Lithuania's external and internal imbalances have deteriorated in the past year, making the economy more vulnerable to a costly adjustment to a slower growth rate. Fitch forecasts a widening in the current account deficit to almost 14% of GDP in 2007, from 11% in 2006, against the backdrop of a more uncertain global financial environment. Lithuania's inflation rate has accelerated since its application to join the euro zone was rejected in mid-2006: the 12-month HICP inflation rate has risen to 7.6% in October 2007 - a ten-year high. Fitch expects an average HICP inflation rate of 6.8% in 2008 due to continued domestic demand pressures, higher energy prices and hikes in excise taxes. Outturns for the first 10 months of 2007 suggest credit growth in the private sector will be a rapid 40% in 2007 (no material slowdown from 2006). Furthermore, Lithuania's tightening labour market and strong wage growth (averaging around 18% in real terms in the first three quarters of 2007) has negative implications for inflation and competitiveness.
Lithuania's external imbalances partly reflect its strong economic growth, which has averaged almost 8% over the five years to 2006, and is expected to reach 9% in 2007. However, at almost 67% of GDP in 2007, Lithuania's largely private-sector external debt burden was above the 'A' range median of 50% (though less than Estonia's at 106% and Latvia's at 126%) and will continue rising as current account deficits persist in the medium-term. While adopting the euro would make the risk of external financing and currency crises negligible for Lithuania, Fitch considers that the deterioration in price stability and the uncertainty over the inflation outlook has pushed back the timetable for joining the euro zone to 2013.
Policy action to bring about a gentle slowdown to a more sustainable growth rate has been limited. Lithuania's CBA means there is only limited scope for monetary policy to tackle inflationary pressures. However, the fiscal policy response to signs of overheating has been unambitious. Despite the cyclical peak, the government is planning to run small budget deficits this year and next, compared with budget surpluses in Estonia and Latvia. Furthermore, commercial banks do not appear to be slowing the pace of credit growth.
Lithuania's almost entirely foreign-owned banking system and strong public finances partly mitigate the country's external weaknesses. Almost two-thirds of the gross external debt burden of the banking sector is long-term loans from parent companies, which carries lower re-financing risk than market debt. Nevertheless, an insufficient policy response to slow domestic demand and continued deterioration in Lithuania's external imbalances would lead to a further rise in external debt ratios and increase the risk of a painful adjustment to a slower growth rate to restore external competitiveness. This would increase negative pressure on the ratings. Furthermore, Fitch would view a loss of depositor confidence in the Lithuanian litas, which leads to severe pressure on the currency as a negative event with adverse implications for sovereign creditworthiness. However, Fitch believes that this is currently an unlikely event.
