Introduction

1.  Since independence was regained, Lithuania has made major strides towards stable macroeconomic conditions and the establishment of a market economy. The macroeconomic stabilization strategy has been centered on the currency board arrangement, which was put in place in April 1994, and on supporting budgetary policies. At the same time, a broad-ranging structural reform program aimed at establishing a market-based economy has been carried out, including privatization, legal reforms, price deregulation, trade liberalization, and bank restructuring. The structural reforms have been combined with the reorientation and strengthening of government institutions to ensure that they can carry out effectively the functions of the state in a market economy. These efforts have laid a sound basis for sustained economic growth; indeed, prior to the Russian crisis and the associated tensions in international capital markets, Lithuania was enjoying rapid economic growth.

2.  This progress, however, suffered setbacks in the wake of the Russian crisis. Given Lithuania's still-high dependence on exports to Russia and other CIS countries, the economic downturn in those countries led to a drop in exports and real GDP. The decline in GDP was exacerbated by faltering private domestic demand. Real GDP fell in the first three quarters of 1999 when compared with the corresponding period of 1998, but economic activity showed some signs of stabilizing towards the end of 1999. Inflation remained subdued throughout 1999. The drop in exports initially led to a widening of the external current account deficit in late 1998, but subsequently the current account deficit declined as domestic demand weakened. To cushion the effects of international developments on domestic enterprises, the government in late 1998 adopted a set of temporary anti-crisis measures, including higher import tariffs on selected agricultural products. The general government fiscal deficit widened in the second half of 1998 and in 1999, in part reflecting weak revenues due to the economic slow down, but also because of government support for enterprises facing difficulties--in particular in the energy and agricultural sectors--as well as outlays under the Savings Restitution Plan and cash injections to Mazeikiai Oil Company. Moreover, extra-budgetary funds did not adjust their spending commitments in line with lower revenue, giving rise to an accumulation of outstanding payment obligations in the latter part of 1999.

Economic Strategy and Macroeconomic Outlook

3.  The principal goal of the program will be to achieve an orderly current account deficit reduction and lay the basis for sustainable economic growth. The overarching policy objective is to achieve a return to high economic growth, by moving Lithuania towards a fully-fledged market economy with the private sector as the engine of growth, anchored by membership in international organizations such as EU and WTO. In support of these goals, the government and Bank of Lithuania will pursue a three-pronged strategy:

(i) maintenance of the currency board arrangement in its present form;

(ii) a major reduction in the general government fiscal deficit with a view to balancing the budget in 2001, in order to help reduce the current account deficit in the near term; and

(iii) implementation of a set of structural reform policies, geared towards underpinning government budget adjustment and, over time, improving the external position and boosting the growth in productivity and incomes.

4.  The macroeconomic framework underlying the program envisages economic recovery, low inflation, and a gradual reduction in the current account deficit. The economic recovery should be helped initially by continued export growth to western markets combined with a bottoming-out of the decline in exports to CIS markets, and a modest recovery in domestic demand. On an annual basis, real GDP is expected to return to positive growth in 2000, to the tune of 2 percent, increasing to 4 percent in 2001. Inflation is expected to remain low, in the 2-3 percent range in 2000-2001, reflecting the maintenance of the fixed exchange rate under the currency board arrangement and the fiscal tightening. As exports recover and cautious demand management helps constrain import growth, the current account deficit is expected to decline gradually. The government will pursue a prudent external debt management strategy. Accordingly, the proceeds of the euro bond issue in February 2000 have been set aside as a reserve in a blocked account at the Bank of Lithuania, to help ensure that the government can meet its debt service payments in the second half of the year and compensate for possible shortfalls in access to financing during the year. Based on the fiscal adjustment and structural reforms envisaged under the program, Lithuania should be able to maintain a sustainable external debt position. In the event of adverse external developments, the currency board mechanism would be allowed to function freely to tighten monetary conditions, and the Bank of Lithuania would take additional measures to tighten monetary conditions as needed; the government would also stand ready to strengthen fiscal and structural policies as necessary, in consultation with Fund staff.

5.  The currency board arrangement will continue to anchor macroeconomic policies. Accordingly, no changes in the currency board arrangement will be undertaken during the Fund program period. The currency board will provide a stable framework for macroeconomic policies, in particular fiscal policy, and should help keep inflation low. External competitiveness will be maintained through fiscal and monetary restraint and continued productivity growth resulting from structural reforms and new investments. Competitiveness should be helped also by the flexibility of the labor market and the conservative government wage policy.

6.  To safeguard monetary restraint, the program features performance criteria on the net foreign exchange coverage under the currency board arrangement and on minimum required bank reserves. Moreover, to help ensure financial stability, the program envisages limited reliance on privatization proceeds for budgetary financing, and the Bank of Lithuania will use repos, deposit auctions, and other instruments to regulate liquidity as necessary. Further development of monetary policy instruments is planned with a view to approaching European Central Bank (ECB) requirements. In that regard, the Bank of Lithuania envisages a gradual reduction over time in the minimum reserve requirement towards ECB levels. While the first step in this direction is expected to take place in the third quarter of 2000, for programming purposes it has been assumed that no change will take place in the design or the level of the reserve requirement. Any changes will be discussed with Fund staff (specifically, the reduction in the reserve ratio envisaged for 2000 will be discussed in connection with the first program review). Any reduction in the required reserve ratio will be combined with offsetting measures as needed to maintain monetary restraint.

Fiscal Policy and Budget Management

7.  The centerpiece of the program will be a major reduction in the general government fiscal deficit. Fiscal policy will be geared towards containing domestic demand and imports so as to achieve a gradual reduction in the current account deficit, and to ensuring that the government borrowing requirement is consistent with available financing. The bulk of the fiscal adjustment during the program period will fall on the expenditure side, as there is limited room for tax increases. Fiscal policy also will be guided by the objectives of achieving a broadly balanced fiscal position in 2001 and beyond, while safeguarding well-targeted social expenditure. The government is mindful that achieving these objectives will require an active policy to ensure that spending pressures arising from EU and NATO accession, an aging population, structural unemployment, and energy sector reforms are not allowed to erode the overall fiscal position (although the government will continue to implement the law requiring a gradual increase in defense spending, which stipulates that such spending will increase to 1.7 percent of GDP in 2000). Concretely, the aim is to reduce the national government financial deficit to LTL 800 million, or 1.8 percent of GDP, in 2000, consistent with the reduction in the general government fiscal deficit to 2.8 percent of GDP, and to balance the general government budget in 2001. The government is committed to undertaking more ambitious fiscal adjustment in the event of adverse external developments. To allow monitoring of the progress in fiscal retrenchment, the program contains quarterly ceilings on the general government fiscal deficit and net lending; the latter ceilings also reflect the government's goal of reducing substantially government lending activities.

8.  A range of government expenditure reductions is envisaged for 2000, including: (i) a freeze of the wage bill of the state government and extrabudgetary funds (which should have an important signaling effect to the private sector); (ii) an elimination of civil service bonus payments; (iii) a partial hiring freeze in the civil service; (iv) a reduction in subsidies (e.g., abolition of the VAT reimbursement on energy consumption combined with a targeted subsidy for poor households, and cuts in agricultural and transport subsidies); (v) a cut-back in public investment not related to Lithuania's obligations to international financial institutions; (vi) a reduction in purchases of non-essential goods and services; (vii) a streamlining of state government institutions and extrabudgetary funds; and (viii) a postponement of restitution payments for land and houses. In addition, the reduction in the fiscal deficit of the general government will be helped by the steps to improve the financial position of the social insurance fund (SoDra), described below (paragraph 13).

9.  To further reduce the fiscal deficit, off-budget spending of privatization proceeds will be cut substantially. In particular, in light of the overriding need to reduce the fiscal deficit, a delay in the Savings Restitution Plan has become unavoidable; implementation of this Plan has been put on hold for two years, and the outlays of LTL 1 billion (2½ percent of GDP) previously planned for 2000 therefore will not go forward. Also, the use of privatization proceeds to support companies will be discontinued. The future use of privatization proceeds will be considered in the context of the establishment of a Fiscal Reserve Fund for the investment of privatization proceeds (see paragraph 14).

10.  The government will reduce its net lending activities in 2000. To this end, government on-lending for investment purposes will be reduced below LTL 200 million in 2000 (this amount includes investments financed by borrowing from official creditors, and does not include on-lending for investment of funds provided by non-official lenders or investments in national defense). Moreover, in line with the privatization agreement for Maeikiai Oil Company, the fiscal framework assumes that budgetary support to the company will be reduced to US$21½ million in 2000, in addition to a conversion into 7-year loans of existing loans of US$155 million falling due in 2000 (it is assumed that possible new government guarantees for external borrowing of US$88 million by Mazeikiai in 2000, also provided for under the privatization agreement, will not be activated). If additional support to Maeikiai Oil Company proves unavoidable under the terms of the agreement, the government will take offsetting revenue measures to ensure that the program ceilings on the fiscal deficit are observed.

11.  Government expenditure arrears, which increased towards the end of 1999, will be cleared expeditiously within the overall budget ceilings. To this end, extra-budgetary funds and municipalities have been instructed to identify measures to make room for arrears payment, and to pay off their outstanding arrears from their own revenue in 2000. Moreover, the government is committed to avoiding accumulation of new arrears, and also to avoiding tax offsets or any other mutual offset or netting mechanism to clear existing arrears. To reinforce the efforts to deal with budgetary arrears, the Ministry of Finance is strengthening its monitoring of the budgets of government entities. Moreover, the program contains performance criteria calling for the elimination of budgetary arrears, as well as a package of measures designed to strengthen budgetary management and avoid future arrears build-up (see paragraph 15).

12.  The program is based on cautious government revenue projections. Concerning tax policy, excise tax rates on heavy fuel were increased effective January 1, 2000, and excise tax rates on tobacco will be increased by March 1, 2000; in addition, the excises on gasoline, liquid petroleum gas and methane (when used as a propellant), and diesel will be reviewed, with a view to increasing them, by June 30, 2000. To streamline the tax structure, the government plans to make proposals to Seimas by mid-2000, as follows: (i) for the personal income tax, a raise in the tax rate on income arising from author's rights from 13 percent to 20 percent, which is the rate applied for income from other non-salary sources; and (ii) for the corporate income tax, a modification of section 21 of the tax law to limit the current practice of providing both zero-rated taxation of reinvested profits and subsequent depreciation of the capital acquired via the reinvestment. Also, the corporate profit tax rate will be lowered from 29 percent to 24 percent in 2000. Finally, the Ministry of Finance will review, by mid-2000, the scope for reducing the exemptions in the tax stability provisions of the Law on Investments, in consultation with Fund staff. Concerning tax administration, the government is in the process of improving customs collection through coordinated documentation for exports and imports, strengthened administration of the State Tax Inspectorate and the Customs Administration, and computerization. It has also introduced standard guidelines for tax inspectors and intensified actions to collect tax arrears, including more active recovery of assets of tax delinquents. The fiscal targets under the program do not assume major additional revenue from the tax policy or tax administration measures (except for the SoDra-related measures described below). In the event that government revenue exceeds the projected levels, the government will seek to reduce further the fiscal deficit in 2000.

13.  The government is taking immediate steps to put SoDra on a sound financial footing, and ensure a small surplus in SoDra's budget in 2000. The planned strategy emphasizes steps to raise revenue, in order to avoid undue cuts in social benefits and to protect the most vulnerable population groups. As first steps, the cap on payroll tax contributions was removed effective November 1, 1999, and the payroll tax rate increased from 31 percent to 34 percent effective January 1, 2000. Additional measures to achieve the targeted surplus, and for which the necessary legal amendments have been presented in the Seimas, are: (i) accelerating the increase in the pension age; (ii) increasing in the number of days of sick leave paid by employers; and (iii) limiting the entitlement of working pensioners to the basic pension. In addition, the government will change the indexation of pension benefits, in consultation with the World Bank. Finally, the coordination between the State Tax Inspectorate and SoDra will be strengthened in order to improve payroll tax collections. These immediate measures will be combined with comprehensive medium-term reform of the pension system, for which preparatory work has already started.

14.  The government will take a range of measures to strengthen budgetary management and improve transparency. The prospective availability of large privatization proceeds calls for an appropriate framework for the management of such funds, both to safeguard fiscal restraint and to ensure the transparency of the use of privatization proceeds. Accordingly, high priority will be given to establishing a Fiscal Reserve Fund (FRF) for the investment of privatization proceeds. Creating the legal and institutional framework for the FRF is a central element of the program. To this end, the government already has set up a unified account at the Bank of Lithuania for the investment of privatization proceeds, and will present to Seimas by end-June 2000 the necessary legislative documents, including amendments to the Privatization Law and The Savings Restitution Law. These legal amendments will include clear guidelines for the use of privatization proceeds, limiting it to government debt reduction, pension reform, and government investment included in the approved government budget. The goal is to have the FRF fully operational by end-2000. While this framework is being put in place, the government will strictly limit its recourse to privatization proceeds for budget financing. The budgetary framework assumes that privatization proceeds of no more than LTL 400 million will be used for budgetary financing in 2000, with the utilization spread evenly over the year; decisions on any use of privatization proceeds over and above this amount will be taken only after consultation with Fund staff.

15.  Other measures to help improve budget management, planned for the program period, include (i) presenting the draft Organic Budget Law to Seimas by March 31, 2000, providing for inclusion of most extrabudgetary funds in the annual government budget, measures to avoid year-end surges in government expenditure, inclusion of planned government loan guarantees in the annual government budget, and transfer of the responsibility for the formulation and monitoring of the public investment program from the Ministry of Economy to the Ministry of Finance beginning with the 2002 budget (in the meantime, the formulation and implementation of the investment program, including the coordination between the Ministry of Finance and the Ministry of Economy, will be strengthened); (ii) requiring that the budgets of extrabudgetary funds that remain outside the budget be reported to Seimas in conjunction with the regular budget process, and that these reports be made public, by 2001; and (iii) taking further steps toward the completion of the Treasury system, including (a) establishing the system functionality to make direct payments to suppliers of goods and services, and resolve legal issues to allow electronic transactions between the Treasury, banks, and spending units for the purposes of payments processing, accounting, and reporting, both by end-June 2000; (b) reorganizing revenue accounts of state tax inspectorates into state Treasury zero-balanced deposit accounts by end-2000, converting individual bank accounts of all state government units into Treasury subaccounts by end-2000, with expenditures via these subaccounts restricted to cash payments of wages and minor cash payments within strict limits, and closing individual expenditure bank accounts for three ministries and the associated spending institutions by end-June 2000; (c) establishing a computerized transactional Treasury system capable of producing daily and monthly fiscal and financial reports (to this end, a pilot project will be established in the Ministry of Finance and two more ministries by end-April 2000, and extended to all central government financial operations by end-December 2000); and (d) implementing treasury-based commitment registration and controls (the pilot projects in the Ministry of Finance and two more ministries will be completed by end-September 2000 and extended government-wide by end- 2000).

16. Civil service reform will be initiated, with a view towards consolidating government finances over the medium term. In this regard, the government will, by March 2000 and building inter alia on technical assistance from the Fund, adopt a program for such reform. This program will aim to eliminate overlaps in the functions of government ministries and agencies, and privatize and outsource selected functions. As a first step, a review of the civil service, including employment levels and government functions, will be completed by June 2000. The civil service reform also will aim to decompress the wage scale to help retain highly skilled civil servants and to simplify the civil service wage structure.

17.  The structural reform agenda under the program will focus on measures to underpin external adjustment, by limiting the potential recourse by enterprises to budget support through fundamental sectoral reforms and enhancing non-government saving and efficiency of investment. High-priority reform areas to these ends include restructuring of the energy and agricultural sectors, privatization and improvements in corporate governance, and further strengthening of bank supervision.

18.  Sectoral reforms. The government gives high priority to dealing with the fundamental problems in the energy and agricultural sectors, which have been a source of budget pressures in the past. In order to improve the financial performance of the energy sector, the program features: (i) the adoption by the Energy Price Commission of an increase in electricity tariffs by 18.7 percent, effective January 1, 2000, with a view to ensuring that the Lithuanian Power Company (LPC) can service its debt from own resources in 2000; electricity tariffs will be reviewed in consultation with the World Bank, and increased further if needed, by end-June 2000; (ii) the granting of a greater role to the Energy Price Commission and individual enterprises in initiating tariff increases; (iii) finalizing the proposal for restructuring the electricity sector by May 1, 2000; and (iv) engaging advisors of international repute by April 1, 2000 to advise in the partial privatization of electricity sector entities. The government also has increased gas prices for all classes of consumers, and is preparing the privatization of Lithuanian Gas Company. Regarding the agricultural sector, the following actions will be taken: (i) budgetary support to market regulation and income support (not including export subsidies, as defined in the GATT Agreement on Agriculture) in the 2000 budget will be kept to the nominal level of 1998 (excluding support from extra-budgetary funds); (ii) the necessary legal documents will be adopted by end-March 2000 to allow ownership of agricultural land by domestic legal entities; and (iii) land restitution will be essentially completed in 2000.

19.  Privatization, corporate governance, and budget support. The program includes measures designed to expose companies to market pressures and promote the necessary restructuring of the economy. To this end, the government is committed to moving ahead with the privatization of large enterprises during the program period, including Lithuanian Airlines, GeoNafta, Lithuanian Shipping Company, additional shares in Lietuvos Telekomas, and the two remaining state controlled banks (see paragraph 23). To ensure that the Lithuanian economy reaps the full benefits of privatization, the government will follow sound principles for large-scale privatization, including (i) compatibility of privatization plans with the adopted regulatory and policy framework for the relevant sector, (ii) use of an open and transparent tendering process with equal access for all international and domestic investors, and (iii) hiring of financial and legal advisers with strong expertise in the relevant sector, chosen through tender. Moreover, the government will refrain from giving tax breaks or other government support, monopoly rights, or special import protection for individual investors. In line with our commitment to transparency in the privatization process, we have published the general terms of the Maeikiai privatization agreement. Furthermore, with the objective of strengthening bankruptcy policies and competition, a revised Bankruptcy Law will be presented to Seimas, and members of the Competition Council have been appointed and the statutes of the Council adopted. The government is currently working to streamline business regulations and, to this end, will adopt by end-June 2000 an action plan for deregulation. This action plan will include measures to simplify access to non-agricultural land ownership and streamline the land restitution process, reduce licensing fees for businesses, speed up the procedures for obtaining construction permits, and ease enterprise registration for joint ventures. Finally, the program ceilings on net lending, and government guarantees for domestic and external borrowing by non-government entities are designed to help substantially scale back government support for individual enterprises.

20.  Trade policy and anti-crisis measures. The government remains committed to an open and liberal external trade regime. The current efforts in this area center around the ongoing WTO accession negotiations and the establishment of free-trade agreements (FTAs) with partner countries or groups of partner countries. Lithuania's WTO accession negotiations are at an advanced stage. The government intends to remove all remaining obstacles to completing the accession negotiations with WTO, including the outstanding issues relating to import duties on agricultural and petroleum products, and hopes to accede by mid-2000. Meanwhile, FTAs are in effect with the EU, EFTA, and the Baltic neighboring countries, and almost all Central European countries (Slovakia, Slovenia, Poland, and the Czech Republic) as well as Turkey and Ukraine. Moreover, an FTA with Hungary was ratified by the Seimas in November 1999 and will come into effect on March 1, 2000, and negotiations on FTAs with Bulgaria and Romania are underway. About two-thirds of Lithuania's trade is currently conducted on the basis of FTAs. However, a set of temporary measures, including increased import tariff and import reference prices for selected agricultural products, were introduced in the autumn of 1998 as a response to the crisis in Russia (Government Resolution No. 1122 of 1998). To start rolling back these measures, the import reference prices will be eliminated as of April 1, 2000. Moreover, the government on February 17, 2000 adopted a resolution, specifying that the other temporary anti-crisis measures stipulated in Government Resolution No. 1122--relating to the increase in conventional and autonomous import tariffs for selected agricultural products and public procurement procedures aimed at favoring Lithuanian suppliers --will expire on November 1, 2000. Finally, the remaining export taxes (which relate to raw hides and skins) will be abolished by January 1, 2001. As an interim measure, the export taxes on raw hides and skins were reduced from 30 percent to 15 percent, effective January 10, 2000.

21.  Financial sector. The restructuring of the banking sector in the period after the 1995/96 banking crisis, as well as improvements in bank supervision and prudential standards in that period, has left Lithuania with a more robust banking system. Nevertheless, the government and the Bank of Lithuania recognize that the economic downturn and the repercussions of the Russian crisis call for continued vigilance and strengthening of bank supervision, including ensuring the independence of the Bank of Lithuania in carrying out all its responsibilities. The Bank of Lithuania is determined to take action as needed against banks that do not comply with prudential regulations or face financial difficulties. In particular, rescue operations for insolvent banks will be avoided. In that connection, the Bank of Lithuania in September 1999 initiated bankruptcy proceedings for a bank deemed to be insolvent, and it is expected that the bankruptcy proceedings for this bank will be completed soon.

22.  To strengthen bank supervision, the Bank of Lithuania and the government in December 1998 resolved to implement the Basle Core Principles for Effective Bank Supervision. Also, the Bank of Lithuania is implementing various EU Directives relating to bank supervision. The adoption of the Core Principles and implementation of EU Directives in effect lays out a strategy for strengthening of bank supervision. Specific actions that are envisaged for the program period include: (i) a reduction of the limits on overall exposure in foreign exchange, from 30 percent to 25 percent of capital, effective July 1, 2000; (ii) adoption by Seimas of an amendment of the Commercial Bank Law to allow the introduction of cumulative limits on large exposures; (iii) adoption by Seimas of an amendment of The Bank of Lithuania Law in line with EU requirements to ensure the autonomy and accountability of the Bank of Lithuania; and (iv) introduction of EU capital adequacy directives for market risks by end-2000; the draft amendments relating to (ii) and (iii) above have already been presented to Seimas.

23.  To further develop the banking system, promote competition, and reduce government involvement, the government puts the highest priority on completing the privatization of the two remaining state-controlled banks. To this end, the government will finalize the preparations and bring Agricultural Bank to the point of sale by April 2000, while the State Savings Bank will be brought to the point of sale by September 2000. Also, to promote the development of capital markets, amendments to the Law on Public Trading in Securities in line with EU directives will be presented to Seimas by end-2000.

Performance criteria, benchmarks, and reviews