According to the survey of market participants conducted by the Lithuanian Free Market Institute (LFMI) in January and February 2007, Lithuania’s economic growth was strong in 2006 and market participants predict that it will remain so in 2007. However, seeking to retain a stable economic growth, it is vital to firmly and promptly continue  implementing the promised tax-cuts policy and tax administration reforms, to formulate clear strategies for keeping labour in the country (and attracting new workers) and “to rescue” the country’s feeble education and healthcare systems. It is also crucial to tighten the administration of public finances, especially to trim budget expenditure.

 

Both consumer and producer prices will continue to rise in this and the coming year. Such expectations can be explained largely by government-adopted decisions and uncertainty regarding potential changes in energy prices. On the other hand, strong competition on the domestic market continues to hold back a more rapid price growth.

 

Market participants polled by LFMI raised their earlier forecasts by 0.15 percentage point and think that Lithuania’s gross domestic product (GDP) grew by 7.18 percent in 2006. The economy is expected to grow by 6.85 percent in 2007. 

 

A growing consumption and domestic market and a steady export growth continue to stimulate Lithuania’s economic development. A continued strong economic development and a declining supply of labour keep augmenting personal earnings and household income.

 

A persisting economic growth and expectations of further growth build favourable conditions to reform the systems of energy, healthcare, education, transport, social security and state finances. Meagre foreign investments also reflect the lack of, and the need for, reforms.

 

Migration and a shortage of labour and a surging price of the labour force are among the main factors behind the lower prognoses of economic growth in 2007. The reduction of the personal income tax has not been sufficient for attracting foreign investments or markedly reducing the shadow economy. To that end, the personal income tax must be slashed to at least 20 percent and other means such as introducing an upper ceiling on contributions to the State Social Insurance Fund (“Sodra”) must be launched.  Meanwhile, a careless fiscal policy and growing budget revenues and expenditures push up the level of inflation and arrest economic growth.

 

Market participants polled by LFMI think that the shadow economy did not contract so sizeably as predicted before – it decreased only to 20.7 percent in 2006.

 

The results of the current survey indicate that the shadow economy was about a half percentage point smaller in 2006, compared to 2005, and accounted for 20.7 percent of GDP. Market participants expect that the shadow economy will decrease in 2007 and will account for approximately 19.5 percent of the entire economy, although in the previous survey they predicted a decline to 19 percent.

 

A negligible decrease in the shadow economy points to stagnation in those areas where serious reforms would contribute to a more noticeable decline in the shadow economy. Profound reforms are exigent not only in the tax system but also in the areas of regulation of economic activity, licensing, fees and charges and land regulation.

 

It is very likely that unpredictable tax policy is also holding back a more substantial decline in the shadow economy. In the middle of the year the Lithuanian Government kept on changing its decisions regarding the tax policy (for example, it put forth various scenarios for the social tax and an increase in the real estate tax, exerting disastrous effects on small-scale business) which did not allow companies to plan their income and expenditures, also undermining their confidence in official authorities.

 

Contrary to the public opinion, market participants say that the share of workers receiving unofficial wages remains still large – about 41 percent, although they admit that the fight against “envelope” wages indeed reduces unofficial payments to employees.

 

The shadow economy and pessimistic expectations are pillowed by a heavy administrative burden. According to market participants, the administrative burden keeps growing (42.5 percent) and remains unchanged (54.5 percent). Only three percent of respondents reported that the administrative burden was decreasing. Market players think that it not only boosts the time costs but also provokes non-productive investments and corruption.

 

 

Improved expectations regarding import growth can also be related to increasing personal earnings, the purchasing power and consumption, coupled with hopes that investment processes will start to revive after a stagnation that lasted for several years. However, as real steps to amend this situation, especially as regards government policies, have not been taken so far, it is very unlikely that investment flows will increase significantly in the short run.  The investment climate could be enhanced considerably by such government-initiated measures as the ceiling on “Sodra” contributions, simplification of land acquisition and construction development procedures, and a reform of studies and education system. On the other hand, import of investment goods is growing: import of these goods went up by 28.8 percent in 2006, as compared to 2005, and currently accounts for 16.7 percent of total imports.

 

 

Regulation of heating prices and a continuing upsurge in fuel prices will keep inflating prices most significantly in the short run. However, these prices barely dependent upon the Lithuanian Government’s decisions and its anti-inflation measures.

 

Prices also rise as additional money is thrown into the market. Increases in taxes (e.g. excise duties), restricted competition (e.g. in the energy sector) and government-stimulated consumption (e.g. tax favours for housing loans and compensations for heating) have also been augmenting prices in Lithuania.

 

The demand for certain products is growing faster than their supply, which is yet another cause of inflation. The most glaring example in this respect remains the Lithuanian real estate market.

 

The continued growth of consumption is affecting prices as well. With rising household income, an evident boost of consumption has persisted for several years in a row, although the situation has slightly improved recently as a result of households’ heightened interest in savings and investments.

 

However, as far as controlling consumption is concerned, it is indispensable that the Lithuanian Government began with clearing its own yard and restricted government consumption, established fiscal discipline and abstained from wasteful spending.

 

Mounting energy prices keep augmenting the prices of producer goods sold. As refined oil products constitute a large portion of Lithuania’s entire industrial production, changes in the prices of these products, as the official indicators also show, have and will continue to have a considerable impact on the overall producer price index. A one-fourth leap in oil prices during this year has certainly affected the annual producer price index. According to Statistics Lithuania, producer prices went up by 7.6 percent in 2006. Market participants provided a slightly lower forecast for 2006 than the figure presented by Statistics Lithuania, 5.2 percent. The LFMI survey shows that producer prices will grow at a similar rate, by about 6 percent, in 2007.

 

This may be related to increases in prices of almost all consumer goods and services. Apart from the above mentioned refined oil products, the figures provided in the LFMI survey may also be possibly explained by a ten-percent rise in prices of electricity, gas and water supply, as well as increases in prices of manufacturing, mining and quarrying.

 

High prognoses for producer prices for 2007 can be primarily attributed to rising prices of energy and natural gas, which in turn has resulted in climbing prices of central heating. In addition, uncertainly on the energy market and continuing international debates over the future of the energy sector also led market participants to expect a high price growth. 

 

According to market participants, the rate of unemployment was 5 percent at the end of 2006, compared to 7.34 percent at the end of 2005. It is expected that unemployment will continue to fall and will stand at 4.6 percent at the end of 2007.

 

Emigration and a lack of qualified labour remain central problems in the labour market. But purely administrative means are insubstantial to solve the genuine causes of emigration. The government must reduce labour taxation, liberalise employment regulations and ease the administrative burden for business (especially restrict the role of controlling institutions). In addition to that, it is urgent to reform the healthcare sector and the pension system.

 

Market participants think that the tax burden was 32.8 percent of GDP in 2006, compared to 34.6 percent in 2005. The LFMI survey participants project that the tax burden will slightly decrease in 2007 and constitute 32.3 percent of GDP.

 

Changes in the Lithuanian tax regime in the previous year - a reduction of the personal income tax, an imposition of the social tax, and expectations regarding further personal income tax cuts – are among the main factors behind the estimates and forecasts reported by market participants.

 

The implemented tax reform has not bolstered significantly market participants’ optimistic expectations, although the figure of the tax burden was reduced anyway. The cuts of the personal income tax have been counterbalanced by the introduction of the social tax and uncertainty of future plans (particularly concerning possible increases in excise duties and the real estate tax and the expansion of the tax base).

 

Timid tax reduction, imposition of temporary taxes and vague plans regarding the tax reform may exert grave consequences on business’ investments and certainly do not elevate the confidence of the market.

 

As the LFMI survey indicates, the average monthly household income rose by 12.4 percent in 2006, as compared to 2005, and amounted to 2,472 litas. Six months ago market participants expected a 9.5-percent growth of household income in 2006. Monthly household income per household member averaged 951 litas.

 

Household income has been steadily rising over the past six years, in line with the growing economy. A considerable decline in unemployment during this period, a significant rise of earnings in recent years and earning opportunities abroad are the primary factors related to the increased household income. Household income was also augmented as household members, employed in foreign countries, sent or transferred portions of their wages to family members in Lithuania.

 

Government-made steps of social policy undoubtedly augmented household income last year, but they are powerless in eliminating the defects of the social security system in the long run. The growing “Sodra” budget and its current surplus has presented the most favourable conditions ever to implement far-reaching structural reforms, such as furthering the pension reform – a tool to settle problems in the future. However, the current situation is being wasted on attaining temporary political goals.

 

As the LFMI survey shows, the financial situation of households will continue to improve this year. Market participants project that average household income will grow at a higher rate in 2007 than in 2006 – by approximately 12.5 percent, and will amount to 2,594 litas per month. Income per household member will exceed 1,000 litas, amounting to 1,066 litas per month.

 

Market participants believe that average net earnings increased by about 12.5 percent, or 150 litas, in 2006 and amounted to 1,335 litas per month. 

 

Wages are rising for all workers – the number of workers receiving the minimum wage and low earnings is diminishing, while the number of those receiving wages of more than 1,000 litas is on the rise. The proportion of those receiving minimum or similar wages is expected to decline markedly in 2007, in line with a shrinking share of illegal “envelope” payments to workers.

 

According to the LFMI survey participants, about 41 percent of all employees are paid unofficial wages “in envelopes.” But as much as 94 percent of those polled by LFMI said their share in the market was shrinking. As the main causes behind declining unofficial wages in the labour market the LFMI respondents indicated the State Tax Inspectorate’s campaign against “envelopes” and the related leaked cases of unofficial remuneration for work. The reduction of the personal income tax, employees’ awareness and a need for bank loans, plus a shortage of labour and surging earnings, are among other factors of decreasing “envelope wages.”

 

According to market participants, average monthly net earnings will continue to grow at a similarly fast rate in 2007: they are expected to edge up by nearly 15 percent, amounting to 1,535 litas at the end of 2007.

 

A shrinking supply of labour will continue to have the biggest effect on wage growth. A constantly falling number of unemployed people is reflected in the process of emigration rather than the official figures of unemployment. Meanwhile, the feeble and unreformed education system does not bolster expectations that this trend may be reversed before long.

 

 

A year ago market participants thought that households saved more than they invested. The previous survey indicates that household savings accounted for 15 percent of household income and investments accounted for significantly more, 18 percent. However, when providing estimates for 2006, market participants reported that household savings accounted for 15 percent and household investments, for 14 percent of total household budgets.

 

It is important to note that, according to market participants, the share of income that households saved in one-year period slightly shrank, instead of growing, compared to 2005. The amount of income invested by households underwent a meagre increase, but its share in total household budgets dropped to 14 percent. This indicates that although Lithuanians no longer spend all of their income on food only, household savings and investments are declining. In 2005 household savings and investments accounted for 32.5 percent and in 2006 they accounted for 28.7 percent of total household budget, although nominal amounts apportioned for saving and investing are insignificantly rising.

 

Market participants provided higher forecasts of household savings, compared to household investments. Household savings and investments are expected to rise more (21 percent) than personal earnings (15 percent).   This means that Lithuanians will have more extra money left after all needed daily items are purchased. The LFMI survey indicates that household investments will rise by 16 percent and amount to 396 litas per month, accounting for 15 percent of household budgets at the end of 2007 (this figure is much lower than the prognoses reported six months ago, 496 litas per month). Household savings are expected to edge up by 26 percent in 2007 and will total 464 litas per month, accounting for 17 percent of household budgets.

 

Six months ago the LFMI survey participants predicted that the profit margin would average 6.3 percent in 2006. In the current survey, they raised their earlier forecasts of the 2006 profit margin and think that the average profit margin was 6.9 percent in 2006, while the average return on equity was 11.7 percent.

 

Market participants predict that the profit margin and return on equity will not change considerably in 2007. The average profit margin is expected to go down to 6.51 percent, while the average return on equity will increase to 11.8 percent in 2007.

 

Such expectations are likely to be related to the continued growth of the Lithuanian economy, rising domestic demand and the benefits of the membership of the EU. On the other hand, a shortage of qualified workers and growing costs of skilled labour may have had an adverse impact on corporate indicators.

 

Generalised answers of market participants lead to a conclusion that the investment climate in Lithuania neither improved nor deteriorated last year (17 respondents reported positive answers and 15 of those polled answered negatively). They pointed to bureaucracy and problems of public administration as the major roadblocks to business activities in the country. Rising costs of labour also pose considerable concern. According to the survey participants, the primary tool to amend the situation is to reduce taxes and corruption.

 

According to market participants, the share of reinvested profits averaged 44 percent in 2006, compared to 46 percent in 2005 or to as much as 66 percent in 2001.

 

The persisting stagnation of reinvested profits can be directly linked to the changes in taxation in 2002, more specifically the decision to apply the corporate profit tax to all investments. During the years when the best indicators of reinvested profits were recorded (1997-2001), investments were not taxed. Shortly after the tax on reinvested profits was levied, the companies’ reinvested profits plummeted and have not recovered since then.

 

Market participants do not anticipate noticeable changes. They think that reinvested profits will increase and average 46 percent in 2007.

 

According to the LFMI survey participants, innovation processes are declining in line with reinvested profits. Market participants estimate that expenses on research and development accounted for 5.2 percent of companies’ total expenses in 2006, although the figure provided in the previous survey was 6.04 percent.

 

As supply of labour decreases and the price of labour and corporate profits surge, innovative solutions should be seen as a helping hand in retaining the desired and appropriate level of efficiency of business’ activity. However, the results of the LFMI survey show that expenses on research and development do not grow so fast as it might have been expected.

 

Several reasons can be attributed to this phenomenon. First, market participants may not ascribe all applied innovative solutions to innovations, classifying them as investments. Second, the problem of activity’s efficiency is likely being solved by other means. Third, market participants may not yet be able to discern the problem of activity efficiency, resulting from the shortage of labour and rising costs of labour.

 

The results of the survey show that expenses on research and development will increase in 2007. Market participants project that the share of expenses on research and development will reach the level of 2005, or 6.2 percent.

 

Given the rapidly growing costs of labour, the figures of expenses on research and development are not at all gratifying. In an attempt to retain their competitiveness, Lithuanian companies will be forced to increase labour productivity more promptly in the future. The situation is being even more aggravated by the fact that foreign investments, another major source of innovations and new technologies, are actually not rising.

 

The LFMI survey reveals that the cost of borrowing from commercial banks increased in 2006. According to market participants, interest on 1 to 12-month loans in litas climbed from 5.26 percent at the end of 2005 to 5.74 percent in late 2006. Interest on loans of more than one year went up slightly as well (5.17 percent and 5.27 percent respectively). The LFMI survey participants predict that the price of borrowing will rise in 2007: 1 to 12-month loans will cost on average 6.22 percent and those over one year will be drawn for 5.74 percent.

 

Market participants suggest that the price of borrowing, somewhat established for a few years (it varied just a couple of percentage points over 2003-2005), started to increase. This is not entirely surprising, since the level of interest rates in Lithuania is a reflection of global trends – the European Central Bank’s (ECB) strict monetary policy. The ECB keeps pursuing its line of raising the base interest rates, which was started in late 2005. In March 2007, the base interest rate in Europe was increased to 3.75 percent. For this reason, high figures provided by market participants do not cause surprise. In addition to that, climbing interest rates, albeit relatively not sizeably, are also being affected by a high liquidity of the Lithuanian banking system and strong competition in the banking sector (according to the Bank of Lithuania, the real profit margin on interest did not increase last year, accounting for 2.54 percent on 1 January 2007).

 

Deposits grew much less considerably last year than loans. Such trends can be explained by optimistic expectations, increased consumption and increasingly popular alternative means of investing. According to the Bank of Lithuania, deposits kept at Lithuanian commercial banks totalled 30.3 billion litas in 2007. The deposit portfolio went up by 21 percent during one year. This figure is twice lower than the 2005 indicator, when the deposit portfolio surged by 40.7 percent. Deposits of individuals saw the most sizeable leap (1.8 billion litas, or 29.9 percent).