Public Information Notice No. 03/115

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Republic of Lithuania

September 9, 2003

On September 5, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Lithuania.¹

Background

The Lithuanian economy is enjoying a broad-based economic expansion with very low inflation, despite the slowdown in Europe. Real GDP grew by 6.7 percent in 2002 and by 9.4 percent in the first quarter of 2003. Investments and exports continued to be a major source of growth, while consumption has gradually accelerated. The current account deficit widened somewhat in 2002 to 5.3 percent of GDP, due to the fast growth of investment-related imports. Despite the real appreciation of the litas vis-à-vis the U.S. dollar, competitiveness remains strong, reflected in the good export performance with substantial gains in market shares. Fiscal consolidation continued: the general government budget recorded a deficit of 1.2 percent in 2002 and a surplus of 0.8 percent in the first quarter of 2003.The unemployment rate declined to a four-year low of 9.4 percent in June 2003.

Money and credit aggregates grew rapidly in 2002 and in the first quarter of 2003, with monetization converging toward the level of other advanced transition economies. Credit to the private sector expanded by 35 percent, albeit from a low base, in response to low interest rates and increased economic activity. This rapid private sector credit expansion does not give rise to immediate concern, however, in view of the high-quality banking supervision, but will require continued monitoring.

The authorities' strategy to join the ERM II very soon after accession, maintaining an unilateral commitment to the Currency Board Arrangement, 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 European Union authorities, appears appropriate, provided that domestic policies, in particular fiscal policy, continue to be supportive and competitiveness remains appropriate.

Fiscal policy remains anchored to the objective of reaching a structurally balanced budget in the medium term. However, driven by the need to accommodate upfront expenditure related to EU membership, the fiscal deficit for 2003-04 is expected to deviate from the medium-term fiscal path. This widening of the fiscal deficit should not jeopardize macroeconomic stability provided that it remains limited and temporary, given the current strong economic position, the good track record of prudent economic policies, and the authorities' commitment to medium-term fiscal balance.

Progress in structural reforms was recorded during the past year, but deeper reforms are needed to underpin growth and employment creation. EU funds are expected to provide resources to help restructure the agricultural sector, and privatization appears to be picking up speed with a number of large sales expected in 2003. In addition, a meaningful pension reform is needed to ensure the long-term viability of the pension system, which would stimulate private savings and financial markets.

The potential for sustained economic growth is in place provided prudent macroeconomic policies and structural reforms to improve the business environment continue. The stable macroeconomic environment and restructuring undergone in the past three years have enabled businesses to achieve profit growth. EU accession should provide additional stimulus due to the inflows of grants and opportunities created by further integration of trade and finance.

Executive Board Assessment

Executive Directors commended the Lithuanian authorities for their successful implementation of sound economic policies that have led to a strong economic expansion with very low inflation and to Lithuania's graduation to a non-program relationship with the Fund. Directors welcomed Lithuania's signing of the EU Accession Treaty last April, and considered Lithuania well-placed to achieve a reasonably rapid integration into the euro zone. Nevertheless, Directors noted that unemployment and the external current account deficit remain relatively high—though unemployment has moderated somewhat recently—and encouraged the authorities to continue pursuing policies aimed at maintaining macroeconomic stability and furthering structural reforms necessary to raise productivity and sustain high growth.

Directors were of the view that the currency board arrangement continues to serve Lithuania well and has helped to anchor macroeconomic stability. They noted the real appreciation of the currency and advised that Lithuania's competitiveness and external vulnerability be monitored closely. Directors endorsed the Lithuanian authorities' strategy of seeking early entry into ERM II after accession and maintaining the unilateral commitment to the currency board arrangement until the adoption of the euro. They noted that all relevant decisions regarding ERM II entry and EMU participation should be made in mutual agreement with the EU authorities. Furthermore, they underscored that the success of the ERM II strategy hinges on the ability of the authorities to maintain prudent policies, in particular rigorous fiscal discipline.

Directors commended the progress made in recent years in lowering the fiscal deficit, noting that Lithuania is one of the few accession countries that already comply with the fiscal convergence criteria of the Maastricht Treaty. However, they observed that in both the near and the medium term, the authorities face upward pressure on public spending and a projected further decline in the revenue-to-GDP ratio. In this regard, Directors urged the authorities to meet the budgeted fiscal deficit for 2003, limit the 2004 deficit to significantly below 3 percent of GDP, and develop a credible medium-term fiscal plan that takes into account all outstanding fiscal liabilities. They emphasized the need to leave adequate room for countercyclical policies in the event of a slowdown or adverse external shocks, and to prepare for the future fiscal costs associated with a rapidly ageing population. They stressed the importance of carefully prioritizing expenditure, resisting spending pressures in the run-up to parliamentary elections, and eliminating expenditure arrears. They noted that any slippages that would threaten compliance with the Maastricht criteria and commitment under the Stability and Growth Pact would undermine confidence in the currency board arrangement, macroeconomic stability, and the strategy for an early adoption of the euro.

Directors expressed concern about the decline in revenue and underscored the need to stabilize tax revenue in GDP terms by eliminating tax exemptions and improving tax administration. They noted that the tax reform had failed to stabilize revenue and urged the authorities to find alternative sources of revenue in the event the elimination of some taxes is required.

Directors stressed the need for strict banking and insurance supervision and high standards in bank credit management given the rapid growth in credit. They endorsed the authorities' plan for a gradual reduction of the reserve requirement ratio to the ECB required level, while underscoring the need to proceed with caution. Directors welcomed the efforts made by the Bank of Lithuania to implement FSAP recommendations and the favorable assessment of the FSAP follow-up report. Directors welcomed the steps taken by the Bank of Lithuania to increase its ability to detect and prevent money laundering and financial crimes, which include strengthening of bank inspection and reporting requirements and better cooperation between financial and law enforcement agencies.

Directors noted mixed progress in structural reforms, and urged the authorities to step up their reform efforts. While the financial situation of the Health Insurance Fund and municipalities has improved, more measures are required to enhance the efficiency of the health sector and solve the underlying problems of municipalities. Given the ageing population, Directors underscored the importance of adopting measures that would ensure the long-term viability of the pension system. They welcomed the first steps taken to develop a privately- and voluntarily-funded pension system.

To sustain rapid investment and economic growth, Directors put special emphasis on energy and transport privatization, the modernization of the agriculture sector, and streamlining of the legal framework to enhance transparency, governance, and the overall business environment. They stressed the need for measures to increase labor market flexibility in order to generate jobs and reduce regional income disparities. In this context, they emphasized the importance of reforming the social safety net to improve efficiency and achieve better targeting. Directors also commended Lithuania's open trade policy, while noting that harmonization of the country's trade regime with that of the EU may result in an increase in some tariffs.