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Lithuania’s economic development and outlook

The global economy is recovering, but with uneven development trends. With prices rising less and real income slowly recovering, the services sector has strengthened in many regions of the world. It is benefiting not only from the favourable situation in the labour markets of various countries, which has contributed to a fairly significant rise in wages, but also from the continuing increase in demand for the services whose availability was limited during the pandemic. In the euro area and in some other regions, the expansion of the services sector accounts for the bulk of overall economic growth. The manufacturing sector is underperforming. The start of a decrease in stocks accumulated by enterprises and the growing purchasing power of the population led to a recovery of the manufacturing sector in the first half of 2024, however this recovery was not observed everywhere. The industry in the US and China picked up, but the euro area industry continued shrinking. In the euro area countries, industrial output has been decreasing since the beginning of 2023 and is currently only at the level observed in 2019. Surveys of purchasing managers suggest that the situation in the manufacturing sector in many regions of the world will be challenging in the near future due to a significant increase in the number of various restrictions on international trade and continued considerable geopolitical uncertainty. In both the euro area and other regions, manufacturing is not expected to expand in the short term.

Economic activity has also picked up in Lithuania. The services sector is the main driving force behind overall economic growth. For some considerable time now, information and communication activity has been growing to a significantly greater degree than the economy as a whole. Upon attracting an increasing number of workers over the past few years, it accounted for about a quarter of total economic growth in the first half of this year. During this period, the added value generated by information and communication activity was almost one tenth higher than a year ago. Other services, namely, professional, scientific, administrative and support services, which play an increasingly important role in economic development, also contribute rather significantly to overall economic development. Domestic trade is also expanding, with real household income rising markedly. Private consumption is now much higher than a year ago. Private consumption as a whole is actually influenced not only by higher wages and other income, but also by population growth. Real private consumption per capita has still not returned to the historical peak observed in early 2022, before the period of higher inflation rates set in. To a lesser extent than many other activities, manufacturing is nevertheless bolstering economic activity this year, although the sector shrank significantly last year. Stocks of manufactured goods have decreased considerably, while orders for industrial goods have increased. In all major manufacturing industries, the situation has improved, or at least is not substantially worse than a year ago.

The labour market situation remains good, but there are some unfavourable developments. The total number of persons employed has decreased over the last few months.[1]

[1] Based on data of the State Social Insurance Fund Board under the Ministry of Social Security and Labour.

This is mainly due to economic activity in the transport sector. Excluding the latter, hiring remains at about the same level as a year ago. Other unemployment trends are also emerging. After starting to rise in 2022, the unemployment rate has not yet declined. It has risen by almost 2 percentage points in two years. Unemployment has increased in many social groups, namely, among both women and men, in urban and rural areas, and in different age groups. As the number of unemployed persons continues to grow, the duration of unemployment is increasing. Two years ago, the number of the unemployed mostly grew because of the short-term unemployed with up to 2 months out of work, while more recently the growth has been driven by the unemployed for 3 to 11 months. With growing unemployment, continued positive net international migration and a rather uneven recovery in various sectors of the economy, the labour shortage is less pronounced and the pressure on wages is easing. The growth of wages has been slowing down, especially in the private sector, for two years. Wage growth is also being held back by labour productivity, which has not yet recovered. The latter has not increased for the third consecutive year and is well behind the growth trajectory observed before the shocks of recent years, i.e. behind the trend observed until 2019. The sluggish expansion of the exports sector, the continued higher prices for raw materials compared to prices a few years ago and the desire to retain existing workers in anticipation of a strengthening of demand (especially in foreign markets) in the longer term, all seem to be contributing factors to such productivity dynamics.[2]

[2] This is known as labour hoarding.

Economic activity is projected to grow slowly. In the second half of 2024, Lithuania’s economic development will be slower than in the first half of the year due to the weaker performance of foreign economies and is expected to pick up next year. Economic growth will be stimulated more by rising foreign demand. With prices rising less, real income of the population increasing and financing conditions improving, some economies (more specifically in the euro area) are expected to grow faster. As a result, demand for goods and services exported from Lithuania will rise more rapidly. The amount of European Union (EU) support funds available for investment is expected to increase next year. This will outstrip the rise in nominal gross domestic product (GDP), which will have a significant impact on economic development. The use of EU support funds, more robust domestic and foreign demand should lead to higher investment by both the public and private sectors, outweighing the temporary decline in investment observed in 2024. The favourable situation in the labour market should also contribute to economic growth, allowing for a rise in real personal income and consumption. Real GDP is projected to increase by 3.1% next year after growing by 2.2% this year. Faster economic development is also expected in the following years. In 2026, real GDP is projected to grow by 3.3%. However, it should be noted that the economic growth rate will not be as rapid as observed before the shocks that occurred in recent years. Economic development will be constrained by reduced opportunities to make increasingly inclusive use of existing labour resources, aggravating domestic demographic challenges, and the markets of major trading partners expanding less than in the previous decade.

Price dynamics remain sluggish. For more than a year and a half, the overall level of consumer prices in Lithuania has been fairly stable. In the first seven months of this year, it exceeded the year-earlier figure by a meagre 0.9%. Price increases have been held back by economic recovery that has not been robust in all regions of the world, energy commodities that essentially have not become more expensive, a rise in the supply of food commodities, and a significant easing of tensions in global supply chains for goods and commodities. Partly as a result, energy and unprocessed food prices in Lithuania have been lower this year than a year ago, while prices of processed food and industrial goods (excluding energy) have risen only marginally. Overall consumer price increases in Lithuania are mainly stimulated by labour costs. For some considerable time now, wages have been rising much to a greater degree than labour productivity, creating continued pressure on prices, especially for services. So far, the slowdown in the rise of prices for services that are less sensitive to labour costs has been more significant, while prices for services that are more sensitive to labour costs are still rising at a rather fast pace. Core inflation, and hence prices for services, is also significantly affected by inflation inertia, which includes menu costs, the impact of price indexation taking into account previously high inflation rates, expectations and uncertainty about the future.[3]

[3] For more information on core inflation, see Box 4.

Rising prices for services are expected to be the main driver of headline inflation throughout the projected period, as labour costs will continue to increase markedly. Over the longer term, as commodity prices stabilise and economic growth picks up in some regions of the world, energy as well as processed and unprocessed food prices will increasingly boost headline inflation. After falling to 1.0% this year, average annual headline inflation is projected to reach 2.5% next year and 2.6% in 2026.[4]

[4] The impact on inflation of excise duties raised to meet the need to finance future defence expenditure is projected to be 0.3 percentage points per year between 2025 and 2026.

Table 1. Outlook for Lithuania’s economy

	September 2024 projection^a			June 2024 projection
	2024b	2025b	2026b	2024b	2025b	2026b
Price and cost developments (annual percentage change)
Average annual HICP inflation	1.0	2.5	2.6	1.2	2.4	2.4
GDP deflatorc	3.4	3.1	3.1	3.0	2.9	3.0
Wages	9.8	8.5	8.1	10.2	8.5	8.1
Import deflatorc	–0.8	1.8	2.3	0.4	2.6	2.5
Export deflatorc	1.4	1.7	2.4	1.7	2.8	2.6
Economic activity (constant prices; annual percentage change)
GDPc	2.2	3.1	3.3	1.9	3.1	3.3
Private consumption expenditurec	3.6	3.7	3.7	3.4	3.7	3.7
General government consumption expenditurec	0.2	0.0	0.0	0.1	0.0	0.0
Gross fixed capital formationc	–3.6	6.6	5.1	4.5	4.1	5.2
Exports of goods and servicesc	1.2	3.1	3.8	1.2	3.7	3.7
Imports of goods and servicesc	0.0	4.5	4.5	1.5	4.6	4.5
Labour market
Unemployment rate (annual average as a percentage of labour force)	7.4	7.1	6.9	7.3	7.1	6.9
Employment (annual percentage change)d	1.6	–0.4	–0.3	0.5	–0.2	–0.3
External sector (percentage of GDP)
Balance of goods and services	6.1	5.0	4.6	4.5	3.9	3.5
Current account balance	3.2	1.6	1.1	1.8	1.2	0.5
Current and capital account balance	5.1	3.7	2.7	4.1	4.0	2.7

a The macroeconomic projections are based on assumptions about the international environment, constructed using information made available by 16 August 2024, and other data and information made available by 30 August 2024.

b Projection.

c Adjusted for seasonal and workday effects.

d National accounts data; employment in domestic concept.

1.International environment

Global economic growth has remained stable although slower than the historical average. The global GDP is expected to grow by 3.2% this year and 3.3% next year.[5]

[5]Macroeconomic projections of the IMF, July 2024.

Economic activity has been driven by international trade, which had started to recover from stagnation last year. It is expected to grow in line with GDP, with trade increasing by slightly more than 3% both this and next year.[6]

[6]Ibid.

Global inflation should continue to decline and central banks in advanced economies are likely to reach their targets in the second half of next year. Rapidly rising nominal wages, coupled with services inflation, pose risks to global disinflation. In addition, geopolitical tensions and further restrictions on international trade remain significant downside risks to a more substantial economic recovery.

GDP growth in the US has remained strong although a greater slowdown is expected next year. It is expected to rise to 2.6% this year, 0.9 percentage points above the average growth rate for developed countries.[7]

[7]Ibid.

A slightly sharper slowdown (to 1.9%) is expected next year. This implies that growth in the US will be broadly in line with GDP developments in other advanced economies. The reasons for the projected slowdown are high key interest rates and gradually tightening fiscal policy, factors that are slowly cooling the domestic labour market.[8]

[8]Ibid.

While real GDP will remain above its potential this year, economic growth is expected to taper to its potential by the end of next year.[9]

[9]Ibid.

China’s economy is expected to grow slightly faster than previously anticipated, though growth remains slower than the pre-pandemic average. GDP is expected to grow by 5.0% this year and 4.5% next year. China’s short-term growth outlook has been revised upward on the back of a rebound in consumption and higher exports in the first quarter of 2024.[10]

[10]Ibid.

Nevertheless, private investment contributed negatively to GDP growth at the beginning of this year[11]

[11]IMF China Article IV Consultation Report, August 2024.

signalling diminished confidence in the future economic outlook. A dip in confidence is reflected in household savings that have remained above their historical average, with slowly rising retail sales and consumer price inflation. As a result, medium-term GDP growth is projected to continue to fall short of its potential.[12]

[12]According to the IMF 2024 China Article IV Consultation Report, the Chinese GDP growth will fall short of its potential in 2024 and 2025.

The euro area economy is expected to recover modestly this year with a slightly stronger GDP growth projected next year. GDP growth is expected to be 0.8% this year and economic activity should accelerate further to 1.3% in 2025.[13]

[13]Macroeconomic projections of the ECB, September 2024.

Private consumption will be the main contributor to growth in 2024–2025, driven by declining annual average headline inflation (2.5% in 2024 and 2.2% in 2025) and rather rapidly rising wages despite a relatively high savings rate.[14]

[14]Ibid.

Foreign demand, which has been accelerating after last year’s stagnation, will also significantly contribute to the euro area’s GDP growth this year. However, geopolitical shocks continue to be a source of downside risk for both inflation and economic activity.

Germany’s economy is expected to return to positive growth this year, but a more significant recovery is not anticipated until 2025. GDP growth is expected to reach 0.3% this year and 1.1% next year.[15]

[15]Macroeconomic projections of Deutsche Bundesbank, June 2024.

The modest growth this year is largely due to a rebound in private consumption, driven by a decline in inflation from 6.0% in 2023 to 2.8% in 2024. Low unemployment and sharply rising wages (with nominal wages expected to increase by around 6%) will further support this recovery.[16]

[16]Macroeconomic projections of Deutsche Bundesbank, June 2024.

While export growth is expected to gradually recover in the second half of this year, it should be weak, reaching just 0.9% of GDP due to the weakened competitiveness of Germany’s external sector, impacted by higher wage costs, regulatory environment, and energy prices.[17]

[17]Ibid.

Export growth is projected to pick up to 2.1% next year but will continue to lag behind demand growth in main sales markets.

Poland is expected to see a significant recovery this year, with GDP growth accelerating further next year. After GDP grew at a rate of 0.2% last year, economic growth is projected to accelerate to 3.0% and 3.8% in 2024 and 2025 respectively.[18]

[18]Macroeconomic projections of Narodowy Bank Polski, July 2024.

The recovery is underpinned by the diminishing impact of global shocks, for instance, a reduction in energy and food price inflation contributes significantly to slower consumer price growth and hence normalisation of consumer confidence.[19]

[19]Ibid.

Private consumption and investment are projected to be the main drivers of recovery, especially in 2025.

Projections for the neighbouring Baltic countries vary, with Latvia’s GDP projected to grow this year and the downturn in Estonia expected to continue. After last year’s stagnation, the recovery of Latvia’s GDP is underpinned by a significant decline in inflation, from 9.1% in 2023 to 1.5% in 2024, and rapidly rising wages.[20]

[20]Macroeconomic projections of Latvijas Banka, June 2024.

However, geopolitical risks and uncertainty about the future continue to have a negative impact on consumption and investment decisions in the private sector. Annual GDP growth in Estonia is projected to be negative, despite the economy picking up in the second half of 2024,[21]

[21]Macroeconomic projections of Eesti Pank, July 2024.

driven by a recovery in demand from Estonia’s main trading partners.

2.Monetary policy of the Eurosystem

In June, the Governing Council of the ECB began easing the restrictive monetary policy stance. It decided to cut the key (deposit facility) interest rate by 25 basis points to 3.75%. This was the first change in interest rates since the cycle of interest rate hikes of 2022–2023, after which the rate remained unchanged at 4% for nine months. The decision took into account the decline in inflation over this period, easing pressure of underlying inflation and improving inflation outlook. These changes ensure that the price stability objective will be achieved with a slightly less restrictive monetary policy stance. In parallel, it was decided in June to reduce the reinvestment volume under the pandemic emergency purchase programme by an average of €7.5 billion per month in the second half of 2024. In July, considering the necessity to maintain the current monetary policy stance in the context of persistent strong domestic price pressures, the decision was made to keep the key interest rate unchanged.

Following the update of macroeconomic projections in September, it was decided to cut the key interest rate again by 25 basis points. The Governing Council considered that inflation dynamics and its outlook were consistent with the 2% target over the medium term allowing for a further moderate easing of the monetary policy stance. The outlook for economic growth was slightly downgraded, while the projected headline inflation remained unchanged. It was also decided not to commit to possible future decisions and to respond flexibly at each meeting based on all available data.

Interest rates, which still ensure the restrictive monetary policy stance, will continue to help inflation to get back to the 2% target. Inflation in the euro area has fallen four-fold since it went over 10% in October 2022 (see Chart 1). Although inflation is currently still above the ECB’s price stability target, it is expected to reach around 2% in the second half of next year. This will be driven both by the impact of past interest rate hikes and their continuing restrictive level. Financial market participants expect interest rate cuts to continue as inflation gets closer to the target level. However, the Governing Council of the ECB will adopt its decisions at each meeting on the basis of all available information.

Key ECB interest rates have started to decline but are still high.

Chart 1. Interest rate and inflation dynamics in the euro area

Sources: ECB and LSEG Datastream.

Note: Data as of 12 September.

Falling interest rates are spilling over into the loan market (see Chart 2). The sharp rise in interest rates on new loans in 2022–2023 was driven by an increase in the variable component of interest rates on loans as a result of monetary policy decisions. Accordingly, this rise stopped in the second half of 2023 and was replaced by a gradual decline in 2024 as the Governing Council of the ECB stopped raising interest rates giving rise to an expectation of a rate cut. In Lithuania, interest rates on new loans are still higher than the euro area average and the difference is larger in the segment of new housing loans. Part of the difference is explained by the fact that almost all housing loans in Lithuania (around 97%) have variable interest rates (usually 3, 6 or 12-month EURIBOR), while the euro area average is much lower (around 18%). As a result, Lithuanian borrowers experience the rise in interest rates immediately, while most euro area borrowers experience it only after a while. The future dynamics of interest rates on loans will depend on the nature of monetary policy and financial situation of the economy and banks.

Financing conditions in the euro area and Lithuania remain tight but are gradually easing.

Chart 2. Average interest rates on new MFI housing loans and loans to NFCs

Sources: ECB and Lietuvos bankas calculations.

Notes: 3-month moving average. Excluding revolving loans and overdrafts.

3.Real sector

After two years of stagnation, Lithuania’s economy returned to growth in the first half of 2024. It grew by 0.9% in the first quarter and 0.7% in the second quarter.[22]

[22] Unless otherwise indicated, the indicators discussed in the chapter are adjusted for seasonal and workday effects.

As a result, Lithuania’s GDP was 2.1% higher in the first half of 2024 than a year earlier (see Chart 3). This economic recovery was broad-based, with the value added of many economic activities increasing. However, manufacturing and trade and transport activities were the main contributors to the increase in economic activity in the first half of this year. According to output sales data, three quarters of the rise in manufacturing sales was driven by oil refineries and producers of chemicals, plastics and other non-metallic mineral products. The main driver of the growth in value added of trading companies was the significant increase in household consumption at the turn of the year, while the growth of transport activity was driven by the normalising situation on the EU market where there was an oversupply of transport capacity in 2023. Renewed growth in household purchasing power, gradual recovery of external demand, EU support funds and government investment should continue to drive the development of the Lithuanian economy in the second half of this year. Real GDP is projected to be 2.2% higher this year than in 2023 and to grow by 3.1% and 3.3% in 2025 and 2026 respectively. The balance of risks surrounding these projections is broadly balanced according to Lietuvos bankas. On the one hand, geopolitical tensions or slower-than-expected growth of external demand could lead to a more sluggish economic development than expected, while, on the other hand, stronger growth of household consumption could lead to a more favourable economic development.

After two years of stagnation, Lithuania’s economy returned to growth in the first half of 2024.

Chart 3. GDP developments and its contributions (by production approach)

Sources: State Data Agency and Lietuvos bankas calculations.

With inflation subdued, a favourable labour market situation and positive household sentiment are fuelling the recovery in household consumption. Although it contracted by 1.8% in the second quarter of 2024, the strong growth of household consumption at the turn of the year led to a 3.1% year-on-year increase in the first half of this year (see Chart 4). Thanks to this rapid recovery, the consumption expenditure of Lithuanian households was already higher in the first half of this year than it was before the spike in inflation caused by the energy price shock. The recovery in household consumption is supported by a gradually fading impact of the significant economic shocks of recent years (see Box 1 for more details). This, coupled with the still favourable labour market situation for workers (see Chapter 6 for more details) and improving sentiment, is encouraging consumers to once again spend a larger share of their income on goods and services. For instance, at midyear, consumer sentiment on major purchases at present was at its best since the beginning of 2022. This view is partly explained by the fact that household sentiment about the changes in their financial situation over the next 12 months is almost the most positive since the start of data publication, while their sentiment about their financial situation remains very favourable. This positive sentiment about the income growth is also linked to the trends of recent quarters. Lietuvos bankas estimates that real disposable income of households, which continued to decline in 2023, will grow by 6.5% this year. Rising wages and social benefits will be the main contributors to the increase. The factors discussed suggest that household consumption will continue to grow strongly in the near future as well. It is expected to increase by 3.6% in 2024 and by 3.7% in both 2025 and 2026.

With inflation subdued, a favourable labour market situation and positive household sentiment are fuelling the recovery in household consumption.

Chart 4. Real household consumption and revenue developments

Sources: State Data Agency and Lietuvos bankas calculations.

While exports of higher value-added goods and services are recovering, the existing production overcapacity does not motivate companies to invest in capacity expansion. In the first half of 2024, real exports of goods and services were still below the level they were before the outbreak of russia’s war in Ukraine. Exports were most constrained by the decline in re-exports of goods, while higher value-added exports, particularly of goods of Lithuanian origin, were growing (for more on foreign trade, see Chapter 5). With both exports of Lithuanian origin and manufacturing output still below their levels recorded at the beginning of 2022, the level of capacity utilisation of manufacturing companies remained markedly lower than the long-term average. This has had a negative impact on investment which contracted by 7.9% year on year in the first half of this year. The most significant decline was in capital goods investment, with a particularly sharp fall in investment in vehicles which was affected by transport overcapacity on the EU market in 2023, the fall in transport prices and tighter monetary policy. Although investment trends have not been favourable in recent quarters, the ratio of investment to GDP remains close to the long-term average (see Chart 5), which indicates that both the authorities and business are allocating funds to capital which should help to address current challenges and contribute to Lithuania’s faster development in the longer term. While the above-mentioned factors will continue to constrain investment developments in the short term, the anticipated increase in the absorption of EU support funds by almost a third this year and investment projects of the general government sector suggest that the downward investment trend recorded in the first half of 2024 will not be prolonged. Investment is projected to fall by 3.6% this year before going up to 6.6% and 5.1% in 2025 and 2026 respectively.

While the existing production overcapacity is dampening investment activity, the investment to GDP ratio remains above its long-term average.

Chart 5. Investment to GDP ratio (calculated at current prices)

Sources: State Data Agency and Lietuvos bankas calculations.

Box 1. Impact of unpredictable events on the post-2020 developments of Lithuanian household consumption

As the Lithuanian economy began to recover after the global financial crisis, household consumption expenditure grew at a steady pace for almost a decade. However, with the start of the COVID-19 pandemic in 2020, a period characterised by a large number of significant shocks has begun.

The outbreak of the COVID-19 pandemic forced countries to introduce lockdown and other measures to limit the spread of the virus. This led to significant parts of the economies being constrained or suspended. Such a sudden and large-scale imposition of restrictions led to a disruption of supply chains. Meanwhile, the authorities put in place stimulative fiscal and monetary policy measures to avoid significant negative economic consequences.

As the COVID-19 pandemic receded, the Lithuanian economy faced a new wave of challenges as russia began its war of aggression against Ukraine. Due to high energy dependence on russia, the EU’s decision to stop procuring energy from that country was one of the main factors behind the sharp spike in prices. The search for new suppliers of other raw materials, such as timber and metals, has also been a challenge for the Lithuanian economy. To cushion the impact of the price hikes, authorities introduced further measures, fiscal authorities tried to mitigate the impact of the shocks adopting support and compensatory measures,[23]

[23] For more on these measures, see Stability programme of Lithuania for 2023. Ministry of Finance of the Republic of Lithuania.

while monetary policymakers tightened the monetary policy significantly to curb inflation.[24]

[24] Between July 2022 and September 2023, the ECB raised the key (deposit facility) interest rate 10 times from −0.5% to 4.0% before cutting it down to 3.75% in June 2024.

All of these factors affected consumption decisions of Lithuanian households.

To better understand the impact of these shocks on the development of household consumption, the results of the structural vector autoregression model are discussed in this box. The model identifies structural shocks by applying sign restrictions (the model structure and sign restrictions are presented in the table below). Six variables are used in the model: real household consumption expenditure, terms of trade (calculated as the ratio between the GDP deflator and household consumption deflator), real GDP, household consumption deflator, interest rates on mortgage loans in Lithuania[25]

[25] Statistical information published by Lietuvos bankas on the interest rate on outstanding amounts of housing loans of households with an original maturity of up to 1 year is used.

and euro short-term interest rates.[26]

[26] The indicator is composed of the time series of EONIA (2010–2019) and euro short-term interest rate (2020 to Q1 2024).

The model estimates the effects of five types of shocks:[27]

[27] The shocks in the model are based on Bobasu A. and Gareis J. (2022), “The impact of higher energy prices on services and goods consumption in the euro area”, The ECB blog (see here), Gambetti L. and Musso A. (2017), “The macroeconomic impact of the ECB’s expanded asset purchase programme (APP)”, ECB Working Paper Series, No 2075.

1.Terms of trade shock. An example of such a shock is the falling prices of energy commodities. For instance, the prices of imported commodities would fall faster than those of exported commodities during a favourable shock of terms of trade. Cheaper imported commodities reduce cost pressures on domestically produced goods and services and have a downward effect on domestic price levels. This, through increased competitiveness of exporters and higher purchasing power of households, boosts economic activity and household consumption.

2.Aggregate demand shock. Examples of such a shock would be reduced/increased government spending or tax changes. For instance, an increased aggregate demand shock should lead to an increase in economic activity and household consumption expenditure in the economy which would also put upward pressure on domestic price developments.

3.Aggregate supply shock. An example of such a shock is a reduced tension in supply chains. For instance, in an event of a favourable supply-side shock, favourable factors bolster domestic economic activity and the price level in the economy decreases due to additional supply, which has a positive impact on the purchasing power of households and terms of trade.

4.Credit supply shock. Examples of such a shock are reduced risk aversion by credit institutions, less stringent lending standards or more active lending. For instance, a favourable credit supply shock typically leads to lower interest rates on bank credits, which facilitates the ability of businesses to expand their activities by affecting positively the economic activity as well as boosting household consumption. Meanwhile, rising demand in the economy also increases inflationary pressures.

5.Monetary policy shock. An example of such a shock is an increase (decrease) in central bank interest rates. A cut in interest rates by a central bank lowers the cost of borrowing for businesses and consumers, which has a positive effect on domestic demand boosting both household consumption and national GDP. And increased demand increases inflationary pressures.

Model structure

	Shocks
	terms of trade	aggregate demand	aggregate supply	credit supply	monetary policy
Terms of trade	+		–
Real GDP	+	+	+	+	+
Household consumption deflator	–	+	–	+	+
Interest rates on housing loans				–
Euro short-term interest rates*					–
Real household consumption	+	+	+	+	+

Notes: Sign restrictions apply only during the initial period of the shock in the model. “+” (“−”) means that the impulse response of the variable in question to the shock is positive (negative). A blank entry means that no restrictions apply. The model is estimated using quarterly growth rates, with the exception of the interest rate on housing loans and euro short-term interest rates, for which no transformation is applied. The estimation covers the time series from the first quarter of 2004 to the second quarter of 2024, including a dummy variable for the global financial crisis. The model is built using 4 lags, with normal diffuse priors. The model is estimated using the BEAR toolbox.[28]

[28] Dieppe, A. & van Roye, B. & Legrand, R. (2016), “The BEAR toolbox”, ECB Working Paper Series, No 1934.

* The euro short-term interest rate is included in the model using block exogeneity. As a result, the development of other variables during a shock does not affect the euro short-term interest rate. This assumption is made because the development of the Lithuanian economy does not have a significant impact on the development of the euro area economy, and, consequently, on monetary policy decisions.

The historical decomposition of the development of household consumption expenditure in the model presented in the chart below suggests that the shocks identified in the model have had a significantly stronger impact on the development of household consumption expenditure since the outbreak of COVID-19 pandemic at the beginning of 2020. The analysis suggests that the negative impact of the shocks considered could have been by 0.34 percentage points higher between 2020 and the second quarter of 2024 than in 2010–2019.

Model simulations indicate that the shocks of terms of trade and aggregate supply, such as the spike of energy prices or supply chain disruptions, had the largest negative effect on household consumption expenditure between 2020 and the second quarter 2024. During this period, they decreased the growth rate of household consumption by 0.2 percentage points per quarter. These shocks led to an increase in the household consumption deflator (prices of goods purchased by households) both in 2021 and especially in 2022, which significantly constrained household consumption through their declining purchasing power. It is important to note that the shock of terms of trade was particularly strong in 2022, reducing the growth of household consumption expenditure by more than 1 percentage point on average each quarter. The adverse effect of these shocks was partly offset by positive aggregate demand shocks, such as the government’s energy compensatory measures or support to business during the COVID-19 pandemic. These shocks had a positive impact on the development of both the whole economy and household consumption over almost the entire analysed period. Aggregate demand shocks had the strongest positive impact on household consumption in 2021–2023, with a stimulating effect of almost 0.5 percentage points per quarter during this period. The impact of credit supply and monetary policy shocks on household consumption development varied, being more stimulative in 2020–2021, but becoming more restrictive after the start of russia’s war in Ukraine when inflation spiked, especially in 2023.

Since 2020, economic shocks have significantly constrained the development of household consumption.

Historical decomposition of the effect of shocks on the development of household consumption

Sources: Lietuvos bankas calculations.

Notes: The effect of each shock was calculated using the median of 2,000 iterations.

4.Labour market

The Lithuanian labour market situation continued to be good in the first half of 2024. Favourable migration trends of recent years have had a significant impact on labour market indicators. The labour force has reached its highest level in two decades. A similar indicator was only reached around 2004, before the big wave of emigration following the EU accession. As Lithuania’s population continues to grow and more workers enter the labour market, the level of employment has reached a peak last seen only in 2007. As the economy recovers and the labour force continues to grow rapidly, the unemployment rate, which was growing previously, should stabilise in Lithuania.

Economically active population continues to grow rapidly in Lithuania. In the second quarter of this year, the labour force indicator reflecting long-term potential economic growth is 2.4% higher than a year ago. This increase in labour supply in the second quarter of this year is due to a rising labour force participation rate and continuing increase in the population. The latter factor accelerated labour force growth by 0.9 percentage points. The near-record high participation rate of the population aged 15–64 contributed slightly more to labour force growth, by around 1.5 percentage points. Compared to other euro area countries, Lithuania has one of the highest labour force participation rates (see Chart 6). However, there is limited scope for more efficient use of labour market resources (see Box 2 for more details) since the labour force participation rate is close to historical highs.

The labour force participation rate is among the highest in the euro area and is therefore likely to have a lesser impact on the labour force and the Lithuania’s potential economic growth in the future.

Chart 6. Labour force participation rate (15–64 years) by gender (left-hand panel) and labour force participation rate (15–64 years) in the euro area countries (right-hand panel)

Sources: State Data Agency and Eurostat.

The continuing increase in the total number of persons employed shows the resilience of the labour market. According to the State Data Agency, the number of persons employed in Lithuania in the second quarter of 2024 was by 1.8% higher than a year earlier. However, employment did not increase as fast as at the beginning of this year, when annual growth of almost 3.0% was recorded. In the past two years, when economic activity in Lithuania stalled, persistent labour shortages have prompted companies to retain their employees in an attempt to protect themselves against costly recruitment in the future when economic growth picks up. Immigrants arriving to work from abroad are contributing to the still favourable employment trend by helping to reduce labour demand: in January–July this year, some 16,000 more people entered Lithuania than left. Rapidly rising wages are also encouraging people to join the ranks of the employed. In terms of economic activities, the number of persons employed has been increasing in the public sector (see Chart 7), where vacancy statistics show a severe staff shortage. However, employment growth in the latter sector is slowing down. Strong hiring has also highlighted shortages of employees in the information technology (IT) sector, where the number of persons employed is by about 16% higher year on year. Employment indicators in industrial activities have also recovered. In the period under review, the highest annual contraction in employment were recorded in real estate, finance, transport, trade and agriculture. Although the employment indicator is not encouraging in some sectors of the economy, companies have no intentions to significantly reduce the total number of employees in Lithuania in the near future. Hiring expectations have been close to the long-term average in recent months, so there are no signs of concern, at least in the coming quarters, as a significant contraction in employment is unlikely in the short term.

Slower employment growth is largely the result of a slowdown in hiring in the transport and public sectors.

Chart 7. Number of the employed by economic activity (contributions)

Sources: State Data Agency and Lietuvos bankas calculations.

Labour market tensions in Lithuania are gradually easing. The unemployment rate in Lithuania increased in the first half of this year as the labour force grew rapidly and hiring slowed. In the second quarter of 2024, it stood at 6.9%, up by 1.0 percentage point year on year. Analysis of longer-term data indicates an elevated unemployment rate; however, it stabilised over the period concerned: adjusted for seasonal effects, it remained almost unchanged over the quarter. The registered unemployment rate published by the Employment Service also shows no signs of deterioration: the ratio of the unemployed to labour force stood at 8.6% in July this year and remained at the same level as in the previous year. The increase in the unemployment rate observed in recent quarters is not expected to persist. Labour demand should not weaken as the economy recovers. This development of key labour market indicators reflects a gradual easing of labour market tensions, which has implications for the slowdown in wage growth.

Wages in the Lithuanian economy excluding individual enterprises grew by 9.8% in the second quarter of this year, the slowest pace since mid-2020. Since the beginning of last year, the dynamics of wage growth in the public and private sectors have remained unchanged: wages in the public sector continued to grow at a faster annual rate (11.6%) than in the private sector (9.0%). The latest administrative data from State Social Insurance Fund (Sodra) confirm that wage growth in Lithuania is no longer accelerating: average insured income in April–June rose by around 10% year on year (see Chart 8). However, from a historical perspective, such growth of labour income is still rapid and, in an environment of sluggish labour productivity growth, remains as one of the risks to Lithuania’s economic competitiveness.

The pace of wage growth has been slowing down for more than a year but growth remains robust.

Chart 8. Annual development of average wages and average insured income

Sources: State Data Agency, Sodra and Lietuvos bankas calculations.

Box 2. Impact of labour market developments on economic growth in the Baltic countries and the EU as a whole

In the longer term, economic growth is perhaps most significantly driven by an inclusive and improving education system, business environment that reflects current realities and fosters growth, innovative management and production methods, and continuous technological progress. In the search for growth opportunities, all existing resources can be used more efficiently, both by investing in resource productivity and by making them more integrated into economic activities.

In a converging economy such as the Lithuanian economy, the changing labour market plays an important role. In addition to factors that boost labour productivity, economic development can be positively affected by higher population participation in the labour market (resident participation rate), rising employment and falling unemployment (declining share of the population that is unemployed but actively seeking work), while economic growth can be dampened by population ageing (growing share of non-working age population).

This box aims to assess the extent to which a more inclusive use of labour resources, demographic processes and overall increase in labour productivity have contributed to economic growth over the last decade (starting with the economic recovery after the global financial crisis of the 2000s). In other words, the attempt is to determine to what extent and how economic development was driven by various changes on the labour market. It analyses the development of real GDP per capita in Lithuania, Latvia, Estonia and the EU as a whole.[29]

[29] The analysis uses aggregated data for EU27.

For comparability purposes, information from a single data source, the EC’s AMECO database, is used.

Over the period under review, a number of labour market indicators improved in the Baltic countries and across the EU. In 2010–2023, the resident participation rate, i.e. the share of the population in employment and looking for work, increased from 72.6% to 83.8% in Lithuania[30]

[30] For the purposes of this box, the resident participation rate is defined as the ratio between the employed and job-seeking residents (labour force) and the working-age population (15–64 years).

(see Chart A, panel a). The trend of rising participation rates was also observed in Latvia, Estonia and the EU as a whole. This development of the participation rate was supported by reforms, such as the increase of the retirement age, and the growing demand for workers which facilitated the entry of the population into the labour market. The latter factor contributed to higher employment rates and lower unemployment. In 2010–2023, the unemployment rate in Lithuania fell from 17.8% to 6.8% (see Chart A, panel b). Unemployment has also fallen in the other Baltic countries and across the EU. The labour market trends discussed have had a positive impact on economic development. Rising resident participation and employment rates have, ceteris paribus, contributed to a higher real GDP per capita.

Chart A. Key labour market indicators in the Baltic countries and the EU

Sources: EC’s AMECO and Lietuvos bankas calculations.

However, there were also negative changes on the labour markets of the Baltic countries and the EU as a whole during the period under review. In 2010–2023, the share of the working-age population declined in Lithuania, Latvia, Estonia and the EU as a whole[31]

[31] For the purposes of this box, the working-age population is defined as the population aged 15–64.

(see Chart A, panel c). In Lithuania, this share fell from 67.5% to 65.1%. However, in recent years, the share of the working-age population in Lithuania has stopped declining due to changes in international migration trends. Population ageing has a negative impact on economic development and, ceteris paribus, reduces real GDP per capita.

Rising resident participation and employment rates have accounted for around half of the increase in real GDP per capita in Lithuania since 2010.[32]

[32] In 2010–2019, i.e. before the shocks of recent years, the impact of these labour market factors on the growth of real GDP per capita in Lithuania was quite similar, accounting for about half of the increase in the GDP indicator.

^, [33]

[33] The contributions of real GDP per capita are calculated as the product of labour productivity, employment rate, participation rate and share of the working-age population.

The latter indicator increased by 64.2% in 2010–2023 (see Chart B, panel a). The main contributing factor to this increase was the rise in labour productivity (which grew by 29.9% over the period; see Chart A, panel d), while the resident participation rate was the second most important contribution to the change in real GDP per capita. Increased population participation in the labour market accounted for around a third of the growth in real GDP per capita. A further quarter of the latter indicator’s growth was due to rising employment. At the same time, population ageing had a dampening effect on economic development. The fall in the share of the working-age population slowed down the growth of real GDP per capita by 4.5 percentage points.

Developments on the labour market have also had a positive impact on economic development in the other Baltic countries and the EU as a whole. During the period under review, higher resident participation and employment rates accounted for around half of the increase in real GDP per capita in Latvia (see Chart B, panel b) and around four-fifths of the indicator’s increase in Estonia (see Chart B, panel c). In Estonia, however, partly as a result of a prolonged labour hoarding, the impact of these labour market factors on economic development has been unusually strong in recent years. In the period leading up to the shocks of recent years (2010–2019), higher resident participation and employment rates accounted for around two-thirds of Estonia’s real GDP per capita growth. Such significant and favourable labour market developments were not confined to the Baltic countries. Across the EU, the labour market factors in question accounted for around four-fifths of the increase in real GDP per capita in 2010–2023 (see Chart B, panel d).

However, the opportunities to further utilise the existing labour resources in Lithuania are limited. The resident participation rate in Lithuania, while not the highest in the EU, is already well above the average for this group of countries. However, continued positive net international migration may have an upward effect on the resident participation rate as immigrants from other countries usually come to Lithuania to work. The employment rate has also risen considerably: it is quite close to the EU average and not far from the historical peak observed in Lithuania. Therefore, further changes of the labour market indicators concerned, i.e. the resident participation rate and employment rate, are unlikely to contribute much to the increase in real GDP per capita in Lithuania. This is supported by macroeconomic projections published by some institutions which indicate that economic development in the coming years is expected to be driven mainly by rising labour productivity (see Chart C),[34]

[34] It should be noted that the solid line in Chart C shows the change in the variable over one year, while the solid line in Chart B shows the accumulated change in the variable since 2010.

while other labour market factors are likely to have only a marginal impact.

Chart B. Real GDP per capita in the Baltic countries and the EU

Sources: EC’s AMECO and Lietuvos bankas calculations.

Chart C. Real GDP per capita in Lithuania

Note: The macroeconomic projections for 2024–2025 are based on the projections of the EC published in May 2024.

Sources: EC’s AMECO and Lietuvos bankas calculations.

5.External sector

Since the beginning of 2023, the net balance of goods and services has been positive. Calculated at current prices and adjusted for seasonal and workday effects, it amounted to €1.3 billion, or 6.8% of GDP, in the first quarter of 2024 and €1.1 billion, or 5.9%, in the second quarter of 2024 (see Chart 9). Exports of goods and services grew by 4.4% in the first quarter of 2024, mainly due to an increase in exports of goods, while they contracted by 2.1% in the second quarter of 2024, mainly due to a decrease in exports of services. Imports of goods and services contracted by 1% in the first quarter and by 1.3% in the second quarter due to a drop in imports of services. A significant increase in exports of goods and services in the first quarter and a contraction in imports of goods and services in the first half of the year resulted in net exports of goods and services rising by €0.6 billion, or slightly more than twofold, in the first half of the year. Exports of goods and services are projected to grow by 1.2% and imports by 0% in 2024.

The net balance of exports of goods and services is broadly at its highest level since early 2021.

Chart 9. Development of net exports of goods and services (left-hand panel) and nominal exports of goods and services (right-hand panel)

Dalintis:

Sources: State Data Agency, Lietuvos bankas and Lietuvos bankas calculations.

Nominal exports of goods were positively affected by the recovery of exports of Lithuanian origin in the first half of the year. Recovering chemical industry and exports of reagents, polyethylene terephthalate (PET) products and pharmaceuticals led the recovery of exports of Lithuanian origin. An expansion in exports of mineral products of Lithuanian origin also made a significant contribution. The largest negative contribution came from exports of agricultural and food products due to a lower volume of gross agricultural production than a quarter earlier. In the short term, exports of Lithuanian origin should continue to develop positively: according to the latest crop area projections, the cereal harvest in the third quarter of 2024 is expected to be better than a year ago, which is likely to have a positive impact on exports of agricultural and food products. Meanwhile, the resumption of operations by AB Lifosa would contribute to a faster development of phosphate fertiliser exports. However, slower-than-expected developments in key partners and deteriorating confidence indicators of the Lithuanian industry suggest that, although the development of exports of Lithuanian origin will be positive, the growth rate will still be slower than the long-term trends. Market shares of exports of Lithuanian origin have not grown since 2022 due to structural factors: the production of goods that are not in demand, such as furniture, and the stagnation of fertiliser exports. Rising labour costs could have also contributed to the stagnation of market shares of exports of Lithuanian origin (see Box 3 for more details).

Re-exports declined year on year, mainly due to a decrease in re-exports of vehicles and machinery and equipment to the CIS countries. A slight quarter-on-quarter increase in re-export volumes was recorded in the first quarter, while re-exports fell again in the second quarter. The attractiveness of Lithuania as a transit country for re-exporting goods has been significantly reduced by the tightening of requirements for trading with the CIS countries, and there is little potential for faster growth in re-exports.

Exports of Lithuanian origin, the most important export component, are showing signs of recovery but risks related to the future remain.

Chart 10. Development of nominal exports of goods, adjusted for seasonal and workday effects (left-hand panel) and development of real exports of Lithuanian origin and their market shares and contributions (right-hand panel)

Dalintis:

Sources: Eurostat, U.S. Census Bureau, HM Revenue & Customs, State Data Agency and Lietuvos bankas calculations.

Since the beginning of 2024, the four-quarter moving amounts of the current account balance have been positive. This is due to a narrowing deficit of trade in goods and growing exports of services (see Chart 11). The impact of other components of the current account balance on the overall balance has changed little, with a positive impact of the secondary income surplus, mainly due to a reduction in foreign support for general government and other sectors, and a negative impact of the widening primary income deficit in the first quarter of 2024 on the current account balance. This was due to a widening of the deficit on investment income balance and narrowing of the balance of other primary income.

In the short term, however, the growth of the current account balance will be held back by subdued development of exports of services. According to the latest balance of payment data, nominal exports of services contracted significantly in the second quarter, likely reflecting the difficult situation in the transport sector. The onset of the pandemic resulted in imbalanced supply chains and lower transport efficiency. Inefficiencies led to capacity shortages, which resulted in a higher number of truck purchases and higher prices. In 2022, EURIBOR started to rise, industrial production declined and a large imbalance between demand and supply emerged. Lithuania’s main exporters of transport services have recently been reducing the number of trucks: in the first half of 2024, the number of new registered trucks contracted by almost half year-on-year. A lower number of trucks and trips, subdued foreign demand, requirements of the Mobility Package and rapidly rising labour costs suggest that exports of transport services will not grow in 2024. The current account surplus is projected at 3.2% of GDP this year and 1.6% in 2025.

Since the beginning of 2023, the current account balance has been recovering mainly due to a better balance of goods and services.

Chart 11. Components of the current account balance (left-hand panel) and exports of services (right-hand panel)

Dalintis:

Sources: State Data Agency, Lietuvos bankas and Lietuvos bankas calculations.

Box 3. Developments of export market shares due to changes in labour costs and non-price competitiveness factors

In Lithuania, wage growth has outpaced labour productivity growth in recent years. The resulting gap raises concerns that growing labour costs are creating risks to export price competitiveness and could lead to a decline in export market shares. While price competitiveness is important for the development of export market shares, it is not the only factor of their growth. For instance, various non-price competitiveness factors, such as specialisation in emerging markets, switching to higher value-added products, increasing production capacity, etc., can have a positive impact on the development of export market shares and can help offset the losses due to decreasing price competitiveness. Taking into account the totality of these factors, the box examines how export market shares have evolved historically in the context of changes in Lithuania’s price and non-price competitiveness.

In the box, the price competitiveness is assessed by analysing the relative changes in labour costs[35]

[35] For the purposes of the box, labour costs are defined as real unit labour costs which are calculated as the ratio between the sum of total compensation for the employed and the nominal value added in a given activity (Lebrun and Perez, 2011).

in the Lithuanian manufacturing industry.[36]

[36] The relative growth of Lithuanian labour costs is estimated by comparing the growth of Lithuanian labour costs with the growth of the labour cost index of Lithuania’s competitors. The index was composed by calculating the shares of exports of individual economic activities of EU Member States in the total exports of these countries and exports of respective economic activities to the EU. The resulting market shares were used as weights to compose the index. The moving averages of the market shares for the three last years were multiplied by the real labour costs of the specific activity of each country. Then, the relative increase in the Lithuanian labour costs was estimated by calculating the extent to which the growth of real labour costs in Lithuania outpaced the growth of the index.

Non-price competitiveness is understood as a residual market share growth factor which cannot be explained by a deterioration of price competitiveness, i.e. rising labour costs, development of factors of production and revealed comparative advantage of exports.[37]

[37]The impact of different contributions on the development of export market shares was calculated by regression analysis. The regression equation was based on a slight modification of the export change equation proposed by Armington (1969). The export market share equation includes four variables and can be expressed as follows: Δlog(MS) = c + Δlog(ULC) + Δlog(I) + Δlog(RCA_H) + Δlog(RCA_MH) + Δlog(RCA_ML) + Δlog(RCA_L), where the dependent variable is MS - annual change in market shares, independent variables are: ULC - annual relative change in labour costs, I - annual change in production capacity development in terms of real investment per employee, and RCA – annual change in the revealed comparative advantage of exports of high-tech, medium-high, medium-low and low-tech goods respectively. In the regression equation, the annual change in the export market share that could not be explained by independent variables was considered to be a change due to factors other than the increase (decrease) in price competitiveness.

Chart A. Annual changes in labour costs and export market shares in 2010–2022 (2010–2023 for manufacturing) (left-hand panel) and the increase in labour costs and export market shares in 2022 (2023 for manufacturing) compared to 2010 (right-hand panel)[38]

[38] In this and other charts of the box, the names of economic activities are abbreviated. Food and tobacco corresponds to activities C10–C12 “Manufacture of food products, beverages and tobacco”, textiles to activities C13–C15 “Manufacture of textiles; manufacture of wearing apparel; manufacture of leather and related products”, wood to activities C16–C18 “Manufacture of products of wood, paper and paper products; publishing and printing”, chemicals to activity C20 “Manufacture of chemicals and chemical products”, plastics to activities C22–C23 “Manufacture of rubber and plastic products and other non-metallic mineral products”, metals to activities C24–C25 “Manufacture of basic metals and fabricated metal products, except machinery and equipment”, computers to activity C26 “Manufacture of computer, electronic and optical products”, electronics to activity C27 “Manufacture of electrical equipment”, machinery and equipment to activity C28 “Manufacture of machinery and equipment n.e.c.”, vehicles to activities C29–C30 “Manufacture of transport equipment”, furniture to activities C31–C33 “Manufacture of furniture, jewellery, musical instruments, toys; repair and installation of machinery and equipment”.

Dalintis:

Sources: State Data Agency, Eurostat and Lietuvos bankas calculations.

Note: The size of bubbles is adjusted according to the average share of activities in total manufacturing.

An increase in relative labour costs in the short term slows down the growth rate of export markets or even turns it into negative (see Chart A, left-hand panel). It should be noted that, among the largest manufacturing activities[39]

[39] The largest manufacturing activities are those that, on average, accounted for 10% or more of value added of manufacturing in 2010–2019.

in Lithuania, rising labour costs have the largest short-term (annual) negative impact on activities where labour costs account for a relatively larger share of total production costs and which are consequently more labour-intensive[40]

[40] Labour-intensive manufacturing activities were considered to be those in which labour costs accounted for a fifth or more of the total value of output in 2010–2019.

(see Chart A, left-hand panel).

Despite the negative short-term impact of labour costs, in the longer term, i.e. more than a decade (see Chart A, right-hand panel), almost all the activities increased their market shares on the EU market even in the face of rising relative labour costs. In computer activities, labour costs grew at the fastest rate but the increase of the market shares was also among the highest. Textiles was the only activity whose export market shares declined as labour costs rose.

The faster growth of labour costs can be attributed to the slower development of export market shares. However, despite the negative impact of labour costs on price competitiveness, export market shares grew over the long term.

Chart B. Annual increase in market shares of manufacturing compared to the first quarter of 2006[41]

[41] Coefficients of the resulting regression equation (2006 to Q1 2024): Δlog(MS) = 3.71 – 0.54Δlog(ULC) + 0.11Δlog(I) – 46.66Δlog(RCA_H) + 17.24Δlog(RCA_MH) + 26.14Δlog(RCA_ML) + 21.31Δlog(RCA_L). All independent variables except for RCA_L, were statistically significant within the 95% confidence band (p < 0.05). The number of observations is 73 and the coefficient of determination and adjusted coefficient of determination are 0.72 and 0.70 respectively. It should be noted that a negative coefficient of high-tech goods was also estimated in other studies (such as Osbat, Benkovskis, Bluhm, Bobeica and Zeugner (2017)) in the context of analysis of the development of market shares of the new EU Member States. The negative effect is explained by the fact that Lithuania and the other new members expanded their market shares by increasing their specialisation in medium-high technology industries rather than in high-tech industries.

Dalintis:

Sources: State Data Agency, Eurostat and Lietuvos bankas calculations.

A more detailed analysis of contributions indicates that the negative impact of labour costs is gradually being offset over time by other factors in manufacturing activities (see Chart B). Following the 2008–2009 crisis, labour costs were the most important contribution, with the relative decline in labour costs due to the internal devaluation leading to a significant increase in the market share of manufacturing. However, with the start of the MMW growth from 2012 onwards and mounting labour market tensions, the relative competitiveness of labour costs started to decline which had a negative impact on the growth of market shares. It was also negatively affected by the erosion of revealed comparative advantage, mainly in the medium-low and low-tech product groups.

Despite the negative impact of the factors discussed, the positive contribution of other factors allowed export market shares to continue to grow rapidly. The increase in production capacity was an important factor. As the economy gradually recovered after the 2008–2009 crisis and investment by companies increased, the development of new production capacity (opening of new production lines, new product development, etc.) strengthened and had a positive impact on the development of market shares.

However, the growth of non-price competitiveness was not the most important factor for the development of export markets as the increase of non-price competitiveness largely accounted for more than half of the positive contribution to the development of export market shares over the whole period under review. The analysis confirms the prevailing view in academic literature that it is increasingly difficult to explain the change in exports and export market shares by price competitiveness as the level of development of countries is on the rise (Kaldor, 1978; Sanchez and Rubalcaba, 2006) and the growth of market shares is mainly underpinned by factors related to non-price competitiveness.[42]

[42] Previous studies analysing the case of Lithuania also confirmed the insight that much of the growth of Lithuania’s exports and export market shares, despite the relative growth of the labour force and decline of price competitiveness, has been driven by non-price competitiveness factors (Fabrizio, Igan and Modi, 2007; D'Adamo 2017; Kostinas and Vilniškis, 2021).

Given the increasing importance of non-price competitiveness, the natural question is what is driving the increase in non-price competitiveness and whether the loss of price competitiveness in the future will become even less important for the development of export market shares. A number of factors can contribute to an increase in non-price competitiveness, such as foreign recognition and quality improvement of products exported by the country, growing popularity of brands, support of export promotion institutions, level of corruption in the country, buyer behaviours and preferences, etc. (Benkovskis and Wörz, 2013; Gräbner, Heimberger and Kapeller, 2019). Exports that do not compete on price have certain advantages over exports that do. The relative value of goods that do not compete on price tends to be higher, so manufacturers of these goods can expect to sell them at prices higher than market prices and earn higher revenues (Vandenbussche 2014; Kostinas and Vilniškis, 2021). Higher revenues enable companies to pay higher wages and to mitigate the negative effects of a potential loss of price competitiveness due to rising labour costs. As the ability to meet the needs of niche markets or individual consumers can also be seen as non-price competitiveness, countries with limited human resources and therefore limited ability to benefit from economies of scale may be better off competing on the basis of such strategy (Eesti Pank, 2018; Kostinas and Viliskis, 2021).

On the other hand, demand for non-price-competitive and relatively more expensive goods is sufficiently pro-cyclical (Dutt and Padmanabhan, 2011; McKenzie and Schargrodsky, 2005, 2011; Flatters and Willmott, 2009; Kayatz and Gul, 2014). This implies that when a country’s exports compete exclusively on non-price dimensions, external economic shocks can have a particularly significant negative impact on export volumes and, consequently, economic growth. As can be seen in Chart B, the positive impact of non-price competitiveness on the development of export market shares would diminish after various economic shocks (economic crisis in 2008, annexation of Crimea in 2014 and associated trade restrictions in the following years, russia’s war in Ukraine in 2022 and energy price shocks). It should also be noted that, as already shown in Chart B, the relative decline in price competitiveness has had an increasingly negative impact on the development of export market shares in recent years. In this context, it is important to ensure that productivity of companies grows as it allows to manage the pressure of rising labour costs.

Although relative labour costs have been growing for some time, the development of production capacity and increasing non-price competitiveness have offset the loss of price competitiveness and led to a rapid growth of export market shares.

6.Prices

With energy and commodity prices virtually unchanged for about a year now, the pressure of external factors on prices remains subdued. This leads to monthly price developments remaining close to long-term dynamics and annual inflation at low levels. However, it should be noted that the trend of annual inflation, which was falling from its peak for a year and a half, reversed: having declined to 0.4% in March–April of this year, it gradually increased on the back of the base effect reaching 1.1% in July (according to provisional data, it stood at 0.7% in August). This was mainly due to the waning effect of falling energy prices. As regards the structure of inflation, it should be noted that two components have stood out in recent months: energy, which had a downward effect on inflation, and services, which acted as the main driver (see Chart 12). Given the continued favourable developments of energy prices expected on the markets, average annual inflation is projected to reach 1.0% in 2024 and go up to 2.5% in 2025. The recovery of private consumption and wage growth, albeit at a slower but still rapid pace, will mean that services, which are more affected by domestic factors than other groups, will continue to be the main driver of inflation this and next year.

Annual inflation has gradually started to pick up, with services being the main driver of inflation.

Chart 12. HICP inflation and its contributions

Dalintis:

Sources: State Data Agency and Lietuvos bankas calculations.

Note: Inflation data for August are provisional.

Energy prices continue to put downward pressure on inflation but this effect is diminishing. It is the main factor behind the rise in inflation in recent months. In the first quarter of 2024, energy was around 13% cheaper than a year earlier, but as early as in July the annual rate of change was merely -5.9%. These trends have been significantly influenced by the lower comparative base effect when this year’s energy prices are compared with the already declining level of energy prices a year ago. Looking at the structure of energy prices, electricity and solid fuel[43]

[43] Firewood accounts for the bulk of solid fuel.

prices stand out as the main reducing factors of inflation in recent months (see Chart 13), which in July were around one-sixth and one-quarter lower year on year respectively. Although there is a risk that the escalation of the conflict in the Middle East could have a negative impact on energy commodity prices, a favourable development of their prices is currently[44]

[44] Data as of 30 August.

anticipated by the markets. For instance, oil prices are projected to decline steadily, while gas prices are expected to average around 42 €/MWh during the heating season.[45]

[45] Gas prices averaged around 34 €/MWh during the 2023–2024 heating season.

Against this background, energy prices are projected to be lower in 2024 than last year, before rising slightly in 2025. This development of energy prices in 2025 will be affected by both the expected higher electricity and gas prices on the markets and the introduction of the measures of the Defence Fund package, such as the increase in the CO2 component for various energy commodities.

Energy prices continue to put downward pressure on inflation but this effect is diminishing.

Chart 13. Impact of energy on annual headline inflation

Dalintis:

Sources: State Data Agency and Lietuvos bankas calculations.

At all stages of the food supply chain, pressure on food prices remains weak. As a result, prices of food, including alcoholic beverages and tobacco, have remained at similar levels for about six months now and had a minimal impact on annual inflation (see Chart 12). In particular, the reduced pressure on food prices continues to be reflected on the food commodities market, with global food commodity prices falling at an annual rate of 2.9% in July, while prices of imported food and producer prices on the domestic market, which reflect the situation downstream the food supply chain, remained unchanged over the year.[46]

[46] Price data for imported goods are as of June and producer prices as of July.

These trends also underpin the subdued increases in the prices of food, including alcoholic beverages and tobacco, for consumers: their prices rose at an annual rate of 0.6% in July, with alcoholic beverages and tobacco accounting for the bulk of the increase. This year food, including alcoholic beverages and tobacco, price developments are projected to continue to benefit from the easing of food price pressures. Next year, prices will rise at a faster pace, but growth will be similar to that in 2017–2019, when economic development was not challenged by war and pandemic. This will be driven by slower decline of food commodity prices and introduced measures of the Defence Fund package, such as faster increase of excise duties on alcoholic beverages and tobacco.

Core inflation has continued to decline (see Chart 12). It has been mainly driven by developments in prices of industrial goods as the growth of services prices has remained broadly unchanged. Prices of industrial goods, which rose at an annual rate of 3.4% at the start of the year, grew by a mere 0.2% year on year in July. Most industrial goods are cheaper than a year ago, with price increases in this category mainly driven by the rise in prices of pharmaceuticals. The prices of pharmaceuticals, which represent on average 3.6% of the consumer basket, rose in July at a declining yet still high annual rate of 8.1%. The slowdown in the growth of prices of industrial goods is due to the reduced commodity price pressures as a result of lower input prices and eased tensions in supply chains. In view of the easing pressure, the rise in prices of industrial goods this year and the next is projected to be close to typical growth when economic development was not challenged by war and pandemic.

Prices of services have been rising at a fairly stable annual rate of close to 6% in recent months and are a key driver of both core and headline inflation. In terms of the drivers of changes in prices of services, catering services stand out. Since January, the annual growth of their prices accelerated following the expiry of the temporary VAT exemption. In recent months, prices of these services have increased at an average annual rate of 9.2–9.5%, accounting for about a third of the increase in prices of all services. In general, domestic factors have a greater impact on the prices of services than for other groups. Thus, while labour market tensions are easing and wage growth has somewhat slowed, it remains strong and has a significant impact on the developments of prices of services, with wage-sensitive services accounting for almost two-thirds of all service price increases in recent months. In line with expected wage developments (see Chapter 4 for more details), prices of services are projected to rise at a similar annual pace in the remaining months of the year, while the impact of slightly slower wage growth will be more pronounced in 2025.

Box 4. Phillips curve models reveal that the impact of labour market tensions on quarterly core inflation weakened, but inertia supported the latter

Regression analysis based on Phillips curve models carried out in 2022 showed that external factors, such as imported energy and food prices in the EU, were the main contributors to headline inflation during the surge of inflation. In addition to external factors, core inflation was significantly affected by labour market tightness. In order to identify the impact of the factors that had previously contributed to inflation in view of declining inflation and, more generally, to identify the drivers of inflation, this box presents an updated analysis under the Phillips curve models, which is extended by additional model specifications.

The Phillips curve models presented in the box are obtained by updating their earlier versions, and the additional specifications of models are based on the same methodology described in the analysis of 2022. As before, this box presents the analysis of the drivers of both headline and core inflation. Factors reflecting inflation inertia and expectations, demand pressures and supply shocks are included as independent variables. Inflation lags are included to estimate the impact of inflation inertia, while demand pressures are represented in the models by a cyclical demand factor linked to domestic economic developments, such as the output gap, unemployment rate, labour market tightness or real GDP.[47]

[47] In order to extend the analysis, this time real GDP, which was not analysed as a possible cyclical demand factor in the previous analysis, is also included in the estimations.

The set of variables reflecting supply shocks largely reveals the impact of external factors and includes variables, such as imported energy, imported durable and non-durable goods or food prices in the EU. It should be noted that the updated Phillips curve models have remained relatively stable, with no significant changes in the relationships between variables after including new data.[48]

[48] The primary equations describing the models can be found here.

The final specifications of both the previously designed and only now updated models and the new models are based on economic theory, robustness criteria of the models and removal of insignificant variables.

The effect of external factors that put upward pressure on headline inflation has weakened and many of them are now exerting downward pressure on inflation. According to both the updated breakdown of headline inflation (see Chart A, left-hand panel) and the new specification (see Chart A, right-hand panel), imported energy prices, electricity and gas prices in the EU have put downward pressure on average on headline inflation since 2023. The impact of imported durable goods and food prices in the EU has also diminished significantly. In addition to prices of energy and other commodities, the expectations of residents about price developments have changed significantly in recent years. For instance, at the peak of inflation, residents expected prices to increase by almost a third over the next 12 months, while the expectations in the second quarter of this year were for the rise to be more than twice lower over the next 12 months. A new extended version of the Phillips curve model provides an indication of how expectations have affected headline inflation. A 1% quarter-on-quarter increase in the growth rate of consumer expectations of expected price developments was found to enhance quarterly headline inflation by 0.03%. Given the actual development of expectations, they had an upward effect on quarterly headline inflation until the third quarter of 2022 and were already an inflation-reducing factor in subsequent periods (see Chart A, right-hand panel). The impact of cyclical demand factors has also changed in recent quarters. With higher unemployment and labour market tightness gradually easing, the impact of unemployment (see Chart A, left-hand panel) and labour market tightness (see Chart A, right-hand panel) on quarterly inflation weakened. Although the labour market situation remained good, economic theory suggests that rising unemployment is a sign of a worsening cyclical situation of the economy, i.e. a slowdown in economic activity leading to a weaker demand for goods and services which depresses price growth.

The effect of external factors that had put upward pressure on headline inflation has weakened and many of them are now exerting downward pressure on inflation.

Chart A. Breakdown of quarterly headline inflation

Dalintis:

Sources: State Data Agency, Eurostat and Lietuvos bankas calculations.

Note: Actual quarterly inflation is seasonally adjusted based on dummy variables.

Although core inflation is not as dependent on external factors as headline inflation, its decline has been mainly driven by lower electricity and gas prices. The unprecedented surge in energy prices in 2021–2022 was the main contributor to the rise in core inflation, while the fall in energy prices was the main factor behind its decline (see Chart B). Electricity and gas prices accounted for more than half of quarterly core inflation between the fourth quarter of 2021 and the first quarter of 2023, before largely fading in the second quarter of 2023.

Labour market tightness had a weaker impact on quarterly core inflation, but inertia supported the latter. Inertia is a key driving factor of core inflation. The weaker effect of labour market tightness is reflected both in the updated Phillips curve model (see Chart B, left-hand panel) and in the new specification of the model with added expectations (see Chart B, right-hand panel). In contrast, the impact of inflation inertia on core inflation increased as the upward effect of various factors faded. The indexation of various prices on the basis of the previous high inflation rate, the continued, albeit weaker, uncertainty about the future development of the economy, menu costs[49]

[49] Costs incurred by sellers of goods and providers of services in changing prices.

and expectations of core inflation development are important factors explaining the impact of inertia on core inflation. The fact that expectations are one of the factors affecting inflation inertia is illustrated in the right-hand panel of Chart B, where the inclusion of expectations in the model adds to the effect of inertia.

The development of electricity and gas prices was the main contributor to the decline in quarterly core inflation.

Chart B. Breakdown of quarterly core inflation incorporating labour market tightness as a cyclical demand factor

Dalintis:

Sources: State Data Agency, Eurostat and Lietuvos bankas calculations.

Note: Actual quarterly core inflation is seasonally adjusted based on dummy variables.

Alternative core inflation Phillips curve models, which include real GDP and output gap as cyclical factors, confirm the reduced effect of domestic factors and increased impact of inertia. Moreover, these models provide additional insights into external factors. The inclusion of imported non-durable goods in the models reduced the importance of energy prices for core inflation dynamics, and imported non-durable goods contributed most to the rise in core inflation, followed by a recorded decline.

Alternative core inflation models confirm the importance of inflation inertia.

Chart C. Breakdown of quarterly core inflation including real GDP (left-hand panel) and output gap (right-hand panel) as a cyclical demand factor

Dalintis:

Sources: State Data Agency and Lietuvos bankas calculations.

Note: Actual quarterly core inflation is seasonally adjusted based on dummy variables.

The analysis of Phillips curve models indicated that the external factors that contributed most to the rise in headline inflation in 2021–2022 were also the main drivers of its decline. Although core inflation is not as dependent on external factors as headline inflation, its decline has also been mainly driven by external factors, such as lower prices of electricity and gas and imported non-durable goods. The impact of domestic factors diminished during the period of declining headline and core quarterly inflation. In contrast, the impact of inflation inertia on core inflation increased and is the main driving factor of quarterly core inflation.

7.Financing of the economy

Although financial liabilities of households have been rising faster since the cost of borrowing went down and expectations are improving, the economy is being financed in a sustainable manner and there is no excess borrowing. Net financial assets of households and businesses have been increasing steadily. The annual growth of financial liabilities of Lithuanian households accelerated from 3% to 13% in the first half of the year, but with a further increase in financial assets (mainly due to the growth of deposits and listed stocks), net financial assets of residents grew by 4% year on year to €58 billion in the first quarter of 2024. Financial liabilities of non-financial corporations (NFCs) grew at an annual rate of 3%, while long-term liabilities have grown faster, in particular long-term borrowing from banks and other NFCs. With corporate financial assets growing by 6% year on year (mainly due to growth in deposits and long-term loans to other companies), net financial assets increased by almost a fifth year on year to €17 billion in the first quarter of 2024.

The annual growth of the credit portfolio of Lithuanian residents in MFIs has remained strong: the corporate credit portfolio is growing faster, growth of the consumer loan portfolio is continuing unabated and there are signs of a recovery in housing loans.

Chart 14. Annual change in the portfolio of MFI loans to Lithuanian NFCs and households

Dalintis:

Source: Lietuvos bankas.

With falling interest rates on new loans to households, the growth rate of new lending and the total loan portfolio have accelerated. The household loan portfolio grew by 7% year on year at the end of the second quarter of 2024 (see Chart 14) and remained strong compared to the euro area, where it grew by 0.3%, thanks both to the continued consumer lending and stronger recovery of demand for housing loans. The decline in EURIBOR (by 0.5 percentage points since autumn 2023) and housing loan margins (median margin was 1.5% in June 2024, 0.9 percentage points lower than four years ago) led to a recovery of housing credit in the second quarter of 2024 and its strongest activity in the last two years, with a 14% year-on-year increase in new housing loans and the value of such loans growing at a similar pace (see Chart 15). Consumer lending has also continued to grow, with the portfolio of consumer loans of Lithuanian residents being a fifth higher than a year ago. Despite the continued lending, the gap between the actual ratio of household loan portfolio to GDP and the long-term trend has remained consistently negative (-2 percentage points), while the ratio of housing loans to GDP has remained among the lowest in the euro area (at 17% at the end of the first quarter of 2024), thus no excess borrowing is observed. The Bank Lending Survey conducted by Lietuvos bankas indicates that household credit standards eased in the second quarter of 2024, along with a slight easing of housing loan conditions, which also contributed to the recovery of housing lending. Further developments in lending to households will benefit from a decline in inflation and rising real household incomes as well as the expected further decline in interest rates.

With a stronger recovery in demand for corporate and new housing loans recorded by banks, demand for new consumer loans has remained strong.

Chart 15. Quarterly flows of MFI loans to Lithuanian NFCs and households and average interest rates on new loans

Dalintis:

Source: Lietuvos bankas.

In an environment of falling interest rates, corporate borrowing for longer periods increased. The portfolio of loans to NFCs grew by 8.5% year on year in the second quarter of 2024 (see Chart 14), compared with just 0.2% in the euro area. The annual growth of the number of new loans granted was already positive in June 2024 and the value of new loans in the second quarter of 2024 was by a tenth higher than a year earlier (see Chart 15). This trend is confirmed by the Bank Lending Survey which indicates that demand for corporate loans has not declined for two consecutive quarters. Notably, the ratio of corporate (household) loans to GDP has remained among the lowest in the euro area (15% at the end of the first quarter of 2024). The Bank Lending Survey of the second quarter of 2024 indicates that corporate lending standards did not change significantly in the last six months after the tightening seen in 2022–2023. Banks consider that the financial health of transport companies is the worst, thus competition in lending to these companies has also declined, followed by tighter lending to real estate companies, hotels and restaurants. However, the share of companies in financial difficulty has not increased significantly.

The level of non-performing loans in the portfolio of bank loans to households and NFCs and the number of corporate bankruptcies remained low. Only the quality of consumer loans has deteriorated slightly and there was a limited deterioration in the quality of loans in the manufacturing sector and increase in the number of bankruptcies in the transport sector. The share of non-performing loans in construction and hotels and restaurants remained the highest compared to other sectors but it declined by more than 4 percentage points year on year, standing at 3.4% and 4.3% respectively. Cautious optimism has recently spread in the corporate segment, as reflected in the improvement in the confidence indicators of companies compared to a year ago.

8.General government finance

In the first half of 2024, the financial situation of the general government remained broadly unchanged, as revenue growth continued at a strong pace, but expenditure also increased.In the first quarter, the ratio of general government balance to GDP (measured on a four-quarter moving amount) declined by 0.2 percentage points to -0.6% of GDP. Nonetheless, the development of general government finance indicators in the first and second quarters of 2024 was quite different, with the general government balance improving in the first quarter as a result of a strong increase in general government revenues and a more moderate increase in expenditure. However, the significant rise in central government expenditure in the second quarter is likely to have led to a faster increase in the total general government expenditure, so the ratio of general government balance to GDP likely returned to its level recorded at the end of 2023. The available data suggest, however, that the ratio of general government deficit to GDP in 2024 will be significantly lower than planned in the 2024 budget (2.9%).

General government revenues continued to increase rapidly in the first half of 2024. In the first half of this year, general government revenues rose by almost a tenth (see Chart 16). The main contributors to the revenue growth in the first quarter of 2024 were revenues collected from current income and property taxes. This growth was driven in particular by a 50% increase in corporate income tax revenues. However, this rise was mainly due to solidarity contributions paid by commercial banks since, excluding this effect, corporate income tax revenues fell by around 0.5% year on year in the first half of the year. The slight decrease in corporate income tax collection in the first half of the year, excluding the effect of solidarity contributions, was mainly due to one fertiliser producer. The increase in personal income tax revenues was driven by a favourable labour market situation and growth of the general government wage bill. Although the development of the wage bill is closely linked to social contributions, the latter increased slowly in the first quarter, mainly due to the irregular payments by the state for publicly insured persons. In the second quarter, the growth of collected social security contributions accelerated due to the receipt of contributions from the state budget for publicly insured persons. Excise revenues increased by a tenth driven by the rise in excise duty rates effective from 1 January 2024, while the growth rate of VAT was influenced by rising household consumption expenditure, mainly driven by the continuing strong growth of wages, improving household expectations and weaker inflation.

The growth of general government revenue was supported by an increase in direct tax revenue.

Chart 16. Annual growth of general government revenue and their contributions

Dalintis:

Sources: State Data Agency and Lietuvos bankas calculations.

In the first half of the year, general government expenditure increased by around a tenth year on year, but with significant quarter variations. In the first quarter, general government expenditure grew by around 8% year on year (see Chart 17). The main factor contributing to the increase in general government expenditure in the first quarter was compensation of employees, with the general government wage bill being 13% higher than a year earlier, mainly due to the increase in wages and number of people employed in education, health and social work, public administration and defence. Investment also increased by a third, with significant contributions from the absorption of EU structural assistance and support under the Recovery and Resilience Facility. The subdued growth of social benefits was affected by lower social benefits for family support which declined by a quarter year on year, but spending on pensions increased by around 11% year on year, mainly due to the annual indexation of social insurance pensions (in the second half of the year, the average amount of all types of pensions grew by 9–10% year on year). The only factor that reduced general government expenditure was the fall in subsidies due to the disappearance of the need to compensate businesses and households for higher electricity and gas prices and the end of subsidies to businesses and households affected by the COVID-19 pandemic as a result of the increase in electricity prices. According to the monthly central government data published by the State Data Agency, the main factor driving a faster year-on-year growth of general government spending in the second quarter of 2024 was the surge in central government spending in May, with grants and other expenditure contributing more than three-quarters of the surge.

The increase in government spending was driven by higher compensation of employees and increased investment.

Chart 17. Annual growth of general government expenditure and their contributions

Dalintis:

Sources: State Data Agency and Lietuvos bankas calculations.

Compared to the end of 2023, the ratio of general government debt to GDP did not change substantially in the first half of 2024. The increase in the ratio of general government debt to GDP by 1.9 percentage points to 40.1% in the first quarter was mainly due to the placement of a 10-year Eurobond issue which raised €1.5 billion on international capital markets. According to the latest government borrowing and debt repayment statistics, total borrowing was around €1.1 billion lower than repayments in April–June this year, bringing the ratio of general government debt to GDP back down to around 38.3% in the second quarter as a result of negative net borrowing and increase in nominal GDP.

Abbreviations

AB public limited liability company

CIS Commonwealth of Independent States

EC European Commission

ECB European Central Bank

ESCB European System of Central Banks

EU European Union

Eurosystem European Central Bank and euro area central banks

GDP gross domestic product

HICP Harmonised Index of Consumer Prices

IMF international Monetary Fund

MFI monetary financial institution

MMW minimum monthly wage

NFC non-financial corporation

SDA State Data Agency

US United States of America

VAT value added tax

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The 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 this review is the result of statistical data analysis, modelling and expert assessment. The review is prepared by Lietuvos bankas.

The cut-off date for the data used in the publication is 31 August 2024, except for information on monetary policy decisions.

Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

ISSN 2029-8471 (online)

Lithuanian Economic Review (September 2024)