the lift in inflation outlook. According to current projections, inflation will stand at. per cent in 7. The projected inflation levels for this year are much higher than they have been in the past few years, yet the upswing in inflation is seen as temporary. It is assumed that next year global oil prices will not rise, while global food commodity prices will show weak growth compared to this year. Hence, in 8, Lithuania s inflation should decline and stand at. per cent. Outlook of Lithuania s economy in 7 8 June 7 projection a March 7 projection 7 b 8 b b 7 b 8 b Price and cost developments (annual percentage changes) Average annual inflation, as measured by the HICP GDP deflator c Wages Import deflator c Export deflator c Gross domestic product c Private consumption expenditure c General government consumption expenditure c Gross fixed capital formation c Exports of goods and services c Imports of goods and services c Labour market Unemployment rate (annual average as a percentage of labour force) Employment (annual percentage changes) d External sector (as a percentage of GDP) Balance of goods and services Current account balance Current and capital account balance a These projections of macroeconomic indicators are based on information made available by 7 May 7. b Projection. c Adjusted for seasonal and workday effects. d National accounts data; employment in domestic concept. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

7 I. INTERNATIONAL ENVIRONMENT Global economic recovery is gaining strength; however, a great amount of uncertainty prevails. According to the IMF, this year s real global GDP growth will see a year-on-year increase of. p.p. and reach. per cent. This increase will mostly be induced by the growth in emerging market economies and accelerating GDP growth in the US. The projected rapid growth of the US economy (.%) will be affected by internal demand: increasing consumption induced by lower unemployment rate and business investment spurred on by possible tax cuts. However, in general, projections come with uncertainty due to China s economic development, geopolitical tensions in different world regions and the fiscal policy plans of the new US administration, which are under consideration. The euro area GDP growth rate is expected to remain similar to the rate of (.7%). Increasing employment and wages will stimulate private consumption, helping to maintain such growth. However, household purchasing power will be limited by higher inflation. Investments will also grow at a rate similar to. Investment growth will be stimulated by low financing costs and greater global economic activity. The unemployment rate should continue to decrease due to improving conditions in the labour market. That will result in the higher tax revenue and lower demand for social benefits. These factors will contribute to decreasing budget deficits of the euro area states. Low interest to be paid along with existing debts will also contribute to the reduction of budget deficits in euro area states. Uncertainty associated with these projections is linked to political events in Europe and the UK s negotiation with the EU. More rapid economic growth is projected for the UK compared to last year; however, prospects for the following year are still viewed conservatively. Projections for the short-term are underpinned by favourable private sector confidence indicators and the perception that the growth of the UK economy in 7 will be determined by rapid growth in exports due to the devalued GBP as well as the growing global economy, which might possibly be masking certain consequences of the UK s referendum for leaving the EU. Slower GDP growth in the UK is only projected for 8, mostly because of the projected decrease in business investment and the real disposable income of households (the latter is expected to decrease because of higher inflation), as well as several factors that add uncertainty to the equation, i.e., negotiations with the EU and the transferral of part of the financial services sector to other EU states. Projections show that this year, economic situation in all of Lithuania s most important export partners will improve, while the growth rate of Germany s economy will remain stable. In, Russia s GDP decreased by. per cent (by.8% in ), but this year Russia s economy is expected to start growing. These optimistic projections for Russia s economy are based on higher oil prices and the data from early 7 that demonstrates real income growth. However, a sense of uncertainty remains due to geopolitical tensions. GDP growth for 7 in Estonia (.%) and Latvia (%) should increase due to recovering investment, but projected economic growth in these countries might not be reached if the absorption of EU funds takes longer than expected. Both in Estonia and Latvia, a rise in wages should increase private consumption. Growing wages and emigration should also reduce the level of unemployment in Latvia. As projected for the short-term, the Estonian labour force will grow more rapidly than employment and this will be the consequence of a new reform encouraging individuals of retirement age to return to the labour market, and positive migration balance. Polish economic development in 7 should mostly be determined by internal demand stimulated by fiscal policy. The growth of internal demand will also be affected by increasing social benefits and the improved situation in the labour market: increasing According to the IMF, economic development in 7 should be more rapid both in emerging market economies and in advanced economies. GDP developments and inflation in selected advanced and emerging market economies Real GDP change, per cent 7* 8* Global... Advanced economies.7.. USA... Euro area.7.7. UK.8.. Emerging market economies...8 China.7.. Russia... Brazil...7 Inflation, percentage Advanced economies.8..9 USA..7. Euro area..7. UK... Emerging market economies..7. China... Russia 7... Brazil Source: IMF. * April 7 projections. Recently, the global composite Purchasing Managers Index mostly grew due to the improving situation in the euro area countries. Chart. Development of Purchasing Managers Indices Index 7 China Euro area US World Source: Markit. The economic development of important Lithuanian export partners is getting stronger at a moderate rate. Chart Variation and projections for real GDP of Lithuanian export partners Per cent, annual change 7 8 Estonia Germany Latvia Poland Russia Source: IMF. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

8 wages and decreasing level of unemployment. Projections show that Polish export growth will remain stable, while growing wages will not influence competitiveness significantly because of increasing employee productivity. In Scandinavian countries, economic development varies: Sweden s economic growth pace is rapid, but it is expected to become slower. Denmark and Norway s economies are growing slower, but economic development shows an upward trend. In Sweden, projections show a possible fall in public sector consumption due to lower expenses for the asylum seekers and decreasing investment in construction due to a shortage of qualified labour and decreasing supply of land suitable for construction. The uncertainty of global demand may also have a slowing effect on business investment in Sweden. The economic development trends emerging in Denmark and Norway are mostly related to a growth in private consumption. This development is stimulated by increasing employment and disposable income. The income level of Denmark s residents should increase due to planned structural reforms, while predominant low interest rates should lead to growth in individual and business investment. Monetary policy implemented by major central banks is still loose; however, policy intensity is decreasing. In December, the Federal Reserve began gradual tightening of monetary policy and raised US interest rates by. p.p. In December and March 7, the Federal Reserve raised interest rates by. p.p. each time. There is an expectation that these interest rates will continue to be raised in 7 and 8. The main reason for this is a significant change in macroeconomic situation: labour market indicators are close to full employment indicators, inflation has almost reached the objective set by the Federal Reserve, and fiscal policy is expected to become more accommodative. In the euro area, an expanded APP continues to be implemented, and it is expected to be implemented up to at least December 7 (for more, see Section II of this review). A fair amount of uncertainty is prevalent in the UK due to the effect of its exit from the EU; however, the country plans to stick to its accommodative monetary policy without any change in its degree. The level of the monetary policy implemented by Sweden s central bank should not change in 7. Sweden s interest rates, which have now reached. per cent, are also not expected to be adjusted at least until mid-8. In Japan, it is expected that inflation will rise slightly due to the weak yen, while the monetary policy implemented by the Bank of Japan does not demonstrate any intention to change the nature or level of accommodation. Denmark and Norway s economic growth is expected to increase more rapidly due to increasing private consumption, while Sweden s economic development is expected to be slower due to decreasing public sector consumption. Chart. Change in real GDP of Scandinavian countries Per cent, annual change 7 8 Denmark Norway Sweden Source: IMF. The prices of agricultural raw materials are not changing substantially, while metal prices are growing and oil prices, which increased in mid-, are now changing less. Chart. Price index for raw materials Index, m. = 7 Agricultural raw materials Metals Crude oil* Sources: IMF and Bank of Lithuania calculations. * Brent, WTI and Dubai Fateh average oil prices. Trends in primary commodity prices have lately varied. The rise in metal prices was spurred on by demand for metals in China, which grew due to accommodative fiscal policy and investment in construction, the closure of certain mines due to insufficient investment and in reaction to concerns about air pollution.. IMF projections show that the prices of the majority of metals should remain similar as they are now throughout 7, but compared to, they will be up by per cent. However, if uncertainty about demand in China continues to prevail, metal prices may fluctuate. The prices of agricultural raw materials which rose faster last year, are expected to increase at a slower pace this year. Such IMF projections are based not only on expectations of more favourable weather conditions for farming, but also on the accumulated agricultural raw materials reserves of certain countries, e.g., China. Oil prices at the beginning of 7 were almost 8 per cent greater than a year ago, however, they fell substantially in mid-march. The cause of such a sudden drop was a surplus in oil supply. The great supply of oil is mostly contributed by the US, while OPEC members and other countries who have signed the For more on the causes of recent metal price growth, see: L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

9 agreement regarding the reduction of oil production are decreasing production at slower rates than agreed upon. Besides, three countries Libya, Nigeria and Iran were not included in the agreement and thus produced greater amounts. A further drop in oil prices may be affected by the fact that global demand for this raw material is evaluated more carefully than before. This evaluation is based on the possible decrease in demand for oil in certain countries (e.g., China). 7 L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

10 II. MONETARY POLICY OF THE EUROSYSTEM 8 From November to May 7, the Eurosystem continued implementing particularly accommodative monetary policy and announced plans to maintain it for a long time. With the aim of bringing inflation and its expectations closer to the price stability objectives established by the ECB in a sustainable manner and ensuring more robust economic growth in the euro area, the Eurosystem extended its expanded APP. In addition to this, the ECB Governing Council continued to maintain key interest rates at low levels and expected them to remain at present or lower levels for an extended period of time, and well past the horizon of the ECB s net asset purchase programme. In December, the Governing Council of the ECB decided to extend the expanded APP until December 7 or longer if necessary. In any case, it will run until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim, which is lower, but close to per cent over the medium term. The predetermined end-date (March 7) for the expanded APP had been approaching, but according to the Governing Council, price growth had not yet been sufficiently sustainable, thus the expanded APP was extended. However, its scope was reduced: from April 7, the amount of DSI bought up in a month was reduced from EUR 8 to billion because the risk of deflation had decreased cardinally. In order to ensure the smooth implementation of the expanded APP, the decision was made to shorten the minimal residual maturity of DSI that can be purchased under the Public Sector Purchase Programme (PSPP) from two years to one and, if necessary, buy DSI with a yield below the deposit facility interest rate (.%). The Governing Council has not altered key interest rates since March and continues to declare forward guidance indicating that key ECB interest rates will remain at present or lower levels for an extended period of time, and well past the horizon of its net asset purchases. The Eurosystem continued to smoothly implement the expanded APP. The expected overall duration of the expanded APP will be months the programme is intended to run at least until the end of December 7. The overall scope of the programme amounts to EUR. trillion. By the end of April 7, assets worth EUR.8 trillion had been bought under the expanded APP. The DSI purchases made by the Eurosystem under the PSPP amounted to EUR. trillion, which makes up 8 per cent of all asset purchases made under the expanded APP. The Bank of Lithuania, like all the other national central banks in the euro area, has continued to proportionately contribute to the implementation of the Eurosystem s expanded APP. Until the end of April 7, the Bank of Lithuania had purchased DSI amounting to EUR 7.7 billion under the PSPP. The majority of these were DSI by European institutions. The remaining share of these purchases consisted of the Lithuanian government s DSI. The Bank of Lithuania, together with the ECB, had purchased DSI by the government of Lithuania worth EUR. billion until the end of April 7. In March 7, the Eurosystem completed the implementation of quarterly TLTRO-II. The total sum lent to banks over the four distribution stages of TLTRO-II amounted to EUR 7 billion: new loans amounted to EUR 7 billion, while the remaining EUR million were used by banks to refinance TLTRO-I (the amount of EUR billion had been lent under TLTRO-I). Banks were especially active participants in the last TLTRO-II, implemented in March 7 because this was the final opportunity to receive long-term (four-year) financing for especially low interest rates (.% to.%, based on the dynamics of lending). The possibility of implementing TLTRO-III was not considered because of the improved assessment of the economic situation in the euro area. In response to sluggish euro area economic recovery and falling inflation, the Eurosystem has been gradually cutting ECB interest rates since. Chart. ECB deposit facility and MRO interest rates and inflation Per cent MRO interest rate Deposit facility interest rate Annual change of HICP Source: Thomson Reuters Datastream. Expanded APP had made the greatest impact on the decrease in the yields of DSI by governments in the euro area before it was even announced because financial markets had adjusted asset prices based on the increasing probability that the ECB would implement non-standard monetary policy measures. Later, much of the fluctuation was caused by other factors. Chart. Annual yields on euro area government bonds with the maturity of years, issued in national currencies Per cent Euro area average Germany France Italy Spain Lithuania Sources: ECB and Thomson Reuters Datastream. Eurosystem s monetary policy instruments contribute to maintaining favourable financing conditions for households. Chart 7. Average interest rates on new MFI mortgage loans Per cent Dispersion across the euro area countries In the euro area In Lithuania Sources: ECB and Bank of Lithuania calculations. Note: -month moving average; interest rates in Greece have not been included due to exceptional economic conditions there. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

11 Since the end of, yields of euro-denominated DSI have re mained essentially unchanged. The DSI yield for non-financial corporations and average long-term ( years) government DSI yield fluctuated only slightly. In fact, in 7, the DSI yield of certain euro area Member States (especially France) increased due to the growing political risk of Euro-sceptic politicians or parties winning national elections. However, this risk turned out to be short-lived. The expanded APP had made the greatest impact on the decrease in the yield of euro-denominated DSI before it was even announced because the worsening economic prospects of the euro area had meant an increasing probability that the ECB would implement non-standard monetary policy measures. Later, much of the fluctuation was a consequence of other factors because the greater part of the impact of the expanded APP had already been calculated into the asset prices by financial markets. The Eurosystem s set of monetary policy measures continued to contribute to favourable financing conditions and stimulate crediting in the real sector of the euro area and Lithuania. Average interest rates on new loans both for households and non-financial corporations did not significantly change from the end of and remained at the lowest levels in the history of the euro area. This had a positive effect on the ability to borrow in the real sector. In Lithuania, loan portfolio expanded much more rapidly than in the rest of the euro area. The interest rates on new loans stopped falling in Lithuania earlier than in the remaining euro area because demand for loans grew more rapidly and the share of loans for which a rate of. per cent was applied instead of negative EURIBOR rates for determining interest payments increased. The especially accommodative monetary policy applied by the Eurosystem continued to exert a positive effect on the macroeconomic development of the euro area and Lithuania. According to ECB experts, the large-scale accommodative monetary policy implemented by the Eurosystem will lead to both the GDP of the euro area and price level to rise faster by.7 p.p. from to 9. The Eurosystem s accommodative monetary policy has a positive effect on Lithuania s economy mainly through the exporting sector: higher demand in the euro area and the depreciation of the euro exchange rate provide more opportunities for Lithuania s export. According to the Bank of Lithuania, this accommodative monetary policy will increase the growth of our country s real GDP and inflation by.9 and. p.p. respectively in 9. The financing conditions for non-financial corporations remain favourable due to the Eurosystem s monetary policy instruments as well. Chart 8. Average interest rate on new MFI loans to nonfinancial corporations Per cent Dispersion across the euro area countries In the euro area In Lithuania Sources: ECB and Bank of Lithuania calculations. Note: -month moving average; interest rates in Greece have not been included due to exceptional economic conditions there. The Eurosystem s favourable financing conditions contribute to the crediting in the real sector of Lithuania and the euro area. Chart 9. The dynamics of MFI loans to households and nonfinancial corporations in the euro area and Lithuania Per cent, annual change To households in the euro area To non-financial corporations in the euro area To households in Lithuania To non-financial corporations in Lithuania Sources: ECB and Bank of Lithuania calculations. Note: adjusted for sales and securitization. 9 For more on the causes behind the rapid growth of the Lithuanian loan portfolio, see Section VII of this review. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

12 III. REAL SECTOR After strengthening in the second half of, the development of the Lithuanian economy continues at a healthy rate. Greater GDP growth in the second half of was the result of trade and transport development and the subsiding decline of the construction sector. The development of these economic activities outweighed the impact of the year s poor harvests and, in turn, the weak activity of the agricultural sector. The value added generated by most other economic activities also increased, and their impact on GDP growth resembled their impact in the first half of. Escalating tensions in the labour market, wages rising more than productivity, and high use of production capacity in the industrial sector demonstrate that the economy is near its potential level or has slightly surpassed it, i.e., the production gap is likely to be positive. Household consumption remains the main factor behind the growth of the Lithuanian economy. One of the key factors determining domestic consumption growth is a favourable labour market for households, particularly robust wage growth. In, the trend of faster wage growth among those with lower income prevailed. As the average propensity to consume of low income households is greater than the corresponding propensity to consume for high income households, the above mentioned trend in income growth has contributed to the rapid growth of household consumption even when disposable income growth was much weaker. The latter was only increased by growing wages, more generous social benefits and net current transfers. Income from other sources, for example, economic activity or accumulated capital, decreased. Even though there are, as of yet, no plans to increase minimum wage this year, certain administrative decisions have been made that should contribute in 7 to the growth of income for low income individuals. These decisions increased non-taxable income amounts and oldage pensions. Exporters ability to compete and the recovery of external demand determined the growth of real export, particularly services. Rapidly growing service exports can be mostly linked to the transportation sector and the ability of enterprises operating in this sector to find new trade partners in Western markets. This growth of transportation activity is not just the consequence of growing demand abroad the latter grows slower than the activity transportation companies. Transportation companies occupy an increasingly larger share of various export markets and compete with transportation companies from other states. As foreign trade in the EU recovers and carriage capacity grows, prospects for the growth of the transportation sector in 7 are viewed favourably. Last year, industry s export increased as well. Activity in this sector was mostly influenced by manufacturing, especially of chemical, pharmaceutical and metal products (excl. machinery and equipment). Increased activity in the chemical industry was mostly influenced by demand for PET pellets due to warmer than usual temperatures in Southern Europe. Activity in the pharmaceutical sector increased because an increase in production capacity led to the continued growth of exports of biotechnological products. The situation in the metal product (excl. machinery and equipment) industry improved due to stabilising investment. The scale of manufacturing activity mostly grew due to extensive development, i.e., increasing hours worked, while the impact of intense growth (productivity growth) was only slight in the recent years. Experiencing a significant fall in the first half of, EU funding flows stabilised in the second half of the year and were among the most critical factors of the stagnation of investment and drop in activity within the construction sector. In, EU funds allocated for capital formation amounted to EUR million (this made up.% of the GDP for the corresponding period) less than the year before. However, After strengthening in the second half of, the development of the Lithuanian economy continues at a healthy rate. Chart. Contributions to real GDP by expenditure approach 7 7 The exporters ability to reorient their activities to faster growing regions and the revival of external demand determined the growth of real export, particularly, services. Chart. External demand and real exports of goods and services (chain-linked volumes, seasonally and calendar adjusted data) Experiencing a significant fall in the first half of, EU funding flows stabilised in the second half of the year and were among the most critical factors of the stagnation of investment and drop in activity within the construction sector. Chart. Capital transfers to Lithuania (at current prices) 7 Agriculture, forestry and fishing Industry Construction Trade, transportation, accommodation and food service activities Financial and administrative activities, real estate Other services Taxes, subsidies and statistical error GDP (rh scale) Per cent, annual change 8 Per cent, annual change 8 Foreign demand Real export of goods and services Sources: ECB and Bank of Lithuania calculations. Per cent Per cent Capital transfers to Lithuania and GDP ratio (seasonally adjusted) Per cent, annual change (rh scale) Sources: Statistics Lithuania, Bank of Lithuania, and Bank of Lithuania calculations. 8 L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

13 this year, a substantially larger sum is expected. In, greater drop of investment was prevented by more active investment by both private and government sectors in the projects that could not have been financed with EU funds. Based on scale, investment in national defence stood out in the government sector, and investment in housing in the private sector. However, neither housing, nor national defence are areas in which investment would significantly increase Lithuania s labour productivity, an indicator that has failed to meaningfully increase for the past two years. Even though Lithuanian spending on productive investment and R&D has increased in the recent years, Lithuanian indicators are still poor within the context of the EU. The ratio of Lithuania s productive investment (machinery and equipment, excl. transport equipment, and intellectual property products) and GDP from to was one of the lowest in the EU. Lower indicators were only produced by Cyprus, Greece (both these countries experienced economic recessions during the reference period) and Luxembourg. Lithuania is also a member of the group of EU states that invest the least in research and development (R&D). From to, the ratio of spending on R&D and GDP did not exceed per cent. Most investments in R&D in Lithuania are made by higher learning institutions, and their spending makes up over half of all Lithuanian spending on R&D. Business sector investment in R&D makes up slightly more than a quarter of all spending, or. per cent of the GDP. Compared to leading countries in this field, the ratio of Lithuania s business sector spending on R&D and its GDP is especially low. For example, the business sectors in Austria, Denmark, Finland, Sweden and Germany spend about per cent on R&D in relation to their respective GDPs. Low spending on R&D limits the ability of corporations to produce products of higher value added, which would allow them to compete more successfully in international markets. Even though spending on productive investment has increased in Lithuania almost up to the highest level since records began, Lithuania s productive investment and GDP ratio remains one of the lowest in the EU. Chart. Productive investment and GDP ratio in Lithuania and the EU 8 Share of GDP, per cent 8 Three lowest ratios European Union Lithuania Sources: Eurostat and Bank of Lithuania calculations. Notes: due to lack of data Romania (-), Ireland (), Belgium (), Hungary () and Germany () are not included. Productive investment is defined as machinery and equipment, excl. transport equipment, and intellectual property products. The ratio of spending on R&D and GDP among Lithuanian companies is one of the lowest in the EU. Chart. Spending on research and development in Lithuania and the EU Share of GDP, per cent Three lowest ratios European Union Lithuania Sources: Eurostat and Bank of Lithuania calculations. Notes: due to lack of data Ireland () is not included. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

14 IV. LABOUR MARKET A large part of the increase in declared emigration over the past years was caused by non-economic factors. Tightening of the regulation of temporary residential permits for foreigners contributed to the increase in emigration in. This caused a larger number of Russian, Ukrainian and Belarusian citizens to emigrate from Lithuania. Also, many individuals may have been motivated to declare their emigration in and the beginning of this year by more active encouragement to check whether they hold any debts for their compulsory health insurance. Probably some of the potential debtors had already emigrated, but had not declared their emigrant status previously. Seeking to terminate their debt, these individuals may have declared their status even though they had emigrated a long time ago. For this reason, emigration dynamics should be viewed in light of other data sources, for example, statistics from other countries about immigrants or Lithuanian residents requesting social insurance numbers. Even though such data is not provided by every country, it does cover a substantial portion (around two thirds) of Lithuania s total emigration. This data shows that emigration from Lithuania in and did not increase and resembles the levels recorded in. However, compared to emigration levels in other new EU members, it was still very high. New jobs are being created two times more slowly than the average growth rate recorded during a period of economic recovery. Slower growth was determined by the construction and manufacturing sectors. The more than year-long downturn of the construction sector forced construction companies to cut jobs. However, the latest data shows that construction activity is recovering: fewer companies are encountering insufficient demand, and the scale of construction activity is increasing. By the end of last year, new jobs were not being created in the manufacturing either. This trend prevailed in many of its industries: food, wood, furniture, and equipment production. Nonetheless, other indicators production volume, confidence indexes and hiring intention indicators show that the situation in the majority of these industries is sufficiently positive. Only the situation in the furniture industry, which experienced a slowdown production growth, was in less favourable. The transportation sector faired relatively well. Its companies were able to re-orient some of their operations towards the western markets and create new jobs. Statistics of foreign countries show that over the past two years emigration from Lithuania was probably stable. Chart. Emigration to the United Kingdom, Norway, Ireland, Denmark and Sweden Thousands of persons Lithuanian emigration data Imigration or social security data of foreign countries Sources: Statistics Lithuania, statistiical agencies of foreign countries and Bank of Lithuania calculations. * Emigration to these counrties account for approximately per cent of total emigration from Lithuania. The increase in the number of jobs is noticeably slower. This is caused in some part by a downturn in the construction sector and hardly increasing number of jobs in industry. Chart. Contributions to job dynamics Per cent, annual change.. Other than industry, construction, trade and transport activities Industry Construction Trade Transport Number of jobs (rh-scale) Employment and emigration continues to reduce unemployment rate. In the second half of last year, it reached 7.8 per cent and was per cent lower than the corresponding period in. However, unemployment among the unskilled persons, associated with structural unemployment, has started to decrease at a noticeably slower rate. In general, the unemployment rate among such individuals was high and stood at per cent. Unemployment among skilled individuals (who make up 9% of the labour force) continued to fall and reached. per cent in the second half of the year. This rate of unemployment, combined with rather high levels of emigration and declining number of young individuals entering the labour market, means that companies find it increasingly difficult to find employees. Increasing minimal wage and public sector wages as well as a favourable labour market for employees has resulted in especially rapid wage growth. Last year, the decision was made to increase the wages of employees working in public administration, education and healthcare. This caused wages in the public sector to increase at a faster rate similar to that in the private sector. The country s wage growth was also affected by the decision to increase minimal wage. In January, it increased by EUR, and a further EUR in July (reaching EUR 8). However, a high rate of growth was also observed for employees whose wages are unaffected by a rise in minimum wage. For example, a quarter Wages in the public and private sector have started growing at similar rates. Chart 7. Wage dynamics Per cent, annual change Private sector Public sector Source: Statistics Lithuania. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

15 of highest-earning employees experienced around per cent increase in wages. This demonstrates that the employee-friendly labour market situation is a very important factor in wage growth. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7

16 V. EXTERNAL SECTOR Having recovered from the difficulties of, exports are now growing at a similar rate as before the Russian trade limitations were placed. Data in constant prices from shows that service exports are growing rapidly as much as per cent annually. Such rapid growth means that for the first time since, service exports are contributing to export growth more than re-exports and exports of goods of Lithuanian origin. Even though much of this growth can be accounted for by intense expansion in the transport sector, other service exports are also growing. For example, last year, construction service exports increased by around per cent, even though the entire construction sector shrank within Lithuania itself. Based on data on chain-linked prices, exports of goods of Lithuanian origin, excl. mineral products, also grew at a similar rate as before trade limitations had been placed. Exports of timber, furniture and wood products increased the most. Last year re-exports did not decrease. Slight negative growth was only observed in the export of mineral products of Lithuanian origin. In, rising foreign demand helped Lithuanian exports and it is expected to rise further in the mid-term. Even though imports increased for most countries (at least in nominal value), Lithuanian exports were especially affected by the stabilising situation in Russia in. Russia remains an important Lithuanian export partner last year, exports to Russia made up per cent of all exports of Lithuanian goods. Even though, in, exports of Lithuanian goods to Russia and other CIS countries decreased, the rate at which exports decreased was much slower than in. At the beginning of 7, the Russian economic situation improved notably: nominal import of goods and the rouble to euro exchange rate increased by per cent. Lithuanian re-exports to Russia grew correspondingly, excl. mineral product exports. However, exports of products of Lithuanian origin, excl. mineral products, to Russia did not grow (in part due to the aforementioned sanctions and mostly due to the decreased profitability of the Russian market). In the mid-term, more rapid growth is expected due to the growth of foreign demand resulting from the GDP growth of developed economies (especially the US) and the positive growth of the Russian economy. Recent exports to the euro area have increased notably, while exports to the UK have decreased. At the beginning of, exports of goods, excl. mineral products, to the euro area grew slowly due to the falling prices of fertilizer and the reconstruction of one of the major fertilizer factories. Exports of goods of Lithuanian origin, excl. mineral products to the euro area, were falling for most of the year (in nominal value). Fertilizer prices remain low, but after completion of said reconstruction work exports began to grow towards the end of. In addition to this, as the Lithuanian transport sector reorients itself, re-exports to the euro area are growing. Nominal export data to the UK has declined: having increased rapidly at the beginning of, exports to the UK grew increasingly slowly, and even shrank by the beginning of 7 (by more than a tenth). The exports of other EU states to the UK also slowed compared to exports to non-uk countries. This may point to the negative impact of the UK s decision to leave the EU on Lithuanian foreign trade. However, Lithuanian data shows that some exporters chose to participate in alternative markets, and the overall scale of exports did not decrease. In, the current account was close to balanced and less negative than in. This situation was for the most part precipitated by a surplus in service trade and a decreasing goods trade deficit. The latter decreased due to temporary factors: lower prices of energy products, and reduced imports of investment goods. Now that economic development has recovered (increase of global prices of energy raw materials, more active investment in Lithuania), the balance of trade in goods could dete- Having recovered from the difficulties of, exports are now growing at a similar rate as before the Russian trade limitations were placed. Chart 8. Dynamics of Lithuanian export and foreign demand (constant prices) As the Russian economy recovers, Lithuanian reexports to Russia are growing. Chart 9. Nominal export of Lithuanian goods to Russia, nominal import of Russian goods and rouble exchange rate (-month moving averages) The current account is almost balanced. Per cent, annual change Export of services Re-export of goods Exports of mineral products of lithuanian origin Exports of other goods of lithuanian origin Export (rh scale) Foreign demand (rh scale) Sources: ECB, Eurostat, Statistics LIthuania and Bank of Lithuania calculations. Per cent, annual change 8 7 Russian ruble per euro exchange rate Russia's imports of goods Re-exports of goods from Lithuania to Russia Exports of goods of lithuanian origin to Russia Sources: Eurostat, Statistics Lithuania, Reuters and Bank of Lithuania calculations. Chart. Balance of current account and its component parts (%, compared to moving GDP averages of four quarters) Percentage of GDP Secondary income balance Primary income balance Services balance Goods balance Current account balance Sources: Statistics Lithuania, Bank of Lithuania and Bank of Lithuania calculations. L I T H U A N I A N E C O N O M I C R E V I E W / J u n e 7