Public Information Notice No. 99/68

Public Information Notice: IMF Concludes Article IV Consultation with Lithuania

August 3, 1999

On July 26, 1999, the Executive Board concluded the Article IV consultation with Lithuania¹.

Background

Lithuania has made impressive progress in macroeconomic stabilization and market transition. Following the introduction of the currency board in 1994, inflation has come down rapidly, and market reforms have provided a sound basis for economic recovery. The progress suffered setbacks in the wake of the Russian crisis, however, as a fall in exports led to lower growth and initially an increase in the current account deficit.

The economy cooled down rapidly starting in the third quarter of 1998, while inflation continued on a downward trend; the current account deficit widened in the second half of 1998 but subsequently contracted. Real GDP growth came to a halt in the fourth quarter of 1998, while preliminary data suggest that real GDP fell by 5¾ percent year-on-year in the first quarter of 1999. Meanwhile, reorientation of food supplies from the Russian to the domestic market, appreciation of the litas against the currencies of western trade partners (the litas is pegged to the U.S. dollar), and softer domestic demand all contributed to a decline in inflation to a 12-month rate of ½ of one percent in June 1999. The current account deficit widened from 10 percent of GDP in 1997 to 12 percent of GDP in 1998, before falling to 9½ percent in the first quarter of 1999. As the current account deficit has been financed mainly by privatization-related foreign direct investment, external debt increased only moderately, from 25¾ percent of GDP at end-1997 to 26½ percent at end-1998.

Fiscal policy became more expansionary starting in mid-1998, reflecting in large part use of privatization proceeds on current spending. While central government expenditure in 1998 stayed within the limits approved by the Parliament, the government spent privatization proceeds on off-budget items. The most important items were the Savings Restitution Plan (SRP) and support for companies affected by the Russian crisis. Capital expenditures, by contrast, remained below 3 percent of GDP in 1998. Government revenue held up well in 1998. Overall, the fiscal deficit rose to from 2 percent of GDP in 1997 to 5¾ percent of GDP in 1998.² In January-May 1999, weak revenue due to the decline in economic activity, further SRP payments, and net lending contributed to a fiscal deficit of 4 percent of projected annual GDP.

The currency board has withstood pressures caused by the turmoil in international markets. Starting in September 1998, there were net foreign exchange outflows through the currency board, which initially led to an increase in interest rates to about 14 percent in October (on three-month treasury bills). From October onwards, the government used privatization funds to meet part of its financing need, while foreign exchange outflows tapered off. By June 1999, interest rates had declined to about 10 percent. The foreign exchange coverage under the currency board has remained comfortable, at about 143 percent of litas liabilities at end-May. Reflecting a resumption in credit growth and the SRP payments, broad money growth increased from 14½ percent (12-month rate) in December 1998 to 20 percent in May 1999.

Recent progress in privatization has been good, while government support and weaknesses in the framework for market entry and exit (including bankruptcy procedures) have tended to soften enterprises' budget constraints. The Privatization Agency has been restructured as called for under the Privatization Law of December 1997, and completed 345 privatization transactions with a total value equivalent to 5_ percent of GDP in 1998. The electricity sector has experienced intensifying cashflow problems, because of high costs, lags in adjusting tariffs, and difficulties in collecting payments on exports. In agriculture, the progress in reducing government support has suffered setbacks against the background of low world commodity prices and a severe impact on food industries of the Russian crisis.

The banking system has so far withstood the Russian crisis, because banks had limited direct exposure to Russia. A major strengthening of prudential regulations and supervision since the banking crisis in 1995/96, as well as a major shake-out in the sector during that period, have helped bolster the banking system. Worries remain, however, pertaining to credit quality following the Russian crisis, short-term foreign borrowing, and market concentration.

Lithuania's economic database is generally adequate for economic analysis, although large revisions to balance of payments and national accounts data underscore the need for improvements.

Executive Board Assessment

Executive Directors commended Lithuania's significant progress in economic stabilization and market reform since independence. Economic performance had suffered setbacks in the wake of the Russian crisis, whose impact policies since mid-1998 had aimed to cushion. The challenge facing the authorities now was to take strong and early actions to continue Lithuania's earlier achievements so as to return to sustained economic growth and to ensure external sustainability. Directors noted the advances in structural reform in recent years but, partly because of Lithuania's EU accession plans, considered that an acceleration of actions was needed.

Directors endorsed the authorities' decision to maintain the currency board arrangement. However, noting the impact of external events in the region on top of an already high external current account deficit and rising debt, they considered that further efforts to maintain macroeconomic stability were called for. Directors recommended that the authorities tighten fiscal policy and stand ready to act if balance of payments pressures emerged. They encouraged the authorities to maintain their close policy dialogue with the Fund.

While not viewing external competitiveness as a problem at present, Directors were concerned at the relatively rapid growth in wages in recent years. The fact that wage pressures remained despite high unemployment underscored the need to ensure labor market flexibility.

Directors agreed on the need to proceed cautiously in changing the exchange rate peg to an interim basket before an eventual peg to the euro, but several Directors were not convinced of the case for such an interim move. They emphasized the need for careful preparation for any eventual exit from the currency board arrangement.

Directors agreed with the government's emphasis on fiscal policy as the cornerstone of the external adjustment strategy in the near term. They looked forward to early implementation of the government's expenditure reduction plans for 1999, especially for current outlays. Directors considered that the 2000 budget should continue the adjustment process, with the focus on further restraint on current expenditure. In this connection, they called for public sector wage restraint and civil service reform. Directors advised against any tax measures that could undermine fiscal adjustment and suggested that any reduction in tax rates be accompanied by a lowering of exemptions.

To support fiscal adjustment, Directors called for a strengthening of budget procedures. They encouraged the authorities to establish a fund for investment of privatization proceeds, with clear guidelines for its utilization, and urged the adoption of the new Budget Law. Directors saw a need for an acceleration of pension reform, to which better payroll tax collection would contribute.

Regarding other structural reforms, Directors welcomed the acceleration of privatization, the new Competition Law, and the revision of the Bankruptcy Law. They called for the scaling back of budgetary support to enterprises and of import protection for specific sectors-particularly agriculture and the oil industry-and the simplification of regulations and licensing requirements. These efforts should serve to scale back the role of the state in the economy, while enhancing competition and improving the environment for greater private sector activity.

Directors welcomed the Bank of Lithuania's efforts to strengthen further the supervisory framework, including the decision to implement the Core Principles for Effective Banking Supervision, which had been reflected in greater soundness of the banking system since the banking crisis of 1995-96. While noting the limited direct exposure to Russia of Lithuania's banks, Directors nevertheless expressed concern about the potential secondary effects through domestic borrowers exposed to the CIS. Some Directors also drew attention to the increase in foreign currency lending. These factors called for continued careful monitoring and oversight of the banking system.

Directors commended the authorities' emphasis on ensuring transparency in economic policy and improving economic data. They welcomed the authorities' decision to participate in the pilot project for publication of Article IV consultation staff reports.