Economy and financial system gained immunity, yet new challenges await
Lithuania’s economy has returned to the pre-pandemic level in terms of its gross domestic product (GDP) and the financial system has successfully weathered the challenges of the pandemic so far. Given the good economic performance at the start of the year, the GDP projection can be revised upwards to a 5.1% growth expected this year. However, vigilance is needed in the face of rising budget deficit and public debt, the continuing risk of a wave of corporate bankruptcies and a buoyant residential real estate market.
“The Lithuanian economy has had a relatively mild “bout”, even if the symptoms in individual sectors of the economy have been, and still are, quite severe. Mitigation measures for those most affected by the pandemic remain important, but we already need to do our homework to ensure that the support is not squandered away and is invested effectively, thereby contributing to sustainable long-term post-pandemic economic growth,” said Gediminas Šimkus, Chairman of the Board of the Bank of Lithuania.
According to him, the investment of billions of euros of European support in economic transformation would boost the long-term potential of the economy and facilitate future reduction in public debt. The approved 2021 Stability Programme and budget amendments currently under discussion envisage that debt will increase by nearly 10 percentage points to 58% of GDP between 2020 and 2023, approaching the Maastricht criterion of 60% of GDP. The budget deficit will go up to 6% next year, twice as high as expected earlier, and will drop back below the 3% threshold of the EU Stability and Growth Pact by 2024 only.
The economists of the Bank of Lithuania have raised their GDP growth projection by 2.2 percentage points to 5.1% for 2021 and to 4.1% for 2022 (previously projected to be 5.1%). A stronger economic recovery this year has been underpinned by confident consumption and recovering business investment which have been positively affected by the accelerating vaccination and improving epidemiological situation both in Lithuania and its main export markets. As the economic recovery has picked up pace, prices have risen faster as well. However, the increase in inflation is expected to be temporary and moderate this year. Inflation in Lithuania is projected to be 2.2% this year and 2.1% in 2022. Wages are expected to continue to rise faster than prices. According to the projections, wages will go up by an average of 7% this year and 5.9% next year.
So far, the Lithuanian financial system has not suffered significant losses due to the pandemic, and the stress testing of banks suggests that they have sufficient capital buffers to withstand even a significant hypothetical economic downturn of 6.8%. Major risks to the financial system are the deterioration of the financial health of companies affected by the restrictions and the associated economic consequences as well as the risk of overheating of the residential real estate (RE) market which has reached historic highs. Considerable uncertainty still surrounds the future scale of corporate bankruptcies, especially for businesses continuing to rely on state aid measures. These are the so-called zombie companies that will default on their obligations and go out of business once the aid stops. In the pandemic year 2020, the number of corporate bankruptcies was half of that in 2019. This year, the number of bankruptcies has fallen even further, with almost two-thirds fewer bankruptcies in the first five months of the year, compared to the same period in 2019. If the number of bankruptcies went up sharply in the future above the normal pre-pandemic levels due to the companies that have become dependent on state aid and have failed to adapt, it would have an adverse effect on other sectors as well.
The residential RE market has been feeling the effects of demand that piled up during the pandemic, as a significant rise in demand pushed housing prices up, increasing the risk of a possible overheating of the housing market.
“According to the economists of the Bank of Lithuania, housing prices currently are still in line with the fundamentals, which have also improved during the pandemic, as wages, savings and the population in the major cities have grown rapidly. However, a cocktail of a prolonged boom in the RE market and over-optimistic expectations could lead to unsustainable price increases and an overheating of the housing market. This is why we are closely monitoring this market and are ready to respond when we see the need to do so,” said Šimkus.
However, it is not over-crediting but the spiralling demand, which has emerged during the pandemic, that poses a risk to the RE market. The share of homes purchased with loans has been stable and the requirements of the Responsible Lending Regulations are a reliable safeguard against excessive borrowing.
The most significant temperature rise has been seen in the primary market, i.e. new housing sold by developers. This is where the demand-supply gap has emerged and players went back to speculation on reservations, which has been forgotten since the previous RE crisis, where the aim is to resell the reservation contract at a premium rather than to buy the reserved property. No objective assessment of trends in this market can be made due to the lack of real-time official data on reservations, which is why the Bank of Lithuania has put forward a proposal to make the registration of such contracts mandatory. A register of contracts would improve transparency of this market and help identify the number of provisional sales, the number of transactions based on drawings as well as speculative reservations.
A review of property taxation could also contribute to better sustainability of the RE market. The Bank of Lithuania is ready to play an active role in discussions on the improvement of the property tax framework.
Capital requirements for credit institutions that were relaxed during the pandemic remain in place. The Bank of Lithuania reviews the countercyclical capital buffer rate, which is currently set at 0%, on a quarterly basis and banks will be able to use a sectoral systemic risk buffer following the implementation of the Capital Requirements Directive of the EU later this year. This buffer can be used to increase capital requirements for a specific lending segment such as housing loans. The share of housing loans in the portfolios of banks has been rising since 2016, and the housing loan portfolio itself has continued to grow rapidly. For several years now, the growth of housing loans and house prices in Lithuania has been among the fastest in the EU. If the importance of housing loans in the financial system continued to increase, the situation remained the same and the economy continued to grow, the Bank of Lithuania would consider using a sectoral systemic risk buffer for the housing loan portfolio to increase capital buffers of banks and their resilience to the risk of a possible overheating of the residential RE market.
The Financial Stability Review is published by the Bank of Lithuania on an annual basis. Its purpose is to assess potential risks to the Lithuanian financial system and identify possibilities to withstand them. The Macroeconomic Projections of the Bank of Lithuania are updated on a quarterly basis.