Public Information Notice No. 98/52

Press Information Notice: IMF Concludes Article IV Consultation with Republic of Lithuania

July 21, 1998

On July 13, 1998, the Executive Board concluded the Article IV consultation with Republic of Lithuania¹.

Background

The recovery of the Lithuanian economy, which started in 1995, gathered further strength in 1997, with real GDP growth reaching nearly 6 percent. Meanwhile, inflation remained on a downward trend, falling from an average rate of 24.7 percent in 1996 to 8.8 percent in 1997. The latest available information shows continuation of these tendencies: real GDP grew by close to 7 percent in the first quarter of 1998 from the same period in 1997; industrial production rose by 10 percent in January-May 1998 relative to the first five months of 1997; and inflation fell to 6 percent for the 12-month period ending in June 1998.

External trade flows continued to expand rapidly in 1997, with both exports and imports rising by around 25 percent. The current account deficit widened from 9.1 percent of GDP in 1996 to 10.3 percent of GDP in 1997. The deficit was financed predominantly by medium- and long-term borrowing and foreign direct investment, with the latter more than doubling to 3.4 percent of GDP. Overall, the balance of payments was in surplus and official foreign exchange reserves grew by US$245 million, ending the year at US$1.1 billion. Foreign exchange reserves stood at US$1.2 billion at end-June 1998 and were further augmented in July by substantial privatization proceeds. Lithuania has remained relatively unaffected by financial turbulence in the region.

The process of remonetization began in 1997 and continued in 1998, partially reversing the decline in monetary aggregates that followed the December 1995 banking crisis. Broad money and private sector credit rose, respectively, by 23 percent and 29 percent in the 12 months through May 1998. At the same time, in parallel with progress in lowering inflation, interest rates declined substantially: rates on three-month treasury bills moved from a peak of 39 percent in 1996 to slightly less than 9 percent in early July 1998.

Lithuania’s fiscal stance was tightened significantly in 1997 as the general government fiscal deficit was reduced from 4.5 percent in 1996 to 1.8 percent of GDP, reflecting both strong growth of revenue and expenditure restraint. In the first five months of 1998, the general government fiscal deficit amounted to LTL 180 million, a figure consistent with the annual deficit objective for 1998 of around 1 percent of GDP. Nevertheless, the social insurance fund (SoDra) continued to show signs of financial fragility in 1997 and early 1998.

A number of legislative and administrative measures have been taken, or are under discussion, to support the ongoing process of fiscal consolidation. Recently introduced fiscal measures include increases in excises, amendments to the Law on Employment, and additional actions to improve tax collections. A comprehensive reform of personal and corporate income tax legislation is under way. In addition, major changes to the budgetary process are to be introduced, particularly with a view to casting the budget in a medium-term framework, ensuring the allocation of spending in accordance with policy priorities, and enhancing the transparency of the process itself.

The Bank of Lithuania has been implementing steadily the first phase of the medium-term strategy to exit from the currency board arrangement, including the introduction in mid-1997 of repurchase operations in treasury bills and time deposit auctions. A Lombard credit facility should to be operational in the near term. The exit strategy’s next step is the submission to parliament of amendments to the Law on the Central Bank to strengthen its independence and set price stability as its overriding objective.

Structural reforms proceeded on several fronts. In the banking sector, the State Commercial Banks was liquidated and its performing assets were transferred to the Savings Bank. The privatization of the Agriculture Bank is under way, and the authorities announced their intention to privatize the Savings Bank. Several large nonfinancial companies are also being privatized: a 60 percent stake in the telephone company was sold to a foreign consortium in early July; and discussions are ongoing regarding sales of public companies in the transportation and energy sectors. Other major reforms of the energy sector, including the establishment of the Energy Pricing Commission, have contributed to a significant reduction in consumer arrears on energy deliveries and the elimination of delays on payments to foreign gas suppliers.

Executive Board Assessment

Executive Directors commended the authorities for their successful implementation of policies under the Extended Arrangement that was concluded last year and welcomed their willingness to continue to cooperate closely with the IMF. Directors noted that Lithuania’s overall goodpolicy implementation record had resulted in a generally positive economic performance marked by robust growth, and by low and declining inflation and interest rates.

Directors observed that the key challenge faced by the authorities was sustaining the favorable economic performance, and in this connection, they stressed the risk posed by the present level of the current account deficit and the need to raise the rate of national saving. While, to date, there had been little contagion from the Asian crisis or the turbulence in the Russian financial markets, there was no scope for complacency. Accordingly, Directors called for determined action to reduce the vulnerability of the economy to external shocks, especially through the capital account.

While acknowledging progress to date in budgetary consolidation, several Directors called for a further tightening of fiscal policy. In particular, Directors recommended that the target date for balancing the budget set by the government for 1999 be advanced to this year and, at a minimum, that fiscal balance be maintained in 1999. Such a strengthening of the fiscal position would, Directors stressed, send a clear signal of the authorities’ commitment to prudent macroeconomic policies over the medium term and create a cushion that would reduce the government’s vulnerability to disruption in financing.

Welcoming the progress in improving revenue performance, Directors recommended that further fiscal adjustment be focused on the expenditure side of the budget by limiting the growth of current expenditure, especially the wage bill. Directors expressed concern about delays in reforming the Social Security Agency (SoDra), and called for the speedy implementation of measures to deal with its cash flow problems by improving tax administration and strengthening its medium-term financial sustainability by accelerating the schedule for raising the retirement age.

Directors welcomed the government’s proposal to increase the transparency of the budget process and to adopt an explicit medium-term framework for its implementation. Directors recommended, however, that the process be strengthened further by incorporating all extrabudgetary funds, including SoDra, into the budget process. Directors agreed with the staff’s recommendations to place greater reliance on domestic financing.

Directors noted that the currency board arrangement had served Lithuania well. Some Directors supported the Bank of Lithuania’s medium-term strategy of preparing an orderly exit from the currency board arrangement, but a few other Directors thought it might be advantageous to keep the currency board arrangement or recommended some caution regarding the timing of the exit. Directors observed that, to this date, the exit strategy had been implemented with pragmatism and without undue reliance on rigid deadlines. All Directors stressed the importance of fully meeting the necessary preconditions for an exit, including a strong and independent central bank, a deepening of financial markets, and a reduction in the current account deficit. In this connection, they agreed with the Bank of Lithuania on the need for strengthening the legal basis for central bank independence and for establishing price stability as the central bank’s overriding objective. They called on the Bank of Lithuania to set its objectives and operating procedures in a transparent manner and to maintain at all timesadequate external reserves. Several Directors agreed with the staff’s view that, over the medium term, consideration might be given to introducing a degree of flexibility in the exchange rate arrangement.

While acknowledging that the situation in the banking system has improved, Directors stressed that a further strengthening was needed, and called on the authorities to address the remaining weaknesses, especially those related to state-controlled banks. Directors recommended their speedy privatization, and emphasized the need to ensure that their operations in the meantime are in full compliance with prudential regulations and are carried out on a strictly commercial basis. Directors called on the Bank of Lithuania to remain vigilant in guarding against excessive reliance by the domestic banking system on short-term inflows from abroad.

Directors commended the authorities for their forceful approach to the privatization of large enterprises in the telecommunications, transport, and energy areas. They emphasized, however, the need to revitalize the privatization program of small and medium-size enterprises. Directors called on the authorities to speed up restructuring by the strict forbearance from bailouts of any sort, enforcement of a new bankruptcy code, and elimination of ownership restrictions on agricultural land.

Directors commended the authorities for their efforts to improve the availability of statistical information, citing in particular the decision to subscribe to the Special Data Dissemination Standard, to publish the International Investment Position on a quarterly basis, to strengthen the monitoring of short-term debt exposure of resident banks and nonbanks, and to provide a wide range of current information on the Internet.