Public Information Notice No. 02/4

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the Republic of Lithuania

January 24, 2002

On January 16, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Lithuania.¹

Background

Lithuania has firmly implemented its adjustment and reform program in 2001 with impressive results. The external current account deficit declined sharply and external vulnerability decreased; real GDP growth resumed and inflation remained subdued. Confidence in the currency board and in Lithuania's policy making in general was restored, allowing for favorable access to domestic and international capital markets. The pace of structural reforms accelerated markedly in energy restructuring, fiscal structural areas, privatization particularly in the banking sector, trade policy, labor and in the social security system. Significant progress has also been made in the overarching objectives of EU and NATO accession, which are widely supported across the political spectrum.

Real GDP grew by 5.1 percent year-on-year for the first three quarters of 2001, and it is expected to grow by 4.5 percent for the whole year, driven initially by strong export growth, which has been complemented lately by a gradual recovery of domestic demand. The latter was supported by a resumption in credit growth to the private sector, following stronger competition in the banking sector, lower interest rates, and improvements in the business environment. The external current account deficit is expected to narrow to 5.8 percent in 2001 from 6.0 percent in 2000, mainly because of rapid export growth. Fiscal adjustment continued in 2001, despite revenue shortfalls. The general government fiscal deficit for the first nine months of 2001 declined to 1.2 percent of GDP compared to 3.1 percent in the corresponding period of 2000. In order to stabilize revenue and create a tax system consistent with EU requirements, the government prepared and submitted to Seimas an ambitious tax package of laws on value-added tax, and corporate and personal income taxes, which aims at removing exemptions and broadening the tax bases.

Underpinned by fiscal adjustment, the currency board continued to provide a sound anchor for credible macroeconomic policy in Lithuania. In view of the progressive orientation of trade toward the euro area and greater economic integration in the region, the authorities announced in mid-2001 the repegging of the anchor currency from the dollar to the euro, which will take place on February 2, 2002, based on the European Central Bank reference exchange rate of the euro for the dollar of February 1, 2002. The announcement on June 28 was well-received by the markets and the Bank of Lithuania has largely completed the preparations for the repegging. Financial sector vulnerability indicators improved over 2001.

The pace of structural reforms accelerated markedly in 2001 in several areas. To coordinate and monitor financial issues related to EU accession, two new departments at the Ministry of Finance were established. To strengthen municipal finances, new legislation allocating expenditure responsibilities to municipalities and the concomitant resources was passed by Seimas, and a set of measures have been prepared to deal with municipal arrears. Important reforms of the Treasury system have been implemented. The restructuring of the energy sector was completed, paving the way for privatization in 2002. Bank privatization increased efficiency and competition. A number of measures have been undertaken to improve labor market flexibility and enhance the business environment. Labor laws were amended to reduce restrictions on hiring and firing of workers, and new solvency laws were adopted.

EU accession negotiations have advanced rapidly, with agreement reached on 21 chapters (out of 31) of the acquis communautaire. Lithuania submitted its preaccession economic program to the EU commission in October 2001. The EU accession report of November 2001 concludes that Lithuania is a functioning market economy, and should be able to cope with competitive pressures within the EU in the near term.

Executive Board Assessment

Executive Directors commended the authorities for maintaining macroeconomic stability, continuing the strong growth performance, and implementing important structural reforms. While progress has also been made in reducing vulnerability, Lithuania nevertheless remains exposed to the risk of exogenous shocks, which Directors agreed, highlights the importance of continuing with sound financial policies and structural reforms aimed at creating conditions for sustained growth, foreign direct investment, and enhanced competitiveness.

Directors noted the important role that the determined implementation of an ambitious fiscal adjustment has played in improving macroeconomic conditions and in underpinning the credibility of the currency board arrangement. They considered that the 2002 budget appropriately aims at consolidating the recent adjustment, while seeking to limit the erosion of tax revenue and addressing expenditure needs in line with medium-term priorities. They urged the authorities to adhere to the 2002 deficit target, resisting pressures to increase expenditures without accompanying revenue measures.

Directors considered that, given persistent shortfalls, measures to stabilize tax revenue constitute an urgent priority. In this context, they welcomed the comprehensive tax package prepared by the government, which would eliminate exemptions, and thereby allow to reduce rates, while preserving tax revenue. They cautioned against the preferential treatment of particular groups and sectors, which would jeopardize the tax reform objectives and the ultimate goal of stimulating growth.

In light of new EU accession-related expenditure commitments, Directors emphasized the importance of careful prioritization, rationalization of expenditure and strengthening of budgetary control. They welcomed improvements in the administrative framework, allowing Lithuania to make effective use of EU structural funds, and encouraged the authorities to further increase implementation capacity in this area.

Directors supported the measures taken to improve the financial situation of the Health Insurance Fund and municipalities and prevent the accumulation of arrears. Regarding the latter, they underscored the importance for the government of using all legal means to oblige municipalities to follow the new principles of financial relations between the state and municipal budgets. They also looked forward to the new pension system which will put Lithuania's social security system on a sound financial footing.

Directors endorsed the plan to switch the peg of the litas from the dollar to the euro, consistent with greater economic integration with the EU. They welcomed the authorities' strategy to make the process transparent and looked forward to a smooth transition. Directors underscored the need to maintain macroeconomic discipline, including prudent debt management policies, and to continue structural reform efforts aimed at ensuring competitiveness over the medium term.

Directors welcomed the significant acceleration in structural reforms in 2001, in particular the progress made in restructuring the energy sector and in bank privatization. They urged the authorities to reverse recent initiatives to set indicative prices in agriculture, and encouraged them to continue to implement structural reforms critical for investment, growth, and reducing unemployment. In this regard, they looked forward to the early implementation of measures to enhance labor market flexibility and training opportunities.

Directors welcomed the authorities' participation in the Financial Sector Assessment Program (FSAP). They encouraged the authorities to continue efforts to strengthen the banking system, following the FSAP recommendations, which, together with bank privatization, will enhance the efficiency of financial intermediation and further improve confidence in the domestic financial system. They also welcomed the authorities' participation in the pilot project to assess anti-money laundering policies and practices.

Directors commended the authorities' commitment to transparency in the conduct of economic policies and in data provision.