Public Information Notice No. 05/46

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with the Republic of Lithuania

March 31, 2005

On March, 23, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Lithuania.¹

Background

Following severe economic difficulties in 1999, Lithuania accelerated its efforts to make a transition towards a competitive market economy. Lithuania acceded to the European Union on May 1, 2004 and entered ERM II on June 28, 2004, as a prelude to possible euro adoption by early 2007. With its accession to the EU, Lithuania has now embarked on another ambitious transition, this time to advanced European living standards. The discipline of the Maastricht criteria has added a further policy anchor to its existing currency board arrangement. This additional anchor is important and effective because of the wide political support for euro adoption.

Impressive growth continued unabated in 2004. GDP expanded by an estimated 6¾ percent in 2004, driven by vigorous private consumption and investment growth. The unemployment rate declined to 10½ percent of the labor force but bottlenecks have developed in certain sectors, exacerbated by migration flows to the EU and the United States. Inflation remained low, with the consumer price index reaching 1¼ percent in 2004. However, increases in excise taxes and energy prices, coupled with strong demand, caused inflation to accelerate rapidly in the second half of the year.

The current account deficit widened in 2004 to about 8½ percent of GDP owing to a deterioration of the trade balance of some 1 percent of GDP. Larger dividends and repatriated earnings on past foreign direct investment aggravated the negative income balance, which also worsened by 1½ percent of GDP in 2004.

With strong economic growth and low interest rates, credit expanded rapidly in 2004. Early in the year, the speed of credit expansion briefly touched 70 percent on an annual basis before coming down to a still high 40 percent. Credit to households expanded at a more rapid rate than to the enterprise sector; however, the bulk of the credit continued to be absorbed by the productive enterprises.

The budget deficit widened appreciably from 1¾ percent in 2003 to 2¼ percent of GDP in 2004, imparting an expansionary fiscal stance. The widening reflected higher-than-expected pension reform costs, discretionary expenditures in the midyear budget and prior to the elections in November, and end-of-year spending on savings and real estate restitution; EU-related cofinancing expenditures played a smaller-than-anticipated role. Higher-than-expected personal and corporate income tax revenues helped contain the deficit; however, the single largest source of revenue, the value-added tax provided receipts that fell short of projections by about 15 percent.

Structural reforms continued in 2004, but deeper reforms remain necessary to keep Lithuania on a real convergence path with the EU. Further changes are needed to improve the financial viability of the social safety and health systems, and to enhance the focus, reduce the gaps, and raise the quality of the numerous social assistance programs. EU funds should be used effectively to help restructure the agricultural sector, and more generally to enhance the supply side of the economy. Continued efforts to make the economy more competitive by improving the business climate are also called for.

Executive Board Assessment

Executive Directors complimented the Lithuanian authorities for the implementation of sound macroeconomic policies and structural reforms. These efforts have helped achieve a lasting transformation of the economy, rapid growth, and low inflation, paving the way to EU accession and continued prosperity. Directors welcomed Lithuania's entry into ERM II and noted that the economy appears broadly on course to meet the Maastricht criteria and adopt the euro in early 2007.

Directors cautioned, however, that challenges remain for both the near- and the long term. A variety of indicators suggest limited slack in the economy. The current account deficit has widened appreciably in 2004 and is forecast to deteriorate further. Inflation, though low, has accelerated, and domestic bottlenecks and higher oil prices could raise the inflation rate temporarily above the Maastricht limit. In addition, a key long-term challenge is to ensure the implementation of reforms aimed at continued high productivity growth.

With indicators suggesting that output will remain above potential in 2005, an expansionary fiscal stance could add to inflationary pressures and the current account deficit. Short-term stability requires a more cautious fiscal policy than that contemplated by the authorities to allow for automatic stabilizers to operate, and Directors encouraged the authorities to build a safety margin to be used in the event of a slowdown. In this connection, a mid-year reopening of the budget to allow additional expenditures should be avoided, and a few Directors suggested that there is room for cutbacks in current expenditure.

Directors welcomed the authorities' plan to lower the personal income tax rate so as to improve incentives to raise employment and productivity. However, they emphasized that tax cuts should be phased in together with complementary measures so as not to jeopardize fiscal consolidation. In this context, the proposals to reduce tax exemptions, introduce a more wide-ranging property tax, and improve tax administration were seen as appropriate steps.

Directors noted that public expenditure reforms should be undertaken at both the central and local government levels, aimed at increasing transparency and control. They emphasized that the social protection system—including pensions, social assistance programs, and the health sector—needed further attention, with a view to improving their effectiveness and ensuring financial viability.

Directors supported the staff's proposal for enacting a Fiscal Responsibility Act. This, together with the currency board and the commitment to the Convergence Program, would provide a comprehensive and transparent framework for efficiently implementing fiscal policy at all levels of government within a multi-year setting.

While recognizing that an expansion of the deficit could be expected during the income convergence process, some Directors expressed concern about the widening of the current account deficit in the context of the relatively high rollover requirements of short-term debt, and risks of shifts in capital market sentiments. They emphasized the importance of close monitoring of the current account and its financing, and of the need to promote additional flows of FDI.

Directors noted that the regulation and supervision of banking and securities markets are well developed. They recognized that the mainly foreign-owned banking system has a low credit-to-GDP ratio and maintains adequate protection from shocks. However, Directors stressed that the trend growth in consumer borrowing and significant foreign currency exposure of the private sector require close monitoring of credit quality to track vulnerabilities. They encouraged the authorities to proceed with an FSAP update, which would examine these issues.

Directors encouraged the authorities to accelerate structural reforms necessary to support increased productivity, competitiveness, and long-run growth. In addition to lowering labor taxes, the authorities should take specific steps to introduce greater flexibility in short-term labor contracts, improve training, and ease construction and land use regulations. It will also be important to improve the business environment by fostering small and medium-sized enterprises through EU business development funds, as well as by promoting Research and Development and innovation, and deregulating the health and education sectors.