Be happy, but not complacent - Prospects for the Lithuanian economy

Lars ChristensenSenior Analyst, Head of New Europe Research

Danske Research, Danske Bank

+ 45 45 12 85 30 (direct)

+ 45 40 74 49 51 (mobile)

larch@danskebank.dk

web site: www.danskebank.com/research

May 2007

2

A booming economy is slowing

• The Lithuanian economy continues to grow strongly

• But LUCKILY growth is now showing (minor) signs of slowing

• Growth is good, but it should be based on productivity growth – and not on lending growth

.

02 03 04 05 06percent

4

5

6

7

8

9

10

11

12

percent

4

5

6

7

8

9

10

11

12

GDP growth, Lithuania

3

Productivity versus lending

• High lending growth is not a problem if it is financing “productive” investments

• However, over the last 1-2 years productivity growth has slowed dramatically while lending growth has been very high

• A shift towards more sustainable growth is necessary

.

02 03 04 05 06 07percent

-10

0

10

20

30

40

50

60

70

percent

-10

0

10

20

30

40

50

60

70

Productivity growth

Credit growth

% y/y

4

This cannot go on forever…private consumption growth has to slow

down• Private consumption has been very strong in

recent years due to:• Strong wage and employment growth• Strong credit growth and low interest rates• Strong development in asset prices (real estate

and equities)• However, private consumption will have to slow

down to bring a better “balance” into the Lithuanian economy

• In the long-run, private consumption cannot grow faster than the rest of the economy unless public consumption grows more slowly

• Higher European interest rates and more restrictive lending policy from the banks and possibly a drop in property prices will reduce private consumption growth

• In the coming years, private consumption is likely to return to the growth of the late 90s of 5-6% per year – maybe lower in a period

• Credit growth needs to slow

.

98 99 00 01 02 03 04 05 06

percent

2

4

6

8

10

12

14

percent

2

4

6

8

10

12

14Private consumption% y/y

5

Investment growth looks more healthy

• Investment growth has been strong over the last couple of years. That is clearly positive as it increases long-term productivity growth

• The investment ratio is still fairly low so there should be room for continued fairly strong investment growth

• …but we would be more optimistic if private consumption eased to create even more room for investment growth

• EU membership will continue to support investment, but continued effort to deregulate the economy and reduce corruption and red tape is warranted

.

98 99 00 01 02 03 04 05 06

percent

-30

-20

-10

0

10

20

30

40

percent

-30

-20

-10

0

10

20

30

40Real investment growth% y/y

.

00 01 02 03 04 05 06 07

percent

17.5

20.0

22.5

25.0

27.5

30.0

32.5

35.0

37.5

percent

17.5

20.0

22.5

25.0

27.5

30.0

32.5

35.0

37.5

Investment ratios in...

Poland

% of GDP Estonia

Latvia

Lithuania

6

Strong domestic demand hits net exports

• Import growth has significantly outpaced export growth over the last year

• This clearly is a result of (too) strong domestic demand

• To reverse this trend domestic demand has to slow down

• Unfortunately, export growth is unlikely to improve: European and Russian growth is set to slow in 2008

.

02 03 04 05 06 07

percent

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

percent

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

Real domestic demand >> (invers axis)

% y/y% y/y

<< Net export

.

00 01 02 03 04 05 06

percent

-12-11-10

-9-8-7-6-5-4-3-2

percent

-12-11-10

-9-8-7-6-5-4-3-2

Current account (% of GDP)

7

GDP growth set to slow- a soft landing is still possible, but the risks

are high• Growth in domestic demand has been too strong in recent years

and external imbalances have grown too large• Therefore, domestic demand has to slow – in particular the growth

in private consumption will have to slow down significantly• There is a significant risk of a hard landing, but a soft landing is

still possible• A (very) soft landing scenario would imply GDP returning to around

5% in the next 2-3 years. However, that would leave imbalances in the economy more or less unchanged. Hence, we would expect a period (ie, 2-3 years) of below-trend growth

• Therefore, we expect GDP growth around 6½% in 2007 and 4½-5% in 2008 and 2009

• In a hard landing scenario, Lithuania could face negative GDP growth for a prolonged period

8

A traffic light analysis of imbalances in New Europe

What does it tell us about Lithuanian imbalances?• We focus on EU8+2: the Baltic States, Poland, Hungary, the Czech Republic, Slovakia,

Slovenia, Romania and Bulgaria• And examine the following key factors to assess the risk of a hard landing and/or financial

distress:

• Unsustainable GDP growth• Inflation• Current account situation as % of GDP• Real effective exchange rate• Credit-to-GDP ratio• Credit growth• FX reserves-to-import ratio• Exports-to-imports ratio• Short-term debt/FX reserves• Real interest rates• Public finances

• See our report “New Europe: A warning not to be ignored”, February 23, 2007

9

What might happen to the countries in the “Danger zone”?

The countries in the Danger zone face a heightened risk of:

• A hard landing in the economy• A property market bust• A significant rise in “bad loans” and credit defaults• A credit crunch• Downgrades of credit ratings – both on sovereign debt

and potentially also on financial institutions• Financial market distress – sell-off in local equity and

fixed income markets and pressure on currencies

10

Lithuania growth is too strong…but not as “bad” as elsewhere

GDP growth

0

2

4

6

8

10

12

14

Latv

ia

Esto

nia

Slo

vaki

a

Rom

ania

Bul

gari

a

Lith

uani

a

Cze

chR

ep.

Pol

and

Slo

veni

a

Hun

gary

% y/y

Overheating Getting hot Sustainable

Note: Measured Q3 2006

11

This will not get Lithuania into the euro

Inflation

0

1

2

3

4

5

6

7

8

Latv

ia

Hun

gary

Bul

gari

a

Esto

nia

Rom

ania

Lith

uani

a

Slo

vaki

a

Slo

veni

a

Cze

ch R

ep.

Pol

and

% y/y

Cool down - now please! Sustainable

Getting ready for EMU

Note: Figures are year end 2006. Slovenia joined the EMU on J an. 1, 2007.

12

Too much in red…also Lithuania

Current account balance

-20-18-16-14-12-10

-8-6-4-20

Latv

ia

Bul

gari

a

Esto

nia

Lith

uani

a

Slo

vaki

a

Rom

ania

Hun

gary

Cze

chR

ep.

Slo

veni

a

Pol

and

% of GDP

Take cover! Unsustainable Healthy

Note: Figures are from Q3 2006

13

No room for credit growth, …but more sustainable than elsewhere in the Baltics

Credit to Privat Sector Relative to Income

Slovenia

Slovakia

RomaniaPoland

Lithuania

Latvia

Hungary

Estonia

Czech Rep.Bulgaria

0

10

20

30

40

50

60

70

80

90

0 5 10 15 20

GDP per capita - 1,000 USD

Credit % GDP

Right on!

Room for credit growth

Burning

14

BUT be careful anyway!!

Credit growth

0

10

20

30

40

50

60

70

Latv

ia

Lith

uani

a

Rom

ania

Esto

nia

Slo

veni

a

Hun

gary

Bul

gari

a

Slo

vaki

a

Pol

and

Cze

chR

ep.

% y/y

SustainableThis is unsustainable!

Note: Credit growth rate of credit to private sector (average %)

Getting hot

15

Public finances are strong –in Lithuania tooBUT fiscal policy should be tighter!

Public Finances in 2007

Hungary

Slovenia

Poland

Czech Rep.

LithuaniaRomania

Slovakia

Bulgaria

EstoniaLatvia0

10

20

30

40

50

60

70

80

-8 -6 -4 -2 0 2 4Government budget % of GDP

Govt gross debt % of GDP

Source: European Commission: European Economy, November 2006 no. 5

16

The traffic light:Lithuania is in the ”Danger Zone”

Cze

ch R

ep.

Pol

and

Slo

veni

a

Hun

gary

Slo

vaki

a

Lith

uani

a

Bul

gari

a

Latv

ia

Rom

ania

Esto

nia

Sustainable zoneReason

for concern

Danger Zone

Cze

ch R

ep.

Pol

and

Slo

veni

a

Hun

gary

Slo

vaki

a

Lith

uani

a

Bul

gari

a

Latv

ia

Rom

ania

Esto

nia

Sustainable zoneReason

for concern

Danger Zone

17

Beware of contagion

• In conclusion, Lithuania is clearly in the “Danger Zone” and hence caution is very much needed – for investors, households and policymakers (and banks)

• A further risk is the risk of contagion from overheating problems in Latvia and Estonia

• If the crisis in Latvia worsens, a negative spill-over to Lithuania is very likely. Lithuania is no island

• The Lithuanian interest rate spread vis a vis Euroland has widened nearly 100bp since the beginning of the Latvian crisis

.

J an07

Feb Mar Apr May

percent

-100

0

100

200

300

400

500

600

700

percent

-100

0

100

200

300

400

500

600

700 3m interest rates vis a vis Eurolandbp

Latvia

Latvia

Lithuania

Estonia

.

J anuary07

February March April May

percent

0102030405060708090

percent

0102030405060708090

Latvia

Lithuania

3m interest rate spread, Lithuania vs Eurolandbp

18

Overheating in the labour market

• Wage growth is far too strong and is exceeding productivity significantly

• This is obviously not sustainable

• A further drop in unemployment is not possible without sustainable structural reform

• Unemployment below 8-10% (given the present structures in labour) is inflationary

.

02 03 04 05 06 07

percent

-5.0-2.50.02.55.07.5

10.012.515.017.5

percent

-5.0-2.50.02.55.07.5

10.012.515.017.5

Real wages

Productivity% y/y

.

02 03 04 05 06 07

percent

4

6

8

10

12

14

16

18

percent

-20

-15

-10

-5

0

5

10

15

20

Unemployment >> (reserve axis)

<< Productivity adj. real wage growth

%% y

19

Inflation is still far too high

• Inflationary pressures remain far too strong

• Inflation is mostly driven by three factors:

• Too-strong domestic demand (and strong wage growth)

• Energy prices (most natural gas prices)• Food prices

• We expect inflation to be 4.8% in 2007 and 4.0% in 2008

• Inflation will probably not be around 2% before 2010-2011 – and the risk to the forecast is clearly to the upside

• Hence, adoption of the euro is unlikely until after 2010-11

• Measures to curb domestic demand are necessary to curb inflationary pressures especially from the labour market

.

04 05 06 07

percent

-15

-10

-5

0

5

10

15

percent

-15

-10

-5

0

5

10

15

Headline inflation

Communication

Housing, water and electricity

Food

Hotel, cafes and restuarants

% y/y

20

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