According to the survey of market participants conducted by LFMI in January to February 2006, the economic situation in Lithuania this as well as the next year remains stable and is better than had been previously predicted. Economic indicators remain rather high; trade is continuing to grow, the financial situation of businesses is improving, and so is the financial situation of Lithuanian households. In this survey greater attention was devoted to situation in the labour market. According to market participants, the average salary was growing very fast in 2005, and this trend is continuing into this year. The indicators of unemployment – to the contrary – have fallen radically over the last year, and this downward trend should continue in 2006. Rapid changes in market participants’ prognoses show their concern with emigrating workers, stagnated situation in the education sector, and harsh - and increasing - competition in the labour market. Emigration, competition for labour, and fast economic growth are contributing to rapid salary growth. In turn, bigger monthly salaries, together with the money that Lithuanians working abroad are sending back to their families, contribute to improving financial situation of Lithuanian households. Greater income fuels consumption and expansion of internal market, which in turn stimulates economic growth. However, the consumption also contributes to an increase in prices, which have been growing considerably faster in the last couple of years. Market participants’ optimism was also shadowed by the still high levels of shadow economy, high tax burden, negligible levels of foreign investment, massive emigration wave, also lack of strategic planning in the government, all of which could prevent the economy from keeping up high growth rate in the future. 

 

Market participants polled by LFMI think that Lithuania’s gross domestic product (GDP) grew by 6.5 percent in 2005, as compared to 6.8 percent in 2004 – thus their earlier forecasts of 6.3 percent have been slightly increased. Survey participants predict a similar but somewhat decelerating economic growth for 2006. They believe that the economy will grow by 6.2 percent in 2006. Compared to the forecasts of other official – national and international – institutions, the market participants’ prognoses are average. Everybody agrees on the general economic trends – the economic expansion of 6-7 percent in 2005, and somewhat slower growth this year.

 

Lithuanian economy is still boosted by good trade indicators, especially continuous export growth, also growing public and industry confidence.  Market participants’ expectations are also boosted by the benefits derived from the European Union (EU) membership. The impact of the membership is already evident, in particular regarding the positive changes in the division of labour, increased specialisation and changes in foreign trade.

 

However, market participants do not share the prevalent notion about the positive impact of structural funds; in fact, they are rather sceptic in evaluating the impact that the EU support will have on the country’s economic development. Although they recognise that structural funds have some positive effects on economic growth, market participants also think that they can entail serious negative consequences and, in particular, distort competition. The LFMI respondents were almost unanimously stating that structural funds pervert competition, and one-third of those polled thought the negative impact was especially strong (almost two-thirds (62 percent) of those polled thought that the negative impact would not be very strong, but only eight percent said that structural funds did not distort competition at all). In any case, the positive impact of EU support and even labour division and specialisation is likely to fade away in time, while structural funds may even exert grave and long-term consequences due to withdrawal of resources, also the criteria of allocation, which could distort competition, etc. Thus seeking to use these sources in the most efficient way and to sustain a viable economic growth after they are depleted, it is indispensable to stimulate growth by pursuing a strict fiscal policy, further liberalising the market and resisting the temptation to artificially stimulate the economy by increasing government spending.

 

It has been traditionally repeated in the LFMI survey that the country’s economic development is being hindered by continued absence of structural reforms in a number of strategic areas, while the current economic situation is especially favourable to institute fundamental changes – further delay may lead to economic stagnation in the near future. The lack of, and the need for, essential reforms is also reflected in meagre investments, high levels of shadow economy, emigration of Lithuanian residents and a growing lack of qualified labour.

 

As the LFMI survey indicates, market participants did not change their opinion regarding the shadow economy. Just as six months ago, they think that the shadow economy in Lithuania accounts for about one-fifth of the entire economy. Until 2002, market participants provided quite optimistic estimates of the shadow economy, every year reporting lower figures. However, in the recent years the trend has been reversed and now market participants do not seem to expect any further contractions of informal part of the economy: they believe the shadow economy accounts for approximately one-fifth of GDP, although in several recent surveys they reported even higher figures. The results of this survey show that the shadow economy accounted for 21 percent of GDP in 2005. Market participants expect that the shadow economy will slightly decrease in 2006, to account for 20 percent of the entire economy.

 

The considerable and persistent tax burden, inconsistency and unpredictability of the tax policy, often ambiguous market regulating rules, strict regulations of the land market and multiple barriers to land acquisition and construction activities, coupled with high excise duties, deteriorated conditions for individual businesses, complicated licensing procedures, and new EU rules and regulations as well as expensive implementation of quality, security and other requirements explain the persistent pessimistic forecasts of the shadow economy.

 

 

 

Market participants’ expectations and resulting high estimates and prognoses (especially regarding export) are stimulated by fast economic growth in Lithuania’s main trading partner countries, namely the U.S. and the partners to the East, as well as hopes that the growth rate of the euro zone economies will finally pick up. Expectations are still positively influenced by the absence of barriers to trade with the EU (which at the time of discussion remains Lithuania’s main trading partner), and are further fuelled by still growing prices of oil and metals.  High export indicators, strongly affected by increased specialisation, contributed to expectations regarding overall economic performance. Figures of export growth should remain relatively high in the near future due to very fast growth of Lithuania’s two main export markets, namely Russia and Latvia. On the other hand, the less optimistic (as compared to the official figures) estimates for export growth are likely to be related no only to concerns about the lack of improvement in the EU markets, but also uncertainties due to the closure of the 1^st reactor of the Ignalina nuclear plant, especially now, when the question of economic dependency is hotly debated not only on the national, but also on the international, level. Although the EU membership undoubtedly brought about significant trade benefits, import figures were not growing as fast as predicted. That could be a reflection of negligent foreign investment growth, and stagnation of the euro zone economies.

 

Several factors have a strong impact on price dynamics in Lithuania and lead to an increase. First, it is important to note that the prices in the energy, transport and healthcare sectors are still heavily regulated by the state. And despite the Government’s efforts to cushion the growth of gas, electricity and transport prices, the leap was the most significant in these particular sectors. Second, the Lithuanian price level is one of the lowest in the entire EU, and prices in one market usually tend to converge. Third, continuously growing government expenditure (including EU support) also pushes up the level of inflation. In addition, rapidly rising personal earnings, long-term consumption-driven market expansion, and such measures as increases in the mandatory minimal wage (indirectly, through increased salaries for employees of budgetary institution and increased consumption) also drive prices upwards. Consumer and, especially, production, price indexes were - naturally - also inflated by continuing upsurge in oil and gas prices.

 

As of last year and due to this figure’s decisive role in final EU decisions, the indicator of inflation has been increasingly attentively monitored and the growth of prices especially thoroughly measured and debated in light of Lithuania’s expected membership of the euro area, seeking to evaluate the risks to Lithuania’s plans to introduce the euro from 2007. It is crucial to understand in this situation, however, that a pursuit of stable and sound fiscal and economic policies is more important than a launch of the single currency from 2007. Introduction of such “synthetic” measures as subsidies and/or price freezes could potentially lead to deleterious effects in the future, no matter if the euro were introduced as planned or not. On the other hand, a strict fiscal policy, reduction of budget expenditures, continued liberalisation, elimination of tax exemptions and temporarily slashed various compensations could help to not only bring the euro but also to kick-star Lithuania’s entire economy.

 

The situation in the labour market has been changing noticeably for some time now, with the figures of unemployment constantly and rapidly decreasing. According to market participants, the rate of unemployment was 7.34 percent at the end of 2005, compared to 9.6 percent the year before. It is expected that unemployment will continue to fall over the next year and at the end of December 2006 will stand at 6.9 percent.

 

Although continuous economic expansion as well as confidence about the future undoubtedly have an impact on downward trend in unemployment indicators. However, the main factor that affected the sharp drop in unemployment over the last year, is emigration. While the indicators of unemployment are decreasing, the number of people in employment is not growing at the same rate. Therefore smaller figures do not mean that the problems in the country’s labour market are being solved – to the contrary.  Especially high drop in unemployment estimates shows market participants’ concern with massive emigration of Lithuanians to EU labour markets and with lack of qualified labour at home, and thus does not allow for optimism over low figures.

 

The role of the government in trying to keep the labour force in Lithuania is very specific – to build a needed environment and create conditions that would motivate workers to stay in the country. To attain this, it is crucial to cut labour income taxation, to liberalise employment regulations, to reduce the administrative burden for business (and to restrict the role of regulatory institutions in particular) and to reform the education, health care and pension systems.

 

Market participants think that the tax burden constituted 34.1 percent of GDP in 2005, as compared to 35.4 percent in 2004. The LFMI survey participants do not expect the tax burden to decrease over this year. They believe that in 2006 the tax burden will remain similar to the levels recorded in 2005, and constitute 34.1 percent of GDP.

 

A year ago market participants predicted a heavier tax burden in 2005: they thought it would constitute about 36.3 percent. A lower figure in this survey could be directly related to the certainty about the outcome of the tax reform, while a lack of clarity of how Lithuanian tax system will look like definitely had a negative effect on market participants’ earlier prognoses. There were indeed quite a few important decisions regarding the tax policy taken in Lithuania in 2005:  for example, the profit tax calculated from turnover was finally abolished and a gradual reduction of the personal income tax was envisaged. The latter decision, which will decrease the income tax rate from 33 to 24 percent, is especially welcome and has had a positive impact on forecasts reported by market participants. Sadly, however, the government has chosen the least effective way to implement the goals of the tax reform. The tax rate will be reduced not in one go, but rather gradually over three years: from 33 to 27 percent starting from 1 July 2006, and then again to 24 percent from 1 January 2008. Gradual reduction of taxes will neither considerably alleviate the tax burden for those who are employed legally and declare taxes nor for business people; therefore it will not serve as an effective tool to reduce the shadow economy in Lithuania (which was said to be one of the primary goals of the reform).

 

Unlike cuts of the personal income tax, other aspects of the tax reform will hardly contribute to enhancing the country’s competitiveness, which is also an important objective for Lithuania. Seeking to compensate for a potential loss of budget revenues, a temporary “social” tax and a 1 percent real estate tax for private persons (applied to real estate used for commercial purposes) were imposed. The instituted overhaul of the tax policy has not provided a push to the Lithuanian economy so far and, due to its insularity, is unlikely to do so. This is the case because the reform is based not on long-term economically grounded objectives, but rather on short-term measures aimed at satisfying the government’s short-term tasks, such as balancing off the national budget and compensating for ineffective government expenditure by introducing new taxes. Such policy is futile in encouraging the business community to create new jobs, decreasing the shadow economy, reducing emigration, and attracting foreign investments; it is similarly ineffective in seeking to stimulate both consumption as well as labour markets.

 

Market participants think that the tax burden will be 34.6 percent of GDP in 2005, compared to 35.4 percent last year. The LFMI survey participants do not expect the tax burden to decrease in the coming year. They believe the tax burden will remain similar, compared to 2005, and constitute 34.5 percent of GDP in 2006.

 

2005 was a year of harsh debates about the tax burden and particularly the tax reform, which was supposed to reduce the heavy burden. The final version of the reform, however, is rather controversial. Certain aspects of the tax reform are definitely welcome and has had a positive impact on forecasts reported by market participants. For example, it should be applauded that the road tax has been eliminated and – finally - the personal income tax rate was lowered from 33 percent to 24 percent. Sadly, however, the government has chosen a very ineffective method to implement these changes. The tax rate will be reduced not in one go, but rather gradually over three years: from 33 to 27 percent starting from 1 July 2006 and then again to 24 percent from 1 January 2008. In the current form, the conducted tax reform will not considerably alleviate the tax burden for legal workers and business people, therefore it will not serve as an effective tool to reduce the shadow economy in Lithuania (while this was among the primary goals of the reform). Other aspects of the tax reform will hardly contribute to enhancing the country’s competitiveness, which is also an important goal for Lithuania. Seeking to compensate for a potential loss of budget revenues, a “solidarity” tax and a 1 percent real estate tax for private persons (applied to real estate used for commercial purposes) were imposed. The terms and conditions of taxation will be the same as those applied to business entities. Apartments used for personal accommodation were excluded from taxation.

 

Consequently, the tax burden is not likely to decrease; its weight will be simply shifted and divided differently among different taxes. It can be firmly said that the enacted tax reform is just an imitation of a real reform and is based not on long-term economically grounded objectives, but rather on short-term measures aimed at satisfying the government’s short-term tasks, such as balancing off the national budget and compensating for ineffective government expenditure by new taxes. Such policy does not encourage the business community to create new jobs and is not effective in seeking to stimulate the labour markets and consumption.

 

Households

 

Compared to other institutions, the market participants polled by LFMI remained rather moderate in terms of their average salary growth predictions over the last couple of years. While others have been boldly predicting fast growth in earnings for some time now, market participants were more pessimistic about the possibilities of such an increase:  in 2001 to 2004 they did not see any changes that could give rise to a considerable leap in earnings, and this was reflected in their estimates and forecasts, which were barely altered in a number of previous surveys. It should be noted though that before Lithuania joined the EU market participants provided quite – and possibly over - optimistic forecasts. However, their ex poste estimates indicate that no jump in earnings occurred right after EU accession. In the current survey, however, market participants already raised the forecasts of the 2005 wage growth, and in general are more optimistic about the prospects of wage growth in 2005 and 2006. Market participants believe that average net earnings increased by nearly 13 percent, or 134 litas, in 2005 and amounted to 1,185.9 litas per month. Average monthly net earnings will continue to grow fast this year: they are expected to edge up by more than 10 percent by the end of 2006, amounting to 1,316 litas.

 

The survey indicates that more optimistic prognoses for both last and the current year are being bolstered by several factors: first, by rapidly falling unemployment and labour competition caused by large-scale emigration, as well as by endemic weaknesses of the education system, and second, by growing profitability and increasing productivity of companies, fuelled by new technologies and modernisation. Repeated increases in the mandatory minimum monthly wage, as well as salary increases for budgetary employees, also have an indirect impact on the wage growth.

 

The economic growth has had a continuous positive impact on the financial situation of Lithuanian households. According to market participants, average monthly household income rose by 9.4 percent in 2005, as compared to the previous year, and amounted to 2,166 litas. The updated forecast is 2.8 percent higher than the figure reported six months ago. Monthly household income per household member averaged 849 litas.

 

The yearly estimates obtained from the survey of market participants show a steady growth of household income over the past five years. Rapidly falling unemployment and growing earnings are the primary factors behind the rise in household income. In recent years, various and numerous social assistance payments from the state budget also contributed significantly to an increase in average household income. In addition to that, market participants believe that household income was also augmented by emigration as household members, working in foreign countries, sent or transferred some portion of their wages to their family members in Lithuania.

 

Numerous social benefits paid from the state budget – especially generously increasing maternity/paternity benefits and payments for children, also various pensions - undoubtedly raise the indicator of household income.  The same time, however, they pose serious concern and raise questions about growing inflation, the budget shortfall and the justification of balancing the national budget by raising taxes, the government’s long-range strategies and a general course of economic policy.

 

The LFMI polled market participants estimate that the financial situation of households will continue to improve this year. The forecast offered by survey participants is as much as 8 percent higher than the figure presented six months ago. Market participants project that average household income will grow at a higher rate in 2006 than in 2005 – by approximately 12 percent, and will amount to 2,425 litas per month, or 951 litas per household member.

 

The LFMI survey reflects a continued upsurge in both household investments and savings in 2005, as compared with 2004. While in 2004 the indicator of household investments was reduced, this time it has again been raised sizeably, although household savings continue to exceed the level of household investments. Market participants think that household savings soared and totalled 373.21 litas per month in 2005, compared to 283 litas per month in the year before. Household investments meanwhile amounted to 331.94 litas per month in 2005 - a growth of 66 litas per month, compared to 265 litas per month in 2004. Household savings accounted for 17 percent of household income and investments accounted for 15 percent. 

 

One year ago market participants expected a 12-percent rise in household savings, but this time the prognoses were increased, and in the current survey they think that household savings edged up by nearly one-third in 2005. Judging by international standards, such tendency to save, which markedly exceeds investments, is not optimal. In specialists’ view, the situation is not changing due to a lack of information about securities and their management, people’s reluctance to risk and, as mentioned, their old habits. On the other hand, today people in Lithuania save not just for unplanned purchases or consumer durables, as they used to do for a long time, but instead for their holiday needs, hobbies, etc.

 

The higher indicators of loans, on the other hand, shows that people invest more often too. Since investments have long been seen as a more risky undertaking, the boom of investments can be interpreted as a sign of a growing consumer confidence – both in general economic performance as well as in credit institutions. An upsurge in household investments could be driven by the boom of the real estate market and the surge in prices of housing, also by a growing interest in life insurance. The investments are also augmented by fierce competition in both banking sector as well as financial lease market.

 

For this year, too, market participants provided higher forecasts for growth of household investments and savings, with the latter expected to go up by as much as one-tenth. Market participants predict that household savings and investments will rise at a similar rate this year: household savings are expected to grow by 12.4 percent and household investments will edge up by 12.7 percent in 2006. Savings - again - will be slightly greater than investments, 419.45 litas per month and 374.12 litas per month respectively. Just as in 2005, savings will account for about 17 percent of overall household budgets, whereas investments will constitute a slightly smaller share – 15 percent.

 

 

The expectations of market participants in terms of corporate indicators have been modestly optimistic and have changed very inconsiderably for some time now. In the LFMI survey six months ago market participants forecast that the profit margin and return on equity would improve slightly, by a fraction of a percentage point. This time the corporate indicators have been raised once again, albeit not very substantially. According to the market participants, in the year 2005 the profit margin was on average 6.5 percent, while the return on equity reached 12.1 percent.

 

The LFMI survey indicates that the indicators of profit margin and return on equity should remain relatively unchanged in the year of 2006. Market participants predict that the average profit margin will go down slightly to 6.3 percent, while the return on equity will increase by a half of a percentage point to 12.6 percent in 2006. Unchanging, although modestly optimistic, expectations, are very likely related to the continued growth of the Lithuanian economy, rising domestic demand and the benefits of the membership of the EU. A growing demand for, and costs of, skilled labour and a shortage of qualified workers may have had an adverse impact on corporate indicators.

 

The LFMI surveys show that the share of reinvested profits increased steadily from 1997 until 2001, but also that this trend was reversed in 2002 and since then remains largely unchanged. According to market participants, the proportion of reinvested profits averaged 46 percent in 2005, down from 49 percent a year before, and as much as 20 percentage points lower than in 2001 (66 percent). Market participants lowered their forecast since the end of the last year, when they predicted the reinvested profits to remain at 49 percent. After a lower estimate of 2005, market participants expect the reinvestment indicators to go back to the previous years’ levels. They think that reinvested profits will increase by three percentage points and stand at 49 percent at the end of 2006.

The tendency of prolonged indicator stagnation can be directly linked to the changes in taxation in 2002, more specifically the decision to apply profit tax to all investments. During the years when the best indicators of reinvested profits were recorded (1997-2001), investments were not being taxed. As soon as the taxation laws had been changed and the new tax started to be applied, the companies’ reinvested profits, according to the market participants, plummeted, and have not recovered since. A more noticeable drop of reinvestments to 46 in 2005 could also be related to debates about changes in taxation. The solidarity tax, in particular, could have had a strong negative impact, since it was introduced after the companies had already planned their finances for the year ahead. It is possible, that aiming to keep a fiscal balance, companies chose to lower their share of reinvestments.

 

Although the share of reinvested profits, according to the LFMI survey participants, shrank, innovation processes did not slow down in 2005. According to market participants, expenses on research and development (R&D) accounted for 6.2 percent of companies’ total expenses in 2005, which is a little more than in 2004 (5.9 percent), but less than was expected in the previous survey (6.9 percent), and much less than in 2001 (7.2 percent).

 

The 2006 forecasts are less optimistic, the share of expenses for R&D is expected to decrease. Market participants think that the share of expenses on research and development will be reduced to 6 percent of total expenses in 2006.

 

The LFMI survey shows that the cost of borrowing from commercial banks decreased slightly at the end of 2005, as compared to the end of 2004. According to market participants, at the end of 2005 loans up to one year in litas 5.3 percent, while loans for more than one year cost on average 5.2 percent, as compared to 5.5 percent in 2004. This year the costs are expected to grow to 5.6 and 6.1 percent respectively.

 

In addition to bank loans, lease and factoring are getting increasingly popular. The lease and factoring portfolios account for an increasingly bigger proportion of bank loans (including bank loans extended to other banks and financial institutions) and their rate of growth is as high as that of bank loans.

 

* * *

 

The next survey will be conducted in the second half of 2006 and will show if and how market participants’ expectations for the year 2006 will change and what trends are expected in 2007.