Lithuanian economy fell between the hammer and the anvil

Lithuanian economic skies are getting cloudier with increasing possibility to dip into recession, which will be longer and deeper than the one experienced during the COVID‑19 pandemic, but milder and shorter compared to the one faced during the global economic crisis in 2009.

During the COVID‑19 recession both governments and central banks collectively engaged in unprecedented economic stimulus, which enabled fast and robust “V‑shaped” recovery once the fear of the virus had gone and lockdown restrictions have been lifted. This time, however, the central banks collectively engage in aggressive tightening of monetary policies aimed at dampening rising inflation. But it is well known that higher interest rates not only dampen inflation – they also dampen economic growth. Energy price shocks also dampen economic growth – especially in countries that are highly dependent on energy imports such as Lithuania. Hence, it can be said that Lithuanian economy fell between the hammer (energy price shock) and the anvil (rising interest rates), which will likely push it into recession in 2023. Yet, despite numerous headwinds the recession will likely be shallow and relatively short, followed by a rapid and broad‑based “U‑shaped” recovery once energy price shock will recede easing inflationary pressures. The big role will be played by fiscal policy, which will have to balance a tightrope between alleviating energy price shock pressure for the most vulnerable ones and at the same time keeping fiscal balances intact. We predict that Lithuanian economy will contract by 1.2% in 2023 followed by a robust recovery of 5.5% in 2024 with inflation decelerating from 17.2% in 2022 to 4.5% in 2023 before dropping into negative territory in 2024.

Lithuanian economy has started this year on a high note with GDP expanding at 4.4% y/y in 2022 Q1. The growth was a continuation of a rapid and broad‑based “V‑shaped” post‑pandemic recovery, primarily driven by export‑oriented manufacturing and high‑tech service sectors (ICT and fintech). As a result, exports were growing at an impressive 18.8% and were 28% higher compared to pre‑pandemics levels in 2019 Q4 – the second fastest increase in the EU (behind Ireland). Domestically‑oriented sectors have also demonstrated strong growth with private consumption increasing by 6.6% in 2022 Q1. Household consumption growth was driven by rapidly rising wages, growing employment and released pent‑up demand once COVID‑19 restrictions were finally lifted. An ongoing housing market boom have also contributed to consumption growth as it increased demand for furniture and other consumer durables.

Russia’s invasion of Ukraine has shaken the consumer and business confidence, but Lithuanian economy has managed to withstand the initial shock better than expected. Lithuanian GDP declined by a mere 0,5% q/q in 2022 Q2 with an annual growth still remaining in positive territory at 2.6% y/y. Retail trade has not experienced any noticeable drop and housing market have also partly recovered following a short‑term drop in March 2022. Manufacturing sector have also demonstrated its resilience thanks to re‑orientation of its export markets away from Russia already back in 2014‑2015 (Exports of local origin goods to Russia constituted a mere 0.7% of GDP in 2021, which is at par with the EU average). Hence, as we have expected, almost complete cut‑off of trade relations between the EU and Russia did not have noticeable negative effect on Lithuanian economy thanks to its long‑term strategy to move away from Russia towards Western markets. Moreover, Lithuania not only has relatively small economic exposure to Russian economy, but also managed to achieve almost compete energy independence from Russia, which also increased macroeconomic stability of the country and improved its international image e.g. Lithuania became the first country in the EU to completely end imports of Russian natural gas. Yet, despite withstanding the initial shock caused by Russia’s invasion of Ukraine, Lithuanian economy is facing an increasingly strong headwinds, which are likely cause the economy to dip into recession.      

Lithuanian economy is facing increasingly strong headwinds

The strongest headwind faced by Lithuanian economy is an energy price shock, caused by an ongoing Russia’s energy war against the EU. Russia has started energy war with the EU already in mid‑2021 by purportedly leaving natural gas storage facilities in Germany, Austria and Netherlands (controlled by “Gazprom”) virtually empty thus causing a jump in natural gas and electricity prices already in autumn 2021 i.e. well before Russia’s invasion of Ukraine have commenced. On top of this, Russia has also started to arbitrarily cut natural gas supplies to selected EU countries e.g. natural gas flows to Poland (via “Yamal‑Europe” pipeline) was halted already in December 2021. These Russian actions caused a jump in market prices of electricity and natural gas: natural gas prices (TTF trading point in Netherlands) jumped to 115 EUR/MWh in December 2021 and were 7 times higher compared to December 2020, while electricity prices (“Nord Pool” Lithuania price zone) jumped to 212 EUR/MWh in December 2021 – almost fivefold increase compared to December 2020. Russia’s invasion of Ukraine has added fuel to the fire by causing a jump in global oil prices, which, coupled with weakening euro and shortage of diesel fuel, raised fuel prices in Lithuania to all time heights. Natural gas and electricity prices also continued to drift higher and jumped to an all‑time record heights in August 2022 after Russia halted gas supplies via the “Nord Stream” pipeline. Natural gas and electricity future contracts suggest that natural gas and electricity prices will remain elevated well into 2023 with Russia expected to use energy as part of a hybrid war against the EU. The EU, on the other hand, has been increasing its dependence on Russian energy imports (especially Germany) and hence now has very few viable options to reduce energy prices. 

Being highly dependent on energy imports (not only on oil and gas, but also on electricity), Lithuania is among the most vulnerable EU countries to withstand the prolonged energy price shock. Energy price shock reduces purchasing power of households, weakens international competitiveness of local businesses and transfers wealth away from Lithuania to energy‑exporting countries. Please note that low energy prices acted as a tailwind for Lithuanian economy during the COVID‑19 crisis, which softened economic shock and helped generating record‑high international trade surplus in 2020. Yet, in 2022 the situation has turned upside down with high energy prices now acting as a headwind. Lithuania is forecasted to have ~6,0 billion euros (~10% of GDP) trade deficit in energy products (oil, gas and electricity) in 2022 alone – almost five times higher than in 2020 (1.3 billion). This will result in substantial wealth transfer away from Lithuania, which will not be compensated for even with record‑high inflow of EU funds (2.5 billion euros in 2022). Energy price shock is also reducing purchasing power of households as wage growth is not able to catch‑up with rapidly rising prices. Hence, real wage growth in Lithuania will turn negative in 2022, which will depress domestic consumption. Negative wage growth is not common phenomenon – over the last 20 years it has been observed only during the “belt‑tightening” period in 2009‑2011. Energy price shock also negatively affects international competitiveness of Lithuanian companies. Lithuanian producer price inflation increased by 22%, compared to 10% in the USA, 9% in Japan and a mere 2% in China. If sustained, these developments could limit export growth potential and potentially cause sharper increase in unemployment. 

Another headwind to Lithuanian economy comes from rising interest rates. ECB is fearful that an energy price shock may lead to inflation becoming broad‑based and entrenched, hence it risks hiking interest rates fast despite rising risks of recession. The ECB hiked the main policy rate from 0 to 0.5% in July and again by 0.75% in September to 1.25%. Financial market participants expect that 6‑month Euribor will reach 2.5% in mid‑2023, which would substantially increase borrowing costs for households, businesses and governments. Rising interest rates should deflate highly inflated housing prices in the euro area, which in turn will hamper housing market growth in 2023 and 2024. Lithuanian housing market will not be immune to these developments, although we do not forecast sharp reduction in housing prices due to an ongoing robust income growth and low household indebtedness level. The key challenge for Lithuanian housing market will remain the lack of supply, which can become even more scarce given that some developers are postponing their projects due to high uncertainty about the construction cost developments and future demand. Rising interest rates will also limit the ability of governments to “stimulate” economy via increased borrowing, hence one should no longer expect that governments will do “whatever it takes” to help with an ongoing energy price shock just as they did during the COVID‑19 pandemics. 

Increased geopolitical uncertainty is another headwind for Russia’s neighbors as it may temporarily reduce the appetite of foreign investors to invest in this region. Although Ukraine has managed to stall Russian advance and has recently made substantial progress in liberating occupied areas in Kharkiv and Kherson regions, under the baseline scenario we make a conservative assumption that the military conflict may last until mid‑2023. Under this scenario, trade and investment flows with Ukraine will remain fairly limited until mid‑2023 and hence the expected economic boost from the reconstruction of Ukraine will come in 2024 and beyond. Correspondingly, trade and investment relations with Russia and Belarus would continue to gradually deteriorate ‑ both because of ongoing sanctions and economic recession in Russia. 

Finally, there is a small risk that COVID‑19 restrictions may be reimposed, but we do not assume it under the baseline scenario, given decreasing popularity of these measures in Western countries (primarily due to never‑ending lockdowns in China) as well as success of the countries which have chosen not to impose mandatory lockdown measures (e.g. Sweden, which has not imposed mandatory lockdowns, has one of the lowest mortality rates in the EU and ~5 times lower compared to Lithuania). The absence of COVID‑19 restrictions should reduce uncertainty – especially for leisure and travel service companies. Yet, the removal of lockdown and travel restrictions will encourage consumers to switch away from consuming durable goods (e.g. furniture), to consuming more leisure and travel services. Hence, Southern European countries will reap relatively more benefits from the removal of lockdown restrictions compared to Northern ones including Lithuania. Moreover, removal of lockdown restrictions will further ease strains in global supply‑chains, which would benefit large global German corporates at the expense of smaller Lithuanian companies ‑ some of which are struggling with their own supply chain challenges after imports routes via Russia and Belarus have been cut. 

Increasing recessionary risks will ease inflationary pressures

On a positive side, we expect that increasing global recessionary risks, improving supply‑chains and tighter monetary policy will ease inflationary pressures in 2023. Energy was will not last forever, since the EU will find alternative suppliers of gas, increase investments into renewable energy and increase energy savings, hence natural gas and electricity prices are also expected to gradually drop. We forecast that Lithuanian inflation will drop from 17.2% in 2022 to a mere 4.5% in 2023 before dropping into negative territory in 2024. Inflation growth in Lithuania now is exceptionally fast and exceeds 20%. It is primarily driven by jump in energy and food prices, which together account for 3/4 of inflation growth. Yet, history shows that price increases of such an extent are usually not sustainable in the longer‑term, especially given an ongoing drop in global food, energy and metal prices since spring 2022. Moreover, overall price level of consumer goods in Lithuania have possibly reached 95% of EU average in 2022, hence limiting further scope for price convergence with the rest of the EU. Prices of food and non‑alcoholic beverages jumped by an impressive 30.6% in August 2022, which is the fastest increase in the EU. Preliminary estimated suggests that the price level of food and non‑alcoholic beverages in Lithuania already exceeds the EU average, which also gives limited scope for further price increases in the future. Price level of services in Lithuania is still substantially lower than the EU average, but there has been substantial price convergence over the last years as well. Prices in Lithuanian restaurants have been growing the fastest in the euro area every year since 2015. 

From no growth and high inflation in 2022 to high growth and no inflation in 2024 

Elevated inflation, rising interest rates and ongoing geopolitical uncertainties will dampen Lithuanian economic growth in 2023, but in 2024 Lithuania should experience a rapid and broad‑based economic recovery combined with no inflation or possibly deflation. This is rather unusual, but very positive phenomenon, reminiscent of the period experienced in 2014‑2015. High‑tech service and manufacturing sectors are expected to remain the key economic growth drivers, while housing market is expected to rebound owing to higher stability of construction costs and housing prices. Private consumption will also increase due to lower uncertainty and rising purchasing power of households. 

Yet, the future economic development to a large extent will depend on the outcome of the war in Ukraine, the EU’s success in fighting an energy war with Russia and the role of fiscal policy, which can act as stabilizing as well as destabilizing force. Lithuania itself has fairly limited impact on the first two aforementioned factors and has limited maneuver in fiscal policy due to rising interest rates and exceptionally high dependence on energy imports. Given high uncertainty, Lithuania should focus more on long‑term opportunities (e.g. development of ICT and fintech sector and investments into renewables) and structural reforms and not waste too much time and resources on short‑term challenges. This would allow increasing Lithuanian long‑term competitiveness and would ensure ongoing income convergence with the West. It will not be an easy task, given very rapid price convergence in 2020‑2022 and new challenges due to increasing talent migration.