Inflation risk

Most of Lithuania’s statistical indicators for 2007 seem in pretty good shape. Annual GDP growth accounted for 9 percent in the first three quarters of 2007, leaving year-end growth at a forecast 8.3 percent. Average earnings rose by almost 20 percent in the same period. Unemployment is very low at 4 percent and the fiscal indicators are looking good. Which leaves inflation...

International financial experts all too often see the three Baltic countries as a unified region. A lot of criticism has been directed at Latvia – justifiably, since the macro indicators there are quite poor – but unfortunately what happens in Latvia also reflects badly on Lithuania where the indicators are in fact quite healthy. What the experts tend to criticize is that the bulk of the growth so far seen in the Baltic countries is based on household consumption.

Household expenditure is indeed growing very fast – the gap between consumption growth and GDP growth is getting wider. There is an even bigger disproportion between the pace of expansion in the domestic trade sector and the income growth of the population, which means that today households are living on future consumption.

It looks as though consumers here want to rapidly catch up on those in Western Europe – at the cost of living on loans.

The dynamics on loan portfolio growth do indeed show that consumers are still taking loans. In the last nine months, Lithuania has been the leader in the Baltic states in terms of consumer loan growth.

The fast growth in consumption has inevitably had an impact on the economy. Over the last couple of months alone inflation has accelerated very much. In 2005, annual CPI growth was 2.7 percent. By June 2007, it had risen to 4.8 percent. In November 2007, it was 7.8 percent – inflation’s highest level since 1997.

The worrisome part is that inflationary expectations are created. To diminish them is a difficult process, especially since a great deal of the inflationary pressures are caused by external factors.

On a global scale, poor crop yields and increasing biofuel production have led to 15.4 percent annual growth in the price of food products in Lithuania. There are also increases in energy prices to contend with. Energy prices in Lithuania are still lower than they are in Germany and other Western European countries, but that is about to change.

Gazprom is raising natural gas prices from January 1, 2008, and the Lithuanian authorities have already announced that prices for households are going to increase by 70 percent.

Then, by the end of 2009, the Ignalina Nuclear Power Plant in northeastern Lithuania is due to shut down. There are increasing calls among Lithuanian politicians to keep it open, but I believe that since the closure is binding according to a contract signed with the European Union, the closure will go ahead.

When the closure happens, the jump in the cost of electricity will be significant. Add to this the coming increases in excise on tobacco, alcohol and fuel, and you have a range of external factors that the Lithuanian government has no power to eliminate.

However, inflation also depends on internal factors, for example low labor productivity. Last year, we saw a gap emerge between productivity growth and the growth in wages. In 2007, we saw that gap widen. The question is – is it possible to solve this problem? I think it is.

To solve it, we need to improve the investment climate, modernize production processes, and attract foreign investment to medium- and high-tech industries. An investment program along these lines was actually prepared two years ago, but has still not been confirmed. We can still do it.

Here the wage inflation spiral should also be mentioned. Wages are still much lower than in developed countries and the natural process of the assimilation of wages in continuing. But a vicious circle is developing. Aggregate demand is growing together with wages and under these conditions prices are growing as well. This in turn reduces the population’s incentives to save.

The rise in demand impairs companies’ incentive to compete since to make a profit they merely raise prices. We go to our bosses and ask for a raise, which in turn serves as a stimulus to spend more – and save less.

The main consequence of all of this is that in the short-term profitability can increase, but in the long-term Lithuania may lose its overall competitiveness with other companies in other countries.

Social tension 

Inflation is already starting to lead to diminishing purchasing power for large numbers of people, the outcome of which is social differentiation and social tension. While the rich do not feel price rises in essential products, for the poor most expenditure goes on household needs.

Another point to remember about inflation is that it is only an average; expensive coffee and tea may stay the same price while products such as milk and bread may go up by 30 percent or more.

So we can expect more strikes in Lithuania. That compares to the situation five years ago when few employees and workers here even knew what a strike was.

Once prices start to grow rapidly, consumer confidence falls. Without a doubt, the deteriorating expectations of the population will contribute to a slowdown in economic growth.

On the other hand, I think that the recent surge of optimism among the population has to some extent lost touch with fundamentals. The impressive improvement in expectations can be explained by the so-called theory of adaptive expectations, which means that people form their expectations about what will happen in the future based on what has happened in the past.

Indeed, membership in the EU has opened many new possibilities. The unemployment level, which was the highest in the EU a few years ago, has almost disappeared. Wage growth has accelerated. These changes have generated euphoric sentiments, which have caused a borrowing and consumption boom.

Accelerating inflation in the current environment has had a sobering effect and people have become more clear-headed. That is why I consider the deterioration of consumer sentiments to have had some positive elements.

After the consumption euphoria fades away, the growth of sectors that target their production to the domestic market will lose momentum. The role of economic growth engines could be taken over by the dynamic foreign-market oriented sectors.

Manufacturing sector in Lithuania makes up as much as 60 percent of exports. Looking at the total export growth for H1 2007, 6.5 percent, this is a very low figure. But take away one single enterprise – the troubled oil refinery Mažeikių Nafta – and exports for the period grew by a very impres­sive 29 percent.

Also on Lithuania’s side is the fact that Lithuanian companies are investing more and more into equipment and technology, representing an increase of 34.7 percent in H1. This means that companies are modernizing, something that will push up labor productivity.

Thinking positive 

This is why I think that in the short to medium term the outlook for the Lithuanian economy is quite good. The problem is that without reforms in the education system, improvement in the overall investment climate, and the attraction of FDI to high-tech industries, Lithuania will not be able to survive. This is especially the case with respect to growing competition from powerhouses like China and India.

Lithuania has to modernize because traditional sectors of the economy still dominate. Only 20 percent of manufacturing can be called medium- or high-tech industry, compared to at least 50 percent in Western Europe.

However, Estonia and Latvia, which are even more dominated by domestic demand than Lithuania, face more economic worries than Lithuania. They will undoubtedly face a significant slowdown in the coming years.

There is also one more positive factor that many experts overlook. At first sight Lithuania’s current account deficit appears unhealthy, but the sums of money returning to Lithuania from the large number of people estimated to be living and working abroad is not taken into account. In 2006, we ourselves calculated that the current account deficit was not the 10.8 percent recorded that year, but 6-7 percent when including the money sent back by emigrants.

In conclusion, this example also shows that deep analysis beyond simply looking at the macro economic figures is always needed when assessing the state of a national economy. The Lithuanian economy is in good shape.