Public Information Notice No. 97/9

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

July 14, 1997

The IMF Executive Board concluded the 1997 Article IV consultation¹ with the Republic of Lithuania on June 25.

Background

Lithuania's economy grew in 1996 by an estimated 3.6 percent, while inflation was reduced to just over 13 percent by year-end and unemployment fell to 6.2 percent of the labor force. Agriculture was the dominant factor in the output expansion, offsetting the contraction of financial system activity following the closure of several banks early in the year. The latest available information indicates a continuation of these positive developments in the first half of 1997; most notably, annual inflation fell to below 8 percent by end-May.

Lithuania's fiscal policy stance remained largely unchanged in 1996 with a borrowing requirement of close to 3 1/2 percent of GDP. In 1997, the deficit is projected by the government to fall below 3 percent of GDP as part of a medium-term policy plan to balance budgeted revenue and expenditure (excluding net lending).

Tax policy reforms, including a broadening of the VAT base in January 1997 and an increase in excise tax rates in April 1997, have underpinned the objective of fiscal adjustment. Further administrative and legislative measures are underway, including a tightening of tax administration, particularly in the area of social insurance contributions, and a comprehensive reform of personal and corporate income tax legislation.

Reflecting inflows under the currency board arrangement, gross foreign reserves increased to US$843 million by end-April 1997, equivalent to 2 1/2 months import cover. Interest rates on treasury bills fell to around 10 percent in early 1997 from over 20 percent during 1996.

In early 1997, the authorities announced a medium-term monetary and exchange rate strategy (covering 1997-99) that envisages a gradual transition from the currency board arrangement to a traditional currency peg. Under the first phase of the program, the Bank of Lithuania intends to introduce new monetary instruments, including repurchase operations in treasury bills and, possibly, a short-term bank credit facility. It is envisaged that the second stage of the strategy will involve a broadening of the definition of eligible reserve assets held by the Bank of Lithuania while maintaining the pegged litas exchange rate to the U.S. dollar.

The rapid expansion of trade flows has continued in 1996 with export and import growth of over 20 percent. The current account deficit remained unchanged in relation to GDP, and was financed primarily by medium- and long-term foreign borrowing and foreign direct investment. The real effective exchange rate appreciated moderately during 1996.

In the area of structural policies, the authorities have implemented major reforms of the energy sector--centered on the commercialization of major energy companies--leading to a reduction in unpaid bills and elimination of delays for the payment of energy supplies from abroad. Significant reforms in both the agricultural sector and the privatization program are anticipated during 1997. Agricultural reforms aim at better targeted and more transparent agricultural support, while the cash privatization program is to be accelerated through international tenders of large enterprises.

Executive Board Assessment

Executive Directors commended Lithuania for the considerable progress made in reducing inflation and in attaining strong growth. Directors noted that, over the period of the program supported by the Extended Arrangement, a stable macroeconomic framework had emerged, outward-oriented trade policy had been pursued, and budgetary management had been improved significantly. Directors nonetheless stressed that, in the period ahead, to enhance prospects for more rapid and sustained growth, further efforts would be needed to increase domestic savings, speedily resolve problems in the banking system, and deepen structural reforms, particularly in the areas of privatization, agriculture, and social security provision.

Directors noted that significant progress had been made in fiscal adjustment and reform. They observed that the authorities had taken timely action to address the risks of slippages in 1996 by improving tax administration and by introducing measures to increase revenues, notably under the value-added tax and excises. Directors emphasized the need for continued vigilance, and took note of the authorities' readiness to take further revenue-raising measures if circumstances required. In that context, they suggested further efforts be made to broaden the tax base and to address tax evasion. They also called for full implementation of the treasury system and further enhancement of tax and customs administration. Directors expressed concern about delays in payments by the Social Insurance Fund and underscored the need for speedy reforms of the financing of that Fund, including its indexation rules and the retirement age. They also encouraged the authorities to improve the composition of expenditures, by giving greater priority to public investment.

Of Directors who spoke on the issue, a few considered that the medium-term exchange rate strategy announced by the Bank of Lithuania was appropriate, against a background of the authorities' desire to develop increased central bank functions. A few other Directors, however, wondered about the wisdom of moving away from the currency board arrangement, which had served as a key element in achieving financial stabilization. They pointed out that the currency board arrangement had provided a credible monetary rule and that it could be adapted to deal with increasing financial sophistication. Directors stressed the importance of ensuring a timely exit from the currency board arrangement, so as to maintain the confidence of market participants while safeguarding central bank independence and its lender of last resort function. Directors emphasized that establishing a sound banking system and central bank independence were key preconditions to a successful transition.

Directors agreed that the completion of banking system restructuring remained an urgent task. They regretted that the overall strategy for restoring financial soundness to the banking system has been neither fully articulated nor pursued consistently. Directors commended the Bank of Lithuania for its actions in dealing with private banks that had failed to meet prudential regulations; they urged the government to bring state-owned banks to prudential compliance as a matter of the highest priority and to ensure that, in the meantime, those banks were not a source of instability in the banking system. Directors expressed their concern about the possible macroeconomic impact of the Saving Restitution Plan, and called on the government to enforce strictly all of the limits designed to minimize threats of instability, and to limit the Plan's fiscal costs.

While significant progress in the area of structural reform had been made, Directors underlined the need for further efforts in order to accelerate growth. They considered the establishment of the Energy Pricing Commission an important step forward, and also commended the authorities' efforts to regularize the financing of the energy sector through the reduction of arrears. Directors encouraged the authorities to take a bolder approach to sales of state holdings, particularly in the energy and transport sectors. As regards agriculture, while welcoming the recent measures to eliminate distortions in that area involving more efficient targeting of budgetary support, Directors encouraged more efficient use of resources.

Directors welcomed the authorities' readiness to continue an active dialogue with the Fund after the completion of the present arrangement.