Be happy, but not complacent - Prospects for the Lithuanian economy Lars Christensen Senior Analyst, Head of New Europe Research Danske Research, Danske Bank (direct) (mobile) web site: 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

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

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

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

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

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

11 This will not get Lithuania into the euro

12 Too much in red…also Lithuania

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

14 BUT be careful anyway!!

15 Public finances are strong –in Lithuania too BUT fiscal policy should be tighter!

16 The traffic light: Lithuania is in the ”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

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

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 – and the risk to the forecast is clearly to the upside Hence, adoption of the euro is unlikely until after Measures to curb domestic demand are necessary to curb inflationary pressures especially from the labour market

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