Lithuania -- 2003 Article IV Consultation, Concluding Statement by the IMF Mission

June 13, 2003

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

This document contains the conclusions of the IMF mission that visited Lithuania during June 3-13, 2003 to conduct the discussions for the 2003 Article IV Consultation, after the completion of the Stand-by Arrangement on March 29, 2003. The mission team would like to express sincere appreciation to the authorities, as well as other participants in the meetings, for the excellent cooperation and the warm hospitality received during the mission. A discussion of the staff report for the Article IV consultation will be held by the Executive Board of the IMF.

1. In the space of a few years, Lithuania has transformed its economy and is now poised to join the European Union in May 2004. At present, the Lithuanian economy appears set to continue its rapid expansion with very low inflation. Real GDP grew by about 6-6.7 percent in 2002 (depending on the impact of the recent revision of the external current account) and, according to preliminary estimates, by 9.1 percent in the first quarter of 2003. Growth continues to be driven by investment and a remarkable export performance, despite the continued softness of the EU economy and the appreciation of the litas. Thus, the external current account deficit was contained at 5.3 percent of GDP. Inflationary pressures appear to be absent so far. The CPI index fell by 0.9 percent in the 12 months to May 2003, due partly to the appreciation of the nominal effective exchange rate but also to productivity advancements and greater competition. The labor market is also contributing, with wages growing by only 3.4 percent in the year to the first quarter, suggesting falling unit labor costs even in the non-tradable sector. This was coupled with a further drop in the unemployment rate to 10 percent in May.

2. The authorities are to be commended for their firm implementation of sound economic policies that have led to these favorable results. The currency board arrangement (CBA), supported by fiscal discipline, has continued to contribute to stability, especially since the smooth repegging to the euro in February 2002. In this environment, Lithuania enjoys access to international capital markets at very favorable rates and is increasingly attracting foreign investment. The reserve coverage of the currency board remains high (156 percent of reserve money at end-April 2003), and interest rates have been falling, in line with EU rates. Moreover, the credibility of the CBA has been bolstered by a dramatic fiscal consolidation since 1999, with the general government budget recording a deficit of 1.2 percent of GDP in 2002, and a small surplus in the first quarter of 2003. The remarkable flexibility shown by the economy and the solid competitive position of Lithuanian producers so far are, to a large extent, the consequence of the wide-ranging structural reforms implemented since 2000. Structural reforms in 2002 brought the tax system in line with EU requirements, improved the financial situation of municipalities and the Health Insurance Fund (HIF), advanced privatization and strengthened the financial sector.

3. These achievements should not lead, however, to complacency. Hard-won credibility could be quickly dissipated if the authorities' commitment to sound policies were to waver. The following issues will require particular attention in the years ahead:

· Fiscal discipline will be key to maintaining credibility. Some widening of the fiscal deficit in 2003-04 is needed to accommodate the large upfront expenditures related to EU accession, but it should remain modest and temporary. Any slippages that would threaten compliance with the Maastricht criteria and the commitments under the Stability and Growth Pact (SGP) would damage confidence, undermining the CBA, macroeconomic stability and the strategy for an early adoption of the euro.

· In the midst of widespread optimism, with rapid money and credit growth, strict banking and insurance supervision is required to safeguard the soundness of the financial system. Overheating is unlikely in the near term, but inflationary pressures can be expected to emerge in the future-as Lithuanian income and price levels converge towards those of the EU-and could be exacerbated by large capital inflows.

· Continued progress on market-oriented structural reforms will be crucial to increase further the flexibility and competitiveness of the Lithuanian economy, and seize the new opportunities for growth and employment creation offered by EU accession. Priority areas are to complete privatization, pension and social expenditure reform, improve good governance and transparency, and remove obstacles to business activity.

· Lithuania remains vulnerable to external shocks due to large gross financing needs in the medium term. Prolonged economic weakness in Europe, turmoil in international currency markets which might affect competitiveness, higher international interest rates, and/or a decline in capital inflows to emerging markets could severely damage Lithuania's external position. The mission has carried out fiscal and debt sustainability analyses, illustrating the impact of some of these risks.


4. With prudent macroeconomic policies and further progress in structural reforms, the potential is in place for a continuation of strong economic growth over the medium term, in the absence of major external shocks. Since the aftermath of the Russian crisis the economy has undergone a dramatic restructuring process in which firms have reorganized, sectors have consolidated, and investments have reshaped and modernized the capital stock. This effort has paid off with strong sales and profitability growth and investors are optimistic about further advances. In the coming years the economy will also see stimulus from a sharp increase in the inflow of EU grants, further trade and financial integration with EU countries, a predicted economic recovery in major trading partners, and further structural reforms that will improve the business environment. If the authorities adhere to their prudent policy stance, the resulting stable macroeconomic environment would be conducive to continued growth. Consequently, the economy could grow rapidly for the next several years, with continued improvements in productivity, and a gradually declining unemployment rate. Inflation is expected to be modest, but wage growth may outstrip productivity growth in the non-tradable sector (the Balassa-Samuelson effect) leading to higher inflation than in the EU. The inflation rate could, however, increase much faster if excessive wage growth started to emerge in specific sectors or if there were a jump in capital inflows.

5. Over the coming years the maturing of the economic expansion is expected to lead to a gradual increase in consumption, as households will start to take advantage of rising income levels. The substantial inflow of EU-grants will support continued investment growth, but exports will become less of an engine of growth, as producers increasingly will orient themselves towards the domestic economy. Real GDP growth is expected to slow slightly to 5.8 percent in 2003, due to a modest worsening of the trade balance, and then accelerate to 6.2 percent in 2004, reflecting increased investment activity. Consumer prices are expected to pick up during the remainder of 2003, although year-average CPI inflation would stay subdued at 0.2 percent, and then remain stable at about 2.5 percent in the following years. The external current account will likely widen to almost 6 percent of GDP in 2003-04, but would then narrow again thereafter due to higher government savings after 2005.

The CBA and Monetary and Financial Policies

6. The maintenance of policy discipline to support the CBA has provided the foundation for the successful development of the Lithuanian economy and is key to ensuring a smooth transition to the euro. The authorities' proposed strategy is to join the ERM II very soon after accession, maintaining an unilateral commitment to the CBA, and adopt the euro after two years of successful membership of ERM II and continued compliance with the Maastricht criteria, subject to the agreement of the relevant EU authorities. The mission recognizes the benefits of this strategy. First, it would promote stability, whereas shifting the regime twice in a short period of time would increase uncertainty and could prove very costly. Second, given the current monetary framework, adopting the euro would not entail losing policy flexibility and would provide important benefits to the economy by bolstering confidence, reducing interest spreads, lowering transaction costs, and increasing transparency. The mission would also like to point out the risks.For this approach to succeed, domestic policies-in particular fiscal policy-must continue to be supportive and competitiveness remain appropriate. Moreover, there is a risk that, with income convergence or large capital inflows, the Maastricht criterion for inflation might be exceeded.

7. Seeking alignment with EU standards, the Bank of Lithuania aims at a gradual reduction in three or four steps of the required reserves ratio from the current 6 percent to the ECB requirement of 2 percent by the time of Lithuania's adoption of the euro. In view of the current high liquidity of the financial system, the mission endorses the authorities intention to take the next step in 2004.

8. The strong growth of broad money (16.4 percent year-on-year by end-April 2003) reflects continued growth in real money demand, with monetization gradually converging toward the level of other advanced transition countries. In response to low interest rates and increased business opportunities, credit to the private sector also grew strongly (34 percent), albeit from a low base, and maturities lengthened. The low credit base and the authorities' careful monitoring of loan quality have contributed to the soundness of banking prudential indicators, well-capitalized banks, improved bank profitability, and falling non-performing loans. Nevertheless, the mission urges the authorities to continue monitoring closely these developments.

9. The mission notes with satisfaction the implementation of measures recommended by the FSAP report as part of the Basle Core Principles (BCP) for Effective Banking Supervision. The draft Law on Banks addresses concerns noted in the BCP assessment, incorporating new powers as well as further strengthening existing capacities of the Credit Institutions Supervision Department in its supervisory and regulatory capacity. The mission welcomes the inclusion in the draft Law of measures to enhance the BoL's ability to detect and prevent money laundering and financial crimes by strengthening inspections, bank reporting requirements, and cooperative efforts amongst financial and law enforcement agencies. It encourages the BoL to maintain rigorous banking supervision in order to ensure financial sector stability, particularly in view of the rapid growth of money and credit.

10. Based on recommendations made in the assessment of the International Association of Insurance Supervisors (IAIS) Insurance Core Principles, a new draft Law on Insurance addresses most of the concerns put forth in the IAIS assessment and the insurance supervisory agency (SISA) is close to achieving the desired level of compliance. However, the draft Law considerably limits the financial independence of SISA. The salary structure and employment of staff will remain determined by the Law on Civil Servants and, as a result, there is concern that salaries are not sufficient to retain highly skilled staff. This is particularly worrisome in light of the added responsibility of pension fund supervision that will be given to SISA.

11. Solid fundamentals and prudent debt management have allowed Lithuania to reduce its debt burden, while lowering significantly its borrowing costs, reflecting access to domestic and international markets at very low spreads. There is room for improvement, however, in two areas:

· The savings securities program, which sells three-year maturities to private individuals, was intended to promote savings and motivate the public to invest in financial instruments. Several reasons argue in favor of eliminating these securities. First, they compete for savings with banks and treasury bills. Second, interest rates for these instruments are not market-determined and,until very recently, remained above comparable bank deposit rates. Third, they can be cashed in at any time, creating significant contingent fiscal liabilities, especially in the event of a rise in interest rates of other instruments and the dramatic increase in the volume of recent sales, with the stock of securities outstanding reaching LTL 784 million at end-May 2003. The mission therefore recommends that the government stop new issues, phasing out the program, and promote treasury bills as an alternative savings option for the non-bank public instead. The combination of encashment risk, interest payments, and commission fees makes these securities a costly means to raise financing and deepen financial markets.

· Despite the declining trend in nominal interest rates for treasury bills, interest rate movements since the February 2003 issue of 10-year treasury bonds indicate an increasing spread over base currency instruments of approximately 180 basis points, well in excess of the 60 to 70 basis points accounting for credit risk. The mission believes that if the government were to utilize its primary dealer system to signal to the market that yields for 10-year bonds will gradually decline, these treasury bonds would still be an attractive option, in light of the limited alternative domestic instruments in which to invest. In this manner, the government would be able to ease its financing costs while continuing to deepen the domestic debt market.

Fiscal Policy

12. From the time of EU accession, on May 1, 2004, Lithuania will be subject to the obligations of the Treaty, limiting the nominal fiscal deficit to 3 percent, and to the Stability and Growth pact (SGP), requiring a structurally balanced budget in the medium term. Moving towards a balanced budget will bolster the credibility of the CBA and help maintain low interest spreads, limit the public sector's call on savings, safeguard the external position, and leave room for maneuver in the event of a need for countercyclical fiscal policies, without jeopardizing compliance with the deficit limits under the SGP. In this context, it is important to prioritize expenditure, promoting productive investment and a well-targeted social safety net, as well as to preserve revenue by improving tax administration, eliminating preferential treatments, and fostering good governance and transparency.

13. Due to unavoidable upfront expenditures related to EU membership, a deviation from the path of fiscal consolidation will occur in 2003-04. Given the solid initial position and the government's commitment to convergence and medium-term fiscal balance, the mission is of the opinion that this widening of the fiscal deficit would not jeopardize macroeconomic stability provided that it remains limited and temporary.

14. Against this background, the mission recommends that the general government fiscal deficit objective for 2003 should be maintained at the budgeted 2.1 percent of GDP (1.8 percent of GDP adjusted for the EFF repurchase). The June supplementary budget does not foresee an increase in the deficit. If revenue shortfalls were to materialize, the government has committed to cut discretionary expenditure. In addition, the mission urges the authorities to resist political pressures for additional spending or preferential treatment to some sectors of the economy. In this regard, the recent concessions to the agricultural lobby set a dangerous precedent.

15. In 2004, expenditure pressures are expected to intensify and strong political will is needed to avoid an excessively large budget deficit. Lithuania, like other EU-accession countries with similar monetary regimes, needs to adopt a fiscal stance sufficiently strong not only to meet EU criteria but also to support its CBA and monetary strategy. In of the high position of Lithuania's economy in the cycle, the mission urges the government to strive to limit the general government fiscal deficit to 2.5-2.7 percent of GDP, so as to provide sufficient margin in the event of a slowdown. EU-related expenditure is set to increase, with compensation for certain outlays only reimbursed in 2005, implying net additional expenditure of 1.5 percent of GDP. In addition, the revenue-to-GDP ratio would decline further--reflecting the impact of tax reforms and further changes in the tax system likely to be required by the EU. Hence, some difficult decisions will have to be made. The mission strongly urges the authorities to prioritize expenditure carefully, as there is little room for further cuts if essential services and social expenditure are to remain adequate, and to resist pressures in the run-up to parliamentary elections. There is no room for topping up EU-related payments to farmers from national funds without compensation from EU funds or scope for accelerating the saving and land restitution plans.

16. Moreover, alternative sources of revenue will have to be sought. The mission is extremely concerned about the decline in tax revenue-to-GDP ratio. The tax reform package recently implemented has failed to stabilize revenue, partly due to a number of last minute exemptions or concessions that were awarded by Seimas (about 0.4 percent of GDP on an annual basis). The real estate tax has not been introduced and pressures to award exemptions or privileges continue unabated. Furthermore, if the elimination in 2004 of the turnover tax and the excise tax on sugar is deemed necessary by the EU, the revenue-to-GDP ratio would decline by almost 0.9 percent of GDP annually. The mission thus urges the authorities to find alternative sources of revenue to offset at least partially these losses, which could include the introduction of a specific turnover tax, a tax on transportation, and higher duties on excises. Furthermore, improving tax administration and fighting tax evasion are key in order to increase revenue.

17. The mission strongly recommends that the momentum for structural reforms to improve the financial situation of HIF and municipalities be maintained. The measures implemented in 2001-02 to limit HIF expenditures have led to a marked improvement in its financial prospects, though further efforts are needed to eliminate its arrears and enhance the efficiency of the health sector. The mission believes that the authorities need to improve further the administration of the HIF, and develop a long-term plan for rationalization of expenditure and infrastructure in order to create an efficient and financially viable health care system.

18. The overall financial situation of municipalities improved in 2002, mainly because of the favorable economic environment, but further accumulation of arrears in the first quarter of 2003 indicates that the underlying problems are far from being resolved. The mission urges the authorities to rationalize expenditure further, enforce borrowing limits, and improve budgeting and planning procedures. Technical assistance from the Fiscal Affairs Department of the IMF is scheduled in this area, as well as to improve budgeting and planning procedures at the central government level, following up on the fiscal ROSC recommendations.

Structural Reforms

19. Maintaining the momentum of structural reforms is critical to foster competitiveness, growth and employment creation. The mission wants to emphasize the following key areas:

· The privatization program for 2003 involves a number of important sales including a second 34 percent stake in the Lithuania Gas, one or two electricity distribution companies, and four alcohol producers. It is important to maintain this schedule to revitalize the privatization process, as this area has recently been subject to several delays, and to conduct the process with the utmost transparency.

· The ageing of the population represents a serious challenge to the current pension system, which is unsustainable. While some steps have been taken to introduce a fully-funded second pillar, meaningful pension reform has essentially been postponed due to short-term cost considerations.It is critical to set the system on a sustainable footing. The surplus projected for SoDra over the coming decade, due to a temporary reduction in the number of pensioners per worker, should thus not be spent on increasing benefits, but saved for the future. The mission recognizes the pressures to raise pensions, but any increases should be financed through new measures, such as increasing the retirement age. Furthermore, the Reserve Stabilization Fund ought be used for pension reform rather than, for example, to expand savings restitution.

· Improving administrative capacity and stepping up measures to fight corruption are crucial, especially in light of the need to administer effectively the large amount of EU funds expected in the coming years.

· The large but relatively unproductive agricultural sector needs to be restructured and creating alternative employment opportunities must remain a priority. In this regard, available EU funds should be used with a view to improving the income-generating capacity of rural areas and not just for direct income support.

· It is essential to improve the business environment to facilitate private sector activity, particularly small and medium-sized enterprises, and attract additional foreign investment. While unemployment continues to decline, regional disparities remain high and rural poverty is widespread. Measures to increase further the flexibility of the labor market and labor mobility would help to generate jobs and even out high and increasing regional differences. Given the large structural component of unemployment, however, well-targeted social support will also be needed. Although the social safety net is extensive,it needs major reform, as it remains inefficient and is not well targeted towards the poorest segments of the population.


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