Republic of Lithuania: Staff Report for the 1999 Article IV Consultation

This 1999 Article IV Consultation highlights that Lithuania has made impressive progress in macroeconomic stabilization and market transition. Following the introduction of the currency board in 1994, inflation has come down rapidly, and market reforms have provided a sound basis for economic recovery. The economy cooled down rapidly starting in the third quarter of 1998, while inflation continued on a downward trend. The current account deficit widened in the second half of 1998 but subsequently contracted. Real GDP growth came to a halt in the fourth quarter of 1998.

Abstract

This 1999 Article IV Consultation highlights that Lithuania has made impressive progress in macroeconomic stabilization and market transition. Following the introduction of the currency board in 1994, inflation has come down rapidly, and market reforms have provided a sound basis for economic recovery. The economy cooled down rapidly starting in the third quarter of 1998, while inflation continued on a downward trend. The current account deficit widened in the second half of 1998 but subsequently contracted. Real GDP growth came to a halt in the fourth quarter of 1998.

I. introduction

1. Missions visited Vilnius May 11–25 and June 23–25, 1999 to conduct the 1999 Article IV consultation discussions.1 The missions met with President Adamkus, Prime Minister Paksas, acting Finance Minister Šemeta, Finance Minister Lionginas, Economy Minister Maldeikis, Social Security Minister Degutiene, Bank of Lithuania Governor Šarkinas, and representatives of government institutions and the banking and business communities.

2. The 1998 Article IV consultation was concluded on July 13, 1998 (SM/98/150 and SM/98/156). Executive Directors noted that the main challenges facing the authorities were to sustain the favorable performance and reduce the vulnerability of the economy to external shocks. They expressed concern about the large current account deficit and low national saving. Directors called for fiscal policy restraint focused on expenditure control, meeting the conditions for an orderly currency board exit, strengthening of the banking system, and revitalization of privatization and further measures to promote restructuring.

3. In the absence of a Fund-supported program, Fund relations with Lithuania have involved an active economic policy dialogue, supported by technical assistance. This dialogue with the authorities was intensified, at the authorities’ request, in the context of staff visits after the Russian crisis, and Mr. Sugisaki visited Vilnius in November 1998. The last Fund arrangement, an extended arrangement, expired in October 1997 (Appendix I); the authorities have indicated an interest in a new Fund-supported program. Lithuania has accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement and maintains an exchange system that is free of restrictions on payments for current international transactions. The Fund has continued to provide technical assistance (Appendix II). The Eleventh Quota Review was approved by Seimas in January 1999, and legislation relating to the Fourth Amendment to the Articles of Agreement will be presented to Seimas in the autumn session. The authorities wish to participate in the pilot study for the public release of staff reports.

4. The Bank and Fund staff working on Lithuania collaborate closely. The World Bank Board approved a Country Assistance Strategy for 1999–2001 in May 1999. The Bank will assist Lithuania in (i) maintaining macroeconomic and financial stability (the Bank has recently carried out a Macroeconomic and Financial Sector Vulnerability Review), (ii) implementing the EU agenda, and (iii) designing social safety net and human development programs. World Bank relations are summarized in Appendix III.

5. Lithuania’s economic database is generally adequate for surveillance purposes, although large revisions to balance of payments and national accounts data complicate macroeconomic analysis and underscore the need for improvements (Appendix IV). Data are available on the web sites of the Bank of Lithuania (BOL), the Ministry of Finance, and the Department of Statistics. Lithuania subscribes to the SDDS.

6. The government changed in mid-1999. Amidst public criticism of economic policies, Prime Minister Vagnorius announced his resignation on April 30. The new government, a center-right coalition headed by Rolandas Paksas of the Homeland Union Party, assumed office in June, The new government has adopted the outgoing government’s program with few changes. Economic policies will continue to be guided by the drive to join western economic and security organizations. Parliamentary elections are scheduled for the autumn of 2000.

II. Recent Economic Developments

7. Since regaining independence, Lithuania has made impressive progress in macroeconomic stabilization and market transition. Following the introduction of the currency board in April 1994, which has been supported by fiscal restraint for most of the subsequent period, inflation has come down rapidly. At the same time, market reforms have provided a sound basis for economic growth. Nevertheless, GDP per capita is modest, and as much as one-fifth of the population is below the national poverty line, suggesting that an equitable increase in living standards should be a goal in the years ahead.

8. The progress in economic performance suffered setbacks in the wake of the Russian crisis. The main transmission mode of the Russian crisis has been through lower exports, which weakened economic growth and initially increased the current account deficit.2 Also, Lithuania has experienced some financial contagion through international capital markets, while the effects through the domestic banking system so far have been limited. Economic policies since mid-1998 have involved fiscal easing, interventions to cushion the impact of the Russian crisis on enterprises, and a postponement of the exit from the currency board (Box 1). External and financial vulnerability increased following the August 1998 events, but has since declined (Appendix V).

A. Growth, Inflation, and the Balance of Payments

9. The economy cooled rapidly starting in the third quarter of 1998. Real GDP growth came to a halt by the fourth quarter of 1998, while preliminary data suggest that real GDP fell by 5¾ percent year-on-year in the first quarter of 1999 (Table 1 and Figure 1). Initially, the downturn was driven by a drop in exports, but lower domestic demand played an important role afterwards, notwithstanding an expansionary fiscal stance.

Table 1.

Lithuania: Key Economic and Financial Indicators, 1995-99

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Sources: Department of Statistics, Bank of Lithuania; and Fund staff estimates and projections.

National accounts, budget, and current account data are preliminary, actuals are for the first quarter; monetary data are actuals for May, and inflation data are actuals for June.

Level in final quarter of calendar year.

In percent; weighted average of rates at commercial banks in December; 1-3 months’ maturity.

Includes discrepancy between above and below the line estimates of the financial balance and balances of budgetary organizations not recorded in the above the line numbers. Also includes savings restitution payments.

Includes public, publicly guaranteed, and private external debt.

Figure 1.
Figure 1.

Lithuania: Growth, Inflation and Trade

Citation: IMF Staff Country Reports 1999, 073; 10.5089/9781451823950.002.A001

Sources: Lithuanian Department of Statistics; Bank of Lithuania.

Status of Currency Board Exit Strategy

The Bank of Lithuania (BOL) approved on January 16, 1997 the Monetary Policy Program of the Bank of Lithuania for 1997-99, which laid out a three-stage strategy for an exit of the currency board arrangement (CBA) consistent with the Program of the Government of the Republic of Lithuania for 1997-2000. The CBA is established by the Law on the Credibility of the Litas that came into force on April 1, 1994. The exit strategy’s principal objective is strengthening economic links with the EU, ultimately leading to membership of the European Monetary Union (EMU).

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10. Inflation continued on a downward trend and wage increases slowed markedly. Reorientation of food supplies from the Russian to the domestic market, appreciation of the litas against the currencies of western European trading partners (the litas is pegged to the U.S. dollar), and softer domestic demand all contributed to a decline in inflation to a 12-month rate of one-half of 1 percent by June. Reflecting the flexibility of wages, the weaker economy led to a reduction in 12-month wage growth from about 30 percent in early 1998 to 7¾ percent in May 1999. Recorded unemployment reached its highest post-independence level of 8½ percent in March, before registering a seasonal easing to 7½ percent in June.3

11. The current account deficit widened in the second half of 1998, but has since contracted sharply.4 Recorded exports fell in the second half of 1998, as exports to the CIS declined by 50 percent year-on-year. By contrast, exports to the West continued to grow rapidly (EU exports grew by 12½ percent). A sizable part of the decline in exports was related to re-exports to Russia and other CIS markets.5 Both weaker domestic demand and the drop in re-exports were reflected in lower import growth in the latter part of 1998. The services balance improved in 1998, boosted by tourism and business services receipts. Overall, the current account deficit widened from 10½ percent of GDP in the first half of 1998 to 13¾ percent in the second half, yielding an annual deficit of 12 percent of GDP in 1998 (Table 2 and Figure 2). Preliminary data suggest that the current account deficit fell to 9½ percent of GDP in the first quarter of 1999, as imports declined further.

Table 2.

Lithuania: Balance of Payments, 1996-2004

(US$ millions)

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Source: Data provided by the Lithuanian authorities; and staff estimates and projections.

Preliminary actual data.

Debt service falling due, including public and private debt, regardless of original maturity.

Figure 2.
Figure 2.

Lithuania: Saving and Investment, Current Account Balance, and Government Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 073; 10.5089/9781451823950.002.A001

Source: Lithuanian authorities; and Fund staff estimates.

12. The current account deficit has continued to be financed mainly by FDI and medium- and long-term borrowing. As privatization of large enterprises got under way (see paragraph 18 below) FDI was bolstered, and covered three-fourths of the current account deficit in 1998. The government returned to the euro bond market quickly after the Russian crisis, with two small bond issues in late 1998 and a five-year euro 200 million bond issue in March 1999. The FDI inflows moderated the external debt accumulation, as external debt increased from 25¾ percent of GDP at end-1997 to 26½ percent at end-1998, and helped improve substantially the international reserves coverage in relation to short-term external debt and reserve money.

B. Fiscal Developments

13. Fiscal policy became more expansionary starting in mid-1998, reflecting in large part spending of privatization proceeds. While central government expenditure stayed within the limits approved by Seimas, the government spent privatization proceeds on off-budget items in the second half of 1998. The most important items were the Savings Restitution Plan (SRP—Box 2) and support for companies affected by the Russian crisis.6 The general government fiscal deficit increased from 2 percent of period GDP in the first half of 1998 to 9 percent in the second half (Table 3).7 On an annual basis, the fiscal deficit rose to 5¾ percent of GDP in 1998. In January–May 1999, weak revenue due to the decline in economic activity, SRP payments, and net lending operations (including loans to the oil sector) contributed to a fiscal deficit of 4 percent of projected annual GDP.

Table 3.

Lithuania: Summary of Consolidated General Government Operations 1/

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Sources: Ministry of Finance, Ministry of Social Security; and Fund staff estimates.

Including the state budget, municipal budgets, Social Insurance Fund and from 1997, the Health Insurance Fund.

From 1997, contributions to the HIF are reclassified from income tax to payroll tax.

From 1997, expenditures of the HIF are reclassified from wages and salaries to goods and services.

The Savings Restitution Plan

In the aftermath of the hyperinflation period of 1991–92 and the administrative restrictions on withdrawal of deposits that were imposed during that period, the government announced in 1993 a plan to compensate losses for deposits in the state banks. Over the period 1993–95, some LTL 226 million (1.9 percent of 1993 GDP) was transferred to depositors.

The government started a second Savings Restitution Plan (SRP) in the fourth quarter of 1998. Under the Plan, the amount of compensation per depositor is determined by taking the smaller of the deposit balances on one of three test dates and applying a multiplicative factor, and netting out any amounts already paid out during the 1993–95 period. Compensation is paid out to individual depositors, not accounts, as had been the case in 1993, and is financed by privatization proceeds. According to the Savings Restitution Law, two-thirds of privatization proceeds are earmarked for restitution of savings. The total cost of the compensation package is estimated at about LTL 3.6 billion, to be paid out over time. In the first round in November 1998, depositors over 85 years old, the disabled, former political prisoners, and persons who were victims of World War II occupation received a total of LTL 445 million (1 percent of GDP). In the second round, in February–April 1999, the government transferred LTL 904 million (2 percent of GDP) in two tranches to persons over 70 years old and families with four or more children and the disabled.

The authorities have taken a number of measures to encourage saving and limit the macroeconomic impact of the transfers, including (i) the payment of a subsidized above market interest rate on restituted deposits at the Savings Bank; (ii) the establishment of a time limit for depositors to apply for the withdrawal of their deposits; and (iii) the introduction of retail savings bonds. In addition, the BOL has increased the use of deposit auctions to offset the liquidity effect of the SRP.

14. The fiscal expansion was driven by a sharp increase in current spending. Spending on goods and services jumped in 1998, while use of privatization proceeds on a range of government programs (including subsidies to households, and support for agricultural and other enterprises) increased. Also, social expenditures went up in the wake of the Russian crisis, complicating the financial position of SoDra. Moreover, strong wage growth led to an increase in the wage bill, from 8¾ percent of GDP in 1997 to 10 percent in 1998, a share of GDP that is in the upper end of the range for middle-income countries. Capital expenditures, by contrast, remained below 3 percent of GDP in 1998.

15. Government revenue held up in 1998 and tax administration improved. Revenue increased to 34 percent of GDP from 32½ percent in 1997, as the effect of the slowdown in the economy was offset by the impact of strong wage growth on payroll and income tax collection. Tax collection was helped also by several initiatives to improve tax administration in 1998, including upgrading of information systems (e.g., information sharing between SoDra and the State Tax Inspectorate), closer collaboration between the STI and the Tax Police, concentration of payroll tax collection at SoDra’s headquarters, and streamlining of regional tax services.

C. The Currency Board and Monetary Developments

16. The currency board has withstood pressures caused by the recent turmoil in international markets. Starting in September 1998, there were net foreign exchange sales to commercial banks through the currency board (Figure 3). Initially, the automatic functioning of the currency board mechanism led to an increase in treasury bill interest rates, from 8¾ percent in July to about 14 percent in October (on three-month bills). From October onwards, however, the government used privatization funds held at the BOL in lieu of treasury bill issues to meet part of its financing need and drew on privatization funds also for the SRP payments, while the foreign exchange sales through commercial banks tapered off. By June 1999, interest rates had declined to 9–10 percent. The foreign exchange coverage under the currency board has remained comfortable, at about 143 percent of litas liabilities at end-May 1999 (compared with 127 percent at end-1997 and 144 percent at end-1998).

Figure 3.
Figure 3.

Lithuania: Financial Indicators

Citation: IMF Staff Country Reports 1999, 073; 10.5089/9781451823950.002.A001

Sources: Bank of Lithuania; Bloomberg news; and National Stock Exchange of Lithuania.1/ Yield spread between Lithuanian Eurobond and U.S. bond; Lithuanian Eurobond maturing July 2002.2/ Calculated from all issues quoted in the current trading list in the last three months, excluding treasury bills and investment companies.

Privatization Proceeds and Budget Indicators

Privatization programs have effects on the budget and the economy both through their impact on government finances and private sector behavior. A key question is whether the proceeds should be viewed as government revenue or as government financing.

Accounting for privatization proceeds. In principle, the treatment of privatization proceeds would depend on the extent to which the government’s net worth is affected by the privatization transaction. In a case where the physical assets sold have no (or negative) value in the hands of the government (e.g., a company that is inefficiently run by the public sector), privatization increases the government’s net worth and loosens its intertemporal budget constraint, similar to a tax increase. This is because the amount of cash that the government receives for the physical assets exceeds the value of the assets in terms of future revenue to the budget. In another case, the government might receive cash and give up a positive stream of future earnings on the assets of equal value. In this case, the privatization would merely involve a one-time shift in the composition of the government’s assets. Privatization, in this event, does not change the net worth of the government and, unlike a tax increase, leaves the government’s intertemporal budget constraint unaffected. In most cases, privatization transactions would tend to be closer to the latter case, which argues for treating privatization proceeds as financing in the budgetary accounts. Also, in doing so, the government would be able to take out from “above the line” the temporary and one-off effect of privatization in order to have a better grasp of the underlying fiscal deficit. Furthermore, to the extent that privatization involves foreign investors, the “domestic fiscal deficit” (which excludes privatization proceeds from revenue and includes the domestic spending of such proceeds) may be a useful budget indicator.

Use of privatization proceeds. The macroeconomic effects of privatization also depend on what the government does with the proceeds. The proceeds can be used (i) to reduce tax income or increase government spending, which increases the fiscal deficit, or (ii) to retire government debt, in which case the fiscal deficit would be lower to the extent that interest payments are lowered (the retirement of debt would be accounted for as negative budgetary financing). If privatization proceeds were used to finance an increase in the fiscal deficit, the effects would be similar to a debt-financed fiscal expansion; i.e., domestic demand would increase with resulting pressures on domestic prices and the external current account. If the proceeds were used to reduce government debt (foreign or domestic), there would be no direct effect on domestic demand, while the budgetary position would become less exposed to shifts in market sentiment. In cases where privatization is financed from abroad, the use of the proceeds to finance the fiscal deficit involves the exchange of foreign currency for domestic currency, which would tend to increase domestic money and credit creation and in turn spur domestic demand. In that sense, the use of privatization proceeds amounts to a discretionary “monetary policy” stimulus.

Budgetary management. Decisions on the use of privatization proceeds also need to take account of practical implications for budgetary management. In particular, treating privatization proceeds as revenue runs the risk that spending becomes entrenched at a level that exceeds the underlying revenue-generating capacity of the government. To deal with this problem, governments at times earmark privatization proceeds for specific expenditures, and exclude the proceeds and the associated spending from the budget. This allows one-off spending to be linked with the receipt of one-off privatization proceeds, and may thus help prevent spending from being ratcheted up on a permanent basis. However, this approach runs the danger of under-estimating the effects of government transactions on the economy and impairing macroeconomic analysis. While earmarking might help avoid a permanent increase in spending, it would be advisable to include the earmarked spending in the budget when analyzing its macroeconomic effects.

Transparency in budget formulation. Excluding privatization proceeds from the budget would tend to diminish fiscal policy control and transparency. This approach could impair parliamentary influence, as the use of privatization proceeds would not be subject to priority setting as part of the annual budget process, and the budget decisions would not be fully open to scrutiny by Parliament and the public.

17. The re-monetization process following the 1995/96 banking crisis has continued. The growth in bank credit to the nongovernment sector was brisk through mid-1998, but slowed in the second half of 1998 as banks became more cautious in their lending practices following the Russian crisis (Table 4); the banks’ greater caution was reflected also in an increase in interest spreads. The expansion of overall net domestic assets of the banking system in 1998 was moderated by the partial saving of privatization proceeds at the BOL and commercial banks. Moreover, the BOL sought to moderate the liquidity impact of the use of privatization proceeds by stepping up the use of deposit auctions.8 Overall, broad money grew by 14½ percent in 1998, mainly reflecting an increase in net foreign assets, and velocity fell from 6 at end-1997 to 5½ at end-1998. In early 1999, as credit growth recovered and SRP payments were stepped up, broad money growth accelerated, reaching 20 percent in May.

Table 4.

Summary Monetary Accounts, December 1996-May 1999

(In millions of litai, end of period)

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Source: Bank of Lithuania

Excludes local government deposits; includes counterpart funds.

On a quarterly basis; the annualized quarterly estimate of GDP divided by the average of end-period broad money in the current quarter and previous quarter.

D. Structural Reforms and Financial Sector 9

18. Recent progress in privatization has been good. The Privatization Agency has been restructured as called for under the Privatization Law enacted in December 1997, and privatization has been facilitated by a new Law on Foreign Investment. The Agency completed 345 privatization transactions with a total value equivalent to 5⅓ percent of GDP in 1998 (Figure 4). In particular, sale of large enterprises in the energy, telecommunications, and transport sectors were undertaken; the largest privatization transaction was the sale of a 60 percent stake in Lietuvos Telekomas (for US$500 million). Privatization continued apace in early 1999, with the sale of a stake in the oil sector complex at an advanced stage.10

Figure 4.
Figure 4.

Lithuania: Privatization Indicators, 1994-Q1 1999

Citation: IMF Staff Country Reports 1999, 073; 10.5089/9781451823950.002.A001

Source: State Property Fund.

19. Sectoral reforms in energy and agriculture have lagged. The electricity sector has experienced intensifying cash flow problems, because of inefficiency and high costs, lags in adjusting tariffs, and difficulties in collecting payments on exports. In early 1999, Seimas approved a government take-over of energy-sector debt. In agriculture, the government’s progress in reducing subsidies and distortionary state support has suffered setbacks against the background of low world commodity prices and a severe impact on food industries of the Russian crisis.

20. The government has provided ad hoc support to enterprises, and weaknesses in the framework for market entry and exit have tended to soften enterprises’ budget constraints. Following the Russian crisis, the government adopted a set of anti-crisis measures, that included changes in public procurement in favor of Lithuanian suppliers and support for agriculture and other sectors in the form of import protection and budget assistance. Government regulations and licensing requirements continue to hamper the starting of new enterprises.11 Moreover, bankruptcy cases are moving slowly because of a lack of skilled liquidation managers and rigidity in asset pricing. On the positive side, a new Competition Law, bringing legislation closer to EU standards, was adopted in April 1999.

21. The banking system has generally withstood the Russian crisis, because banks had limited direct exposure to Russia. A substantial strengthening of prudential regulations and supervision, most recently with the decision in December 1998 to implement the Core Principles for effective banking supervision, has helped bolster the banking system. Moreover, the banking system had undergone a major shake-out since the banking crisis, and foreign investors now play an important role in the sector. All banks reported profits in 1998, and have reportedly been meeting prudential regulations since October 1998. Worries remain, however, pertaining to credit quality following the Russian crisis, reliance on short-term foreign borrowing, and market concentration.12

22. The authorities have continued their determined effort to join international economic and security organizations. Following the approval of the Accession Partnership between Lithuania and the EU by the European Commission in March 1998, the authorities have made considerable progress in meeting the Copenhagen criteria on a functioning market economy and the capacity to cope with competitive pressure and market forces. According to the EU, further progress is needed in enterprise and bank privatization, land reform, and bankruptcy procedures. The authorities are determined to join NATO and have started to upgrade its military defense to that end. WTO accession talks continue, although difficult issues relating to domestic support and protection for agriculture remain; the authorities hope that WTO accession could take place by mid-2000.

Banking Sector Issues

The Lithuanian banking system consists of ten commercial banks (including two large state-owned banks), two branches of foreign banks, one subsidiary of a foreign bank (licensed in May 1999), four representative offices of foreign banks, and two specialized banks. The BOL supervises banks as well as 29 credit unions (whose assets account for less than 0.1 percent of the total assets of the banking system). The two state-controlled banks account for approximately 45 percent of total bank assets, while the two largest private banks account for 40 percent.

The capital adequacy requirement is 10 percent of risk-weighted assets, using EU and BIS methodology since January 1997. The definition of Tier II capital was clarified in 1999. Capital requirements for market risks are expected to be implemented by the end of 2000.

Nonperforming loans and specific provisions have declined significantly since 1997 (see table below). This, in part, is caused by the closure of the State Commercial Bank in March 1998, the transfer of bad loans of the Agricultural Bank to the asset management company, the BOL’s review of banks’ credit policies, and banks’ obligation to write-off loans classified as losses for two quarters (effective January 1, 1999). Loans to a single borrower or group of connected borrowers are limited to 25 percent of own funds (no cumulative limit for all large exposures exist).

Exposure to the property sector is relatively limited, since only 11.5 percent of all loans are collateralized by real estate (March 1999). Banks are subject to supervision on a consolidated basis.

Direct exposure to Russia is reportedly limited. Banks have made additional specific provisions of about LTL 54 million, or about 1 percent of total loans, due to the Russian crisis.

Foreign exchange exposure is passed on to borrowers or hedged (although foreign exchange loans to domestic borrowers could entail credit risk). In early 1998, banks moved from a positive net foreign assets position to a negative net foreign assets position.

Off-balance sheet liabilities increased by 26 percent during 1998 and amounted to about 13 percent of total commercial bank liabilities at the end of 1998. Foreign exchange sale contracts are to a large extent matched by purchase contracts, thus limiting the net open position.

The liquidity requirement is 30 percent of liabilities maturing within one month, but methodology strengthened, effective July 1, 1999. Commercial banks’ portfolios of treasury bills account for about 11 percent of their assets.

All locally incorporated banks reported profits in 1998 after several years of losses in the aftermath of the banking crisis in 1995–96, although external auditors of some banks recommended additional provisions for bad loans. Profits before tax of locally incorporated banks accounted for 0.8 percent of total assets in 1998, compared to -0.7 percent in 1997 (0.2 percent excluding the State Commercial Bank). The spreads between lending and deposit interest rates have since mid-1998 increased from about 5½-7 percent to 7-8 percent (1-3 month maturities).

Commercial Banking Sector Indicators, 1996–March 1999

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Source: Bank of Lithuania.

III. Report on the discussions

23. The Article IV consultation discussions continued after the new government had assumed office, and took place against the background of lingering effects of the Russian crisis on economic activity and the external position. The discussions centered on the strategy to maintain confidence in the currency board, reduce the current account deficit, and reinvigorate structural reforms, with the ultimate goal of returning to sustainable high growth.

A. Macroeconomic Policies

24. The discussions on macroeconomic policies focused on the authorities’ decision to keep the currency board in place at the present exchange rate, and its fiscal policy implications. The authorities recognized the need to reduce the current account deficit, and explained that their strategy would rely on fiscal adjustment and export promotion measures. The staff representatives supported the emphasis on fiscal policy, noting that since Lithuania is a small open economy, fiscal policy should be targeted at external adjustment rather than countercyclical objectives.

The currency board and external competitiveness

25. Because the international environment remains unsettled, the authorities are not currently considering an exit from the currency board. Future exchange rate and monetary policy will be laid out in a new Monetary Policy Program, to be drawn up in late 1999 (the existing Program covers 1997-99 and contains the exit strategy for the currency board). In the meantime, the authorities will seek to reduce the fiscal and current account deficits and prepare for an independent monetary policy (through legal changes to safeguard the BOL’s autonomy and the development of monetary instruments). This would help underpin the currency board, and also improve the prospects that an exit would be orderly, should the new Program envisage such a step. Meanwhile, the BOL plans to withdraw liquidity associated with the use of privatization proceeds, through deposit auctions and possibly central bank securities. The staff supported the authorities’ decision to maintain the currency board so as to reduce the possibility of speculative pressures on the currency and to underpin fiscal discipline, as well as the intention to neutralize the liquidity impact of the use of privatization proceeds.

26. While keeping the currency board in place, the BOL envisages a switch to a euro-U.S. dollar basket, before changing to a euro peg. The BOL sees an interim basket arrangement as justified by the pattern of external trade, external debt, and invoicing, as well as the recent appreciation of the litas vis-á-vis the euro. The BOL will monitor the situation, and expects to make a decision concerning the re-pegging in late 1999 (six months’ public notice would be given before any change). The staff warned that such a gradual approach would require several steps, including an early change of the Litas Stability Law, which would test credibility, and that a basket peg would lack the transparency of one-currency peg. The staff stressed that a change in the peg would not be advisable now, because announcement of a switch (and the necessary legislative period) could lead to speculative pressures, although it agreed that the dollar peg had not been helpful recently. Moreover, an eventual direct switch to a euro peg would be preferable.13

27. Review of a range of indicators suggests that external competitiveness remains adequate. The authorities did not consider competitiveness a problem overall, although they expressed concern that the recent appreciation of the litas vis-á-vis the euro had hurt some export sectors. The mission agreed that the litas is not clearly overvalued, although there is little room for real appreciation or wage increases that are not related to productivity growth (Box 5).14 The macroeconomic scenario presented below assumes that external adjustment will be facilitated by fiscal adjustment, and structural reforms that enhance productivity and competitiveness. However, structural reforms may fail to deliver the projected increase in productivity, or wage growth could outstrip productivity growth. In that event, achieving the necessary external adjustment may require even stronger fiscal retrenchment over the medium term.

28. In the period ahead, exchange rate and balance of payments developments will need to be kept under close review. On the positive side, the litas is underpinned by prospective large FDI inflows and adequate international reserves in relation to reserve money, short-term external debt, and external debt service. Also, recent external and financial vulnerability indicators show some improvement, and the currency board has again shown resilience under duress. Nevertheless, the current account deficit is projected to remain large in the next few years, and Lithuania would need to weather a rapid increase in external debt service (before it declines after 2002). The BOL stressed that if external pressures were to emerge, it would take monetary action as needed.

Fiscal policy

29. The authorities recognized that fiscal policy will need to be the central instrument for reducing the current account deficit in the near term. The government was preparing a revised budget for 1999, in light of lower-than-budgeted revenue. For the revised budget, different options for cutting current expenditure (of up to 1 percent of annual GDP) had been developed, and investment spending could be reduced by postponing projects not already under way (involving expenditure savings of up to ¼ percent of GDP). The government also was reviewing the scope for decreasing net lending. However, presentation to Seimas of the revised 1999 budget was postponed to September, in order to allow a fuller assessment of fiscal performance through June and a more thorough formulation of the expenditure cuts. In the meantime, the government intended to rely on expenditure sequestration and strengthened tax administration, including tax arrears collection. While welcoming the government’s intention to reduce the fiscal deficit, the staff noted that the budget plans were based on relatively high real GDP growth in 1999 (of 4 percent) and that the fiscal deficit was likely to be at least 6 percent of GDP before new measures.15 Also, the staff warned against basing spending plans on expectations of major short-term revenue gains from tax administration measures. It was also pointed out that with new measures of 1½ percentage points of annual GDP, the fiscal deficit could be kept at 0-1 percent of annual GDP in the second half of 1999, or 4½–5 percent of GDP for the year as a whole.16 This should help contain the current account deficit as private domestic demand recovers, and reduce the annual current account deficit below 11 percent of GDP.17 To this end, the staff urged the government to identify additional expenditure cuts.18 Also, the government should not roll over loans to the oil-sector complex when they fall due in July (the authorities explained that the repayment would depend on the agreement on the privatization of the oil-sector complex).

Lithuania: External Competitiveness Indicators

A review of a range of competitiveness indicators suggests that the real exchange rate and the U.S. dollar wage have nearly converged toward their (appreciating) equilibrium levels. Consequently, there is little room for additional real appreciation and real wage increases that are not related to improvements in fundamentals such as productivity increases.

REERs. Since December 1994, the Litas has been steadily appreciating in real effective terms (CPI-based) with a cumulative real appreciation of 63 percent to April 1999 with respect to all trading partners (Figure below). However, the large appreciation is not prima facie evidence that the Litas has become overvalued. First, empirical evidence suggests that there was an initial undervaluation resulting from the depreciation in the first stage of transition. Second, relative productivity gains in the tradable sector (the Balassa-Samuelson effect) imply that the equilibrium real exchange rate (CPI-based) would appreciate. At the same time, the recent narrowing in the inflation differential suggests that the convergence between the (appreciating) equilibrium real rate and the actual real rate may be nearing completion.

RULCs. Relative unit labor costs suggest a loss of competitiveness with respect to Estonia and a gain vis-à-vis Latvia between 1994 and 1998. The RULC may have declined since late 1998, reflecting the lower growth in Lithuanian wages following the Russian crisis.

Equilibrium U.S. dollar wages. Estimates of the equilibrium dollar wage, based on a set of fundamentals (see Krajnyák, K. and J. Zettelmeyer, 1998, “Competitiveness in Transition Economies: What Scope for Real Appreciation,” Staff Papers, 45(2), 309-62), yields a ratio of the actual to the equilibrium dollar wage ranging from 94 percent (when GDP is normalized by employment) to 104 percent (when GDP is normalized by labor force) in 1998.

Export performance. Export market shares indicate that: (i) Lithuania has increased its share in the EU, Russian, and German markets since 1994; and (ii) the EU market share increased in the last two quarters of 1998, which may indicate some reorientation of Lithuanian exports from the Russian market; this increase in the EU share did not come from an increase in the German market, suggesting further penetration into the markets of other EU countries. Lithuania’s recorded exports fell by 5½ percent in U.S. dollar terms in 1998. When interpreting this figure, it should be kept in mind that: (i) the fall masks a decline in CIS exports of 26 percent and an increase in EU exports of 12 percent; (ii) excluding reexports, exports fell only by ½ percent in 1998; and (iii) undervaluation of exports to Russia is believed by the authorities to have increased in 1998.

A01ufig01
1/ Equilibrium wage normalized by employment.2/ Equilibrium wage normalized by labor force.

30. The 2000 budget will be geared towards continuing the current account adjustment, and will be presented to Seimas after the revised 1999 budget. The authorities indicated that the budget would aim for financial balance (excluding use of privatization proceeds and net lending). To this end, the company income tax will not be eliminated in 2000, as planned by the previous government (although the rate will be reduced from 29 percent to 24 percent).19 Also, the government intends to implement a prudent public sector wage policy (looking further ahead, this policy would need to be supplemented by a rationalization of the government structure and civil service reform). Taking into account plans for further savings restitution of LTL 650 million (1⅓ percent of GDP) and net lending, a balanced financial account would imply a fiscal deficit upwards of 2 percent of GDP. The staff recommended that the fiscal effort in 2000 focus on current spending restraint—in particular as regards the use of privatization proceeds, which had provided the basis for the jump in current spending in 1998–99, and public sector wages—more than on tax measures and cuts in investment spending, with the objective of reducing the fiscal deficit to 0-1 percent of GDP and the current account deficit below 10 percent of GDP.

31. Beyond 2000, the government will need to maintain fiscal restraint in the face of increasing spending pressures. Such pressures will arise from accession to the EU and NATO, an aging population, structural unemployment, and energy-sector reform.20 This makes it all the more important to achieve major fiscal adjustment earlier, and move ahead to restructure the energy and agricultural sectors to underpin budget adjustment.

32. Fiscal adjustment is being supported by administrative reforms relating to the use of privatization proceeds, budgetary control, and tax administration. The availability of large privatization proceeds had undermined fiscal restraint since mid-1998, and questions had arisen about the transparency of such spending (which are within the government’s purview). The mission proposed that, as part of the fiscal consolidation strategy and to improve transparency, the government set aside privatization proceeds in a fiscal reserve fund held abroad, with clear guidelines for utilization (for instance, that the fund could be drawn upon only in emergencies, for pension reform, or for debt retirement). The authorities agreed in principle with this proposal, but did not believe that the build-up of such a fund would be feasible in the near term, given the need to rely on privatization proceeds for budgetary financing. They explained that the new Budget Law (see below) will make the spending of privatization proceeds subject to Seimas approval.

33. A new Budget Law has been prepared for submission to Seimas that: (i) calls for the incorporation of extra budgetary funds—including the Privatization Fund, but excluding the Health Insurance Fund and SoDra—in the budget by 2002; (ii) sets limits on line ministries’ end-year spending and includes carry-over provisions, to avoid the end-year spending surge that has complicated budget management in recent years; and (iii) provides for a three-year rolling budget framework. A new Treasury Law was approved in March 1999, inter alia providing the basis for a Single Treasury Account and requiring Seimas approval for the establishment of new extra-budgetary funds. To further improve tax administration, the State Tax Inspectorate is developing standard guidelines for tax collectors to reduce arbitrary tax enforcement and upgrading computer systems, and an anti-smuggling committee has been established.

B. Structural Policies

34. The structural reform agenda represents a continued effort towards establishing a fully functioning market economy, with many specific initiatives guided by EU and WTO membership aspirations. The authorities and the staff agreed that structural policies should be geared toward underpinning the budget, promoting growth in productivity and income, and enhancing nongovernment saving. In this sense, structural reforms would have a central role in achieving the necessary current account adjustment over the medium term.21

35. Pension reform should help address the social insurance fund’s financial problems and promote household saving. The Ministry of Social Security has developed a plan to strengthen SoDra’s finances. In the short term, the plan relies on tightening revenue collection, broadening the payroll tax base, and limiting the increase in pensions. The passage of a new Social Insurance Law in early 1999 was a first step towards addressing SoDra’s cash flow problem. The longer-term sustainability questions associated with the PAYG pension system and an aging population structure would be addressed by increasing the pension eligibility age and changing the indexation mechanism to keep pensions within available resources. Reform of the public system would be supplemented by the introduction of a three-tier pension system, including private pension schemes; a new framework law for private pensions was approved by Seimas in June.

36. Acceleration of privatization should provide a welcome boost to restructuring and growth, and should also help enhance corporate saving. A number of large enterprises have been put on the cash privatization list, and the new government reaffirmed its commitment to move ahead with the divestiture of these companies. The government representatives stressed that, in order to reap the benefits of privatization, sales would be conducted in an open and transparent manner (the Privatization Law permits a number of different sales methods, including public auctions and sale through direct negotiation).

37. Hardening of the budget constraints faced by enterprises is needed to promote restructuring and raise corporate saving. In this regard, the government representatives noted that it will be particularly important to scale back explicit and implicit state support for enterprises, such as loan guarantees. Concerning market entry, the government intends to streamline regulations and licensing requirements, in consultation with the local business community, to facilitate enterprise start-ups. The government also is working to bring into operation the Competition Council, which is envisaged under the new Competition Law as an independent agency. With regard to market exit, the Lithuanian representatives explained that a new Bankruptcy Law had been submitted to Seimas. The new Law will expedite the completion of bankruptcy cases by setting a maximum time limit of two years for completion of bankruptcy cases, increasing flexibility in pricing, and giving liquidation commissions more autonomy.

38. Reforms of the energy and agricultural sectors are needed to reorient the economy and support budget adjustment. In the energy sector, the authorities plan to speed up restructuring, improve corporate governance, and strengthen the financial position of energy companies. Immediate priorities will be to increase electricity tariffs and give the Energy Pricing Commission an increased role in reviewing and revising energy prices. In agriculture, the government program focusses on orienting government support towards private farming and speeding up land reform.

39. Lithuania’s generally liberal trade regime has been key in restoring economic growth, although the government from time to time has resorted to trade measures in support of individual industries. The temporary trade measures introduced immediately after the Russian crisis—including higher import tariffs and binding minimum import reference prices for certain agricultural products—remain in place and no specific dates have been set for their expiration; also, the government in early 1999 increased the import tariffs on some petroleum products.22 The Lithuanian representatives explained that trade policy would be guided by the ongoing WTO accession negotiations, and that the binding import reference prices and the higher petroleum import tariffs would be abolished when Lithuania joins WTO. The export promotion strategy would rely primarily on market research and information dissemination among potential investors and in export markets, as well as training; also, the few remaining export tariffs (on hides, raw skins, and lumber) will be abolished by January 1, 2001.

C. Financial Sector Issues

40. Safeguarding financial sector stability will be important to ensure that the banking system can withstand pressures, and to promote efficient intermediation of saving. In the area of prudential supervision, the BOL’s priority is to continue strengthening the supervisory framework, in line with EU requirements and the Core Principles for Effective Banking Supervision. This will inter alia include the adoption of a cumulative limit on all large exposures and the EU’s capital adequacy directive. In addition, the BOL is working to ensure that banks make adequate provisions for bad loans in the wake of the slowdown in economic growth and higher real interest rates. The BOL sees the need to safeguard competition in the banking sector, and has issued regulations to prevent undue concentration and welcomed foreign investors.23 Concerning financial sector reform, the privatization of Savings Bank and Agricultural Bank will move ahead in 1999/2000. Institutional investors are being encouraged through pension reform and continued adoption of EU standards for securities transactions.

D. Transparency, Economic Data, and Y2K

41. The new government recognizes that transparency in economic policies will be critical for market confidence and for public support of its economic policies. In this regard, it attaches particular importance to avoiding any perception that the privatization process lacks transparency. In line with the policy of openness in economic policy matters, the authorities have decided take part in the pilot project on publication of Article IV consultation reports.

42. Balance of payments data need to be improved. The authorities are engaged in an ongoing effort to improve economic data, with the focus recently being on the strengthening of the collection of balance of payments data. They expect that the forthcoming posting of an IMF resident advisor on balance of payments statistics will help in this endeavor.

43. A number of initiatives have been taken to deal with the Y2K problem. The government has set up a commission that will shortly complete an inventory of all computer systems in strategic sectors. In the financial sector, banks have been required to comply with an action plan for Y2K readiness, and the BOL’s supervision reviews compliance with this plan. The Stock Exchange, the Settlement Center, and the Central Depository all have conducted tests without identifying problems.

IV. Macroeconomic Framework

44. An up-front fiscal adjustment combined with steadfast structural reform should allow a return to sustained economic growth. The staffs medium-term macroeconomic framework—based on an up-front fiscal adjustment, reinforced structural reforms, recovery in export markets, and continued availability of foreign financing—suggests that annual GDP growth, after slowing to about ½ percent in 1999, could recover to 4 percent in 2000 and 5–6 percent annually thereafter (Table 5 and Appendix VI). Inflation could pick up to 2½ percent (12-month rate) during 1999, as prices recover from the initial effects of the Russian crisis, and subsequently remain in the 2–3 percent range. Reducing the fiscal deficit to 4½-5 percent of GDP in 1999 and further to 0-1 percent in 2000 should help reduce the current account deficit below 11 percent of GDP in 1999 and 10 percent in 2000. The staff scenario assumes that recipients of restituted savings would not spend their entire receipts; consequently, an increase in non-government saving also would help the current account adjustment in 1999.24 Thereafter, the main impetus to the external adjustment would come from gradual increases in household saving in response to higher income growth, pension reform, and a more developed financial system, and in corporate saving as a result of privatization and policies to harden budget constraints. The debt-to-GDP and debt-service-to-exports ratios would peak at 38 percent and 27 percent, respectively, in 2002, before declining gradually in the following years.

Table 5.

Lithuania: Medium-Term Macroeconomic Framework, 1996-2004

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Sources: Department of Statistics, Bank of Lithuania, and Fund staff estimates and projections.

Includes discrepancy between above and below the line estimates of the financial balance and balances of budgetary organizations not recorded in the above the line numbers. Also includes savings restitution payments.

Includes public, publicly guaranteed, and private external debt.

45. There are potential downside risks to this macroeconomic scenario: nongovernment saving may fail to recover; export growth may fall short of projections; and access to international capital markets and FDI may be lower. There is the risk that adverse developments could precipitate financial distress, force a sudden current account adjustment, and disrupt growth. Also, weak follow-through on economic policies—e.g., less ambitious fiscal adjustment—could result in adverse external trends over the medium term. Appendix VI explores the implications for external indicators of such developments.

V. Staff Appraisal

46. Lithuania will need to take strong actions to return to sustained economic growth. Lithuania has made great progress in economic stabilization and market reform since independence was regained. The challenge facing the authorities in the period ahead will be to continue this progress and protect confidence in the litas. The first item on the agenda will be to bring fiscal policy firmly under control, supplemented by a reinvigoration of structural reforms.

47. Maintaining the currency board should help protect financial stability. For this to happen, however, the authorities will need to move ahead to reduce the current account deficit and the reliance on external financing. In the meantime, an unequivocal commitment by the authorities to the currency board at the present peg and exchange rate level should help minimize the risk of a speculative attack on the litas. The authorities will need to monitor closely developments in the balance of payments and indicators of external competitiveness, and stand ready to take action if balance of payments pressures were to emerge. The authorities’ commitment to transparency in economic policies should help bolster market confidence, and should be supported by reinforced efforts to improve economic data.

48. A reorientation of fiscal policy will need to be the cornerstone of the external adjustment strategy in the near term. To this end, the government should immediately start implementing the identified expenditure reductions for 1999. The 2000 budget will need to be oriented towards continuing the external adjustment, with the focus on further restraint on current expenditure. No tax measures that could undermine fiscal adjustment should be contemplated, and the staff welcomes the retention of the company income tax (regrettably at a reduced rate). The staff would encourage the authorities to establish a fund for investment of privatization proceeds, with clear guidelines for utilization, to help strengthen transparency and fiscal adjustment; in particular, privatization proceeds should not be used to finance current spending. Public sector wage restraint and civil service reform should also help budgetary adjustment, and should send an important signal to the private sector.

49. To underpin budgetary and external adjustment, it will be important to strengthen budget procedures, accelerate pension reform, and restructure the energy and agricultural sectors. High priority should be given to adoption of the new Budget Law, better payroll tax collection combined with pension reform, price increases and cost cuts in the energy sector, and scaling back of government support for agriculture.

50. To promote restructuring and growth, market exit and entry must be facilitated. The increased extension of government support to agriculture and other sectors, in the form of outright budget support and import protection, was an inappropriate response to the Russian crisis, as enterprises need to be further exposed to market pressures. In this connection, the revival of privatization, the new Competition Law, and the revision of the Bankruptcy Law are welcome. Also, the government’s planned scaling back of support of enterprises and simplification of regulations and licensing requirements should be expedited. Import protection for specific sectors—such as agriculture and the oil industry—should be scaled back.

51. The BOL’s continued vigilance in banking supervision is appropriate. While a sounder banking system has emerged after the banking crisis of 1995/96 and the limited direct exposure to Russia so far has helped weather recent developments, the potential secondary effects through domestic borrowers exposed to the CIS underscores that vigilant prudential supervision is called for also in the period ahead. In that regard, the staff supports the BOL’s efforts to strengthen prudential supervision, including the decision to implement the Core Principles for Effective Banking Supervision.

52. The macroeconomic outlook is favorable, but is not without risks. Fiscal adjustment and market reforms should help Lithuania return to high sustained growth and ensure a viable external position. Even so, adverse developments could jeopardize orderly external adjustment and lead to lower economic growth. The main external risk factors in this regard are the possibility of lower export growth, reduced access to international capital markets, and lower FDI. To limit the destabilizing effects of such developments, fiscal policy must be restrained. If Lithuania were faced with adverse external developments, a further strengthening of fiscal policy and reinforced structural reforms would be called for.

53. It is proposed that Lithuania remains on the standard 12-month consultation cycle. The authorities’ decision to participate in the pilot project for publication of Article IV consultation staff reports is welcome. Given the uncertainties that are bound to characterize the period ahead, Lithuania could be well served by a Fund-supported program.

APPENDIX I Lithuania: Fund Relations

(As of May 31, 1999)

I. Membership Status: Joined 4/29/92; Article VIII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans:

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V. Financial Arrangements:

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VI. Projected Obligations to Fund (SDR Million; based on existing use of resources and present holdings of SDRs):

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VII. Exchange Arrangements:

The currency of Lithuania is the litas. Since April 1, 1994, the litas has been pegged to the U.S. dollar at LTL 4 per U.S. dollar under a currency board arrangement.

VIII. Resident Representative:

The senior resident representative of the Fund in Lithuania is Mr. Adalbert Knöbl, who took up his post in October 1997.

IX. Consultation Cycle:

Lithuania is on the 12-month consultation cycle.

APPENDIX II Lithuania: Technical Assistance from the Fund, 1997-99

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APPENDIX III Lithuania: World Bank Relations

1. Lithuania joined the World Bank in July 1992. Since then, the Bank’s assistance to Lithuania has concentrated on reforms in key areas such as maintaining macroeconomic stabilization to build and maintain investor confidence, reducing government involvement in business activities, and enforcing the basic legal tenets necessary for private activity. Moreover, the Bank is working with the government to strengthen key financial institutions to facilitate the appropriate provision of credit and movement of capital, as well as assisting in reorienting the social safety net, public services, infrastructure, and the energy sector to the needs of a market economy.

2. The table below provides a summary of IBRD loans as of end-May 1999. It includes 12 projects with commitments totaling US$293 million equivalent and disbursements on all Bank projects in Lithuania amounting to US$190 million. Preparation of other operations is proceeding in the areas of infrastructure, health and municipal services.

3. IFC has approved three projects in Lithuania so far: (a) financing of the expansion/modernization of a textile mill with German sponsors; (b) a line of credit to support SMEs; and (c) an equity investment in a venture capital fund supporting medium-sized companies in the Baltic States. IFC has also conducted a series of technical assistance projects ranging from advice on securities markets and leasing regulations to review of various aspects of projects which IFC has been considering for financing.

4. Lithuania is a member of MIGA, which has so far not issued any guarantees, but has four applications pending, government representatives have participated in MIGA-sponsored meetings on investment promotion, and Lithuania is an active user of MIGA’s Internet-based information dissemination facilities. FIAS has just started a study of administrative barriers to investment.

5. The first World Bank Country Economic Memorandum (CEM) was published in April 1993. A Public Expenditure Review was conducted in 1993/94 and was the basis for a donors meeting on public investments in May 1995. The Bank also has prepared an informal enterprise and financial sector study, a private sector assessment, a comprehensive energy sector review, a study of nuclear energy alternatives commissioned by the G-7, an agricultural review, a municipal finance study, a social insurance/social policy note, and an informal note on transport. In 1998, the Bank completed a multi-sectoral collection of policy notes, and a Country Assistance Strategy (CAS) for 1999-2001, which were discussed by the Board on May 11, 1999. Work has been completed on a Macro Financial Vulnerability Study and started on a Country Economic Memorandum that will focus on the challenges Lithuania will face on its path toward joining the European Union.

World Bank Loans Approved by the Board

(As of end-May 1999; in millions of U.S. dollars)

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Source: The World Bank.

Loan closed in December 1995; US$1.2 million canceled.

Loan closed in June 1998.