This Selected Issues paper and Statistical Appendix analyzes four issues relevant to the achievement of high-quality economic growth in Lithuania, namely the composition of government expenditure, financial sector development, foreign direct investment, and entry and exit of commercial enterprises. The paper reviews the composition of public expenditure and draws some comparison with other countries in the region. A discussion of the reforms to date in the area of public expenditure management is presented. The paper also highlights the possible pressures for additional expenditure in a number of areas.

Abstract

This Selected Issues paper and Statistical Appendix analyzes four issues relevant to the achievement of high-quality economic growth in Lithuania, namely the composition of government expenditure, financial sector development, foreign direct investment, and entry and exit of commercial enterprises. The paper reviews the composition of public expenditure and draws some comparison with other countries in the region. A discussion of the reforms to date in the area of public expenditure management is presented. The paper also highlights the possible pressures for additional expenditure in a number of areas.

IV. Structure and Development of the Financial System

A. Introduction

54. Lithuania’s banking system has improved considerably since the start of the transition process, as a result of consolidation after the banking crisis7 as well as the introduction of international accounting standards and Basle capital rules. Nevertheless, as of mid-1998, significant structural weaknesses remain, concentrated in state-controlled banks. While it appears that economic activity has continued to expand despite weaknesses in the banking system, the mobilization of savings over the medium term for purposes of productive investment will play an important role in sustaining growth. This chapter provides an overview of the financial system, reviews indicators of financial development, and suggests possible policy measures to encourage its development.

B. Overview of the Financial System8

55. The financial system consists of commercial banks, other banking institutions, credit unions, leasing companies, brokerage companies, insurance companies, a stock exchange, and treasury bill market; there are no investment funds.

56. The state continues to play a major role in the financial system: it controls two of the largest banks, amounting to about one-half of the assets of the banking system; the stock exchange is 50 percent owned by the government; and the largest insurance company is state owned.

57. Foreign participation in the financial sector is increasing. The stock of foreign direct investment in the banking and insurance sector increased by 25 percent from January 1996 to January 1997, amounting to about US$30 million (about 5 percent of total FDI) as of January 1, 1997. Foreign investors account for about one-third of total bank share capital9 and they have majority ownership in two of the largest private banks; there are two foreign bank branches (one which is just starting operation). They are also represented in nonbank financial institutions, such as leasing, insurance and brokerage firms. Foreign participation in the stock market is significant, amounting to just over 50 percent of total capitalization.10 However, foreign investors currently comprise only about 2 percent of the domestic treasury bill market.11

The banking system

58. The banking system operates under a two-tier system, introduced in 1992, with the functions of commercial banks separated from those of the central bank. At present there are ten operating domestic commercial banks, two “other banking” institutions (the Asset Management Company and the Lithuanian Development Bank) which do not have trans-ferrable deposits and account for 7 percent of total assets of the banking system; and two recently established foreign bank branches, Societe Generale and Polish Credit Bank (Table 5). Total assets of the banking system are equivalent to approximately 20 percent of GDP.

Table 5.

Lithuania: Financial System 1/

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Number in parentheses indicates number of institutions.

59. The banking system is concentrated, with the top four banks (two state-owned banks and two private banks) controlling approximately 85 percent of the total assets and deposits of the banking sector. The two state-controlled banks, Savings and Agricultural banks, account for about 50 percent of total deposits and total assets. The Savings Bank is the largest retail bank in Lithuania; it is 75 percent owned by the government, holds 38 percent of deposits and is the largest holder of treasury bills. The Agricultural Bank, which accounts for 14 percent of total deposits, has been heavily involved in special lending programs to benefit the agricultural sector.

60. The private banks, of which there are eight, are dominated by two banks, Vilnius and Hermis Banks. Strategic investors have a majority stake in both banks and both banks compete for individual and private enterprise customers in the Vilnius market and other major commercial centers. During the past two years, these banks have more than doubled their share of total deposits, from 15 percent in mid-1996 to 33 percent in March 1998. Most of the other remaining banks are small and tend to serve specialized niches.

61. Deposit protection is now provided uniformly for all commercial banks.12 Coverage under the present scheme is in conformity with an EC directive which requires that deposits up to 20,000 ECU be insured. The coverage, which today extends up to a maximum of LTL 25,000 (see Table 6), is to be increased each year until it reaches LTL 65,000 by the year 2000. Since May 1997, the scheme has been financed via an annual 1.5 percent premium levied on total individual deposits of each bank (state and private); the premium is paid on a monthly basis. Additional resources from the state are required to fund the system. It is expected, however, that by 1999 the scheme will be funded solely by premia. Foreign bank branches are required to provide deposit insurance for residents’ deposits; the coverage must not be less than that provided by the Lithuanian scheme.13 Foreign bank subsidiaries are required to be covered under the local deposit scheme and to make contributions to it.

Table 6.

Lithuania: Prudential Regulations and Deposit Protection for Commercial Banks

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Source: Data provided by the Bank of Lithuania.

62. Credit unions have grown rapidly and there are now 25 of these institutions; however, they account for less than 1 percent of the assets of the banking system. Credit unions are not subject to supervision by the BoL and no depositor protection is provided.

The nonbank financial system

63. The nonbank financial system consists of insurance companies, leasing companies, brokerage firms, and holding companies. Nearly all of the leasing companies are bank subsidiaries; 4 of the 36 insurance companies are bank owned, and 5 are life insurance companies.14 Leasing companies are growing rapidly (major players are Vilnius Bank Leasing and Hansa Leasing); automobiles are the main items, but diversification into manufacturing and office equipment is developing.

64. The insurance sector has also grown rapidly in recent years. Collected gross premiums have nearly doubled in the last two years. The sector is dominated by state-controlled Lietuvos Draudimas Group which holds over 50 percent of the Lithuanian market and 14 percent of the Baltic market. It is intended that it be privatized by end-1998. The sector has attracted foreign investors, including from Germany, Switzerland, Russia and Estonia and entry of foreign companies is expected in 1998. Gross premiums as a share of GDP were approximately 0.64 percent in 1997; in terms of gross premiums per capita. Lithuania still lags well behind Latvia and Estonia (US$16 for Lithuania versus US$45 in Latvia, and US$52 in Estonia).15

65. Of the 49 brokerage firms trading on the National Stock Exchange (NSE), 11 are bank-owned and an additional 14 have the full scope of brokerage activity, including underwriting. Foreign investors have interests in 11 of the firms (mainly Estonia). The larger firms offer services in corporate finance, as well as securities and asset management. Consolidation of the number of firms is taking place as capital requirements for brokerage companies were raised threefold at the beginning of 1998.

Capital markets

66. While the stock market is relatively highly capitalized at 18 percent of GDP,16 mainly on account of privatization of small- and medium-sized enterprises, turnover is limited. Stocks listed on the exchange are divided into two main lists: Official and Current Trading. The Official List contains securities of fast growing, profitable and sound companies (companies must prepare annual financial statements in compliance with international accounting standards) and is presently comprised of seven companies, two of which are banks (Hermis and Vilnius). The Current Trading List is divided into Group A and B stocks based on the issuer’s business and financial performance, as well as the liquidity of its securities.17 About one-half of the total turnover is in shares on the Official List. Three brokerage firms (VILFIMA, SUPREMA and Vilnius Bank) dominate activity in the stock market, accounting for over 50 percent of total turnover.

67. A well-developed primary market in treasury bills exists with auctions carried out by the Bank of Lithuania (BoL).18 However, trading on the secondary market, which is carried out by the NSE, is limited. At present, all treasury securities have short-term maturities and domestic commercial banks are the primary holders, holding over three-fourths of total securities issued.

Prudential regulation and supervision

68. The banking system is regulated by the BoL under the authority of the Law on the Bank of Lithuania. Commercial banks are governed under the Commercial Bank Law. Supervision is carried out by the Bank Supervision Department (BSD) of the BoL. The BSD is responsible for examining banks and reporting to the BoL board. All examination reports, imposition of restrictions, and bank closings must be approved by the board.

69. Prudential standards for the banking system are in line with international practices, and there is a full program of on-site and off-site supervision. Since the banking crisis, there has been substantial improvement in regulations. International Accounting Standards were adopted for all regulatory purposes (put into full force in 1997), provisioning regulations have been strengthened, capital adequacy requirements were made in line with Basle standards, more stringent rules on large exposure and connected lending were also adopted, along with stricter rules on foreign currency exposure (Table 6).

70. With the introduction of new BoL regulations on balance sheet consolidation in line with EU requirements, the supervision of certain nonbank financial institutions, in particular leasing and securities businesses which are subsidiaries of banks, now falls under BoL supervision. Insurance businesses, including those which are bank owned, are regulated by the State Insurance Supervisory Authority. Brokerage activities (several of which are bank owned) are regulated by the Lithuanian Securities Commission. Given that some banks are involved in a number of these businesses which are supervised by different regulatory agencies, conflicts in jurisdiction may arise.

71. Regulation of the stock exchange and brokerage companies is carried out by the Lithuanian Securities Commission. The commission, established in 1992, and an independent agency since 1996, is involved in four main areas of regulation: (1) corporate finance: companies with a least 50 shareholders must comply with rules according to prospectus, reporting, ad hoc information, tender offers, and acquisitions of block shares; (2) regulation of the securities depository and brokerage firms: brokerage firms must meet rules concerning capital adequacy, code of ethics, and portfolio management; brokers must pass an examination; (3) investment management: the liquidation or reorganization of 300 voucher based firms into holding companies under the Investment Company Law; and (4) enforcement of regulations: includes investigation of violations.

C. Recent Developments in the Banking System

72. Following the banking crisis of 1995, there was significant consolidation of the banking system, with the number of banks falling from 28 in early 1994 to 11 at end-1997. The consolidation was the result of bank failures (as opposed to bank mergers). With stricter prudential regulations, activities, such as currency speculation and high-margin lending, which had characterized banking in the past, largely disappeared and banking activity has become more concentrated in traditional lending and deposit activities.

73. Privatization of state-controlled banks has proceeded slowly. After several failed attempts at privatization of the State Commercial Bank (SCB), the bank was finally closed in March 1998.19 The Agricultural Bank is to be privatized this year and the Savings Bank would follow one year later. The two state-controlled banks, the SCB (since liquidated) and the Agricultural Bank, were exempted from meeting capital adequacy requirements by parliament in 1997, pending their privatization.

74. Indicators of bank soundness point to a significant improvement in the past few years. However, profitability (measured by return on equity) for the banking system as a whole is relatively low, mainly due to the weak performance of state-controlled banks. All banks are presently meeting prudential requirements, including the two state-owned banks. Nonperforming loans, although still high, have decreased as a share of bank capital and capital adequacy for the banking system has improved (Table 7).

Table 7.

Lithuania: Selected Indicators of Bank Soundness, 1996–98 1/

(In percent)

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Source: Data provided by the Bank of Lithuania.

All operating banks. March 1998 figures exclude the State Commercial Bank.

Methodology for calculating these variables changed in first quarter of 1997.

Excluding the State Commercial Bank, the return on equity for end-December 1997 was 2.7 percent.

75. Demonetization followed the banking crisis of 1995/96 and it was not reversed until 1997. Total deposits began to grow significantly in the beginning of 1997, and increased by over 30 percent in December 1997 relative to December 1996 (Table 8). The pickup in private sector credit followed in the latter part of 1997, and growth continued to accelerate into the first part of 1998. However, indicators of financial development, such as the ratio of private sector credit to GDP and of broad money to GDP have not fully recovered to their levels before the banking crisis (see Section D below.) During the latter part of 1997, borrowing by domestic banks from nonresident banks, which previously had been only moderate, grew rapidly. The large private banks have been able to borrow from foreign banks at very good terms (top tier private banks have been able to obtain lending at only 50 basis points above LEBOR). In addition, there is evidence that borrowing by domestic enterprises from foreign financial institutions is also increasing.

Table 8.

Lithuania: Developments in Financial Markets, 1996–98

(In percent)

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Sources: Data provided by Bank of Lithuania; National Stock Exchange of Lithuania.

LITIN-G index. Calculated for all issues that have been quoted in the current trading list in the last three months, excludes treasury bills and shares of investment companies.

Percentage change since end-December.

In early 1994 there were 28 operating banks.

76. Capitalization of the stock market increased significantly in 1997 to 18 percent of GDP.20 Total turnover increased fivefold and nonresident investments more than tripled, mainly from the United States, Estonia, and the United Kingdom. The stock market index rose about 40 percent in 1997, but has declined slightly since the beginning of 1998 relative to December 1997 (Table 8). Developments in the treasury bill market were characterized by the departure of foreign investors in the second half of the year as rates fell, mainly due to increased demand for bills by commercial banks due to the high level of excess liquidity in the banking system. While yields have risen to more attractive levels (about 10 percent), foreign investors have not yet returned.

D. Indicators of Financial Development

77. Indicators of financial development include measures of the banking sector’s ability to mobilize deposits, such as private credit/GDP, or monetization (M2/GDP). These indicators would be expected to rise over time, reflecting increases in deposits in the banking sector and increased lending activity. Developments in these indicators for 1997-98 reflect the increase in deposits and private sector credit relative to end-1996, although the M1/M2 ratio is more or less unchanged which may be due to faster growth in demand deposits relative to time deposits (Figure 1).

Figure 1.
Figure 1.

Lithuania: Indicators of Financial Intermediation, 1995–98

Citation: IMF Staff Country Reports 1998, 092; 10.5089/9781451823943.002.A004

Source: Bank of Lithuania.

78. Confidence in the banking sector can be assessed by measures such as landing-deposit spreads, the currency deposit ratio, and the money multiplier. A narrowing of lending spreads could indicate a perception of reduced risk on the part of lenders, reflecting increased confidence in the banking system. Since June 1995, these spreads have narrowed from about 10 percent to 5 percent (Figures 1 and 2). The currency deposit ratio, after rising significantly during the banking crisis, has declined but is still high, and the money multiplier remains low. Like the other indicators, these have yet to reach their pre crisis levels.21

Figure 2.
Figure 2.

Lithuania: Interest Rates, 1995–98

Citation: IMF Staff Country Reports 1998, 092; 10.5089/9781451823943.002.A004

Source: Bank of Lithuania.

79. Positive real interest rates can indicate that conditions are favorable for financial deepening, i.e., placing money in the banking system, while positive real lending rates serve to limit excessive lending growth. Lithuania’s real lending rates, which were negative in end-1995, became more positive in the wake of the banking crisis reaching about 10 percent in mid-1997; since then they have eased to about 6 percent as of March 1998. Real deposit rates, which were negative during 1995-96, became positive during the first half of 1997, but have since declined and are close to zero now (Figure 2).

80. Compared to other countries, including the other Baltic countries (which also suffered banking crises), Lithuania’s banking sector still lags behind in development as evidenced by the relatively low degree of monetization (Table 9). In relation to advanced EU economies the gap is even greater, suggesting that there will need to be substantial growth in deposits and lending to significantly narrow the gap.

Table 9.

Lithuania: Comparison of Selected Financial Indicators, 1997

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Sources: Data provided by the Bank of Lithuania; and IMF, International Financial Statistics and World Economic Outlook.

Broad money is defined as money plus quasi money (time, savings and foreign currency deposits of resident sectors other than the central government).

81. Development of the financial markets can also be reflected in the maturity structure of assets and liabilities. In the case of Lithuania, most of these assets are concentrated in short-term maturities, suggesting that there is relatively small amount of long-term financing for investment. Long-term lending accounts for only 20 percent of total assets, while in the other Baltic countries there has already been a significant trend toward lengthening maturities. The sectoral composition of lending is primarily in the manufacturing and domestic trade sectors, which has remained at about 50 percent of lending since end-1995. Investment in real estate has remained low, in the 5-7 percent range. Manufacturing and trade are the main sectors for both short- and long-term lending in the domestic as well as in foreign currencies.

82. Term deposits (by residual maturity) indicate a large concentration in short-term maturities (one to three months), which has remained at about 40 percent of total deposits (in litas and foreign currencies) since mid-1996. Deposits with long-term maturities have fallen from about 15 percent of total deposits in mid-1996 to about 8 percent in the latter part of 1997. However, the pronounced rise in deposits in 1997 is an indication that confidence in the system is growing.

83. While market capitalization, which often serves as an indicator of the development of the stock market, is relatively high in comparison to other markets; the limited turnover and low price/earnings (P/E) ratio suggests that there is substantial room for development (Table 10). Other money markets, such as the secondary market on treasury bills, are also underdeveloped, with annual turnover in the secondary market representing only 0.03 percent of total securities in 1997.

Table 10.

Lithuania Indicators of Stock Market Development for Selected Countries, 1997

(In percent)

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Sources: Financial Times’, Argentinean, Estonian, Lithuanian, Paris, and Warsaw stock exchanges.

For Lithuania, capitalization and turnover excludes treasury bills, capitalization also excludes nonquoted shares; the P/E ratio refers to Official and Group A stocks only; the ratio would be considerably lower if Group B stocks were included.

E. Measures to Promote Development of the Financial System

84. The above indicators suggest that the financial markets in Lithuania, while showing good progress in certain areas (e.g., banking supervision and consolidation) still lag behind in other areas. The lack of a well-developed financial system does not appear to have posed significant constraints on growth. However, over the medium term, an inability to mobilize savings for productive investment would impede growth and the ability of the country to successfully compete with EU countries. Some of the problems, such as the relatively low proportion of long-term lending, would be expected to disappear gradually as the economy matures and advances are made in other areas, such as privatization and corporate governance; however there are other areas where specific action may be taken by policy makers to promote financial sector development.

85. With the growing sophistication of market participants, one would expect, for instance:

  • development of long-term lending. As corporations appear to have a relatively low debt/equity ratio, there appears to be substantial room for growth of lending operations. Lack of expertise on the part of banks in risk assessment appears to be a problem of the past, but there may be problems due to the lack of a track record and nonstandard accounting practices, although the latter are becoming less of a factor as more companies are obtaining international audits. Capital constraints in the domestic banking system are probably only a factor in the case of the largest corporations—major private banks felt they had enough capital to serve large clients, but perhaps not the very largest.22

  • use of more sophisticated financial instruments. The dearth of financial instruments can in part be explained by the lack of sophistication of the local clientele, e.g. hedging is virtually nonexistent. With further development of the corporate sector, the use of more sophisticated financial instruments could be expected to take place.

  • stock market development. Stock market investment could be expected to increase with development of a “corporate culture” and increased confidence in the accountability of management to stockholders. Also, over time, stock market shares may provide another source of collateral; they are not presently accepted by banks as they are perceived as illiquid.

86. In addition, there are specific actions which can be taken to accelerate financial development:

  • privatization of remaining state banks. A clear strategy and prompt action on the part of the government with regard to privatization of the state-owned banks would boost confidence in the banking sector and level the playing field for commercial banks. Experience with the SCB, which could not be successfully privatized, shows the consequences of delays and an unclear strategy. In other countries, such as Latvia and Estonia, which moved to deal with the problems of the state banks in a more straightforward manner, indicators of financial development (such as degree of monetization) suggest a higher level of development than those for Lithuania.

  • ensuring central bank independence. An independent central bank is fundamental to banking supervision and monetary policy credibility. The amendments to the central bank law, presently under consideration, are intended to strengthen central bank independence, in line with EU requirements.

  • maintaining an open market, including for entry of foreign banks and nonbank financial institutions. Further consolidation in the financial system is likely. Already Vilnius Bank has expressed interest in merging with Hermis Bank. The raising of capital requirements to EU standards in banking and nonbank financial institutions will also contribute to consolidation in the financial sector. Maintaining an open market, including allowing entry of foreigners, will help to preserve competition. It will also help to bring in new products and technology into the sector. The legal framework for supervision of foreign banks and subsidiaries may need to be strengthened and clarified.

  • providing a greater variety of financial instruments and development of institutional investors. At present, there are limited options for long-term savings. More financial instruments, such as pension funds, savings bonds, and long-term treasury bills, would provide more ways in which savings could be mobilized. Clarification of the taxation of treasury bills would encourage development of the secondary market on treasury bills. In addition, elimination of provisions entailing double taxation of investment funds (under discussion) would encourage the establishment of institutional investors.

  • improving the legal framework for lending. The ability of legal entities to own agricultural land (presently prohibited under the constitution) would contribute to the development of commercial credit for agriculture and growth in rural areas. A mortgage registry began operating in April 1998 and is of importance to the banking sector as it facilitates the seizing of collateral upon nonperformance of loans. It is too early to evaluate its impact on lending. Facilitating foreclosure, with the new bankruptcy law, would also reduce impediments to lending.

  • strengthening prudential regulations in accordance with development of the financial markets. As the market becomes more sophisticated, the regulatory agencies will need to keep pace with development of new financial instruments, including derivatives. Also, with increased growth of nonbank financial institutions, which are regulated by different agencies, more cooperation among these agencies is also needed.

7

The banking crisis began in end-1995. For further background, see SM/96/128 (6/12/96) and SM/97/149 (6/13/97).

8

The financial sector includes financial intermediaries and financial auxiliaries, i.e. units whose principal purpose is intermediation, as well as units that provide services closely related to financial intermediation, such as brokers.

9

As of October 1997.

10

This estimate does not include all shares as some of these are registered with individual companies.

11

ln the first half of 1997, they accounted for close to 30 percent of the market, but subsequently left the market when interest rates declined to levels close to those for U.S. treasury bills (see Section C).

12

Prior to the banking crisis private banks’ deposits were not protected.

13

A modification of the law; is being considered which would allow foreign branches to participate in the local deposit scheme, if they were not covered by their own country’s scheme.

14

Banking participation in the nonbank financial system is expected given banks’ access to investment funds. One of the major banks, for instance, has 3.5 percent of its assets invested in nonbank financial institutions, including in leasing companies, insurance, asset management and consulting.

15

Source: VILFIMA.

16

Quoted shares as a percent of GDP: excludes treasury bills (LTL 1.5 billion), which are also traded on the exchange, and nonquoted shares of (LTL 1.8 billion). Data are as of end-1997.

17

Modifications have been submitted to parliament which would tighten the qualifications for the Official list in accordance with EU recommendations. With regard to the Current Trading List, only the most liquid securities would remain and admission criteria would closely correspond to EC directives. Other companies could be listed on a voluntary basis and over the counter trading would be provided.

18

The BoL began repo operations in the second quarter of 1997.

19

The SCB, which had traditionally been the source of commercial credit to state-controlled enterprises, experienced severe liquidity constraints and losses in 1996. A temporary administrator was appointed and lending was restricted and most good customers left the bank. Several attempts to privatize the bank yielded no proposals. Lacking new management and a clear strategy for over a year, it became increasingly unlikely that privatization would occur without a significant injection of money from the government. In the event, all liabilities and viable assets were transferred to the Savings Bank; nonperforming loans were transferred to the State Asset Management Company (Turto Bank) with a book value of LTL 320 million (including loans with a book value of LTL 58 million which were transferred at the beginning of 1998) and real estate amounting to about LTL 4 million. The government issued bonds in the amount of LTL 180 million to cover the liabilities not covered by the viable assets.

20

Quoted shares only.

21

Reduced spreads could also indicate more competition in the system and more efficient banking operations.

22

One of the leading private banks was recently able to obtain a US$31 million syndicated loan from ten foreign banks.