Public Information Notice No. 01/6

Public Information Notice: IMF Concludes Article IV Consultation with Lithuania

January 22, 2001

On January 10, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Lithuania.¹

Background

Lithuania made significant progress in establishing a market economy since independence was regained in 1991. Even though the radical restructuring and privatization resulted in negative growth for the first three years, the economy rebounded from 1995 on. Macroeconomic policies have been underpinned by a currency board arrangement since 1994, where the litas has been pegged to the U.S. dollar, providing a framework for strong fiscal discipline.

At the end of 1999, in the wake of the Russian crisis, Lithuania was in the midst of both a political crisis, with its third government in six months, and a year-long recession; an unsustainable fiscal expansion contributed to large current account deficits and increased external debt; structural reforms were lagging; confidence in the currency board was eroded, and access to capital markets became difficult. Local and parliamentary elections and a change of government took place in 2000, but the authorities continued to implement firmly their adjustment and reform program throughout the year. As a result, the external current account deficit declined sharply; real GDP growth resumed; inflation remained subdued; and confidence in Lithuania's policy making was restored, allowing for renewed access to domestic and international capital markets at low spreads. Structural reforms advanced significantly, including in energy sector restructuring, privatization, trade policy, deregulation, and budget and treasury management. Significant progress has also been registered on the overarching objectives of EU and NATO accession. The adjustment represented a considerable political challenge, however, with expenditure cuts and utility tariff increases, while the recovery of domestic demand has been slower than expected, and unemployment has reached a very high level.

Real GDP grew by 2 percent in the first half of 2000, and is expected to grow by 2.3 in the year, fueled mainly by export growth, even as domestic demand remained weak. Impressive fiscal adjustment from a deficit of 8 percent of GDP in the first nine months of 1999 to a deficit of 3.1 percent of GDP in the first nine months of 2000 was achieved, in spite of revenue shortfalls from the erosion of the domestic tax base and non-acceptance by Parliament (Seimas) of some expenditure measures. The fiscal deficit is likely to be 3.3 percent of GDP for the year. The strong fiscal adjustment was key to the significant reduction in the current account deficit, which fell from 11.1 percent in the first half of 1999 to 4.2 percent of GDP in the first half of 2000. The faster than envisaged external adjustment was powered by export growth of 28.4 percent in the first nine months of 2000, which indicated sustained external competitiveness despite the continued real appreciation of the litas, and weak import growth. The current account deficit will likely remain under 7 percent of GDP in 2000.

The currency board has constituted a linchpin of macroeconomic stability. Even with a changing political environment, the currency board has encouraged adjustment. Developments in 1999 demonstrated that the credibility of the CBA needed to be underpinned by an appropriate fiscal stance, and any imbalances had to be quickly corrected. Given continued export growth with success of exporters to improve competitiveness and gain market share in the EU, as well as flexible wages, and stable financial markets, the CBA continues to provide a sound anchor for credible macroeconomic policies in Lithuania.

The notable fiscal and external adjustment led to increased confidence in the litas and stabilization of domestic financial markets in 2000, with interest rates declining. Consolidation progressed in the financial sector, as the prudential indicators of the banking system remained adequate as all banks complied with prudential requirements.

Significant progress was achieved in several areas of structural reform. To improve fiscal management, a new organic budget law, which provides for the consolidation of most extrabudgetary funds into the state budget, strengthened expenditure and debt management procedures, and enhanced transparency, was passed by Seimas in July. Privatization moved forward in the telecommunications and banking while progress was made in restructuring the electricity and gas sectors, laying the basis for privatization. In early 2000, a program for the improvement of the business environment was initiated by the Sunrise Commission. The commission prepared a number of programs and draft laws for Seimas approval, with a view to simplifying taxation rules, reducing licensing requirements, revising bankruptcy legislation, rendering the labor market more flexible, and settling issues relating to land ownership and land restitution. Even as subsidies were reduced substantially to the agricultural sector, the World Bank SAL is supporting further ambitious agricultural reform.

All trade restrictions introduced after the Russian crisis in 1998 were removed effective November 1, 2000. Lithuania joined the WTO in December 2000. EU accession negotiations have advanced, with 16 chapters (out of 30) of the Acquis Communautaire being opened, of which five have been completed. The EU accession report of November 2000 gives a positive assessment of Lithuania's progress in this regard.

Executive Board Assessment

Executive Directors were pleased to note that growth has resumed while inflation remains low, the current account deficit has declined faster than expected, financial markets have stabilized, access to capital markets has been restored, and the credibility of the currency board arrangement has been maintained. Directors considered that this commendable improvement in economic conditions during 2000 was attributable in large measure to the determined implementation of an ambitious fiscal adjustment and structural reform agenda. They stressed the importance of maintaining these policies in order to sustain growth, reduce unemployment, and maintain a viable external position over the medium term.

Directors commended the authorities' determined fiscal policies in 2000, which had substantially reduced the general government deficit. Although an even larger adjustment had been programmed, Directors regarded the outturn as appropriate, in light of the faster-than-expected reduction in the current account deficit, revenue shortfalls due to changes in the structure of output, weak domestic demand, and rising unemployment. Directors commended the authorities for taking difficult steps to reduce expenditures, including the passage of a comprehensive package of expenditure measures for the Social Insurance Fund (SoDra).

Looking to the year ahead, Directors considered that the further reduction in the fiscal deficit targeted for 2001—to 1.4 percent of GDP—is consistent with the authorities' macroeconomic objectives. They underscored the need to monitor revenue closely over the year and to improve tax and customs administration. Directors considered that expenditure restraint, especially at the state budget level, will also be necessary to meet the fiscal objectives. They noted that it was possible that improved external competitiveness could result in a stronger fiscal performance than budgeted. Were this to be the case, Directors stressed that any incremental budgetary resources should be allocated with a clear sense of medium-term budgetary priorities, including the need to improve the tax system. Expenditure targets should only be increased in the event that revenue turns out to be consistently and substantially higher than forecast in the first half of the year, the current account deficit is significantly smaller than projected, and the increases are consistent with medium-term fiscal consolidation. They looked forward to the approval by the legislature of a number of fiscal reforms, and stressed the need for timely implementation of plans to clear the arrears of municipalities by mid-2001, and to collect payments on guaranteed external debt from delinquent debtors.

Directors welcomed the authorities' commitment to prepare a comprehensive medium-term fiscal framework and to achieve a cyclically balanced budget by 2003. They emphasized the need for determined policy implementation to achieve this goal, especially in light of the authorities' intention to limit the increase in the tax burden. Directors emphasized that there was little scope for revenue to decline further relative to GDP, given the many medium-term expenditure pressures, including from costs of European Union and NATO accession, as well as pension reform. Any revenue losses from simplification or elimination of taxes should be offset by compensating revenue measures. Many Directors emphasized the need to reduce the burden of payroll taxation, which acted as a deterrent to job creation. They viewed action to redistribute the burden of taxation away from labor income as a priority, especially in view of the level of unemployment.

Directors welcomed the new organic budget law. They encouraged the authorities, building on their progress to date, to complete the modernization of treasury operations by early 2001 and to set up a reserve stabilization fund for transparent management of privatization proceeds by end-March, 2001.

Directors noted that the currency board arrangement has been a linchpin of stability and continues to serve Lithuania well. They fully supported the authorities' intention to maintain the currency board arrangement, and to announce in the second half of 2001 their plans regarding the switch to a euro peg. Directors urged the authorities to monitor closely developments in the balance of payments, financial system, and indicators of external competitiveness, and to stand ready to revise the policy stance if balance-of-payments pressures were to emerge.

Directors commended the authorities for recent improvements in banking supervision, and encouraged the passage of new legislation on the Bank of Lithuania and commercial banks, as well as the Law on Trading of Securities. Directors urged the authorities to complete the privatization of the two state-owned banks as soon as possible to foster competition in the banking system, and create conditions for a revival of sustainable credit growth. Directors welcomed the authorities' request to participate in the Financial Sector Assessment Program.

Directors noted the significant progress made in restructuring the energy sector and privatization of the telecommunications and banking sectors. They urged the authorities to proceed with determination in completing their privatization program, and welcomed their decision to begin the privatization of gas and electricity distribution companies in 2001. Directors also noted that privatization, notably in the energy sector, should be accompanied by establishment of a pricing and regulatory regime.

Directors underscored the need to improve the business environment so as to make Lithuania more attractive to domestic and foreign investors. In this regard, the passage of legislation pertaining to bankruptcy, the labor market, and land legislation should be given priority. Directors considered that structural reforms should also address the problem of high unemployment, including through measures to make the labor market as flexible as possible.

Directors welcomed the authorities' commitment to trade liberalization, and Lithuania's recent accession to the WTO.

Directors commended the authorities' commitment to improve transparency and data dissemination.