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GOVERNMENT OF THE REPUBLIC OF LITHUANIA EUROPEAN COMMISSION DIRECTORATE GENERAL FOR ECONOMIC AND FINANCIAL AFFAIRS Joint Assessment of Lithuania's Economic Policy Priorities Vilnius, 29 May 2000 In accordance with the recommendations of the Accession Partnership, the Government of the Lithuanian Republic has prepared, with the European Commission, Directorate General for Economic and Financial Affairs, a Joint Assessment of Lithuania’s economic policy priorities. This document presents an agreed set of medium-term economic policies necessary to advance the country’s economic restructuring and to prepare it for accession to the European Union. The document also presents a macroeconomic scenario consistent with the full and timely implementation of the policy measures outlined. Progress in the implementation of these policies will be assessed regularly within the framework of the Europe Agreement. For the European Commission, For the Lithuanian Government, Giovanni Ravasio Valentinas Milaknis Director General, Directorate General of Economic and Financial Affairs Minister of Economy Page 1 Contents EXECUTIVE SUMMARY ........................................................................................................ 3 INTRODUCTION ..................................................................................................................... 6 1. DEVELOPMENT OF LITHUANIA’S ECONOMY AND CURRENT SITUATION .... 7 1.1. Brief overview of transition in Lithuania _______________________________________ 7 1.2. Recent economic developments and main issues __________________________________ 8 2. MEDIUM TERM ECONOMIC POLICY .......................................................................... 10 2.1. Objectives of the medium term economic policy ________________________________ 10 2.2. Macroeconomic Policy ______________________________________________________ 14 2.2.1. Monetary policy _____________________________________________________________ 14 2.2.2. Fiscal policy ________________________________________________________________ 16 2.2.3. Wage and income policy _______________________________________________________ 17 2.3. Policy to complete the transitional period reforms_______________________________ 17 2.3.1. Enterprise sector reform _______________________________________________________ 18 2.3.1.1. Privatisation ................................................................................................................................ 18 2.3.1.2. Industrial policy .......................................................................................................................... 19 2.3.1.3. Small and medium sized enterprises ........................................................................................... 20 2.3.2. Financial sector reform ________________________________________________________ 20 2.3.3. Infrastructure and public utilities ________________________________________________ 22 2.3.4. Price liberalisation and competition policy _________________________________________ 23 2.3.5. Foreign trade policy __________________________________________________________ 23 2.4. Policies directed towards further structural reform _____________________________ 24 2.4.1. Social security reform _________________________________________________________ 2.4.2. Agricultural sector and rural development policy ____________________________________ 2.4.3. Environmental policy _________________________________________________________ 2.4.4. Regional development policy ___________________________________________________ 24 25 25 26 3. DEVELOPMENT OF LITHUANIA’S ECONOMY IN THE MEDIUM TERM ............ 26 Page 2 EXECUTIVE SUMMARY In preparation of Lithuania’s accession to the European Union this Joint Assessment of its Economic Policy Priorities presents the agreed view of the Government of the Republic of Lithuania and the European Commission on the macroeconomic policies and structural reforms needed to ensure macroeconomic stability and sustainable economic growth in Lithuania. The broad aim of the set of economic policies addressed in the Joint Assessment is to allow the Lithuanian economy to regain economic growth rates enabling it to catch up with the more developed EU economies. Recent developments have re-emphasised the need to eliminate the remaining structural sources of macroeconomic imbalances and to remove the rigidities and distortions that in some areas still stifle private sector initiatives and prevent the development of a functioning market economy. This Joint Assessment considers the measures undertaken by the Government as part of a consistent medium-term policy package. The establishment of the Joint Assessment is in line with one of the short-term priorities of the Accession Partnership. It complements other documents referred to in the Accession Partnership, notably the National Programme for the Adoption of the Acquis. Since measures in other areas are discussed in detail in the NPAA, the Joint Assessment only examines those structural issues that have a critical and direct influence on macroeconomic developments. The Joint Assessment is based on Lithuania's own Medium-term Economic Strategy in the context of its Accession to the European Union, which incorporates the existing programs of various individual sectors and which was approved by the Government in June 1999. The Joint Assessment will become the basis for the ongoing evaluation of Lithuania's economic progress and its medium-term economic policy priorities in the framework of the Europe Agreement A high-level working group representing the Lithuanian ministries and the Bank of Lithuania will be set up for this purpose. Since regaining independence in 1990, Lithuania has made significant progress in stabilising the economy and in implementing structural reforms. The currency board introduced in April 1994, which has been accompanied by fiscal restraint for most of the time, has resulted in low inflation. The implementation of essential economic reforms supported sustainable economic growth. As the scope and duration of the Russian crisis was not clear, the Government responded by loosening its fiscal policy. This was meant to cushion the negative impact of the crisis on Lithuania’s enterprises and to give exporters the opportunity to redirect their trade towards the West. The negative consequence of such a policy is, however, that it results in a deterioration of fiscal and external deficits. In 1999 Lithuania’s current account deficit amounted to about 11% of GDP. In the second half of 1999 the Government undertook immediate measures to improve the situation, in particular by reducing the state budget deficit and by freezing the savings restitution plan. Lithuania’s stable currency and sound banking system were the main factors supporting macroeconomic stability and providing the conditions for the recovery of the economy. During the first quarter of 2000 Lithuanian exports rose by 34% and the trade deficit shrank substantially, reflecting the recovery of the economy. The consistent implementation of the measures provided for in the Joint Assessment will create favourable conditions for sustaining the positive development of Lithuania's economy. The Bank of Lithuania intends to peg the litas to the euro in the second half of 2001. Both prior to the pegging of the litas to the euro and at the changeover, the exchange rate of the litas will remain the same. The monetary base and other liabilities of the Bank of Lithuania in litas will remain covered by the official foreign reserves by more than 100%. Page 3 The currency board arrangement entails tight fiscal policy. In this context, the Government intends to reduce the fiscal deficit to 2.8 of GDP and to keep it below that level in the medium term. Including net lending and current spending financed by privatisation revenue, the consolidated budget balance in 1999 was worse than in 1998, when it accounted for more than 5% of GDP. An intended cutback to 2.8% of GDP in the year 2000 is a feasible objective, considering that total privatisation revenue in 1999 amounted to 5% of GDP, of which two thirds were earmarked for savings restitution, which the Government has already postponed. Privatisation in Lithuania has been rapid. More than 80 of the capital meant for privatisation had already been sold in a voucher-type operation in 1991-1995 before the commercial-type selling of larger state-owned enterprises gained momentum. Between August 1996 and October 1999 more than 1000 smaller and larger companies were sold for a total of $715 million. The sale of 60 of the shares of Lithuanian Telecom alone generated $510 million in cash. On 29 October 1999 a new issue of shares of the AB “Mažeikių nafta” has been sold under a special law. This shareholding was acquired by the US company “Williams International” for $150 million. The Government remains firmly committed to a further reduction of the role of the state in the economy and to the improvement of conditions for competition in order to enhance the efficiency and functioning of the market economy. The restructuring of the Lithuanian energy and transport infrastructure and its integration into relevant European infrastructures is an essential prerequisite for the stability of Lithuanian’s economic growth. The Government intends to restructure the Lithuanian Railway Company already in 2000, by splitting it into independent railway infrastructure companies and companies carrying goods and passengers, thus creating conditions favourable for competition and effective management. The first stage of the construction of the railway from the Polish border to Kaunas as part of the link to the trans-European network is one of the major transport infrastructure projects. This year the Government will carry out the restructuring of the gas sector in order to prepare it for privatisation. The Government seeks to achieve that the strategic Western investor takes part in the privatisation. The Government seeks to achieve that strategic Western investors take part in the privatisation, which would not only modernise this sector and its management, but also lead to its participation in the development of regional gas networks, ensuring an alternative gas supply. The restructuring of the Electricity Production and Supply System carried out by the Government in 2000, the privatisation of this sector and the creation of conditions for competition together with the integration of the electricity network into European networks are all very important for the successful integration of Lithuania’s economy into the European Economic Area. The Government and the Bank of Lithuania signed an Agreement with the IMF on a new arrangement. The authorities are also participating in the project involving the public release of IMF reports on Lithuania’s economic progress. In May 1999 the World Bank approved a Country Assistance Strategy for the period between July 1999 and July 2002. It will assist Lithuania in maintaining macroeconomic and financial stability, implementing the European Union acquis and designing social development programmes. In this context, the Government has approved the IMF proposal to set aside privatisation proceeds to the Fiscal Reserve Fund with strict guidelines that it would be drawn up only for such purposes as reduction of government debt, pension reform and investments. One target of Lithuania’s budget reform, which started in 1998, is to incorporate the extrabudgetary funds in the state budget, with the exception of the Social Insurance Fund, the Health Insurance Fund, the Privatisation Funds, and the Fund for the Closure of the SE Page 4 Ignalina NPP. Procedures have been agreed among ministries and state institutions, and they have started to formulate the budget for a three-year period. The draft of the new budget law also addresses a number of issues concerning municipal budgeting. As of 1 January 1998 the provisions of the Budget Law came into effect, according to which income tax of natural persons shall be paid into municipal budgets and profit tax of legal persons into the state budget. Further implementation of the tax reform is planned for the medium term. Ad hoc state aid to enterprises and a lack of effective bankruptcy procedures have acted as impediments to structural reform in the past. Draft amendments to the bankruptcy law aim for shorter liquidation periods and a faster release of the shedded labour. The law also provides for a simplified procedure for the exit from the market of non-viable enterprises. Lithuania's medium-term economic strategy focuses on indiscriminate support for the start-up of small and medium-sized enterprises and on speeding up the ongoing privatisation of agricultural enterprises and natural monopolies. These strategic instruments will be used to enhance productivity growth and flexibility in the face of a changing market environment. Since 1998 the financial sector in Lithuania has witnessed a healthy concentration process. During the Russian crisis the banks managed to attract additional capital and to compensate for the reduced amounts in the accounts of clients who maintained economic relations with Russia. The privatisation of the Savings Bank and the Agricultural Bank, the two remaining state banks, is scheduled for the year 2000. The development of a solid insurance market is one of the medium-term objectives of financial sector. The largest insurance company has already been privatised. In the area of social security and pension reform there will be a greater emphasis on private initiative to complement the social insurance and assistance schemes. Employment programmes will be developed to provide professional training and retraining as well as to increase labour mobility. In this respect Lithuania’s medium-term economic strategy makes note of EU employment policy guidelines which are based on the experience of the EU member states. The Joint Assessment covers a number of other areas that are important for Lithuania’s accession to the EU and in which Lithuania is developing legislation: energy, transport, agriculture and rural development, environment and regional development. In the energy sector Lithuania has taken the important decision on a realistic closure date for Unit 1 of the Ignalina Nuclear Power Plant. This decision has major implications for the energy supply in the medium term. Since the beginning of 1997, a more market-oriented approach is implemented in the granting of aid to agriculture and the support of rural development. Major attention is given to the relations between rural development and environmental protection, and also to the need to assess the environmental impact of the development of industry. Lithuania will promote the drawing up of projects for pre-accession funding under ISPA, SAPARD and other programmes. Several macroeconomic scenarios have been developed for the purpose of this Joint Assessment, reflecting medium-term economic development policies. The presented scenario is based on the assumption that all necessary budgetary, monetary and economic restructuring measures, as described in the Joint Assessment, are fully and timely implemented. In other scenarios the deviation from this policy mix has been simulated. Compared to the presented scenario, those simulations reveal, that - in the short term - a less strict implementation of the indicated policy measures would result in somewhat stronger growth, but - in the medium and long term – this would lead to a significantly lower growth dynamics. As a result, in 2010, Page 5 GDP might be up to 20 lower than in the government scenario. The upshot is that the Lithuanian economy has a price to pay for the restructuring of the economy in the short run, but that it can expect to be amply rewarded by the benefit of stronger growth dynamics which will appear in the medium to long run. INTRODUCTION In its drive for the overall goal to reach sustainable economic growth and establish favourable conditions for a steady improvement in the living standards of the population, Lithuania is currently in the process of completing the transformation of its economy into a competitive market economy. Lithuania’s integration into the EU is not regarded as a goal in itself, but rather as one of the basic preconditions for the implementation of structural reforms which enhance the long-term development of Lithuania's economy. The Opinion of the European Commission on Lithuania’s application for membership, published in 1997, and the European Commission’s Regular Reports of 1998 and 1999 recognise the considerable progress made by Lithuania towards the development of a functioning market economy. The successive documents underline the need to complete the remaining reforms that would enable the economy to cope in the medium term with competitive pressure and market forces within the EU. With a view to the requirements of the Accession Partnership, the Government of the Republic of Lithuania together with the Commission’s Directorate General for Economic and Financial Affairs produced the Joint Assessment of Lithuania’s Economic Priorities. The objective of this document is to agree on a consistent set of medium-term economic policies required to complete the economic transformation of Lithuania and prepare its accession to the EU. The Joint Assessment will help in setting the policies and their sequencing in a medium-term perspective and thus provide a basis for their systematic review. This Joint Assessment focuses on the essential measures for the implementation of the Medium-Term Economic Strategy of Lithuania. The Government of the Republic of Lithuania will approve a comprehensive set of actions and form a working group for the monitoring of the policies set out in the Joint Assessment. The Joint Assessment complements the National Programme for the Adoption of the Acquis (which focuses on the legal and institutional approximation of the acquis communautaire) and the Government of Lithuania’s Medium-Term Economic Strategy of Lithuania in the Context of its Accession to the European Union (which the Government of the Republic of Lithuania approved in June 1999). These documents examine the details of individual structural actions, while the Joint Assessment examines only structural policies to the extent that they have a critical and direct impact on macro-economic developments. The macro-economic section of the Joint Assessment is based on the Medium-Term Economic Strategy of Lithuania, but also incorporates recent economic policy changes and economic developments. It provides updated macro-economic projections and a targeted development scenario. The document consists of three parts. Section 1 gives a brief overview of Lithuania’s economic developments, especially in relation to the impact of the Russian crisis on Lithuania’s economy and its consequences for the setting of priorities. Section 2 of the document presents the main elements of the Medium-Term Economic Strategy and its underlying economic policy analysis. Particular attention is paid to the timing of the measures considered in the Medium-Term Economic Strategy. Section 3 develops a macro-economic target scenario that is compatible with the medium term objectives and policies. This scenario Page 6 reflects the anticipated direction of economic development in the event of full and timely implementation of the intended measures. 1. DEVELOPMENT OF LITHUANIA’S ECONOMY AND CURRENT SITUATION 1.1. Brief overview of transition in Lithuania The regaining of independence in 1990 necessitated the establishment of the institutions of an independent state and the corresponding legal framework. Immediately after independence, extensive liberalisation and privatisation programmes were initiated. In the first years of the transition period the reorientation of the economy induced one of the most severe declines in output registered in Central and Eastern Europe together with a surge in inflation. It was only in 1995, after the introduction of the new national currency and the currency board in 19931994, that the economic downturn was reversed. Agriculture is a key sector of the Lithuanian economy, although in the transitional period its share in GDP has fallen from 10.6% in 1994 to 8.8% in 1999. A rapid privatisation coupled with the restitution of property rights on land has led to a strongly disaggregated ownership structure, resulting in low productivity. The authorities have been protecting the profitability of the sector with subsidies. Moreover, the fall in output has resulted in a less than proportionate employment decline, and the agricultural sector still employs 21% of the workforce. To be able to expose the sector to international competition, a substantial restructuring effort will have to be made which will have significant effects on employment. The Lithuanian government has already taken important steps towards the reduction of production subsidies and their replacement by measures of income support. Industry is still an important economic sector, although its share in gross value added fell from about one third in the early 1990s to less than one fifth in 1999. Industrial employment represents about one sixth of the total workforce. The main industries are the food industry (12.3%) and oil refining industry (about 20%). As prices charged for raw materials and energy approached world prices, the large energy-intensive manufacturing enterprises have been confronted with a sharp price increase of their inputs and simultaneously lost some of their traditional export markets. The transformation of the sector from energy-intensive production to a production pattern which is based on modern technologies and the demand in Western markets is being carried out. Services, which due to historic reasons were underdeveloped, expanded rapidly after independence. Output in the services sector nearly doubled in five years and accounted for 57% of GDP in 1998 and 60% in 1999. Before independence, the private sector practically did not exist. The industry sector consisted of large enterprises, and agriculture was entirely collectivised. A programme of voucher privatisation began in 1991, and succeeded relatively rapidly in privatising a substantial part of the agricultural sector and all small and medium-sized enterprises. However, the state kept an important stake in the larger industrial enterprises, while there was no privatisation in key sectors (e.g. electricity, railways, telecommunications, oil refinery). A second stage of privatisation, including cash payments and various other possibilities, started in 1996. Prices were almost fully liberalised during 1991-1992. Restrictions remain on prices for energy, housing and some prices for public transport and utilities. Goods and services with administered prices represent about 16% in the basket of the consumer price index. Page 7 Lithuania has free trade agreements in place with the EU, EFTA, with Latvia and Estonia, and with most of the member states of CEFTA as well as with Turkey and the Ukraine. At present negotiations are carried out concerning Lithuania’s membership of the WTO. The introduction of the new national currency, the litas, was done in several steps. First, the Russian rouble was replaced by the talonas in October 1992, which was allowed to float freely. The talonas initially continued to depreciate, but stabilised after a tightening of monetary policy. In June 1993 the litas was introduced. On 1 April 1994 it was pegged to the US dollar, at an exchange rate of 4 litas per dollar. Simultaneously, a currency board arrangement was set up to increase the credibility of the litas. In agreement with the Government, the Bank of Lithuania has the right to change the exchange rate of the litas and to repeg it only in case of extraordinary circumstances under which the further retention of the fixed exchange rate of the litas would destabilise the national economy. The litas is fully convertible for current account transactions, and there are virtually no restrictions on capital transactions. Residents and non-residents may open accounts in foreign currencies. The break-up of the close economic relations with the Soviet Union provoked a steep output decline in industry and agriculture during the first years of independence, leading to a contraction of real GDP by almost 40% between 1990 and 1993. In 1994, the economic downturn was brought to an end. In 1995 GDP growth accelerated to 3.3%. Economic growth continued to increase by 4.7% of GDP in 1996, despite the consequences of the serious banking crisis of 1995. In 1997 and 1998 economic growth rate remained strong (7.3% and 5.1% respectively), but the negative impact of the Russian crisis seriously dampened economic activity in the last quarter of 1998. Inflation increased in 1992 not only as a result of rapid price liberalisation but also because of a too strong dependence on the Russian rouble zone. The introduction of the currency board arrangement helped considerably to reduce inflation: in 1994 it dropped to 45.1, and it declined gradually afterwards to reach 13 at the end of 1996. The downward trend in the inflation rate continued till the end of 1999. The decline in food prices due to the loss of export markets in the East and the pegging of the litas to the appreciating US dollar played a major part in the sharp reduction of the inflation rate. The expected adjustments in the relative price of energy products and the recent wage increases are likely to lead to an increase in inflation in the near future. However, the rise in the inflation rate still will remain rather low. Immediately after the restoration of independence, the fiscal policy makers faced the challenge of completely reshaping the tax and budget systems and to adjust them to the rapid change of the economic structure. As a result of such structural changes, tax revenues had fallen from 45% of GDP in 1989 to just 26% in 1992. In order to reverse that trend a number of new tax laws were adopted by the Seimas. As a measure to improve tax collection, the Central Tax Inspectorate was established in 1995 and a Tax Police Department was set up in 1997. A Corporate Tax Law was adopted in 1997, partly with a view to stimulate private investment. In order to improve the tax administration’s efficiency and to broaden the tax base while reducing the marginal tax rates, additional tax reforms have been carried out recently. In 1994 a domestic treasury bill market was established as an alternative source of financing for the state budget deficit. The Government started to borrow in international financial markets in 1995. 1.2. Recent economic developments and main issues Economic growth slowed down in the second half of 1998, when the international economic situation deteriorated significantly. Unemployment rose and inflation fell considerably, partly Page 8 because products meant for export flooded the domestic markets. In addition, the marked appreciation of the real effective exchange rate had a dampening effect on import prices. During 1998 the current account deficit worsened, before it improved slightly in 1999. Sizeable privatisation deals boosted foreign direct investment inflows, providing the resources needed to finance the increasing external deficit. In order to stimulate the domestic economy the government decided to loosen its fiscal policy. Structural reforms progressed but in some important sectors, such as energy, they remained incomplete. In 1998, real GDP rose by 5.1% on the back of strong growth in consumption and investment during the first half of the year. However, after peaking at more than 10% in the second quarter, year-on-year growth came virtually to a halt in the last quarter. The Russian crisis took its toll on the Lithuanian agri-food sector, resulting in the decline of gross agricultural output by 3%, mainly due to a decline in crop production. In 1999, real GDP dropped by 4.1% due to the slowdown of external and internal demand and to an interruption of oil supply to the AB “Mažeikių nafta”, which accounts for over 12% of industrial output. The average registered unemployment rate rose to 8.4% in 1999, up from 6.4% in 1998. Using the ILO definition, the unemployment rate was recorded at 13.3% in 1998 (according to the data of the population survey) and in November 1999 this had increased to 14.1%. The disruption of trade relations with Russia, and the economic decline in the neighbouring countries, was the main cause for the economic downturn in 1999. Exports of goods decreased by 19% in 1999, mainly due to a decrease in exports to the CIS by 58.7%. The imports of goods during the same period decreased by nearly 16.6%. The share of investment goods in imports has been increasing, which is a positive sign for the country’s future economic potential. Foreign trade (in goods and services) deficit, which rose to 12% of GDP in 1998 decreased to 10.3% of GDP in 1999. This reduction was due to the improved balance of the trade in services. The current account deficit increased to 12.1% of GDP in 1998, however in 1999 it dropped to 11.2% of GDP. Net foreign direct investment rose in 1998, largely due to the privatisation of the telecommunications company. However, even without such singular events, foreign direct investment inflows cover a large part of the country’s rising financing needs of the balance of payments. The official reserves cover nearly 3 months of imports of goods and services. The inflation rate has fallen due to the stable litas, the reduction of prices of agricultural products on the domestic market, the global trends in prices and other factors. In December 1999, 12-month inflation was 0.3%, compared to 2.4% in December 1998. In some months of 1999 and 2000 a deflationary trend was observed. Excise taxes and some of the regulated prices were raised, but falling food prices, which account for some 40% of the consumer price index, offset any inflationary pressure. The effective exchange rate appreciated markedly, not only due to the devaluation of the Russian rouble but also due to the peg of the litas to the US dollar, which appreciated significantly against the European currencies. Due to the currency board arrangement Lithuania's financial sector survived the Russian crisis without much difficulty. Fiscal policy was loosened in the second half of 1998. Current revenues fell short of their target as growth slowed, while extra-budgetary expenditures were increased. The most significant measures contributing to this increase, were the Savings Restitution Plan and the state aid provided to enterprises hit by the Russian crisis. Under the savings restitution scheme, the equivalent of 2.5% of GDP has been transferred to households so far. In addition, Page 9 on-lending operations also increased and amounted to 1.5% of GDP. As a result, the general government financial deficit rose from below 1.6% of GDP in 1997 to an estimated 4.6% in 1998. In the first half of 1999 government spending was increasing, while the tax base shrank as a result of the economic decline. When revenues turned out to miss their targets by more than 10% in mid-1999, the government reviewed its budgetary targets and took corrective measures. The transfer of the third and last round of the savings restitution, equivalent to about 1.5% of GDP, has been postponed. Budgetary expenditures in 1999 were cut by about 1% of GDP. The national budget deficit dropped to 0.3% of GDP in 1999 (it was 1.3% in 1998) and the gross fiscal deficit accounted for 7.8% of GDP (in 1998 it was 4.6% of GDP). The lack of efficient bankruptcy procedures, the remaining government stake in the enterprise sector, and the rigidities of the labour market all contributed to a situation in which the Government rendered support to enterprises facing financial difficulties. This relaxation of the financial discipline has softened the shock for the enterprises and has permitted temporarily a higher level of activity, but such interventions prevented the adjustment of enterprises to market conditions and contributed to the increase of the hidden quasi-fiscal deficits. These developments endangered macro-economic stability. The rise in the interest rates was an indicator of severe tensions. Two problems may be distinguished: the state involvement in numerous enterprises – partly due to unfinished privatisation, partly because of the provided state aid – did not ensure a strict financial discipline and an efficient allocation of production resources; the reform of bankruptcy procedures lacked efficiency; structural reforms are not yet completed and are still being carried out. In order to have more room for manoeuvre for restructuring the Lithuanian economy, first of all it is necessary to address the fiscal and the external imbalances. Completing the ongoing reforms is a priority issue in the medium term. The remaining state enterprises will be privatised and restructured. The functioning of the financial sector will be enhanced, by improving competition and widening the capital market. Still administrated prices will be liberalised to allow for a more efficient use of scarce resources. In addition, the social security and pension systems will be modernised, and their financing brought in line with budgetary restrictions. In view of the future membership of the EU, attention will be focused on the modernisation of the agricultural sector. 2. MEDIUM TERM ECONOMIC POLICY 2.1. Objectives of the medium term economic policy The overall goal of the medium term economic strategy of Lithuania is to strive for strong and sustainable growth in order to improve the living standards of the population. The achievement of this goal requires: maintaining economic stability; improving economic competitiveness in general and that of certain sectors in particular. Economic stability relies on the appropriate and timely conduct of macroeconomic policies. Fiscal policy must be co-ordinated with monetary policy: if the main role of monetary policy Page 10 is to ensure monetary stability, the maintenance of sustainable public deficits under currency board arrangement rests with fiscal policy. It needs to be recognised, however, that macroeconomic policy cannot succeed in maintaining stable conditions if important parts of the productive sector of the economy are not viable. Therefore, the second medium term objective is to build up and strengthen the overall competitiveness of the economy in the sense that sufficient profitable productive activity is ensured as the economy opens up progressively to free market forces. Improving the competitiveness of the economy depends both on macroeconomic policy, including income policy (in particular with respect to wage formation in the public sector) and on structural reform. Policies directed at sectors of the economy and structural reforms in general should aim at: stimulating an efficient allocation of productive resources towards viable enterprises. This is determined by the overall structural reforms such as privatisation and financial sector reform. However, specific issues, associated with the faster exit from the market of nonviable enterprises, also need to be addressed. stimulating private investment and private sector development. In this area the main objective is to ensure a favourable legal environment for economic decision making. The following table provides an overview of the main policies and measures and the time schedule for their implementation Table 1 2000 2001 2002 2003 2004 2005 Monetary policy Currency Board Arrangement Currency Board or the participation in the currency exchange mechanism-2 or EMU Unrestricted exchange of the litas for the anchor currency and of the anchor currency for the litas Reserve requirements Open market operations Deposit and repo auctions (already in place) Purchase and sale of debt securities on the secondary market and the issue of securities by the central bank (may be used in future Lending facilities from the Central Bank Overnight lending, for guaranteeing the stability of interbank settlement (after the introduction of the Real time Gross Settlement System) may be supplemented with intraday lending facility) Last liquidity source: liquidity loans and direct repurchase transactions After accession to the EMU, the ESCB monetary policy instruments will be applied Fiscal policy Fiscal deficit of the consolidated budget Adopt the Law on Budget Structure, regulating implementation of goals and objectives Reduce negative impact of fiscal imbalance on the current account deficit Keep the fiscal deficit of the consolidated general government budget below 3 of GDP Page 11 Public expenditure policy. Develop the introduction of budget programming Reduce the volume of state aid provided to energy, agriculture and transport Reduce government commitments to social security system by identifying the addressee of the assistance, its justification and expediency Public Debt Keep external debt below 23% of GDP and gross public debt below 30% of GDP Reduce the volumes of public external borrowing by promoting internal savings and attracting private capital Improve the monitoring of external debt by way of registering internal and external crediting and state guarantees Remove state guarantees on loans and granting of loans given on behalf of the state to profit-seeking economic entities Taxation policy Reduce profit tax rate, reduce the number of possibilities of tax relief and apply equal taxation conditions for different types of income Better administer taxes, develop improved tax regulation mechanism, abandon inefficient taxation measures Page 12 Table 1(continued) 2000 2001 2002 2003 2004 2005 Create a package of measures to increase saving Foreign trade policy Reduce tariffs under Free Trade Agreements Negotiations for the membership of the WTO Income Policy Regulate wage growth (index minimum wages) taking into account developments in labour productivity and wage growth trends Social Security Further strengthen the control of the budget formation, implementation and accounting of the state social insurance fund, bring it in line with EU standards Develop private social security sector by encouraging private pension schemes Adopt the amendments to the Law on Pension Funds Enforce subordinate legislation of the Law on Pension Funds Competition Policy and Consumer Price Liberalisation Introduce a pricing system aimed at promoting energy supplies and energy conservation Abandon subsidies, ensure that the regulated prices of energy supplies are in line with the competition environment and reflect economically justified costs Develop legal framework ensuring conditions for competition, in particular in energy, transport and communications sectors Implement Competition Law, complete harmonisation of the national competition legislation with the EU acquis Adopt the Law on State Aid Draft legislative provisions in compliance with EU legislation, concerning the provision of state aid to separate fields of activities, regions, and sectors of economy Privatisation Complete privatisation of large scale enterprises Privatise small and medium sized enterprises Privatise infrastructure enterprises Enterprise restructuring. Draft and adopt the law on enterprise restructuring and subordinate legislation necessary for its implementation Draft and adopt a new version of the Law on the Bankruptcy of Enterprises and the subordinate legislation necessary for its implementation Develop institutional framework ensuring the enforcement of the laws on the enterprise restructuring and bankruptcy Restructure loss-making enterprises facing temporary difficulties in order to make them more attractive to foreign and local investors Page 13 Table 1(continued) 2000 2001 2002 2003 2004 2005 Establish venture capital fund for small and medium businesses Financial sector Banking Sector Privatise the Savings Bank and Agricultural Bank Expand the range of banking services and products, ensuring their quality both in retail and wholesale banking Promote the establishment of foreign bank branches and subsidiaries in the Lithuanian Banking market, thus promoting sound international competition Develop and direct investments of banks to undertakings engaged in financial crediting activities at the same time increasing the range of services rendered Develop and enforce legal framework regulating leasing activities Fully implement the main principles of effective bank supervision, laid down by the Basle Bank Supervision Committee Approximate legal acts regulating the activities of credit institutions with the EU requirements Securities market Improve accounting of securities Provide information to the public on issues of capital market Increase privatisation scope through the stock exchange Increase investment limits for banks and insurance companies Introduce a new stock exchange trading system Harmonise legal framework with the EU legislation (amend the Law on Investment Companies) Insurance sector Open the market to private and foreign capital Improve the competitiveness of the insurance sector Harmonise legal acts with the EU legislation Agricultural sector and rural development policy Complete land reform Harmonise legal and institutional framework with the EU requirements 2.2. Macroeconomic Policy 2.2.1. Monetary policy Stable and predictable monetary conditions are a vital precondition for a sound economic development for each economy and especially for a small and open economy such as Lithuania, whose economy is particularly sensitive to external influences and international Page 14 developments. The present objective of the monetary policy is to maintain the stability of the national currency. The Bank of Lithuania strives to achieve its main objective by choosing the right anchor currency and maintaining the fixed exchanged rate of the litas. The fixed exchange rate contributes to internal macroeconomic stability and provides a solid framework for the international exchange of goods and services. The fixed exchange rate does not automatically ensure the same inflation rate as it is in the country of the anchor currency, however it contributes to the downward trend of inflation and ensures the relative stability of prices in the long run. In preparing for the membership of the European Economic and Monetary Union, the goal of the monetary policy pursued by the Bank of Lithuania will be revised and aligned with that of the European Central Banks’ monetary system, i.e. price stability. The currency board arrangement was introduced in April 1994, pegging the litas to the US dollar and this arrangement is still maintained. In order to prepare the country for EU membership, the Bank of Lithuania intends to shift the peg from the dollar to the euro in the second half of 2001, maintaining the external value of the litas. The CBA has been very successful in guaranteeing a stable exchange rate, thereby contributing to a decrease in inflation. Inflation has declined since the hyperinflation at the beginning of the year to almost a zero rate in 1999. In addition, weak external demand had a deflationary effect. The monetary policy measures used by the Bank of Lithuania (mandatory reserves, open market operations (OMO), lending facilities) are determined by the fixed rate arrangement, the full backing of the litas by official reserves, the commitment to exchange without any limitations the litas into the anchor currency, as well as by the prospect of Lithuania’s integration into the European Union. The Bank of Lithuania shall apply reserve requirements to ensure the liquidity of the banking system and greater stability of the interest rate level in the money market and regulate the ratio between the monetary base and the money supply, as well as the borrowing and lending of the banking system. Alongside the development of the Lithuanian financial market and its integration at international level, the Bank of Lithuania will continue to reduce the reserve requirements, by approximating them to the requirements of the European Central Bank. The Bank of Lithuania carries out OMOs in order to smoothen temporary liquidity fluctuations in the banking system, causing additional pressures on the fixed exchange rate arrangement, and to co-ordinate the trends in interest rates in the Lithuanian money market and in the international market. The Bank of Lithuania by means of an OMO increases the liquidity of the money market (auctions of repurchase transactions, where the Bank of Lithuania buys securities) or withdraws additional liquidity from the market (time deposit auctions, when the Bank of Lithuania sells securities). Should the need arise to limit longer-term fluctuations, the Bank of Lithuania will perform purchase or sale operations with debt securities in the secondary market and issue its own securities. Prior to its membership of the EMU, the Bank of Lithuania shall bring in line the technology of the application of the measures of the monetary policy and adjust its legal framework with the relevant standards of the euro zone. In addition, it is anticipated that the Seimas shall adopt the amendments to the Law on the Bank of Lithuania, guaranteeing its independence, and setting out explicitly the provision that the Bank of Lithuania shall not be entitled to lend to the government of the Republic of Lithuania, nor to other public bodies and state-owned and municipal undertakings, or to purchase their securities in the primary market, although these provisions have already been set out in the Law on the Bank of Lithuania and the Law on the Credibility of the Litas. Page 15 2.2.2. Fiscal policy The goal of Lithuania’s fiscal policy is to ensure the medium term sustainability of public finances. The Lithuanian government’s firm intention is to conduct a fiscal policy which is consistent with the monetary policy and which contributes to the reduction of the current account deficits. It aims for a balanced budget in the medium term. The target for 2000 is 2.8% of GDP. In the medium term, public debt will not exceed 30% of GDP, and foreign debt will be not more than 23% of GDP. The key condition to enable all this is the reduction of the state budget deficit. The results of the first quarter of 2000 show that the Government succeeded in a significant reduction of the fiscal deficit. According to preliminary estimates the fiscal deficit of the general government budget was about 0.9% of GDP, the target set in the Economic Policy Memorandum approved by the International Monetary Fund at the beginning of 2000. The fiscal deficit of the consolidated central government budget (including privatisation revenues as a source of financing) has surged in the first half of 1999. The worsening of the deficit already started in 1998 (when it reached 4.6%, compared to a deficit of 1.7% in 1997), due to the Russian crisis. The budget revenue decreased to 2% of GDP, and in order to cushion the impact of the Russian crisis, decisions were made to increase subsidies and other expenditure. National budget revenues were 3.6% of GDP below target. The government intends to reverse the trend of increasing budget deficits by the following measures: Delay of the savings restitution plan. Privatisation proceeds will be allocated to the Reserve Stabilisation Fund, the resource which will be used to achieve the strategic goals (pension reform, reduction of public debt, etc.) Actions will be taken on the revenue as well as the expenditure side to reduce the budget deficit further in the next few years and budgetary procedures will be also improved; The new Law on Budget Structure provides that all funds (with the exception of Social Insurance, Health Insurance, Privatisation Fund, and the Fund for the Closure of the SE Ignalina NPP) will be included in the state budget. This will help to manage funds more efficiently and to cut administrative costs. At the revenue side, a tax reform will be implemented, which aims at expanding the tax base and at improving the collection of taxes without increasing the tax burden. The existing taxation legislation will be revised to align it with the requirements of the EU acquis. This will also embrace the increase of excise taxes. The tax administration will be improved by the reorganisation of the existing 56 territorial tax administrations into 10 bigger territorial tax administrations and by the improvements in the information system. On the other hand, the corporate tax rate of 24% is applied to all companies, whereas it was 29% for some companies before. This will be partially compensated by abolishing some possibilities of tax relief. Four new laws are being drafted, which will replace the existing laws and will allow to improve tax administration and management, by bringing them in line with the EU requirements. At the expenditure side, the increase of extraordinary expenditure will be controlled more tightly, the system of benefit payments will be improved by means testing and plans to increase the pension age will be speeded up; The budgetary management will be improved by the presentation of a consolidated government budget, by the introduction of a multi-annual programming budget and by better monitoring and control of public expenditure. Page 16 Budget management and accounting of resources are reformed in order to ensure their compliance with the EMU requirements. The implementation of the short-term measures, aiming at a 2.8% fiscal deficit in the year 2000, may reveal that they are inadequate, except when economic growth would resume strongly. The latter assumption is realistic, taking into account the improved outlook for demand growth in the EU. In order to secure the medium and long term sustainability of public finances, it is important to take into account the consequences of the ageing of the population. In order to maintain the medium-term sustainability of the social security system, Lithuania intends to proceed with pension reform and to improve the financing of the social security system in general. 2.2.3. Wage and income policy During the early years of transition the Lithuanian population was confronted with a marked decline in real wages and an erosion of the purchasing power of their income. The Lithuanian government authorities intend to restore the level of income and raise the living standards of the population. However, they realised that real wage increases cannot be higher than productivity growth for extended periods of time, given the need for improving of the economy’s international competitiveness. Within the context of Lithuania’s exchange rate arrangement, wage formation is one of the main determinants of international price competitiveness. The influence of the government on wage formation in the private sector can only be an indirect one. It can improve the legal and institutional framework for the wage formation process, and it can support labour productivity growth by fostering investment in physical and human capital. It may also exert influence on the formation of wages in the private sector by setting wages in the public sector taking into consideration increase in general labour productivity. It is intend to improve the process of wage formation, modernise industrial relations and facilitate the social dialogue between employers and employees. The legal ground for the establishment of collective agreements regulating wage formation and payment procedures will be further improved. In this way, the Lithuanian system of industrial relations will be brought in line with the EU acquis in the area of social relations. In addition, training programmes will be set up and implemented to help increase labour productivity. These measures will complement non-financial means to foster social integration. The implications of fiscal policy and the relations with regional policy and industrial development will be considered in order to arrive at an equitable distribution of income. 2.3. Policy to complete the transitional period reforms This chapter considers various economic policy priorities aiming at completing the transitional period reforms and firmly establishing the principles of a market economy in Lithuania. The most important issues in that respect are to complete the transition in the enterprise sector by restructuring state-dominated enterprises, by closing down of non-viable private and public companies, and by improving the regulatory framework for the enterprise sector; to broaden and deepen the financial market and to improve its functioning, Page 17 to consolidate the position of the free pricing principle; to safeguard competition as central principle for the interaction of market participants, and to continue the integration of Lithuania’s economy into the EU and world markets. 2.3.1. Enterprise sector reform The overhaul and reform of the enterprise sector is a necessary precondition for securing the overall competitiveness of the economy. The main objective of restructuring is to take nonviable enterprises out of the market and to firmly establish the principle of strict financial discipline, enabling the enterprise sector to operate without direct or indirect government subsidies. The inevitable consequences for employment and economic activity will be cushioned by promoting the creation of new firms and by improving the management of the existing enterprises. Industrial policy and the policy on small and medium sized enterprises thus go together as integrated parts of enterprise sector reform. The inflow of foreign direct investment will contribute to the modernisation of production capacities and the enhancement of the inflow of know-how and modern management skills. The cornerstones of medium-term enterprise sector reform are: the privatisation of the remaining state dominated companies, especially in the infrastructure sector; the restructuring or closing down of non-viable loss-making enterprises; and the improvement of the regulatory framework for setting up, running and liquidation of companies. The government’s initiatives to promote FDI will further contribute to the modernisation of Lithuania’s enterprise sector. Enterprise sector restructuring will have a positive effect on the public accounts. Furthermore, apart from the financing of current account deficits by net foreign capital inflows, foreign direct investment will improve the balance of payments situation in the medium to long run by enhancing the know-how and marketing experience needed for exports. 2.3.1.1. Privatisation The privatisation process launched in Lithuania in 1991 has known two stages: the first a distribution-type asset privatisation with the help of investment vouchers in 1991-1995, and the second a commercial-type privatisation which is still going on. The data of the State Property Fund show that in 1995, at the end of the first stage, 86% of all public undertakings set for privatisation (i.e. subject to privatisation under privatisation programmes) and 81% of the total state-owned capital meant for privatisation were privatised. The rapid pace of privatisation has helped to maintain Lithuania’s favourable image of economic reform and ensured the support of the international community and international financial institutions, such as the IMF and the World Bank. In 1997 large infrastructure enterprises in which the state owned the majority shareholding or even all the shares, were entered in the list, including the public companies Lietuvos Kuras (Lithuanian Fuel), Mažeikių Nafta (Mažeikiai Oil Refinery), Lietuvos Avialinijos (Lithuanian Airlines), Lietuvos Draudimas (Lithuanian Insurance Company), and Klaipėda port companies. Page 18 In the period between August 1996 and 1 April 2000, 1591 enterprises have been privatised for 3.02 billion litas (0.75 billion US dollars.) With the commercial privatisation procedures in place, the largest project has been the sale of 60% of the shares of Lietuvos Telekomas (Lithuanian Telecom) to a strategic investor. Amber Teleholdings – a consortium consisting of the Swedish company Telia and the Finnish company Sonera – paid just over $510 million in cash and committed itself to another $221 million of investments in the next two years. In 1999, 703 business entities were privatised for 573 million litas. Local investors are expected to acquire the largest part of the shares in small to medium sized enterprises, while foreign investors are targeted for the privatisation of large enterprises. The Law on the Reorganisation of Joint Stock Companies Būtingės Nafta, Mažeikių Nafta and Naftotiekis was adopted on 29 September 1998. Under this law, the strategic investor recognised by the decision of the Seimas shall be granted the right to acquire 33% of the AB “Mažeikių nafta”, providing for the possibility to acquire within 7 years additional shares constitung 66% of the total shareholding at present 59% of shares are held by the government. The first tranche of 33% of the shares has been sold to the US company “Williams International” on 29 October 1999 for $150 million, which plans significant investments for the reconstruction of the company. The search for investors performed by the State Property Fund will be intensified. It is the intention of the Government that the scheduled privatisation of large enterprises will be completed in 2001, followed by the privatisation of the remaining medium and small enterprises. The privatisation of infrastructure enterprises and the reduction of state aid to manufacturing enterprises are foreseen. Lithuania’s medium-term economic strategy focuses on indiscriminate support for the start-up of small and medium-sized enterprises and on speeding up the ongoing privatisation of agricultural enterprises and natural monopolies as strategic instruments to enhance productivity growth and flexibility in the face of a changing market environment. 2.3.1.2. Industrial policy The Lithuanian industrial policy is being implemented under the medium term industrial development programme and the strategy of its implementation, emphasising that industrial development issues will be mainly solved by improving competitiveness and restructuring enterprises. In addition to the privatisation of enterprises, the Lithuanian industry has to transform (by means of restructuring and bankruptcy) loss-making enterprises, the major part of which are large scale enterprises previously incorporated in the USSR military complex (electronics, electrotechnics, machine tools) or which were producing for the Soviet consumer market. In many cases, these enterprises find it difficult to redirect their production to Western markets. Either they have to be closed down, or ways have to be found to restructure their production in line with EU rules for enterprise support. For the latter option to be followed, state aid needs to be horizontal and of a non-discriminatory nature. It is designed to help enterprises to target more profitable markets or applying more efficient production technologies. The medium-term industrial policy also provides for other measures which will help to resolve the problem of insufficient competitiveness. Apart from the need to arrive at an adequate structure and regional distribution of industries, industrial policy measures are considered with a view to reinforce the capacity of enterprises to compete in domestic and foreign markets. Great significance is attached in the medium term strategy to research and development. It is planned that larger amounts of information on the latest achievements in science and technology will be disseminated to enterprises, that support will be given to Page 19 applied research and that the conditions for an accelerated application of new R&D results will be created. In addition, the medium-term strategy recognises the necessity to bring in line industrial policy measures with the environmental requirements. This is set out in the Programme for the Development of Cleaner Production and Ecological Industry and other environmental programmes. Within the wider context of enterprise reform, Lithuania’s Medium Term Economic Reform aims for improved and enforceable bankruptcy procedures. To speed up this process and to provide possibilities for companies on the verge of bankruptcy to utilise their assets more effectively, as well as to solve the problem of employee remuneration, amendments to the Bankruptcy Law have been prepared. The amendments suggest that the period of liquidation of bankrupt enterprises shall be shorter, auction procedures simpler, and the mandate of the liquidation commission expanded. Another new law to be passed on 1 July 2000 details the new approach to restructuring. In addition, there are also plans to carry out horizontal programmes intended for structural adjustment and business promotion. 2.3.1.3. Small and medium sized enterprises Taking into account the importance of small and medium-sized enterprises (SMEs) for the country’s economy, especially for the creation of jobs, the promotion of small and mediumsized business forms a central element of the government’s efforts to modernise the Lithuanian enterprise sector. To this end the legal framework for business development is in the process of being amended and new legislation is drafted. Institutions to assist SMEs are being set up and provided with technical and financial support. At the beginning of 1998 the Government approved the Programme for the Development of Small and Medium-sized Enterprises and the measures for its implementation. The major objectives of this programme are: to create the legal and economic environment favourable for the development of business; to reduce bureaucratic barriers and remove red tape; to reshape the system of technical and financial support; to improve the business infrastructure; to provide greater access to credit markets; and to allow for a greater self-governance of the sector. A Small and Medium-sized Enterprise Promotion Fund has been established which, upon the decision of the Business Development Council, shall be used for financing the measures set out in the SME programme. The creation of a Small and Medium-sized Enterprise Venture Capital Fund and a Technology Development and Innovation Support Fund is foreseen. Much attention is paid to the promotion of small and medium-sized business as well as the expansion of its infrastructure. The Government will extend the coverage of the Small and Medium-sized Enterprise Strategy in terms of sectors and regions and to produce Annual Programmes for Small and Medium-sized Enterprise Development. Further efforts will also be made to improve the financial infrastructure and information systems. 2.3.2. Financial sector reform Lithuania has already made considerable progress in establishing a well functioning financial market. Sound banking principles in line with EU requirements have been introduced. The Page 20 implementation of Basle Committee recommendations will further contribute to the development of a reliable and stable financial system which will be created by increasing bank efficiency and competitiveness. The main measures to improve the functioning of the financial markets are the privatisation of state-owned banks, scheduled for 2000, the improvement of banking legislation, the strengthening of the capital markets and the establishment of an insurance market. In the Lithuanian banking system the state still has a considerable direct influence on the banking activities. The share in the equity of the banks held in the name of the government accounted for 33.6% at the beginning of 2000. The government’s influence on the decisions in the banking sector should diminish upon implementing the intended privatisation of the two banks controlled by the state – the AB “Žemės ūkio bankas” (JSC “Lithuanian Agricultural Bank”) and the AB “Lietuvos taupomasis bankas” (JSC “Lithuanian Savings Bank”). In recent years Lithuania has witnessed a concentration of banking activity. At present, the two commercial banks controlled by the state and the largest commercial bank, the AB “Vilniaus bankas” (JSC”Vilnius Bank”), hold nearly 85% of the aggregate bank assets and about 87% of deposits. However, taking into account further market globalisation, such concentration should not be detrimental to competition or prices and quality of financial services on the domestic market, the predominating influence of the aforementioned banks should gradually diminish, in particular with a more active participation in the market of the subsidiary of the largest bank in the Baltic countries, the AB ”Hansabank”, and other foreign bank branches. At present, various other banks are present in the Lithuanian banking sector: the Polish bank „Kredyt Bank SA”, the subsidiaries of the German bank “Nord LB Girozentrale”, the Finnish Bank “Merita Nordbanken” and 5 representative offices of foreign banks. It is anticipated that the growing competition in the banking sector and a widening range of services will increase the volume of the banks’ trade books, which at present is still inconsiderable, and at the same time will necessitate the enforcement of directives CAD I and CAD II. Full implementation of these directives is planned for 2002. The policy of financial sector development, outlined in the Medium Term Economic Strategy, aims at the strengthening of the capital market, the provision of higher liquidity and the creation of more favourable conditions for institutional investors. All this will be done in line with the EU acquis. The aims will be achieved by improving the accounting of securities, by establishing a compensation fund for investors and by disseminating information about the capital market. Privatisation through the National Stock Exchange of Lithuania will become more important in the next few years, investment ceilings for banks and insurance companies will be increased, a new trading system will be introduced, and secondary legislation provided for in the Law on Pension Funds will be adopted. In a medium-term perspective, investment and pension funds, the first of which will probably appear in the middle of 2000, can be expected to become major actors in the capital market. Another area which draws attention is the development of insurance markets. The basic tools in the short term are the provision of long-term life assurance and private pension insurance, and the introduction mandatory insurance of third-party liability for motor vehicles. In the medium term, the taxation of insurance institutions will be improved and conditions for the introduction of new insurance services will be worked out. Page 21 2.3.3. Infrastructure and public utilities Despite the dominant role of the private sector in Lithuania’s economy, a market economy can not function without the existence of efficient, reliable and consumer-oriented public services. The theory of public goods suggests a number of reasons for the public provision of infrastructure and various services, such as the distribution of energy, the supply of water, public transport facilities, etc. The existance and the smooth functioning of these services has immediate implications for the whole economy, as energy input, communications and transport are essential for every production process. The quality and reliability of the provision of public utilities thus has immediate repercussions on the country’s overall productivity and competitiveness. As in many other transition economies, the provision of public services in Lithuania needs improvement. In the field of energy, Lithuania's Medium Term Economic Strategy refers to the National Energy Efficiency Programme and the National Energy Strategy, which states that “in line with the Nuclear Safety Account Grant Agreement Unit 1 of the Ignalina Nuclear Power Plant will be closed down before the year 2005, taking into consideration the terms and conditions of long-term and considerable financial assistance from the European Union, G-7 countries and other states as well as international financial institutions. Due to the age difference between Unit 1 and Unit 2, the issue pertaining to the conditions and precise final date of the decommissioning of Unit 2 shall be solved in the updated National Energy Strategy prepared in the year 2004, when more detailed information on the operation of Unit 2 will be available.” The participation in international energy system integration projects pursuing the aim of interconnecting Lithuanian and West European energy grids is one of the priorities for the development of the energy infrastructure. Environmental goals will be taken into consideration when dealing with energy development matters, and measures to reduce sulphur and nitrogen oxide emissions will be undertaken. In a long term perspective, the primary energy structure will be balanced by increasing the share of natural gas and renewable energy resources. In the transport sector, the integration into the European transport network and transport services market and the development of carriage services under conditions of fair competition are among the main objectives. It is planned that in 2010 the carriage of goods will increase 1.7 times, compared with 2000, and the carriage of passengers 1.8 times. The use of the Klaipeda seaports and the airports for the carriage of passengers will increase by about 1.8 and 1.5 times respectively. Priority will be given in the medium term to the gradual approximation of the Lithuanian transport infrastructure on a technical level to EU standards, starting with the European transport corridors. As regards communications and information, the medium term efforts will be directed towards drafting the programme for the development of an information society, further liberalisation of the telecommunications services market, reduction of the number of licensed telecommunications services and the upgrading of communication technology. The range of services will be enhanced, e.g. more financial services in the postal sector; improved medical services; better training services; use of electronic mail in work place and commerce (upon adoption of the law on electronic signature); new telecommunications services such as wireless satellite technologies, third-generation mobile telephone communication, wide-band multimedia services including video, audio, data transmission, digital radio and TV broadcasting. The institutional framework will be in place after the Telecommunications Regulation Service starts its activities and the necessary legislation is adopted. Page 22 2.3.4. Price liberalisation and competition policy The free formation of prices and competition among producers are key preconditions for the functioning of a market economy. Freely determined prices provide important information on scarce resources and allow for their most efficient allocation. Competition among the suppliers of goods and services guarantees the most efficient use of scarce resources. In the case of Lithuania, about 16% of the prices of goods and services comprising the consumer basket are administered, especially in the area of energy, water supply and heating, transport and telecommunications services. The Lithuanian authorities intend to remove the last remaining price distortions as soon as possible, and to apply the “polluter pays” and “cost recovery” principles where they are relevant. They will take into account the short-term inflationary effect of price liberalisation and the possible negative impact on the income distribution. For instance, low-income groups will be more strongly affected by the rise in energy prices than higher income population groups. Measures to adjust administrated prices therefore should be closely co-ordinated with wage and income policy. Striving to achieve the most effective realisation of fair competition and approximation of basic competition principles with the EU competition law, on 23 March 1999 a new competition law was adopted, replacing the former competition law of 1992. The implementation of the new competition law is a major priority. At present the competition law is being further developed by adopting relevant secondary legislation, and efforts are made to strengthen the Competition authority. 2.3.5. Foreign trade policy For a small open economy such as Lithuania trade policy and its integration into the EU and global economy are of crucial importance. The internal macro-economic developments depend to a large extent upon international trends. The developments in wages and prices have a direct impact on Lithuania’s international competitiveness. The Lithuanian authorities pursue an active policy of promoting the integration of Lithuania into the global economy. Creating the conditions for open trade and promoting the inflow of foreign investment are the most important parts of the strategy for modernising the economy. In addition, Lithuania’s geographical location at the crossroad of Europe provides it with the opportunity to act as a trading intermediary. Enhancing Lithuania’s participation in the European regional trade is one of the medium-term policy objectives. Lithuania’s trade regime is a very liberal one, with import duties being among the lowest in Central and Eastern Europe. It has Free Trade Agreements (FTAs) with an increasing number of countries and is heading for WTO membership. When concluding new FTAs, due regard is taken of the provision for waiving compensation when Lithuania becomes a member state of the EU. Free Trade Agreements have been signed with the EU, EFTA, Estonia, Latvia, Poland, the Czech Republic, Slovakia, Slovenia, the Ukraine, Turkey and Hungary. Negotiations are under way with Romania and Bulgaria. Work has been started on adjusting the Free Trade Agreement with the Ukraine in order to ensure compatibility of this agreement with obligations arising both from the WTO and EU membership Taking into consideration the fact that most FTAs provide for individual tariff reduction schedules in respect of certain groups of goods, and certain positions are subject to tariff quotas, the implications for the fiscal account will be assessed by analysing each position of goods and taking into consideration changes in trade flows, collected customs duties, etc. Page 23 Lithuania’s accession to the WTO will provide an opportunity for further progressive alignment to Community policies during the pre-accession period. Upon WTO accession full alignment to Community policies and commitments within the WTO framework will be necessary. Moreover, close co-operation with the EU and alignment of positions will be necessary both in the framework of the ongoing negotiations in the WTO and in the perspective of a new comprehensive round of negotiations. Besides concluding trade agreements, the Lithuanian government authorities improve international competitiveness by encouraging domestic and foreign investment. Programmes for the promotion of FDI are in place, and international agreements on the mutual encouragement and protection of investments, as well as agreements on the avoidance of double taxation and prevention of fiscal evasion, will continue to be signed. Depending on the negotiations for the membership of the EU, the EU principles applied to the free movement of capital and the non discriminatory promotion of investments will be adopted. 2.4. Policies directed towards further structural reform This chapter contains some major areas for structural reform, necessary to sustain sound public finances in the long run and high economic growth, both in order to bring the Lithuanian economy in full shape for EU membership. 2.4.1. Social security reform The ageing of the population and its implication for public finances is EU wide issue. Measures must be adopted in the near future in order to avoid problems in the long run. It will not only affect pension expenditures, but also health care expenditures. The latter aspect is probably even more important than the need for pension reform; more than 50% of all health care is consumed by the elderly. While implementing social expenditure policy, Lithuania’s medium-term economic strategy emphasises that expenditure and revenues should be in balance. A degree of flexibility will be introduced by giving municipalities greater independence to target social care on those who need it most. The Law on Pension Funds passed in 1999 can be seen as the first step towards a greater involvement of the private sector in the provision of social security system. It is not an immediate solution for the rising pension expenditures because moving from a pay-as-you-go system to a partially funded system implies transition costs. Otherwise, the same workers would have to contribute to the financing of the present pensions of the pensioners as well as to the formation of their own, future, pension under the second mandatory) and third (private insurance) pillar. The increase of pension age will be continued at a faster pace, until pension age reaches 65 years for both women and men. Most of the time, the transition costs take the form of tax exemptions (such as the deduction from the tax base of the compulsory contributions to the second pillar) or reduced social contributions (whereby the contributions to the pension funds are compensated by an equivalent decrease of the social contributions). Given the fragility of the Lithuanian government finances, this is a matter of concern and these budgetary costs should be carefully considered when introducing the funded pension scheme. The introduction of the mandatory and voluntary pension-fund savings scheme can have positive effects on the labour market, if payments into a pension fund are considered to be less Page 24 of a tax on labour income than social security contributions. It can also act as a stimulus to the development of the capital markets, as pension funds tend to channel private savings into long-term assets and shares. This will also promote investments, since it enhances and deepens the capital market. 2.4.2. Agricultural sector and rural development policy The key goal of the agricultural policy with the perspective of integration into the European market is to increase efficiency in agriculture, and co-ordinating the given goal with the employment of rural population, to create favourable environment for economic, social, environmental and ethno-cultural development of the countryside. This will be achieved by the modernisation and technological reorganisation of the agricultural sector and by improving the quality of agricultural products without raising production costs. The quality of Lithuania’s agricultural products is gradually approaching EU standards. They account for nearly one quarter of Lithuania's exports to the EU. The Medium Term Economic Strategy spells out in detail the measures which are envisaged by Lithuania to comply with the EU acquis in the areas of agriculture and fisheries. An integrated Rural Development Plan targeted at the creation of other than agricultural jobs and at the development of small and medium sized business and tourism has been prepared. Among the top priorities are the completion of land reform, the creation of favourable conditions for greater cooperation among farmers in the areas of procurement, marketing, maintenance and other services, as well as the retraining and self-regulation. 2.4.3. Environmental policy The Strategy emphasises efforts to facilitate sustainable economic growth. In setting priorities for the development of industry and its sectors great importance is attached to the assessment of its possible impact on environment and measures to be taken. The major goal of environmental protection is the preservation of a clean and healthy natural environment as well as biological and landscape diversity. Seeking to ensure better investment planning and management in the environment area, Community requirement-oriented sectoral programmes under preparation now, among other things, stipulate the assessment of investment needs. An estimated investment of 4.6 billion litas will be needed up to the year 2015. ISPA funds are expected to contribute some 20-30 million euro per year to the improvement of the environmental infrastructure in the period up to 2006. Total funding under ISPA will amount to twice as much. In 1999, Lithuania adopted a number of horizontal and sectoral laws, which cover a large part of the EU acquis: the programme for the implementation of the approximation of the legal norms, governing the management of water resources in Lithuania, the draft strategic plan for the creation of the network of the municipal landfills as well as the strategy for the introduction of the integrated pollution licensing. Medium-term plans cover the action plan for the enforcement of the Strategy for the Preservation of Biological Diversity and the setting up of administrative structures needed to ensure compliance with the standards related to EU integration by highlighting priorities of this process depending on the size of investments. The formulation of conditions for personal initiative and NGO activities in the area of environmental protection. is also planned. The measures mentioned above will be implemented with due regard to the measures taken to develop industry and improve the energy and transport infrastructure. Page 25 2.4.4. Regional development policy As Lithuania's GDP per capita corresponds to roughly 30% of the EU average, upon its accession to the EU, the whole country will be treated as Objective 1 region under the EU regional policy. The main objectives of the national regional development policy are as follows: promote restructuring and modernisation of economy in the regions; develop rural regions, by transforming and restructuring their economy, by reforming agricultural production, the processing industry and marketing structures by promoting the development of new businesses and services; reduce social and economic disparities between the regions; In the medium term the establishment of the legal and administrative framework of regional development will be completed. The newly established institutions should be flexible as to adjust to the rapidly changing environment, and while administering the pre-accession assistance provided for social and economic cohesion be capable to ensure efficient management of finances and economic investment. Those institutions should also be prepared to manage the EU pre-accession support available for regional development ISPA, SAPARD and PHARE 3. DEVELOPMENT OF LITHUANIA’S ECONOMY IN THE MEDIUM TERM The aforementioned macro-economic scenario reflects the medium-term economic development policies of the Government of the Republic of Lithuania. Several scenarios have been worked out for the purpose of this Joint Assessment in order to analyse the options available to the Lithuanian government in setting its economic policy priorities for the medium term. They are based on the development of the main sectors of the economy between 1993 and 1999, on actual and preliminary data for 1998 and 1999 and the projections of different ministries and government institutions. Calculations using a World Bank model (RMSM-X, Revised Minimum Standard Model) provided a quantitative framework for ensuring the consistency of the different inputs. The model focuses on medium term scenarios up to 2005, although its projections cover the period until 2010. The central and only presented scenario assumes, that all necessary budgetary, monetary and economic restructuring measures, as described in the Joint Assessment, are fully and timely implemented. The calculations are based on the following external and internal assumptions: The Currency Board Arrangement, introduced in April 1994 will be retained during the medium-term period. The pegging of the litas to the US dollar will be replaced by its pegging to the euro in the second half of 2001. The nominal exchange rate of the litas will be kept constant during the whole period. Before mid 2001, the monetary policy instruments used by the Eurosystem (repo operations, deposit auctions and overnight loans) will be in place. It is also assumed that the Seimas will adopt necessary amendments to the Law on the Bank of Lithuania, guaranteeing its independence. This measure cannot be introduced in the model explicitly, because it does not directly influence any variable, but implicitly the reinforced credibility Page 26 of monetary policy is reflected in the containment of inflation at 2% in 2005 and onwards until 2010. GDP growth in the EU remains at around 2.5%, and the economic growth in Russia returns to a more or less normal level and is 4-5%. Due to the Russian crisis, Lithuanian exporters did re-allocate part of their exports to the EU market. It is assumed that this will remain the case because these exporters prefer the more stable EU market and because of the future membership of Lithuania to the EU. Given the anticipated increase in the volume of exports, one can assume that, without a change in real exchange rate, Lithuania’s export to Russia could rise by 5% per year from 2003 onwards and exports to the EU by 7% per year. Average inflation in the EU remains at 2% per year. In Lithuania, average inflation should not exceed 1% in 2000. In the short run, adjustments of inflation may take place as a result of price liberalisation of utilities. In the longer run divergences between the inflation rates of EU and Lithuania can only be the result of wages, if it grows faster than labour productivity. For a small open economy such as Lithuania there are very few options other than maintaining a fixed exchange rate of the litas and almost none once the credibility of monetary policy has been regained by introducing a currency board arrangement. Even small economies with a more flexible exchange rate regime have very little room for manoeuvre in terms of exchange rate movements induced by monetary policy changes. Any depreciation of the currency would rather quickly translate into higher prices and wages, which would erode any short term advantages in terms of price competitiveness. There is even a risk of an inflation spiral that would destabilise the economy. The assumption of a fixed nominal exchange rate and stable and low inflation implies, however, that the necessary adjustments to return to a stable growth path after a shock which has turned the economy away from its equilibrium or steady state have to come from the real side of the economy. The main adjustment mechanism available to the government on that side is fiscal policy. The presented scenario assumes that all planned measures, described in the Joint Assessment are implemented within the indicated time span. The most crucial assumption is to keep wage growth in line with labour productivity growth. This priority is reflected in many ways in the assumptions of the model: first, it is allowed that the inflation rate will be in line with that of the main trading partners, second, it is planned that the real exchange rate does not change and third, that the overall advantage in terms of competitiveness is maintained by moderating the rise in the average wage cost per unit of production. In the period between 1994 and 1999 the nominal effective exchange rate of the litas increased by 130%; with respect to the EU currencies, the increase was about 12%. The difference reflects in particular the sharp depreciation of the Russian rouble with respect to the US dollar, to which the Lithuanian currency has been linked since 1994. Lithuania’s real exchange rate has been steadily appreciating since 1994, both with respect to Russia (81%) and the EU (80%). This is explained by the initial under-valuation of the litas on the one hand, and by the large devaluation of the rouble on the other. The effect of an appreciation of the REER on competitiveness can be offset by the increase in labour productivity, measured by the relative unit labour costs. Since the second quarter of 1997, Lithuania’s RULC increased, reflecting a loss in competitiveness due to average wage increases in Lithuania which were in excess of labour productivity growth. Page 27 In the presented Scenario it is assumed that the real effective exchange rate and the relative unit labour costs are constant with respect to the trading partners. Real wages grow at the same rate as productivity and, as a consequence, inflation rate is similar to that of the trading partners. Taking into account that real wages have been growing much faster than productivity in 1994-1998, and that the wages growth decreases considerably in 1999, one can make the conclusion that the trend has turn around and is in compliance with the requirements set in this Scenario – to improve competitiveness and reduce unemployment. Wage formation can be influenced in a number of ways. By modernising industrial relations and facilitating the social dialogue between employers and employees. The legal framework for the establishment of collective agreements in order to regulate wages and payment procedures will be prepared. Moderately increasing wages in the public sector, which will also have a demonstration effect in the private sector. It is therefore not only instrumental in reducing the state budget deficit but also helpful in maintaining the competitiveness of the economy. Reducing government employment by increasing the labour supply in the private sector, which will help to keep wage increases under control. The Scenario makes the assumption that employment in the public sector will be retained constant – at 520 000 employees. By increasing the legal and effective retirement age (by making access to early retirement schemes less attractive). This will help to alleviate the burden of the ageing population on social security and health expenditures in the medium term. By applying training and retraining programmes. Unemployment in Lithuania reached almost 10% in December 1999 and may still go up in the next few years as a result of restructuring. One of the bottlenecks in reducing the unemployment rate across the country is low labour mobility, due in part to poorly functioning housing markets. Another problem is low labour mobility across sectors. This can be remedied by appropriate training and retraining schemes and other measures which fit the objectives of the SAPARD and PHARE programmes. The Scenario assumes that, in the medium term, unemployment will be in the range of 6-7%. By carrying out tax reform. Changes in direct taxes and social contributions have an effect on changes in wages. Lithuania’s tax reform aims at an expansion of the tax base and an improvement of tax collection. It also envisages the transfer of part of the tax burden from direct to indirect taxes. The Joint Assessment provides a thorough programme of the structural reforms needed to complete the transition process and prepare the economy for future participation in the EU. The structural policy will contribute heavily to increase productivity in the Lithuanian economy sectors. In the short run the current account deficit and the necessity to reduce it to the acceptable level poses major concern. In the second half of the 1990s the savings rate of the private sector fluctuated around 15% of national income, while the investment rate increased from 20.9% of GDP in 1995 to 23.9% in 1997 and 24.8% in 1998 and 21.6% in 1999. The net savings of the private sector are very negative as a result. In order to guarantee economic growth in the future, it is necessary to promote investment . Page 28 Apart from pension reform and its positive effects on the availability of capital in the medium term, the government should stimulate private savings or change the savings behaviour of the population. However more effective is the impact on aggregate demand of a reduction in the state budget deficit. It is assumed in the Scenario that the government’s target of reducing the general government deficit to 2.8% of GDP in 2000 is reached, that public debt will not exceed 30% of GDP and that the foreign debt will remain below 23% of GDP. This requires that the savings restitution plan is delayed, that off-budget expenditure will be kept in check and that plans to increase the pension age and to introduce means testing for social benefits will be speeded up. The calculations show that, if this target is met, and if public expenditure remains below the specified limits, no additional expenditure cutting measures will need to be taken. Furthermore, it is assumed in the Scenario that at least half of the current account deficit remains to be financed by foreign direct investment. The main economic indicators for Lithuania in 2005 and 2010 are presented in table 2: The main results of the scenario as presented are that real GDP growth increases from 2% in 2000 to 6% in 2005 and the average annual growth of GDP will make around 5% in20062010. Tight monetary policy will keep inflation at 2% per year. The fiscal deficit, which in 2000 accounts for 2.8% of GDP, will be reduced to near balance in 2003-2005. This will reduce public debt from 29.9% of GDP (31.03.2000) to less than 12% of GDP in 2010. Foreign debt will also be gradually reduced from nearly 22.6% of GDP in 1999 to 6.5% of GDP in 2010. This means that the constraints put forward in the Medium Term Economic Strategy concerning the debt will never be binding. The foreign trade balance (goods and services) will remain negative. A halving of the deficit to 5.4% of GDP in 2005, and again to 2.5% of GDP in 2010, is projected. This will help to curb the current account deficit from 11.2% in 1999, via 6.6% of GDP in 2005, to 4.3% in 2010. Due to economic restructuring, unemployment will rise in the first years of the scenario. In spite of the acceleration of GDP growth, the unemployment rate will increase to 10.2% in 2001. However, and this is the main difference with other scenarios, the tight policy and restructuring of the first years is projected to result in a reduction of the unemployment rate to 7.2% in 2005 and 6% in 2010. The upshot is that the Lithuanian economy has a price to pay for the restructuring of the economy in the short run, but that it can expect to be amply rewarded by the benefit of stronger growth dynamics which will appear in the medium to long run. Page 29 Table 2 MAIN ECONOMIC INDICATORS OF LITHUANIA Economic indicators 1993 1994 1995 1996 1997 1998 1999 2000 Report data 1. 2. 3. 4. 5. 6. 7. 1. 2. 3. 4. 5. 6. 7. Gross Domestic Product, million litas (at current prices) Gross Domestic Product, million litas USD (at current prices) Annual change in GDP, (comparative prices) Per capita GDP, USD (at current prices) National budget deficit, of GDP Annual inflation, ( December months compared) Average annual inflation, % (periods compared) Foreign trade (goods and services) balance, of GDP Current account deficit, of GDP Foreign Direct Investment, million litas (per year) Foreign Direct Investment, of GDP (per year) Foreign debt, % of GDP (end of the year) Average annual increase of real wages, % Unemployment rate, % (average annual) 2005 2010 Scenario 11590 16904 24103 31569 38340 42990 42597 44409 62176 89717 2662 4227 6026 7892 9585 10747 10649 11102 15544 22429 -16,2 -9,8 3,3 4,7 7,3 5,1 -4,1 2,0 6,0 5,0 714 1136 1622 2128 2587 2903 2878 3004 4226 6117 0,8 -1,9 -1,8 -2,5 -1,0 -1,3 -0,3 -1,8 0 0 189,0 45,1 35,7 13,1 8,4 2,4 0,3 1,6 2,0 2,0 410,2 72,2 39,6 24,6 8,9 5,1 0,8 1,0 2,2 2,0 -7,8 -6,0 -11,8 -9,8 -10,6 -12,0 -10,3 -10,0 -5,4 -2,5 -3,1 -2,1 -10,2 -9,2 -10,2 -12,2 -11,2 -10,6 -6,6 -4,3 135,7 124,7 290,2 609,7 1418,0 3702, 0 1945,8 2900,0 2090,0 3050,0 1,17 0,74 1,20 1,93 3,70 8,7 4,6 6,5 3,4 3,4 10,7 11,7 13,9 15,2 14,6 15,7 22,6 17,3 10,5 6,5 -39,0 14,2 3,5 3,3 13,4 12,8 7,2 2,2 4,7 4,9 4,4 3,8 6,1 7,1 5,9 6,4 8,4 10,6 7,2 6,0 Data sources: Statistical records of Lithuania 1994 - 1995, 1996, 1997, 1998 and 1999; Bulletins of the bank of Lithuania 1993, 1994, 1995, 1996, 1997, 1998 and 1999; Lithuania’s Economic and Social Development Monthly bulletins Vilnius: Department of Statistics under the Government of the Republic of Lithuania, 1997, 1998, 1999; Lithuanian Economic and Social Development Forecast for 2001-2003. Ministry of Economy, Vilnius, April 2000. Page 30