LITHUANIA'S ECONOMIC BOOM: IS THE END NIGH?

UNCLAS SECTION 01 OF 03 VILNIUS 000029

SIPDIS

E.O. 12958: N/A
TAGS: ECON EINV ETRD LH
SUBJECT: LITHUANIA'S ECONOMIC BOOM: IS THE END NIGH?

REF: A) 2005 Vilnius 769, B) 2005 Vilnius 528


1. SUMMARY: Lithuania's impressive economic growth
continued in 2005. Wage increases, rising energy prices,
and strong domestic consumption contributed to inflationary
pressure, but a government budget surplus, improved credit
rating, and a shrinking current account deficit indicate
prudent economic policies. Foreign direct investment flows
and U.S. accumulated investment plummeted in 2005, however.
For the boom to continue, the GOL needs to improve its
ability to attract foreign capital. END SUMMARY.

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Growing Economy Continues to Impress
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2. Lithuania's economy grew 6.9 percent in the first three
quarters of 2005, boosting GDP to LTL 51.4 billion (USD 18.4
billion). (Final 2005 data will not be available until
March.) This puts the country on pace to match the previous
year's growth rate of seven percent, despite widespread
expectations that the rate of economic growth would slow.
Construction and consumer lending led growth, posting
increases of 12 and 12.5 percent, respectively. Other
sectors also saw significant gains: wholesale and retail
trade (11.6 percent increase),hotels and restaurants (11.1
percent),transport and communications (10.9 percent),
electricity, gas, and water supply (9.8 percent),and
manufacturing (7.6 percent).

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Challenges to Growth
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3. Lithuania's economic growth continues in spite of several
challenges. Record-high global oil prices and a rising cost
of labor are pushing production costs higher. Economic
stagnation among many of Lithuania's EU trading partners
hampers the ability of Lithuanian companies to find new
niches in their favorite markets. Increasing pressure from
Chinese competition, especially in textiles and electronics,
also challenges Lithuania's ability to export profitably.

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Prudent Public Finances Keep Lithuania on the Euro Track
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4. The GOL's fiscal position improved significantly during
the first eleven months of 2005. Lithuania ran a budget
surplus equal to 0.4 percent of GDP, in contrast to deficits
of 2.5 percent and 1.7 percent in 2004 and 2003,
respectively. Tight control over spending and a marked
improvement in tax revenues explain this fiscal turnaround.
(In one respect, there was in fact too much spending
restraint; the GOL reneged at the end of the year on a
commitment to NATO and the USG to increase defense spending,
with a view to spending two percent of GDP on such
expenditures within a few years' time.) Statisticians at
the Ministry of Finance told us that the GOL may still end
up in the red for 2005 because of increased spending in the
fourth quarter, but statistics confirming this are not yet
available. The GOL also kept the national debt under
control: 16.9 percent of GDP for the first 11 months of
2005, well below the 60 percent limit required to meet the
Maastricht criteria for joining the euro zone.


5. Lithuania's fiscal prudence looks set to continue, even
though the 2006 budget is 20 percent larger than the budget
for the previous year. If the government meets projected
targets for revenue and expenditures of LTL 16.7 billion
(USD 6 billion) and LTL 18.46 billion (USD 6.64 billion),
respectively, the fiscal deficit will reach approximately 2
percent of GDP -- well under the Maastricht 3-percent
ceiling.

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S&P Confidence in Lithuania's Economic Policies
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6. Standard & Poor's raised Lithuania's long-term foreign-
currency borrowing rating last month from A- to A and its
short-term rating from A-2 to A-1. This vote of confidence
in the government's fiscal abilities should send a powerful
signal to investors and allow the GOL cheaper access to
foreign capital.

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Unemployment Declines, as Workers Leave. . .
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7. The unemployment rate continued to drop in 2005. The
GOL's official registered unemployment rate for 2005 was 4.8
percent, down from 6.8 percent in 2004 and the lowest level
of registered unemployment since Lithuania's transition to a
market economy in the mid-1990s. The Statistics Department's
more comprehensive quarterly survey data showed that
unemployment dropped to its lowest rate in four years -- 7.2
percent in the third quarter -- a sharp decrease from 11.4
percent unemployment in 2004. Emigration of labor
(especially unskilled labor departing for the UK and
Ireland),rather than robust job creation, appears to
account for much of the drop in unemployment. This trend
looks likely to continue as entry restrictions to the EU's
labor market relax further.
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. . . and Wages Rise to Make them Stay
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8. Lithuania's average gross monthly salary increased 9.4
percent in the third quarter of 2005 over the same period in
2004, which was also characterized by a strong rate of
increase. Competition for labor from foreign markets and
the shortage of qualified employees will continue to push
wages higher in 2006. Wage increases contributed to
inflation; consumer prices rose an estimated 2.7 percent by
the end of November. This was slightly less than 2004's 2.9
percent inflation, but near the highest rate permitted under
Maastricht.

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FDI Plummets
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9. Foreign direct investment (FDI) flows into Lithuania
plummeted 28.2 percent during the first ten months of the
year to LTL 1.32 billion (USD 447 million) -- LTL 519
million (USD 187 million) less than the first ten months of

2004. Accumulated FDI reached LTL 17.5 billion (USD 6.3
billion),or LTL 5,139 (USD 1,848) per capita. Leading
investors were Sweden (14 percent),Denmark (13.5 percent),
Germany (13.3 percent) and Russia (12.1 percent). U.S.
investments accounted for less than five percent of the
total FDI inflow, making it the seventh largest investor in
Lithuania.


10. The total stock of U.S. FDI in Lithuania dropped by more
than 30 percent in the first half of 2005, to LTL 740
million (USD 261 million). Officials in the Lithuania
Statistics Department told us that approximately 60 percent
of this decrease is the result of intracompany debt
transfers involving local subsidiaries of U.S. companies.
The head of a prominent local investors' advocacy group told
us that she was unaware of any American-owned business that
has pulled up stakes and left Lithuania recently. She
added, however, that she was not surprised by the drop in
FDI inflows and said that the GOL fails to make attracting
investment a priority.

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EU Membership Spurs Exports, Shrinks CAD
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11. The current account deficit (CAD) deficit reached LTL
3.6 billion, or 6.9 per cent of GDP, in the first three
quarters of 2005, down from 8.4 percent of GDP for the same
period in 2004. Lithuanian exporters continued to enjoy the
export benefits of EU membership, including market access to
all EU member states and subsidies for exports to third
countries. Lithuania's foreign trade deficit increased by
15.3 percent compared with the first ten months of 2004, to
LTL 8 billion (USD 2.9 billion). Exports of goods and
services grew by 25.8 percent to LTL 26.3 billion (USD 9.48
billion),while imports rose by 23.2 percent to LTL 34.4
billion (USD 12.3 billion). Lithuania faces a serious
challenge from China and other Asian countries in many
sectors, but its ability to supply goods to the European
market faster than Asian countries remains a niche
advantage.


12. Current transfers, especially EU funds and remittances
from Lithuanians working abroad, played a key role in
reducing the CAD. These transfers rose more than 56 percent
in the first three quarters compared to the same period in
2004, totaling LTL 1.3 billion (USD 448 million).

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Comment
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13. Lithuania remains one of Europe's most dynamic
economies. A few weaknesses, however, threaten to ground
this high-flying economy in the coming years. With the
exception of EU funds, this government has been complacent
in the global competition for capital. The fall in U.S. FDI
reflects several problems, including the country's imperfect
investment climate, the failure of the GOL to make headway
against corruption, and massive labor flight. It also
reflects Lithuania's institutional inadequacy in effectively
promoting its advantages and attracting investors,
especially in the United States. The multiparty government
seems more willing to rely on EU funds to stimulate the
economy than to pursue a more aggressive reform agenda.


14. Qualifying for entry into the euro zone, the GOL's top
economic policy objective, appears more likely every day.
That accomplishment may help attract more investment
eventually. The GOL needs, however, to begin planning its
post-euro adoption economic strategy today.

MULL