Republic of Lithuania: Request for Stand-By Arrangement
Author: International Monetary Fund
Publication Date:
14 Sep 2001
eISBN:
9781451824063
Language:
English
Keywords:
ISCR; CR; government; authorities' strategy; SDR; EU accession; government regulation; broad money; debt service; banking sector; regulatory agency; financial situation
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Lithuania achieved significant progress in macroeconomic stabilization and structural reforms, under the previous Stand-By Arrangement. Executive Directors welcomed the new program, which aimed at maintaining macroeconomic stability, promoting private sector activity, and strengthening external viability in order to attain sustainable growth and create employment opportunities. They stressed the need to implement fiscal and structural reforms. They agreed that the authorities are following an appropriate approach of preparing a medium-term fiscal framework, determining priorities, and seeking ways to achieve the medium-term goal of a balanced budget.

Abstract

Lithuania achieved significant progress in macroeconomic stabilization and structural reforms, under the previous Stand-By Arrangement. Executive Directors welcomed the new program, which aimed at maintaining macroeconomic stability, promoting private sector activity, and strengthening external viability in order to attain sustainable growth and create employment opportunities. They stressed the need to implement fiscal and structural reforms. They agreed that the authorities are following an appropriate approach of preparing a medium-term fiscal framework, determining priorities, and seeking ways to achieve the medium-term goal of a balanced budget.

I. Introduction

1. Despite the fragmented political environment in Lithuania, clear support for European Union (EU) and NATO accession across the political spectrum has allowed for continued and steady progress in reforms. On June 19,2001, the liberal-centrist government led by Prime Minister Paksas unanimously endorsed an economic program that had been discussed during a Fund staff visit to Vilnius in May.1 However, shortly after having signed the Letter of Intent, the government, which had a very narrow parliamentary majority, collapsed. The social democrat party, supported by the social liberal party, was able to form a majority government, in which six out of thirteen Ministers from the previous cabinet were retained. The newly-appointed government led by former President Brazauskas stressed continuity and reiterated its commitment to the major goals of the previous government, the maintenance of fiscal restraint, and the pursuit of the reforms spelt out in the accompanying MEP.

II. Recent Economic Developments and Performance Under the Previous Program

2. Under the previous SBA, Lithuania achieved significant progress in macroeconomic stabilization and structural reforms, and greatly improved its prospects for EU membership in the first wave of expansion (Tables 1-12). All performance criteria for end-March 2001 were met, except for the elimination of expenditure arrears of the central government, which was missed by a very small margin (Tables 8 -9 and Box 1).

3. All macroeconomic objectives under the previous program were attained.2 In 2000, real GDP grew by 3.3 percent, compared with the previous estimate of 2.7 percent (Table 1 and Figure 1). The recovery was underpinned mainly by export growth, while domestic demand declined by 0.2 percent. The external current account deficit shrank sharply from 11.2 percent of GDP in 1999 to 6.0 percent in 2000, mainly reflecting strong export growth and the demand-containing effects of the fiscal adjustment (Table 3). In the first quarter of 2001, real GDP grew by 4.4 percent year-on-year, led by continued strong export growth and a pick up of domestic demand, which increased by 5.6 percent with respect to the first quarter of 2000. Private consumption grew by 5.5 percent, while total investment increased by 14.6 percent. The current account deficit was about 6.5 percent of GDP, with exports and imports of goods growing at about 17 and 14 percent in U.S. dollar terms, respectively. The increase in imports suggests a pick-up of domestic demand. After a depreciation of 6 percent in November 2000-January 2001, the real effective exchange rate has appreciated recently, reflecting some weakening of the euro (Figure 2).

Lithuania—Structural Conditionality

1. Proposed Coverage of Structural Conditionality in the Program

Structural areas covered by conditionality in the proposed program are: (i) fiscal reforms (municipal finances, pension reform, regulation of usage of privatization receipts); (ii) financial sector reform (bank privatization); (iii) labor market policies to address unemployment; and (iv) business environment. Structural policy benchmarks (MEP, Table 3) focus on actions considered essential to macroeconomic stability and an efficiently functioning market economy, because of their relevance for supporting the targeted budget adjustment, enhancing financial sector efficiency, and fostering private sector activity. Issues outside of the Fund’s core areas, such as labor markets and private sector development, which are covered by conditionality under the program because of their macroeconomic impact in the medium term, are also monitored by the World Bank consistently with the Fund program.

2. Status of Structural Conditionality from Earlier Program.

Under the last stand-by arrangement, structural conditionality was set in the following areas: (i) fiscal reform; (ii) financial sector reform; and (iii) energy sector reform. Progress under (i) and (ii) was broadly satisfactory, although bank privatization took longer than originally envisaged. Progress was also recorded in the restructuring of the finances of the energy sector enterprises, but the privatization process is lagging behind. Measures in the energy sector reform are not included in the proposed program because financial viability of energy utilities has been restored and their privatization will have a macroeconomic impact only in the long run. The World Bank staff, better placed to monitor and advise in this area, is taking the lead. Nonetheless, the Fund will continue to monitor the macroeconomic impact of measures taken in this area.

3. Structural Areas Covered by Bank Lending and Conditionality

Structural areas covered by the World Bank through a Structural Adjustment Loan (SAL II) and several projects (Appendix HI) include: (i) budget management, (ii) pension reform, (iii) unemployment and social safety nets, (iv) private sector development, (v) infrastructure, (vi) energy sector reform, and (vii) agriculture. Staff has closely cooperated with the Bank on the issues of common interest in these areas.

4. Other Relevant Structural Conditions not Included in Current Program.

There are no direct structural conditions related to agriculture, for several reasons: (i) because improvement in this area will be only gradual and in the medium term, as, after reducing and rationalizing government involvement in agriculture, the sector as a whole needs to be restructured; and (ii) other agencies, in particular the EU and the World Bank are taking a leading role on this area. Moreover, a number of structural measures in the business and regulatory environment, which are needed to meet EU standards, are not part of the program and will be followed by the EU, so that Lithuania can remain competitive and take full advantage of the benefits of joining the EU.

Figure 1.
Figure 1.

Lithuania: Selected Economic Indicators, 1996-2001

Citation: IMF Staff Country Reports 2001, 160; 10.5089/9781451824063.002.A001

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

4. Prices and wages increased modestly in the first months of 2001, and unemployment rate started to decline in April for the first time in the last year. The year-on-year CPI and PPI increased by 1.7 and 2.9 percent in May 2001, respectively, reflecting mainly the raise of oil and food prices. Average wages declined by 3 percent hi the first quarter of2001 with respect to the last quarter of 2000, although they increased by 1.2 percent year-on-year. The unemployment rate declined in June for the third consecutive month, reaching 12.1 percent.

5. After significant fiscal consolidation in 2000, when the general government deficit was reduced from 8.5 percent of GDP to 2.8 percent, public finances continued to improve in the first quarter of 2001 (Table 2).3 The general government deficit for the first quarter of2001 amounted to LTL 97 million (0.3 percent of annual GDP less than programmed). Revenue performance of the general government was broadly in line with program projections.4 Expenditure in the first quarter of 2001 was below projections, mainly on account of delays in approving the public investment program. In addition, cash expenditure of municipalities was constrained by a shortfall in the personal income tax (PIT) collection—their main source of revenue. Expenditure of the Social Insurance Fund (SoDra) was below projections due to lower compensation for work accident insurance and pensions. In July Seimas approved a revision of the national budget for 2001, which aims mainly at reallocating expenditure while keeping the budget deficit target of 1.4 percent of GDP unchanged (MEP, paragraph 12).

6. Central government expenditure arrears declined in the first half of 2001 by 0.1 percent of GDP, although the program performance criterion to eliminate them completely by end-March was missed by a narrow margin (less than 0.1 percent of GDP). Central Government arrears remained at the same level at end-June. The Road Fund eliminated its expenditure arrears. However, LTL 14.6 million of state budget arrears remained at end-June, despite the Treasury having allocated sufficient funds for payment of current obligations and outstanding arrears. This was attributable to poor expenditure control, planning and coordination of the very large number of state budget appropriation managers. Arrears of the Health Insurance Fund (HIF) declined from LTL 23 million at end-December 2000 to LTL 5 million at end-June.

Figure 2.
Figure 2.

Lithuania: Indicators of External Competitiveness, 1996-2001

Citation: IMF Staff Country Reports 2001, 160; 10.5089/9781451824063.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.

7. The shortfalls in the PIT and expectations of a bail-out led to an increase by LTL 22 million (0.1 percent of GDP) of expenditure arrears of municipalities in the first half of 2001. Municipalities continued to lobby for compensations for a long list of the unfunded obligations which they argued were imposed by the central government from 1997 to 2001. Municipalities maintained that they had to finance unfunded obligations by delaying cash payments for other expenditures. Arrears were mainly incurred to municipal utility companies, the Lithuanian Power Company, and recipients of allowances. More than 50 percent of arrears were incurred by a few municipalities. These municipalities also incurred arrears on transfers of withheld personal income and payroll taxes of municipal employees to the State Tax Inspectorate (STI) and SoDra, thereby undermining finances of the municipalities receiving transfers from the Equalization Fund and SoDra.

8. Progress was made in fiscal reform. In April 2001, the Ministry of Finance established two new departments to coordinate and monitor financial issues related to EU accession, including mobilization of cofinancing. A new draft Law on Tax Administration, streamlining procedures for penalties, arrears write-offs and tax deferrals, was submitted to Seimas in April. Important reforms of the Treasury system (software upgrade, creation of a single Treasury account, and direct payments for most agencies) were also implemented.

9. Greater confidence in the banking system led to larger-than-expected broad money growth of 19.4 percent year-on-year in the first quarter of 2001 mainly on account of the increase in deposits (Table 4, Figure 3, and Box 2). After falling in 2000, credit to the private sector started picking up again, and grew by 3 percent year-on-year, while investment abroad continued with a further buildup of commercial banks’ net foreign assets by LTL 353 million in the quarter, as banks did not find a sufficient number of projects to finance domestically. Data to June show similar trends in the monetary aggregates. Interest rates in both nominal and real terms continued to fall (Figure 3), reflecting the decline in U.S. interest rates, increased confidence in the financial system and the currency board, and abundant liquidity in the system. Real interest rates fell from 14.6 percent in early 2000 to 10 percent in the first quarter of 2001, but still remain very high.

10. The privatization of the Savings Bank was concluded, with the sale effective as of June 1, 2001. The authorities had authorized its purchase by Hansabank, reserving the right to request for divestiture of one of the banks if the parents of Hansabank and Vilnius Bank (Swed and SEB, respectively) merge. The tender winner for advisors to prepare the Agricultural Bank for privatization was PriceWaterhouseCoopers.

Figure 3.

Lithuania: Financial Indicators, 1997-2001

Citation: IMF Staff Country Reports 2001, 160; 10.5089/9781451824063.002.A001

Sources: Bank of Lithuania; Bloomberg News; and National Stock Exchange of Lithuania.1/ Included are reclassification of 270 million of DMB’s claims on private sector to government lending funds, which were removed from banks’ balance sheets in July, 2000.2/ Yield spread between Lithuanian Eurobond and U.S. benchmark bond; Lithuanian Eurobond maturing July 2002.3/ Calculated from all issues quoted in the current trading list, excluding treasury bills and investment companies.

Banking Sector Issues

The banking sector consolidated after the financial crises of 1995-96, when the number of banks fell from 28 in early 1994 to 12 at end-1995. Although direct exposure of the banks to the Russian crisis of 1998 was minimal, the indirect effects from the sharp dip in growth in 1999 have been pronounced, affecting the willingness of banks to engage in credit activity. Even as the financial sector has deepened and monetization has increased over the past three years, financing of private sector activities from the banking sector has remained sluggish, with private sector credit (excluding write-offs) falling by 1.2 percent in 2000, while real GDP grew by 3.3 percent. Another reason for this apparent malaise was further consolidation of the banking sector, and aggressive restructuring and provisioning in preparation for privatization of three state banks.

Structure of the Sector

As of the first quarter of 2001, the banking sector comprised ten commercial banks of which only one remained majority state owned, together with four branches of foreign banks, and an asset-workout bank, totaling assets of LTL 13.6 billion (from LTL 8.9 billion in early 1998). The newly privatized Savings Bank, which has assets of LTL 3.7 billion, combined with the smaller Hansabank, will have assets of roughly around LTL 4 billion. The remaining state bank, the Agricultural Bank with assets close to LTL 1.8 billion, will be prepared for privatization by PriceWaterhouseCoopers by early fall. The assets of the largest private commercial bank Vilnius Bank, a local subsidiary of the Swedish parent SEB, amount to LTL 5.4 billion, 40 percent of the total assets of the banking system.

Structure of loans. Loan growth and composition of loans improved, although in 2000 there was more consolidation than growth until late in the year (see left chart below). Intermediation improved as long-term loans (over one year) as a proportion of total loans increased from less than 40 percent in 1997 to more than 60 percent in 2000. Loans extended to private enterprises rebounded by 2.4 percent in the fourth quarter of 2000 (q-o-q), and by 6.1 percent in the first quarter of 2001 (y-o-y), even though the share in total loans remained below 1997 levels (Table 12). Average interest rates on loans also fell in the period. For example, interest on loans of up to one month to enterprises in litas after having reached 14.05 percent in the first quarter of 2000, has fallen to 10.9 percent by end-2000. Moreover, spreads between deposit rates and lending rates have also fallen indicating increased efficiency of the banking system (see right chart below).

A01ufig01

Structure of Loans, 1997-2001

Citation: IMF Staff Country Reports 2001, 160; 10.5089/9781451824063.002.A001

A01ufig02

Loan-Deposits Interest Rates Spreads, 1999-2001

Citation: IMF Staff Country Reports 2001, 160; 10.5089/9781451824063.002.A001

Structure of deposits. Deposits increased more than 60 percent from 1998 till the first quarter of 2001 increasing from LTL 6 billion to LTL 9.7 billion. Deposits were 77 percent of broad money, increasing 10 percentage points in the same period. The share of demand deposits in the same period fell almost 20 percentage points from 67 percent to 47 percent. Although the share of foreign currency deposits increased by 10 percentage points, it remained fairly stable for the last year and a half.

Main Issues

  • Competitiveness of the banking sector. The sector has been fairly concentrated, with the state banks unable to provide enough competitive pressures especially with regard to finding loan opportunities. Though sources of funds have not been the bottleneck, savers have few instruments. Increased competition between banks would increase mobilization in the long-term. More liberal rules with the voluntary third pillar of pension reform should also harness greater savings.

  • Capacity of intermediation. A banking system that provides effective financial intermediation mobilizes savings, as well as ensures that the highest return investment projects are financed. To analyze the effectiveness of the banking sector in Lithuania, we examine 3 indicators of intermediation, and compare them with the other two Baltic countries (see chart below). The money multiplier increased from 1.95 in 1998 to 2.64 in 2000, reflecting not only a reduction of required reserves, but also a substitution away from currency in transactions (Table 4). This is slightly higher than either in Estonia or Latvia. Monetization of the economy, measured as the ratio of broad money to GDP, increased from 18 percent in 1998 to 22 percent in 2000, again showing more confidence in the financial system, although it was less than in Estonia and Latvia, where the economies have been growing more robustly as well. Credit to the private sector relative to GDP stayed more or less flat going from 11 percent in 1998 to 12 percent in 1999, and stagnating in 2000. Lithuania’s financing from the banking system was 50 percent less than Estonia, and 33 percent less than Latvia. An effective interbank market would also generate efficiencies of intermediation by allowing banks to hold less precautionary excess reserves, and support higher loan activities. The volume of total transactions in litas fell from the quarterly average of LTL 900 million in 1999 and LTL 535 million in the first quarter of 2001. Interest rates in the same period also fell (Figure 3). On November 13,2000, the BoL started daily reporting of the liquidity of the financial system, which by its transparency should further develop the interbank market, and reduce excess reserves. Currently, the BoL is examining ways to streamline cumbersome collateral requirements.

  • Banking supervision and prudential regulations. Banking supervision has improved since 1997 and prudential regulations have converged to Basle and EU standards, with a comprehensive CAMELS (Capital, Assets, Management, Earnings, Liquidity, and Sensitivity) rating system used to evaluate commercial bank and subsidiary loan portfolios. Branches are supervised by the parent country. On-site inspections are conducted on an annual basis, while off-site submissions are made monthly. Non-performing loans fell to 11.2 percent as a share of total loans in the fourth quarter of 2000 (Table 12). The up tick of non performing loans to 12 percent in the first quarter of 2001 coincides predictably with the timing of the on-site inspections. Capital adequacy requirements were aligned with Basle methodology in 1997, and the risk-weighted capital asset ratio remains above the required 10 percent at 16.4 percent. In case the risk-weights are in doubt, the unweighted capital to total asset ratio was 9.2 percent. Open positions in foreign exchange including off-balance items were also well within legal limits, even though there may still be credit risk exposure originating from the large proportion of foreign currency loans (almost 2/3 of total loans).

A01ufig03

Baltic Countries: Capacity of Intermediation, 1998-2000

Citation: IMF Staff Country Reports 2001, 160; 10.5089/9781451824063.002.A001

Issues for further development of banking sector

Despite improvements in recent years, greater capacity of intermediation of the banking system is needed for the economy to move to a higher steady-state growth path. The privatization of the remaining state bank would not only increase competition and most likely foreign participation, but also would reduce the uncertainty resulting from the long-pending privatization process. Furthermore, a more robust economy would promote further development of the financial system, as well as increase credits extended to the private sector, which is already becoming evident from the upturn of loans both to individuals and enterprises in the fourth quarter of 2000. In preparation for EU accession, a Financial Sector Assessment Program has been requested by the authorities, and it is scheduled for this fall.

11. The BoL announced on June 28 that it will proceed with the repegging of the anchor currency from the dollar to the euro on February 2,2002, based on the European Central Bank (ECB) reference exchange rate of the euro for the dollar of February 1,2002. The announcement was well-received by the markets. The repegging is planned in view of the progressive orientation of trade toward the euro area and greater economic integration with the region. The BoL has been consulting with the ECB and the Fund staff regarding the technical aspects of the repegging. The government also completed the transfer of its Treasury accounts from commercial banks to the BoL on June 30,2001. The BoL is working together with the Ministry of Finance to improve forecasts of Treasury flows, using historical data.

12. In the first half of 2001, good progress was made in improving the business environment and fostering private sector activity. The sunset and the sunrise commissions were revived, with the former established as the institution to formally monitor administrative barriers.5 The market regulation system was streamlined, with the centralization of all business inspection functions in two main agencies. The bankruptcy law and amendments to the labor law were passed by Seimas in March. With regard to privatization, the Lithuanian Shipping Company (LISCO) was sold to a Danish firm in April. In May, a public tender for the advisor on privatization of the Lithuanian Airlines was announced, and a plan for the reorganization of the Lithuanian Railways was approved by the government. Residual government shares in one hundred small enterprises were sold in March-April. On May 31, Lithuania became a member of the World Trade Organization (WTO).

13. Despite the government’s efforts, insufficient progress was made in the restructuring of the energy sector, owing to political disagreement at the parliament of level (Box 3). Nonetheless, the financial situation of energy public enterprises strengthened following tariff increases. In June 2001, the Mazeikiu Nafta Oil Company, which had made losses in 2000 and the first quarter of 2001 due to disruptions in oil supplies, reached a long-term agreement on oil supplies with a Russian company (Box 3).

14. Some progress was made in 2000 to rationalize and reduce agriculture subsidies. Market intervention in the form of price support remains only for grain, while trade is now regulated by WTO rules. The reduction of government support has led to needed consolidation of key processing and export sectors but also to protests by farmers. Seventy five percent of trade is conducted under free trade agreements or most favored nation conditions, including with Russia and other CIS countries, while most tariffs are below the binding rates for the WTO. Despite this progress, little was done in improving the state food market regulatory agency and market regulation policies. This together with insufficient progress of restructuring the energy sector led to a delay in the disbursement of the second tranche of the World Bank’s structural adjustment loan (SAL).

Energy Sector Issues

Background

The energy sector in Lithuania, comprising electricity, gas, and oil transit and refining, has been beset by problems whose origins go back to the pre-independence era, including overcapacity in oil and electricity sectors, and weak operational and financial conditions, leading to fiscal and macroeconomic imbalances. In recent years, good progress has been made in developing a strategy for the sector and addressing these issues. An energy pricing commission was established to function as a regulator of heat, gas, and electricity prices; major measures were taken to commercialize the sector and solve the energy arrears of public authorities; steps were taken to prepare restructuring and privatization plans for electricity and gas; the oil company was partially privatized; and international accounting standards were adopted by the main state-owned energy companies. Efforts at restructuring have been complicated, however by strategic political considerations, including EU accession goals, which have led to steps to close the first unit at the Ignalina Nuclear Power station and to construct transmission lines to link up with Poland, as well as further integration with the West, which led the previous government to seek a Western strategic investor in the oil sector. Lithuania continues to have important supply links to Russia and other CIS countries, increasing the complexity of these efforts.

Electricity

The Lithuanian electricity capacity generation system exceeds the needs of the country. In 2000, the operational capacity was more than three times the peak load, and double the historic peak load in 1991. Around 75 percent of the electricity is generated by one of the two nuclear reactors at the Ignalina power plant, and most of the remainder is supplied by thermal and hydroelectric plants under the Lithuania Power Company (LPC), while district heating is run by municipalities. In 2000, residential users accounted for more than one-third of total electricity consumption, followed by transport and industry. Lithuania imports nuclear fuel mainly from Russia, and exports electricity to Belarus, Latvia, and Russia. Belarus has some payments arrears, despite partial clearance via barter arrangements or sale of the debt to third parties. The export strategy targets to maintain old markets and to find new markets in the West. Thus, in February 2001, Lithuania signed an agreement with Belarus, Estonia, Latvia, and Russia for synchronizing national power grids. Lithuania is also working with Poland on a project for the interconnection of the two national electricity grids, with the assistance of the EBRD; the completion of the project is’expected by 2003.

The Lithuanian Power Company or lietuvos Energjia (LPC), 86.25 percent state-owned, owns and operates the electric transmission and distribution system and all major power plants with the exception of Ignalina. LPC had run big losses in the past, due both to Belarus’s failure to pay for exports, and delays in raising tariffs on a timely basis. In the last five years, steps have been taken to improve the financial situation. In 1996, measures were taken to reduce consumer arrears. In 1997, LPC was reorganized and 16 local district heating companies were established, with shares transferred to the municipalities. In 1997, an independent energy pricing commission was established. The last round of tariff increases took place in January 2000, and a further increase is expected in 2001. In May 2000, a law on restructuring LPC into generation, transmission, and distribution companies was passed, with the intention of privatizing the distribution network by the end of 2001. However, due to technical and political reasons some delays for the privatization of the company have arisen, and the approval by pariiament of the government’s restructuring plan, originally scheduled for January 2001, occurred only in June 2001. The registration of LPC successor companies is expected to be completed by end-2001, and the offer for sale of distribution and generation companies for end-February 2002, with closing of the privatization transactions targeted for end-June 2002. In April 2001, LPC signed an agreement to sell power utility to the Inter RAO UES Russian company for export to Belarus,

IgnalinaNuclearPowerPlant (INNP) Lithuania is one of the most nuclear-reliant countries in the world. The nuclear power is generated by the INPP, which has two Chernobyl-type reactors (the first began service in 1983 and the second in 1987), whose service life is projected to end in 2010-15. At present, only one unit is in service, and it operates at 40-45 percent capacity. In 1993, the first safety improvement program was initiated. Since then, US$200 million has been spent in safety improvements and an additional US$500 million is planned. Moreover, under pressure from the international community, in particular the EU, parliament narrowly adopted the National Energy Strategy in 1999, committing the country to an early closure of the INPP’s first unit by 2005. A decision about the closure of the second reactor should be made in 2004, with decommissioning in 2009, but the EU demands a final decision by 2002, The total direct and indirect costs of the closure of INPP are currently estimated at US$3.5 billion, spread over 70 years. The direct costs associated with the closure of the first reactor are estimated at US$178 million over five years. This amount was pledged by the EU and other donors in June 2000, and a closure fund has been established under the management of the EBRD. Financial assistance would also be needed to shoulder the costs of closing the second reactor.

Oil

Lithuania has small offshore oil reserves in the Baltic Sea, which have been explored by the Lithuanian firm Geonafta and Scandinavian companies, but Russia remains the main supplier of crude oil. The oil sector, which includes an oil refinery, a pipeline, and a new oil terminal at Butinge, was restructured in 1998 as the Mazeikiu Nafta (MN) public company. Before privatization, the company experienced increasing financial difficulties stemming from poor management, overcapacity in the Butinge terminal, and crude oil supply shortages. In October 1999, MN was partially privatized, with 33 percent of the company’s equity sold to Williams International for US$75 million, which was reinvested in the company, after nearly two years of direct negotiations and public controversy over the terms of the deal, leading to the Prime Minister’s resignation. The government provided US$324 million in long-term financing and US$75 million in loan guarantees to the company. Moreover, the government pledged additional guarantees of US$118 million to finance a US$700 million prospective investment program. The refinery requires substantial modernization and investment to produce products suitable for the Western European markets and broaden its sales base. In 2000, MN experienced disruptions in oil supplies from Russia, its main supplier, forcing the refinery to work substantially under capacity. In June 2001, MN was able to secure long-term crude oil supplies from the Russian company Yukos. A key prerequisite for MN to arrange financing for the company’s modernization plans is secure long-term supplies. The government approved the general terms of the agreement with Yukos, and it is currently analyzing the details.

Gas

Lithuania’s natural gas transmission and distribution network is operated by Lithuanian Gas (LG), which is 92.4 percent owned by the government. The main supplier of natural gas is Russia. The transmission network is connected to Latvia, Belarus, and the Kaliningrad region of Russia. As in the case of the LPC, the financial situation of the company was affected by tariffs kept below production costs, but the situation improved after tariff increases in January 2000. LG is currently being restructured and is set to be privatized in the second half of 2001.

Outstanding issues

Considerable progress has been achieved in commercializing the energy sector, strengthening operations, and creating appropriate regulatory institutions, but a number of important issues remain to be solved. First, a strategic western investor has so far entered only the oil sector, and the agreement with Yukos represents a first step in securing supplies. However, there is an urgent need to proceed with the modernization of the refinery, but this will be costly and risky. If it is not done properly, it will entail considerable financial risks to the government. Second, in gas and electricity, strong political commitment will be needed to complete in 2001-02 the privatization of gas and electricity distribution and generation, which could bring major foreign investors. A decision on how to split tariffs of generation, transmission, and distribution of electricity also needs to be made. In addition, the Belarusian debt problem needs to be solved, and new arrangements for exports to Belarus have to be closely monitored to ensure that no new arrears are incurred. Third, in order to complete EU accession negotiations in 2002, a decision must be taken next year regarding the closure of the INPP, with important implications for production and exports in the long run. Energy alternatives exist, but they could be very costly and adversely affect energy prices. The country could import from Russia and Western European countries, in which case new infrastructure and grid interconnections should be put in place. Lithuania could retain self-sufficiency by utilizing the full capacity of Its existing, but largely idle and obsolete, hydroelectric and thermal power stations, but that would require important new investments. The country could build a new nuclear unit in accordance with western standards; it would be a very costly solution in the short run, but with lesser effects on electricity prices than under other options in the long run.

Table.

Lithuania: Importance of the Energy Sector in GDP, 1997-99

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Source: Lithuanian authorities.

III. The program for July 2001-December 2002

A. Objectives and Policies

15. The new program aims at maintaining macroeconomic stability, strengthening external viability, and facilitating private activity. These efforts would help prepare Lithuania for an early accession to the EU and, over the medium term, to attain higher and more sustainable growth, greater employment opportunities, and increased welfare for the Lithuanian population.

16. The program is based on a strategy of maintaining the currency board arrangement, and continuing the fiscal consolidation effort, together with advancing the remaining key structural reforms. The authorities announced that there will be a switch of the anchor currency under the currency board arrangement (CBA) from the dollar to the euro on February 2, 2002. The fiscal consolidation will target a budget deficit reduction path to support the CBA and maintain external viability, with the aim of reaching a balanced budget by the time of EU accession. Fiscal policy will need to balance plans for rationalizing the tax structure with new expenditure obligations, financing of pension reforms, stabilization of municipal finances, and expenditure restucturing in health and education. Structural reform efforts will focus on addressing remaining fiscal structural weaknesses, continuing financial sector reform, improving the business environment, enhancing labor market flexibility, and completing the privatization program.

B. Macroeconomic Outlook

17. After the large fiscal and external adjustments in 2000, macroeconomic policies in 2001-02 aim at maintaining low inflation, and keeping the external current deficit at a sustainable level, supporting the economic recovery (Tables 1- 3). Real GDP is expected to grow by 3.6 percent in 2001 and 4.7 percent in 2002, reflecting a recovery of domestic demand and continued good export performance. Private consumption and private investment are projected to increase from 64.3 percent of GDP and 18.7 percent in 2000, respectively, to 65.3 and 20.1 percent in 2001, respectively, and further in 2002 to 65.8 and 20.3 percent, respectively. The pick-up of domestic demand in 2001 would lead to an increase in imports and a slight widening of the external current account deficit in 2001 (to 6.7 percent of GDP). Subsequently, the current account deficit would start to slightly decline again in 2002, due to sustained export growth, a more business-oriented regulatory environment, and a deepening in structural reforms. The targeted fiscal adjustment will help contain domestic demand, thereby underpinning the projected current account deficit path. Foreign direct investment (FDI) is projected to increase significantly in 2001-02, as several major privatization projects are to be completed during this period. Access to capital markets on favorable terms is expected to continue, and external debt ratios would remain moderate and stable.

Selected Macroeconomic Indicatos, 1999-2005

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18. The projected economic growth path of 5-6 percent annually for the period 2003-05 (Tables 3 -5 and Appendix V) would be underpinned by determined implementation of structural reforms which, together with a possible early accession to the EU, would make Lithuania more attractive for foreign investors and boost confidence in the economy further, thus leading to continued export growth and a further stimulation of domestic demand. The external current account would remain broadly unchanged at around 6 percent of GDP by 2005, supported by the maintenance of fiscal discipline, as well as further improvement in Lithuania’s competitiveness brought about by structural reforms. The projected current account deficit path, while showing a small adjustment in 2001-05, is consistent with a further strengthening of external viability as reflected in a decline of debt ratios. This decline would result from a combination of rapid economic growth and moderate increases in nominal debt, attributable to a large share of FDI in external financing and access to foreign financing at low spreads. Inflation would remain at 2-3 percent. National saving would increase from about 15 percent of GDP in 2000 to more than 17 percent in 2005, owing to further fiscal consolidation, and an increase in private saving, in response to pension reform and availability of a wider array of saving instruments with further progress in the sophistication of the banking system and capital markets.

C. Exchange Rate and Monetary Policies

19. The currency board will continue to anchor macroeconomic policies, providing a stable monetary framework, helping to keep inflation low and bolstering confidence. The public announcement of the repegging, made seven months in advance, should give adequate time to the private sector to minimize their risk exposure to changes in the dollar/litas exchange rate after the switch. Moreover, given the history of currency changes leading to an erosion of savings, the BoL considers that the transparency of their plans for the switch should help maintain confidence in the CBA. In the coming months, the BoL will take preparatory steps for the repegging, according to a carefully laid out timeline, and conduct a comprehensive public relations campaign to keep the population fully informed of the process and minimize uncertainties.

20. Continued monetization is expected during the program period, given the strong confidence in the CBA (Table 4). In 2001, broad money is projected to grow at about 8.9 percent, with some further decline in velocity. Credit to the private sector is envisaged to grow by 9.5 percent, as business opportunities increase, and the banking sector becomes more competitive in the wake of privatization. No reductions are envisaged in the required reserve ratios at this time, since the banking system appears sufficiently liquid and loan/deposit interest spreads are falling.

21. Following the shift of the Treasury accounts from commercial banks to the central bank, greater coordination between the BoL and the Treasury to minimize liquidity fluctuations in the banking system is required. Given the ample liquidity, the system was able to handle the once-and-for-all liquidity contraction. In addition, the BoL intends to create appropriate conditions for enabling banks to cope with liquidity fluctuations associated with Treasury operations. The BoL will examine the efficiency of both the interbank market and foreign exchange markets and consider measures to improve their functioning, such as streamlining and standardizing the current cumbersome collateral requirements in the interbank market, and reducing transaction fees imposed by the BoL in its dealings with commercial banks in the foreign exchange market. At this juncture, the BoL plans to keep interventions in the interbank market at a minimum, consistent with the spirit of the CBA.

D. Fiscal Policy

22. The government’s medium-term objective of achieving a structural balanced budget by the time of EU accession, excluding the cost of the pension reform, will help boost the credibility of the CBA, contribute to a reduction in interest rate spreads, and underpin the projected current account deficit adjustment. To carry out the fiscal deficit adjustment and create favorable conditions for sustainable employment-generating growth, there is a need for expenditure restructuring and tax reform. The amount of revenue losses stemming from the tax reform, however, would have to be limited by the need for continued fiscal adjustment and new expenditure cornmitments, including the cost of EU and NATO accession (MEP, paragraph 11).

23. The government sees a need for a comprehensive tax reform, in order to: (i) stimulate employment-generating growth; (ii) make Lithuania’s tax system compliant with EU requirements; (iii) provide municipalities with their own sources of revenue to strengthen their revenue base and provide incentives for sound financial management; (iv) align capital taxation with EU practices; and (v) eliminate a number of loopholes from the existing tax system. The new government preliminary proposal on the tax reform for 2002 is in line with the staff recommendations and includes an increase of the tax exempt minimum (TEM), changes to the corporate income tax (CIT), and alignment of consumption taxes with EU requirements (MEP, paragraph 10). The new government is working on the details of the tax reform. As regards the medium term, it is important that the reform be consistent with medium-term fiscal viability and expenditure cornmitments (a possible package of tax measures recommended by the staff is presented in Appendix V).

24. The fiscal deficit for 2001 of 1.4 percent of GDP remains appropriate (Table 2). The revised national budget approved by Seimas in July increased both revenue and expenditure targets by LTL 80.3 million (0.2 percent of GDP), while keeping the budget deficit target unchanged. The national budget revenue target has been revised mainly on account of already realized higher nontax revenue. If revenue performance did not meet expectations later in the year, the government is committed to cut back expenditure in order to meet the budget deficit target. Moreover, the operations of the HIF will be rationalized as described in the MEP (paragraph 16). The authorities intend to resist strong pressures for additional expenditure, making sure that all expenditure cornmitments are reflected in the budget, and redoubling their efforts to collect debt payments from their debtors. Thus, the program targets include ceilings on domestic and foreign debt guarantees to limit the government’s exposure to contingent liabilities. In this regard, the government might be obliged to provide further guarantees for the investment by the Mazeikiu Nafta Oil Company as stipulated by the privatization agreement (Box 3). In light of recent developments regarding long-term oil supplies, this obligation appears less needed and the government will make its best effort to refrain from providing these guarantees.

25. The fiscal deficit target for 2002 of 1.3 percent of GDP reflects a balance between a number of considerations. On the one hand, the commitment to continue fiscal adjustment is particularly important in the run-up to the repegging to boost credibility of the CBA. On the other hand, after the sharp adjustment in 2000-01, the deficit reduction in 2002 could only be gradual, given the short-run costs of the first stage of the tax reform, increased expenditure related to EU accession, education, defense and environmental commitments, and the need to maintain an adequate level of essential government functions.

26. General government revenue is likely to decline in 2002 by 1.5 percent of GDP, with one percentage point attributable to slow growth of non-tax revenue and the payroll and PIT tax base and 0.5 percent attributable to the government’s plans to: (i) increase the TEM of the PIT from LTL 214 to LTL 250; (ii) reduce the CIT from 24 to 23 percent and introduce accelerated depreciation in some cases, while eliminating most exemptions and tax breaks; and (iii) realign consumption taxes with a view to bringing them in line with EU requirements (MEP, paragraph 13). Since the tax reform measures need to be approved by Seimas, the final package could be somewhat different, hi that case, the government will propose additional revenue or expenditure measures to reach the targeted fiscal deficit.

27. Although expenditure will remain constant in real terms, the estimated revenue losses relative to GDP will necessitate some expenditure cuts and reallocation. The bulk of expenditure adjustments will fall on the state budget. The state budget will have to compensate municipalities and the HIF for the loss of some PIT revenues (0.2 and 0.1 percent of GDP, respectively). In addition, the operations of the road program will have to be streamlined due to the projected loss of revenue on account of the phaseout of the gross turnover tax. Finally, the state budget will have to cut expenditure by an additional 0.5 percent of GDP to offset losses from the nontax revenue and the implementation of warehousing procedures for excises. Despite a further projected decline of the payroll tax relative to GDP, the deficit of SoDra is projected to decline on account of slow expenditure growth under the current benefit structure.

28. Financing needs in 2002 should be met comfortably, given a substantial lengthening of maturities and deepening of the domestic market for government securities and access to international capital markets on favorable terms. The government plans to tap international capital markets in 2002, to refinance $200 rnillion of the maturing 1997 eurobond. Hence, there is a need to maintain credibility to preserve favorable access.

E. Structural Reforms

Fiscal Sector Reforms

29. The authorities intend to address the structural causes of municipal expenditure arrears. First, draft amendments on the Law on the Methodology of Establishment of Revenues of Municipal Budgets will seek to determine better municipal functions and the funding of state-mandated obligations. Second, the government plans to prepare a comprehensive set of measures in order to overhaul municipal finances by the time of the completion of the first review. Such measures would have to identify new sources of revenue and link any bailout by the state to the implementation of arrears clearance plans. In this connection, the State Auditor will be asked to conduct a performance audit of some municipalities, estimate the amount of arrears related to unfunded obligations, and recommend solutions.

30. The government plans to implement measures to eliminate the existing stock of municipal arrears. First, a Cabinet level cornmission will monitor the arrears situation on a monthly basis. Second, additional financial transfers to municipalities to help clear expenditure arrears will be conditional on the actual progress in arrears clearance (MEP, paragraph 15). The staff underscored that the government will have to refrain from any unconditional bail-outs of municipalities to eliminate the problem of moral hazard.

31. The government will prepare legislation for the upcoming pension reform, introducing a three-pillar pension system (MEP, paragraph 17). As soon as Seimas has passed the reform of the pension system, the government will submit to Seimas a draft amendment to the current Law on Social Security to allow funds to be channeled to the second pillar, and a draft law authorizing private pension funds to manage the accumulated resources under the second pillar. In addition, by end-September the government will submit to Seimas a draft amendment to the law on privatization to institute the Reserve Stabilization Fund (RSF) and by end-November the government will approve the regulations for the RSF in line with the July 2000 Fiscal Affairs Department TA mission recommendations (MEP, paragraph 17). Finally, the government will maintain the improved financial position of SoDra and take steps to reduce eligibility for state pensions paid directly by the state budget

32. The government will further strengthen tax administration and improve administrative capacity and fiscal transparency. The government will resubmit to Seimas a new draft Law on merging the SoDra’s payroll tax collection unit with the STL Moreover, EU grants and the needed cofinancing will be included in the 2002 draft budget. Furthermore, control over appropriation managers will be strengthened through monthly monitoring with a view to establishing better expenditure controls and avoid the accumulation of the central government arrears. Finally, the government intends to request a Report on Observance of Standards and Codes (ROSC) to review its current practices and define ways of improving fiscal transparency (MEP, paragraph 19).

Financial Sector Reforms

33. The authorities will take additional steps to strengthen the banking system, and reduce government involvement further, including by privatizing the Agricultural Bank (MEP, paragraph 25). To complete the legal framework for financial markets, the government will prepare regulations for the implementation of several financial sector laws and amendments to laws recently passed by Seimas. The latter include the amendment to the Commercial Banking law to speed up liquidation of banks undergoing bankruptcy, the amendment to the Pension Fund law to liberalize conditions for the establishment of the voluntary third pillar, and the Insurance law, which establishes similar requirements for foreign and local entities in line with EU regulations. In addition, the authorities have recently submitted to Seimas the amendment to the Securities Insurance law to increase investor protection, and the General Financial Institutions law. The government will follow closely the recommendations of the Financial Sector Assessment (FSAP) mission scheduled for the second half of this year, to assess the legal framework and to improve banking supervision and financial sector efficiency.

Other Reforms

34. Further progress in structural reforms and improving the business climate are key to ensuring an environment conducive to private activity and attracting FDI. Important measures are being undertaken by the authorities in these areas, (MEP, paragraphs 20 and 23), notably continuing privatization of small and large public enterprises, including Lithuanian Airlines; steps to facilitate and enhance business activity, including cutting red tape and facilitating the functioning of currently well-performing enterprises through the revision of procedures for tax arrears write-offs and deferrals accumulated during the Russian crisis (MEP, paragraph 18); and simplification of the restitution of land ownership rights. In addition, despite difficulties and delays in the last months, the government remains committed to make every effort to enhance the efficiency in the energy sector, through the restructuring of the LPC and subsequently the privatization of distribution and generation companies, and the privatization of the Lithuanian Gas Company (MEP, paragraph 24). In all its privatization efforts, the government remains committed to ensuring a transparent process.

35. To reduce unemployment in the medium term, the government will continue to foster labor market flexibility through measures such as short-term contracts and eliminating mandatory minimum number of working hours. To help the unemployed find jobs, the government will continue to finance well-targeted job training programs geared to meet private sector needs. In addition, to codify the existing regulations, a draft Unemployment Insurance law and Labor Code will be submitted to Seimas (MEP, paragraph 22). Since the high unemployment rate is largely of a structural nature,6 related to skill mismatches and limited geographical mobility, its reduction is likely to be only gradual, and the government will seek to improve and target better the existing social safety nets (unemployment benefits, family benefits and social benefits for low-income families), in order to help the long-term unemployed maintain a minimum standard of living.

36. As regards agriculture, further progress is needed to restructure the state food market regulatory agency, which has suffered losses on grain procurement, storage and export operations, limiting the availability of funds for projects that could receive EU SAPARD cofinancing. Priorities for rural development projects include employment diversification and extension of infrastructure (communications, utilities, roads and water supply). The lack of constitutional amendments providing for land ownership by domestic legal entities—including banks—continues to limit development of land and credit markets.

37. Lithuania has made rapid progress in its EU accession negotiations which were initiated in 2000. The authorities are aiming to close all chapters of the EU Acquis Communautaire by end-2002, hoping to join the EU in the first enlargement wave in 2004. The pace of negotiations has accelerated in recent months: 18 of the 29 negotiation chapters plus two appendixes have been closed; additional chapters could be closed by end-2001. However, the EU Commission recently expressed its concern over delays in the energy sector restructuring and insufficient progress in the distribution of EU funds, warning that these issues, if not addressed promptly, might affect the chance of joining the EU in the first wave.

38. Lithuania’s statistics are generally adequate for conducting effective surveillance and macroeconomic analysis. The authorities have subscribed to the SDDS since May 1996. While some weaknesses in national accounts and balance of payments statistics remain, improvements are being made with technical assistance from various organizations including the Fund. As compilation standards strengthen, some data series may be subject to later revisions. The improvement to the compilation of government finance statistics remains a priority under the program.

IV. Program Monitoring, Access Under the SBA, and Capacity toRepay the Fund

39. Program implementation will be monitored through a set of quarterly quantitative performance criteria and indicative benchmarks (MEP, Tables 1 and 2), and a set of structural benchmarks (MEP, Table 3). These performance criteria and benchmarks were selected on the basis of their relevance for achieving the program’s objectives of maintaining macroeconomic stability and accelerating key structural reforms. The first program review, expected to coincide with the 2001 Article IV consultation discussion and to be concluded by end-December 2001, will be based on the end-September 2001 outcomes. At that time, performance criteria and possible additional structural benchmarks for end-March and end-June 2002 will be established. Performance criteria for end-September and end-December 2002 and possible additional structural benchmarks will be specified at the time of the second program review, which will be based on the end-March 2002 outcomes and is scheduled to be completed by June 2002. The last program review will be based on the end-September 2002 outcomes and is expected to coincide with the 2002 Article IV consultation discussion and to be concluded by end-December 2002.

40. Under the program, the proposed access of SDR 86.52 million (60 percent of quota) for a 19-month SBA would contribute to enhance market confidence in the run-up to the repegging. Seven equal purchases of amounts equivalent to SDR 12.36 million would be available, the first one upon Board approval, and then six quarterly purchases (Table 6). The authorities do not intend to draw and would treat the arrangement as precautionary, as was the case with the previous one, unless a financing need were to emerge in the event of adverse external shocks.

41. In view of Lithuania’s good track record in servicing its obligations to the Fund, it is expected that all future payments will made according to schedule. The current debt owed to the Fund is only 3 percent of total debt hi the event the authorities chose to make all available purchases, Lithuania’s debt service to the Fund would peak in 2005, but would only account for slightly over one percent of exports (Table 7).

42. The authorities have submitted to the Fund the necessary documentation for the safeguards assessment, which is currently under review.

V. Staff Appraisal

43. Lithuania made remarkable progress under the program supported by the previous stand-by arrangement. As a result of the authorities’ efforts, the budget and external current account deficits declined sharply; real GDP growth resumed; inflation remained subdued; structural reforms advanced, and confidence in Lithuania’s policy making was restored, allowing for continued access to domestic and international capital markets at declining spreads. Significant progress was also registered on EU accession negotiations, hi spite of this progress, some areas of weakness remain. Unemployment is still high, and social safety nets need to be reinforced. Moreover, the finances of municipalities and the HIF should be strengthened and adrninistrative capacity of public institutions should be improved. Further improvements to the business environment and greater labor market flexibility are needed, in order to promote higher rates of growth, domestic and foreign investment, output, and employment creation. Insufficient progress was made in restructuring the energy and agricultural sectors.

44. The new program aims to build on the successes of the previous program, while addressing the unfinished reform agenda. Preserving macroeconomic stability will bolster credibility in the run-up to the repegging of the litas, and an acceleration of structural reforms will help promote private activity, leading to higher growth and employment creation. Such an acceleration is crucial if Lithuama wants to conclude accession negotiations with the EU in 2002, and to join in the first wave of enlargement. Although Lithuania’s external vulnerability has been reduced, the staff cautions against policy slippages or a loss of the reform momentum, which could lead to a rapid change in market perceptions.

45. The cornerstone of the authorities’ strategy continues to be fiscal restraint, after the substantial fiscal consolidation achieved so far in 2000-01. A further sizable reduction in the overall deficit of the general government is targeted for 2001. The prospect for an accelerated recovery in 2001 is expected to result in a somewhat more favorable revenue performance, thus helping the authorities to achieve their ambitious targets. The staff welcomes the authorities’ commitment to achieve the deficit target and to take any needed additional measures later in the year to this end.

46. In the staff’s view, the 2002 budget target achieves a good balance between the need to maintain a prudent fiscal stance in advance of the repegging of the litas, contributing to enhance confidence in economic policies, and to leave room for financing new expenditure demands, including the potential costs of EU and NATO accession. On the expenditure side, as there may be little room for further cuts if essential services and social expenditures are to remain adequate, the staff urges the authorities to pursue expenditure rationalization and to improve the effectiveness of public administration.

47. The fiscal stance should be assessed in a medium-term context The staff welcomes the authorities’ approach of preparing a medium-term fiscal framework, determining priorities and seeking ways to achieve the medium-term goal of a balanced budget. The staff supports the authorities’ objective of simplifying and making the tax system more transparent, bringing it in line with the EU, but considers there is limited scope for measures that would entail large and immediate revenue losses. A gradual phasing of tax reforms over several years would alleviate the tax burden and promote economic growth, while remaining consistent with the expenditure and fiscal balance objectives. In this connection, the staff welcomes the government’s decision to reduce slightly the CIT in 2002, while easing somewhat the tax burden on labor by increasing the tax exempt minimum for the PIT. Finally, ensuring an effective use of EU cofinancing to support public investment will be key for the achievement of medium-term fiscal objectives.

48. The authorities should continue to implement fiscal reforms. Despite significant progress in improving budget transparency and tax administration, as well as major measures leading to the improvement of the financial position of SoDra, the growth of municipal arrears and the persistence of a small amount of arrears of the central government are worrisome. Prompt corrective actions in this area are required. In this regard, the staff urges the authorities to proceed with the reform of municipal finance, which may take time if the structural causes of the arrears problem are to be effectively addressed, while refraining in the meantime from unconditional bailout or offset operations. Expenditure control and budget management should also be strengthened to eliminate arrears at the central government level. Other important areas of reform are the finances of the HIF and the Road Fund. The staff welcomes the progress in preparing for the pension system reform, to be implemented as of 2003, and supports the authorities’ view that it should be financed by privatization proceeds at the early stage, through the newly established RSF. In view of financial constraints, the staff supports the authorities’ commitment to limit cash outlays for the savings and land restitution programs during the program period, and devote more resources to finance future costs of the pension reform and debt repayments.

49. The staff endorses the authorities’ intention to switch the peg of the litas to the euro, with a view to moving smoothly toward greater economic integration with the EU area, while preserving the credibility of the currency board. The staff shares the authorities’ view that the currency board has constituted a linchpin of stability for macroeconomic policies, providing an incentive to adjustment and an effective defense against spending pressures and populist programs. The staff supports the authorities’ plans to make the repegging process as transparent as possible, and urges the authorities to continue policies that minimize uncertainty and buttress credibility. The authorities are mindful of the risk of a relatively weak euro at the time of the switch. In such circumstances, for the economy to adjust to the new peg without undue output losses, further structural reforms and productivity growth are needed to speed up real convergence with the EU through real appreciation rather than domestic inflation. For the future, the viability of the currency board will hinge on continued fiscal restraint and a strengthening of external competitiveness.

50. Regarding the shift of the Treasury accounts from the commercial banks to the BoL, the staff would like to underscore the importance of ongoing efforts to improve forecasts and coordination of Treasury flows, as well as the functioning of the interbank and foreign exchange markets, so as to prevent excessive volatility of liquidity, especially in the context of the CBA.

51. While macroeconomic performance was better than expected, progress in structural reforms remained mixed. On the one hand, important measures were passed by Seimas in order to promote labor market flexibility and facilitate enterprise restructuring. In this regard, the authorities are encouraged to continue to implement the recommendations of the sunrise and sunset commissions and make further steps in deregulating the business environment so as to promote investment and employment over the medium term. In addition, improvements in the business and regulatory environment should be underpinned by an effective implementation at the administrative level. Privatizations of the Savings Bank and LISCO were successfully concluded. In this regard, the staff welcomes the authorities’ determination to conduct the privatization process transparently, without preferential treatment to individual investors, which is critical for governance and to gain public support for these policies. On the other hand, progress in energy sector reforms and agriculture was disappointing, leading to delays in the disbursements of the second tranche of the World Bank SAL. Thus, looking ahead, the staff urges the authorities to implement structural reforms in these areas more decisively in the coming months. Further delays in the restmcturing of LPC and the privatization of Lithuanian Gas as well as in the reform of the agricultural sector could jeopardize Lithuania’s ambitious timetable for EU accession. In addition, reform of the state food market regulatory agency is needed.

52. The program targets are achievable but, nonetheless, the authorities’ strategy has risks. First, in the context of the currency board, the strategy hinges crucially on stringent fiscal discipline, with little room for slippages. For the fiscal targets to be met, the government will need to resist pressures to increase spending or to provide support or tax benefits to certain sectors, while proceeding cautiously with tax reforms so as to avoid unaffordable revenue losses. Second, passage of a very large number of key legislative proposals by Seimas—in particular those pertaining to energy privatization and tax reforms—is essential to enable reforms to proceed during 2001-02. The government needs to persevere with some difficult reforms in these areas, and to obtain necessary support in Seimas. Third, adverse external developments may also pose additional challenges for economic policy-making, creating additional uncertainties in the run-up to the repegging. A slowdown in partner countries’ growth may exert a negative impact on Lithuania’s ongoing recovery. A further sharp appreciation of the dollar could have an adverse effect on competitiveness and growth. Moreover, pressures in international financial markets might limit the government’s access to foreign financing on favorable terms, driving up debt servicing costs. In that event, the government would have to stand ready to tighten the policy stance, while continuing structural reforms to promote competitiveness and employment-creating growth.

53. Nonetheless, the staff considers that the authorities’ program is strong. The swift endorsement by the new government of the MEP and the package of reform measures, as well as its determination to adhere to ambitious fiscal deficit targets, harnessing broad-based parliamentary support for the goal of EU accession, are reassuring. Overall, macroeconomic conditions are improving and the policy stance remains appropriate. The staff is confident that the authorities stand ready to modify polices promptly and appropriately in response to adverse external or domestic shocks. The staff also trusts that the authorities will make their best efforts to speed up the implementation of their structural reform and privatization programs. Thus, the staff would recommend the approval by the Board of the new stand-by arrangement.

Table 1.

Lithuania: Selected Macroeconomic Indicators, 1998-2002

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Sources: Lithuanian authorities; and Fund staff estimates and projections.

GDP for 1999 has been substantially revised by the Statistical Office since EBS/00/28 has been published.

Registered unemployment, end-of-period.

Gross official reserves reported here differ from the monetary survey because they include reverse repos involving major currencies in both legs.

External liabilities minus equity investment in Lithuania.

CPI-based, trade-weighted real exchange rate against 21 major trading partners in 1999.

Dec. 2000 is adjusted for LTL 270 million of DMB’s reclassified loans. If included, private sector credit would fall by 6.1 percent.

Table 2.

Lithuania: Summary of Consoladated General Government Operations, 1998-2005

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

From 2000 onward, 5 new extra-budgetary funds, which had not been reported before, were added.

Fees paid to educational establishments and their spending (LTL 128 million) were added to general government operations from 2001 onward.

Payroll tax contributions outside the general government are reduced by about 0.8 percent of GDP, due to the pension reform from 2003 to 2005.

Including payments by the general government o f mandatory pension contributions to the second pillar of about 0.2 percent of GDP from 2003 to 2005.

Interest payments do not include provisioning of defaults, which are reflected under “net lending”.

Reflects the operations of the Treasury, Privatization Fund, and prospective Reserve Stabilisation Fund. Net withdrawals from the latter contribute to finance the pension reform from 2003 onwards.

Table 3.

Lithuania: Balance of Paymetits, 1998-2005

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

Gross official reserves reported hers differ from the monetary survey because reverse repos involving major currencies to both legs are included.

External Habililiair minus equity investment.

Debt service comprises interest and gross repayment on external loans, and interest and net repayment on debt securities.

Total external liabilities minus total external assets, excluding foreign direct investment and reserve assets.

Table 4.

Lithuania: Summary Monetary Account, 1998-2002

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Sources: Bank of Lithuania; and Fund stall estimates and projections.

Excludes local government deposits; includes counterpart funds.

Projections for 2001 onwards include Treasury accounts, which will be moved from commercial banks to the BoL by end-June, 2001.

December 5000 is adjusted far reclassification of LTL 270 million of DMB’ ckinis mi private sector to government lending funds, which were removed from balance sheets in july 2000. If included, private credit would fall by 6,1 percent in 2000.

Only annual average velocity is reported at year-end.

Gross official reserves far historic data differ from BOF lable because exposure under reverse repos was not reflected either in foreign assets or liabitilies al the time a fine program design, For projections, assumption is that all reverse repo transactions are unwound.