Republic of Lithuania: Staff Report for the 2003 Article IV Consultation

Lithuania showed strong economic growth with low inflation owing to its sound economic policies. Executive Directors commended this development, and appreciated Lithuania for signing the European Union Accession Treaty. They encouraged the authorities to maintain macroeconomic stability and accelerate structural reforms. They welcomed the efforts of the Bank of Lithuania to implement Financial Sector Assessment Program recommendations. They emphasized the need for energy and transport privatization, the modernization of the agriculture sector, and streamlining of the legal framework to enhance transparency, governance, and the overall business environment.

Abstract

Lithuania showed strong economic growth with low inflation owing to its sound economic policies. Executive Directors commended this development, and appreciated Lithuania for signing the European Union Accession Treaty. They encouraged the authorities to maintain macroeconomic stability and accelerate structural reforms. They welcomed the efforts of the Bank of Lithuania to implement Financial Sector Assessment Program recommendations. They emphasized the need for energy and transport privatization, the modernization of the agriculture sector, and streamlining of the legal framework to enhance transparency, governance, and the overall business environment.

Lithuania: Basic Data

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Sources: Lithuanian authorities; and Fund staff estimates.

Data as of 2001.

Average wags deflated by consumer price index.

Figures for 2001 and 2002 reflect a downward revision of the estimated population.

Calculated on the basis of registered unemployment; period average.

Average annual interest rate on loans in domestic currency; period average.

There is a break in series beginning in 1998 when a new classification of fiscal account was implemented.

Including the discrepancy between monetary and fiscal data.

I. Introduction

1 In the space of a few years, Lithuania has transformed its economy and is poised to join the EU in May 2004, after the favorable results of the referendum last May. Lithuania’s efforts since 2000, under two successive Stand-by arrangements (SBA), have left its economy well placed to rise to the challenges of EU accession. Prudent macroeconomic policies—in particular fiscal consolidation—and a significant breakthrough in structural reforms delivered macroeconomic stabilization, high growth, and low inflation; restored external viability and credibility; and placed the country in the first wave of EU accession. The policy discipline maintained to support the currency board arrangement (CBA) has contributed to macroeconomic stability, and its continuation will be key to ensuring a smooth and fast transition to the adoption of the euro. In 2003-04, a prudent fiscal stance, consistent with EU commitments, is required to bolster the CBA’s credibility, attract FDI and reinforce sustainability. The increase in EU-related expenditures will make the maintenance of such a stance more challenging, however, and additional pressures may arise in connection with the October 2004 parliamentary elections. Structural reforms must be pursued in earnest to increase competitiveness, foster growth, and preserve social support for the reforms.

II. Recent Economic And Policy Developments

2. The Lithuanian economy is enjoying a broad-based economic expansion with very low inflation. Real GDP grew by 6.7 percent in 2002 and by 9.4 percent in the first quarter of 2003. Since the 1999 recession, economic growth has gradually become more balanced (Text Table 1, Table 1, and Figures 1-2). Supported by intense construction activity, investments continue to be a major source of growth, while consumption has gradually accelerated. This reflects higher household income following a gradual decline in unemployment and a pick-up in wage growth from close to zero in 2000-01 to about 5 percent during 2002. Exports continued to perform remarkably well in spite of the appreciation of the nominal effective exchange rate and the persistent softness of the EU economy, as the investments of recent years are loosening capacity constraints. The trade balance, however, remained broadly unchanged, as imports grew in step with exports. Inflation is virtually absent, with the CPI index falling by 0.9 percent in the 12 months to May 2003, reflecting cheaper imports and downward price pressures from increased competition and higher productivity. In these circumstances, wage growth slowed to 3.4 percent in the year to end-March 2003, and indications are that unit labor costs are falling even in the non-tradable sector. This was coupled with a further drop in the unemployment rate to a four-year low of 9.4 percent in June.

Text Table 1.

Selected Macroeconomic Indicators, 1999-2003

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

The figure for the unemployment rate refers to June 2003.

Growth rates for the first quarter of 2003 are based on a comparison with the first quarter of 2002.

Beginning in January 2003, the estimate of the labor force was revised downward causing a one-time increase in the unemployment rate of 0.8 percentage points.

After 1999, data exclude salaries of owner-operated enterprises.

In percent of annual GDP. The figures for 2003 include the early repurchase of Lithuania’s EFF by the BoL in net lending, which reduces the annual deficit by 0.3 percent of GDP.

Table 1.

Lithuania: Selected Macroeconomic Indicators, 1999-2004

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

Registered unemployment, end-of-period. The figure for 2003 Q1 refers to June.

The figures for 2003 include the early repurchase of Lithuania’s EFF by the BoL in net lending.

Gross official reserves reported here differ from Table 2 due to valuation differences.

External liabilities minus foreign equity investment in Lithuania.

CPI-based, 2000-01 trade-weighted real effective exchange rate against 21 major trading partners.

December 2000 is adjusted for reclassification of LTL 270 million of DMB’s claims on private sector, which were removed from balance sheets in July 2000. Also, December 2001 numbers have been adjusted to reflect LTL 785 million of reclassified assets in July 2001.

Figure 1:
Figure 1:

Contributions to Real GDP Growth, 1998-2002

Citation: IMF Staff Country Reports 2003, 295; 10.5089/9781451824056.002.A001

Figure 2.
Figure 2.

Macroeconomic Indicators, 1996-2003

Citation: IMF Staff Country Reports 2003, 295; 10.5089/9781451824056.002.A001

3. Reflecting the litas’ real appreciation and faster growth than in partner countries, the external current account deficit widened somewhat in 2002, to 5.3 percent of GDP from 4.8 percent in 2001 (Table 2). This development does not raise competitiveness concerns so far, given the impressive export performance, with substantial gains in market shares (Figure 3). Also, the fast growth of imports was the result of strong private investment, with the share of capital goods in imports rising from 14 percent to 18.5 percent between 2001 and 2002. The current account deficit was easily financed by foreign direct investment (FDI). Net FDI grew by over 60 percent relative to 2001, reflecting ongoing privatization, as well as an expansion of operations by existing foreign investors and new investments induced by sound policies and the prospect of EU accession. Lithuania continued to tap international capital markets on increasingly favorable terms. Following the issue of a €400 million 10-year eurobond in May 2002, in February 2003, the government floated another €400 million 10-year eurobond at a record-low 74 basis points spread, which was trading at a spread of 45 basis points in mid-July (Figure 4).1 Against this background, gross official reserves reached $2.9 billion at end-March 2003 (covering more than 3 months of imports and just under 100 percent of short-term debt, on an original maturity basis, at end-2002). Preliminary data for the first quarter of 2003 show that the current account deficit narrowed to 3.7 percent of quarterly GDP, reflecting an improvement in the trade balance.

Table 2a.

Lithuania: Balance of Payments, 1999-2003

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Source: Data provided by the Lithuania authorities, and Fund staff estimates and projection.

“-” indicates repurchase; “+” indicates purchase.

The 2003 stocks are calculated based on end-2003 exchange rates. Gross official reserves reported here differ from the monetary summary because revenue repos involving major currencies in both legs are included.

External liabilities minus foreign equity investment.

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

Total short-term liabilities minus total short-term assets, on set original maturity basis.

Debt service comprises interest and repayment on external loans, and interest and repayment on debt securities. The peak in 2001-02 reflects large-scale amortization of dollar-demonistrated debt immediately before and after the rapegging of the litas.

Table 2b.

Lithuania: Balance of Payments, 2002-2008

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

“−” indicate repurchase; “+” indicates purchase.

The stocks for 2003 and beyond are bated on end-2003 exchange rates. Gross official reserves reported here differ from the monetary survey because reverse repos involving major currencies in both legs are included.

External liabilities minus foreign equity investment.

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

Debt service comprises interest and repayment an external loans, and interest and repayment on debt securities. The peak in 2001-02 reflects large-scale amortization of dollar-denominated debt immediately before and after the repegging of the litas.

Oil prices for 2003-08 based on WEO baseline projection.

Figure 3.
Figure 3.

Indicators of External Competitiveness. 1996-2003

Citation: IMF Staff Country Reports 2003, 295; 10.5089/9781451824056.002.A001

Figure 4.
Figure 4.

Interest Rate Spreads, 1999-2003

(Eurobond vis-à-vis German benchmark)

Citation: IMF Staff Country Reports 2003, 295; 10.5089/9781451824056.002.A001

4. Monetary and credit aggregates expanded further in 2002 and the first quarter of 2003. Broad money has been expanding rapidly since 2000 due to the improved economic environment and greater confidence in the banking sector. Credit to the private sector started expanding in late 2001, reflecting improved business confidence, a decline in interest rates, and greater competition and efficiency of the newly privatized banks. Broad money grew by 18.2 percent year-on-year by end-May 2003, with monetization gradually converging toward the level of other advanced transition countries, reflecting improved economic conditions and enhanced confidence in the banking system (Table 3, Figures 5-6). Cash in circulation grew significantly, partly reflecting the conversion of dollars into litai, in response to the dollar depreciation. Credit to the private sector expanded rapidly, by 35 percent, albeit from a low base, in response to low interest rates and increased economic activity. The reserve coverage of the currency board remains high at 155 percent at end-May, and interest rates continue to be low, in line with EU rates. Significant progress was made in implementing FSAP recommendations (see Supplement 1).

Table 3.

Lithuania: Summary Monetary Accounts, 1999-2004

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

Excludes local government deposits; includes counterpart funds.

Data for 2001 onwards include Treasury accounts, which were moved from commercial banks to the BoL at end-June, 2001.

December 2000 is adjusted for LTL 270 million of DMB’s claims on private sector, which were removed from balance sheets in July 2000. Also, July 2001 numbers have been adjusted by LTL 785 million of reclassified assets.

Gross official reserves for historic data differ from the BOP table because of valuation differences.

Figure 5.
Figure 5.

Financial Indicators, 1998-2003

Citation: IMF Staff Country Reports 2003, 295; 10.5089/9781451824056.002.A001

Figure 6.
Figure 6.

Monetization and Private Sector Credit in the Baltics, Selected EU Accession Countries, and the Euro Area, 2002

Citation: IMF Staff Country Reports 2003, 295; 10.5089/9781451824056.002.A001

Sources: International Financial Statistics.1/ Includes Czech Republic. Hungary, Poland, Slovak Republic and Slovenia.2/ Private sector credit includes credit to public enterprises and to non-bank financial institutions.

5. The strong fiscal consolidation initiated in 2000 continued in 2002 and in the first quarter of 2003. The general government budget recorded a deficit of 1.2 percent of GDP in 2002 (compared with 2 percent in 2001), and a surplus of 0.8 percent of annual GDP in the first quarter of 2003 (Table 4). In the first quarter of 2003, revenues were broadly in line with the budget, as shortfalls in the corporate income tax (CIT) and other taxes were offset by higher-than-budgeted collection of personal income tax (PIT) and non-tax revenue. Expenditure was lower than budgeted by almost 0.5 percent of GDP, mainly due to savings in interest and low layouts in goods and services.

Table 4.

Lithuania: Summary of Consolidated General Government Operations, 1999-2008

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

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

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

From 2002 onward, fees paid by trucks crossing the borders of the country were added. In addition, following the new organic budget law, revenue of state institutions for provided services was included in municipal budget.

Grants from EU and related expenditures are not included prior to 2002.

For 2001, current expenditure and non-bank financing include LTL72 million of pharmaceutical arrears rescheduled in December 2001 (according to the definition in the SMEP (EBS/01/211)). The entire amount was repaid in March 2002 through a commercial bank loan contracted by the Health Insurance Fund. The latter operations are recorded in 2002Q1 as domestic bank borrowing for LTL 72 million, and amortization to the non-bank sector by the same amount. The terms of the loan include repayments in right equal tranches of LTL 9 million, starting in 2003, with the final payment due on December 31, 2006.

The early repurchase on January 2, 2003, would reduce the 2003 budgeted deficit by SDR 39.244 million, everything else being equal, as this amount, which was previously on-lent to the monetary authorities, is treated as a repayment in net leading.