Introduction
On March 11, 1990, Lithuania declared the re-establishment of its independence, which was internationally recognized in August/September 1991. Lithuania became a member of the World Bank on July 6, 1992. The first draft Country Economic Memorandum (Report No. 10920-LT) was discussed with the government during October 1992 and is planned for publication in FY93. The report represents the first comprehensive review of the Lithuanian economy. It provides an overview of the economic situation, policies, and economic prospects. It also presents macroeconomic and systemic reform issues and contains detailed discussions of individual sectors. An economic update is planned for 1993. Following the approval of a stand-by arrangement with the IMF on October 21, 1992, the Executive Directors approved the first Bank loan to Lithuania, a Rehabilitation Loan for US$60 million equivalent on October 22, 1992 (President's Report No. P-5845-LT), which became effective on November 5, 1992.
Background
Lithuania has a territory of 65,200 square kilometers and a population of 3.8 million people with 600,000 residing in the capital, Vilnius. Lithuanian terrain is relatively flat, with forests covering 30 percent of the territory. Lithuania has some minerals used mainly in the construction industry, peat deposits and insignificant oil deposits.
Lithuania's annexation by the former Soviet Union (FSU) after World War II resulted in a radical transformation of its economy. The Soviet period was characterized by rapid industrialization brought about by high rates of capital formation and forced labor movements from agriculture to industry and from other parts of the Soviet Union especially Russia. Lithuania's skilled workforce and comparatively well-developed infrastructure motivated central planners to establish sophisticated industries in the country including machine building and metal working industries which became main export products. The textile and leather industry is also important. Agriculture is relatively well developed, and Lithuania is a large-scale exporter of food products to the FSU.
During the late 1980s, the increasing economic and political turmoil in the entire Soviet Union intensified macroeconomic imbalances and led its economy into crisis. Only renewed political and economic independence has now enabled Lithuania to take full control of its domestic economic policies. Lithuania has embarked on a comprehensive and far-reaching economic reform program aimed at reorienting its economy from a centrally planned to a market system. Substantial progress has already been made in this transition, most notably in the areas of price reform and privatization. However, the reforms have started in an unfavorable economic environment, as indicated by declining output, deteriorating terms of trade, and high rates of inflation. The success of the reform program will depend on many factors, including political determination, appropriate institutional support to enhance implementation capacity, and external factors that are not fully within Lithuania's control such as the normalization of trade relations with the former Soviet republics and financial assistance from the West.
Recent Economic Developments
Output and Trade. As a small country whose economy was tightly integrated with that of the FSU, Lithuania depends heavily on trade in general and on trade with the FSU in particular. Following a two and a half months trade embargo imposed by the Soviet government after Lithuania's declaration of independence in 1990, increasingly severe disruptions in trade with Russia and other former Soviet republics have led to a very sharp decline in import volumes and domestic shortages of a wide range of essential inputs into production and many consumption commodities. By the beginning of 1992, the supply situation for many industries had reached a critical state, and some enterprises had to halt production for lack of inputs. This has translated into a marked decrease in the level of output. Real GDP fell by about 7 percent in 1990 and an estimated 15 percent in 1991, and per capita income has fallen accordingly. During 1992, the situation deteriorated further. Further reductions and repeated temporary halts in Russian energy deliveries to Lithuania have resulted in severe energy shortages and rationing. In combination with the continued lack of adequate payment and settlement arrangements for FSU trade in general, this has further accelerated the drop in import volumes and the decline in production, output, and incomes. Preliminary data show a decline in GDP from the first half of 1991 to the first half of 1992 by more than 40 percent, and output and GDP for 1992 as a whole could fall by 30-35 percent or more.
Prices, Wages, and Employment. Lithuania started its price reforms in February 1991 in advance of reforms instituted in Russia. By mid 1992 only few goods and services remained subject to direct price controls (mainly energy products and municipal and public infrastructure services). Indirect controls in the form of controls on profit margins may still exist. Relative prices have started to realign, but adjustments will realistically continue for some time. The price reform has also led to a considerable increase of inflation. The average annual rate of inflation in 1991 was about 225 percent. In 1992 it may be as high as 1100 percent, mainly due to the dramatic increase of energy prices to world market levels. Despite repeated lags in inflation adjustments, average nominal wages rose more or less in line with prices until early 1992. Only recently have real wages fallen significantly. By September 1992, after one month of the Government's new incomes policy (see below), real wages stood roughly 20 percent below those in early 1991, which were only slightly lower than those in 1990.
As a result of the price reform, enterprises' output prices rose faster than the prices of their imported inputs, and their financial situation temporarily improved. These gains allowed enterprises to retain their work force, despite operating at very low levels of capacity. Thus, despite the sharp decline in output during the last two years, official unemployment was only 0.5 percent through the middle of 1992, although it has since risen to 1-1.5 percent. As enterprises undergo restructuring and their financial situation deteriorates, unemployment is likely to increase significantly. Managing the various enterprise restructuring, labor market, social safety net, and fiscal aspects of this process will be a major challenge.
Fiscal and Monetary Policy. Lithuania's central and general government budgets were in deficit throughout the late 1980s. A number of factors moved the general government budget into a surplus of 3 percent of GDP in 1991: the introduction of a profit tax, the temporarily improved financial situation of enterprises, and other tax reform measures, significantly increased social security contributions, a dramatic reduction in subsidies in conjunction with the price reform and the termination of transfers to the FSU. These effects carried over into 1992, but fiscal pressures have started to rise dramatically, due mainly to the negative impact of falling enterprise profits on tax revenues and rising expenditures on unemployment and other social benefits.
Despite serious monetary problems, Lithuania remained in the ruble zone until October 1992. Since late 1991, Russian deliveries of ruble bank notes have been highly irregular. The problems created by the scarcity of rubles, in addition to the more general problems of remaining in an unstable currency area, led the Lithuanian Government to plan the introduction of a national currency, the litas. As a temporary measure to ease the currency shortage, the Bank of Lithuania began on May 1, 1992, to issue coupons (talonai). Initially, the talonas was used alongside and interchangeably with the ruble, but on October 1, 1992, it became the sole legal tender in Lithuania, and the authorities established an exchange rate regime with a unified floating exchange rate and current account convertibility. The Government and Bank of Lithuania are now completing the technical and monetary policy preparations related to the introduction of the litas, which is expected for later this year.
Enterprise Sector. Privatization and enterprise reform have been at the heart of the Government's economic reform program from the very beginning. Legislation on privatization was passed in February 1991. The privatization program, which covers housing as well as small and large enterprises, is generally well developed, and considerable progress has been made in implementing its various aspects. By the end of 1992, the authorities intend to privatize about 60 percent of assets previously owned by the state, excluding land. To improve the management of state enterprises that are not scheduled for privatization in the immediate future, the Government has started to corporatize enterprises and create independent, commercially-oriented entities from previous state-owned conglomerates and large enterprises. They have also begun to break up selected large monopolistic state enterprises. However, the market structures of many Lithuanian industries remain heavily concentrated, with one or very few large and frequently integrated enterprises exerting strong monopoly power. Recently, a Competition Law has been passed and a Competition Agency and policy-making Competition Council have been established to push ahead further in this area. Beyond formal corporatization, there is also a great need to commercialize state enterprises further and gradually make them fully financially autonomous.
Financial Sector. After some significant reorganization over the past two years, the Lithuanian financial sector today comprises the Central Bank of Lithuania, four specialized state banks (the Commercial Bank of Lithuania, Savings Bank, Agriculture Bank, and Investment Bank) and seventeen commercial banks. However, the banking system remains weak, and the financial situation of the state banks is fragile. The Savings Bank in particular, whose major "asset" are non-performing claims on Russia for past transfers of deposits to the former All-Union Savings Bank, is already technically insolvent and nearly illiquid. Both the Commercial Bank of Lithuania and the Agriculture Bank also hold portfolios of uncertain quality, with audits of several branches being expected to reveal significant negative net worths. The resolution of the portfolio problems through a careful audit and restructuring program for the banking sector is an urgent priority. This should be linked to the restructuring of the enterprise sector (the primary debtor of bad loans and the potential recipient of most new loans) and take into account the monetary and fiscal implications of various restructuring options. Institutional support and technical assistance to strengthen the healthy banks are also important.
Social Security System. Before renewed independence in 1990, the Lithuanian social security system was integrated in the social programs in the FSU. Social security operations were financed through the state budget and almost completely regulated by the central authorities in Moscow. Towards the end of 1990, the Lithuanian Government started to prepare changes in the structure and administration of the inherited social programs, which became effective during 1991. The reforms undertaken so far include the introduction of targeted unemployment benefits, the provision of family benefits directed towards the poorer segments of the population, and the provision of essentially flat-rate price compensations for pensioners.
The Stabilization Program
Under the stabilization part of its economic reform program supported by the stand-by arrangement with the IMF and the Bank's rehabilitation loan, the Government intends to eliminate remaining price controls and price subsidies as quickly as possible. Price controls will remain on a few energy products and public services, which can be justified on the basis of monopolistic conditions or social grounds. Energy prices for consumers have been and will continue to be adjusted to cover full costs. Agricultural subsidies will be limited to amounts that can be accommodated within the budget. An early completion of the price reform will help reduce the strain of subsidies on the budget and improve the chances for price stability after the introduction of the litas.
To shorten and facilitate the transition to an autonomous and stable macroeconomic policy, the authorities intend to introduce the litas as soon as posible, following the recent formation of the new Government and the last round of energy price increases to world market levels. The Government also recognizes the need for appropriately tight macroeconomic policies for the foreseeable future to limit inflation, help build confidence in the litas and create a stable framework for enterprise, banking, and sectoral reforms. This will include (a) efforts to achieve a balanced budget for the second half of 1992 and into 1993, based on selected additional tax reform and tax collection measures as well as a further reduction in subsidies and a review of social expenditures; (b) the determined implementation of the Government's new incomes policy that began in September with a two-months wage freeze for budgetary organizations and which limits average wage increases thereafter to certain ceilings established on the basis of changes in the consumer price index; and (c) the design of monetary policy with a view to providing domestic credit at a rate consistent with expected economic activity and the agreed target path for inflation (3-5% per month by end 1992 and 2% per month by March 1993).
The Structural Reform Program
Enterprise Sector Reform and Competition Policy. Rapid privatization of the vast majority of state enterprises is an integral part of the Government's economic reform program. The privatization program is running, on the whole, smoothly and is continually adjusted and improved to maintain the momentum. Most restrictions on sale of non-agricultural land have been removed and land restitution is progressing well. Privatization of small businesses is progressing rapidly. Initiatives to facilitate the privatization of larger enterprises, for some of which there is limited demand include: (a) the break-up, where feasible, into smaller enterprises that are easier to sell; (b) easing of remaining restrictions on foreign investors; and (c) the introduction of a wider variety of privatization techniques. At the same time, measures are being taken to improve the management and competitiveness of enterprises remaining in state hands. State enterprise organization and management will be reviewed further. The Government intends to establish regulations and institutional arrangements for the introduction of new internationally accepted accounting standards and procedures. Subsidies to enterprises (including implicit subsidies through the banking system) will be limited to amounts consistent with a fiscally sound strategy for hardening the financial constraints on enterprises, and a system will be designed for monitoring and restraining inter-enterprise arrears. Competition will be enhanced by building up and strengthening the Competition Agency and Council, and where appropriate, privatization procedures will increasingly include the break-up of larger enterprises. Finally, foreign investment will be promoted further.
Financial Sector Reform. In the financial sector, the emphasis will be on bank restructuring and further reform in areas such as bank supervision and regulation, accounting, auditing and payments systems. With the help of technical assistance, the Government plans to develop a coherent plan and timetable for the financial restructuring of the existing banking system and in particular the large state banks. Following the establishment of a new system of bank reporting for off-site banking supervision, efforts will now focus on the development and training for on-site supervision. Enabling regulations will be introduced and institutional arrangements and training programs will be implemented for introducing new bank accounting, auditing, and payment systems.
Social Protection. An important objective of the reform program is to ensure that the costs of adjustment do not fall disproportionately on the most vulnerable groups, while at the same time providing incentives to facilitate the process of labor force adjustment, and keeping the budgetary costs of the social safety net manageable. The Government will develop a plan for the overall design and financing of the social safety net system within tight budgetary constraints based on an evaluation of the economic, social and budgetary implication of various options. To cope with the expected rise in unemployment, the Government intends to introduce a simplified structure of unemployment benefits and appropriately modified eligibility criteria. The network of local social assistance offices will also be strengthened, and the authorities will work to introduce a realistic poverty line concept, which will be the basis for effective means-testing system for channeling social benefits. Pension reform will proceed in two stages: the preparation of a short-term plan for the quick introduction of a simple flat-rate pension scheme on a transitory basis, if needed; and the development of a comprehensive medium-term reform plan, based on a full costing of options.
Capable public sector institutions need to be in place to ensure the success of the reform program. To that end, the present statistical infrastructure and institutional framework for monitoring economic development will be strengthened. The Government will build up its system and institutional capacity for recording and management of external borrowing and assistance. Finally, a mechanism will be established to set priorities, establish project evaluation criteria, and appraise project proposals for public investment, with the view towards preparing a first rolling three year public investment program.
External Debt and Creditworthiness
Lithuania does not view itself as a legal successor to the FSU and has declared that it bears no responsibility for its debt. According to the Government's Debt Letter that was provided to the Bank prior to the signing of the rehabilitation loan, Lithuania has no external debt except possibly some part of the external debt of Lithuanian enterprises incurred during the Soviet period in an amount of at most US$35.7 million, which is still being negotiated.
Official Lithuanian trade and balance of payments statistics are still rudimentary, and the economic situation as a whole remains highly uncertain, with Lithuania's FSU trade, payment arrangements, and exchange rates in particular being extremely volatile. For this reason, projections of external financing needs are difficult and necessarily tentative and subject to a wide margin of error. Since the finalization of the President's report for the Rehabilitation Loan, only partial and preliminary new data have become available. These data point to two worrisome trends. First, trade with Russia and other former Soviet republics has deteriorated even more than originally assumed. Second, financial assistance from the international community, both multilateral and bilateral sources, has been mobilized somewhat more slowly than originally expected. These two factors have led to a further steep compression of imports and a correspondingly more severe decline of output and incomes. Of course, the forced contraction of imports in 1992 because of shrinking trade volumes with the FSU and the lack of international financial assistance has resulted in a lower projected trade and current account deficit than expected. But it has done so at the cost of a spectacular economic contraction that is turning out to be even worse than expected. Lithuania's actual annual financing requirements to prevent a further compression of imports and deterioration of growth prospects remain high. The partial and preliminary information that is so far available for 1992 confirms that average financing requirements to finance Lithuania's current account deficits, build its external reserves, and begin servicing any emerging external debt might amount to roughly US$500-600 million over the next 2 years. But clearly, these projections are necessarily preliminary given the rudimentary state of official trade and balance of payment statistics. Currently, external aid and resource mobilization is being coordinated through the G-24 framework, with meetings organized by the EC and including representatives from multilateral organizations.
Having only recently regained independence and having no credit record, while being faced with the daunting task of reforming its entire economy, Lithuania will need some time to establish full creditworthiness. Rough and preliminary financing projections for a sustained reform scenario that would prevent a further substantial decline of Lithuania's economy and allow a recovery beginning in 1994 would imply current account deficits of about 10-15 percent of GDP over the next 2 years. Lithuania's debt and debt service ratio would stay within prudent bounds even in the medium term, if: (a) the current account deficit can be brought back down to below 4-5% of GDP by the mid 1990s; and (b) some portion of financing would be in the form of grants or highly concessional loans.
Overview and Objectives of the Strategy
The Bank's immediate objectives are to assist the Government in the implementation of its economic reform program, while providing import financing to maintain essential services and production. The Bank's medium-term objectives are to continue to support a full transition to a market-based economy (including structural measures to ensure a vigorous supply response to the new incentive system), while financing sound investments in key sectors. More specifically, the Bank's activities would aim to: (a) support the process of economic reform by facilitating the implementation of macroeconomic policies and systemic or structural reforms needed to stabilize the economy and stimulate production; (b) strengthen the design and implementation of a social safety net that would protect the most vulnerable groups during the transition period and assist in labor force restructuring; (c) build institutional capacity in economic management to support a market-based economy; and (d) support sector-specific reforms to restructure or expand productive capacity and promote medium-term investments to improve economic efficiency and protect the environment. In realizing these objectives through its lending program, economic work, and technical assistance, the Bank will promote and support Baltic-wide or even wider regional approaches, in particular in areas such as trade policy or energy investments where there are potentially high economic returns from regional cooperation.
Summary of the Bank's Assistance Program
The lending program is designed to combine policy-based lending with investment lending in the coming years. The overall size and composition of the Bank's lending program will be linked to the Government's performance in implementing its reform program. Assuming Lithuania's continued good progress in its reform program, the Bank is planning a gradually expanding lending program over the next three years averaging about US$70 million per year with one to two operations per year. As the economy starts recovering, Bank resources would be channelled into investments aimed at increasing productive capacity, particularly in the private sector, and at rehabilitating the country's infrastructure, while supporting sectoral and institutional policy measures.
The Rehabilitation Loan focusses on the provision of essential goods primarily for the agricultural and energy sectors and the health system, while supporting the Government's economic reform program. An Energy/Environment Project is planned, which would support energy conservation and other possible investments in energy, and related municipal infrastructure, many of which would not only result in significant cost savings and improved services, but would also begin to address environmental issues. In subsequent years, the proposed lending program would include a Private Sector Development Project, focussing on parallel reforms in the financial and enterprise sectors; a Human Resources Development Project, which would focus on reforms and financial assistance needs in the education and health sectors and may also address social safety-net issues; and an Agriculture loan.
The planned economic and sector work would provide the analytical underpinning for the Bank's policy discussions with the government as well as strengthening the basis for future lending. In close coordination with the IMF, European institutions and EBRD, the Bank's work will continue to focus on the sectoral and structural elements of the reform program. The initial CEM provides a comprehensive overview of macroeconomic, structural and sectoral issues, constraints and priorities. An Economic Update is planned to review fast-moving developments in the economy and to reassess overall financing requirements and creditworthiness considerations. In addition, a Trade Study is planned to review trade-related issues in all three Baltic states. Sector work will be initiated in the energy/environment sectors with a separate study on non-nuclear options. Studies on enterprise development and financial sector restructuring issues are planned to support the Government's reforms and lay the foundation for further lending operations.
Substantial technical assistance is required to design and implement structural and sectoral reforms and investment projects. The identification of critical technical assistance requirements has already been initiated in the context of preparing the CEM and the Rehabilitation Loan, and terms of reference have been prepared. The government would understandably prefer to finance this with grant resources. As such, the Bank is making available its preliminary assessment of technical assistance requirements and terms of references to interested donors in order to assist the Government in identifying grant sources of funding and thus ensuring that these core requirements are being addressed. Even though this technical assistance will not be financed through loan proceeds, the Bank will actively monitor the progress of the various studies and programs of advice and support. Future sector operations or projects are also likely to require technical assistance components, particularly for the design and implementation of related policy and institutional reforms.
Other Bank Group Activities
IFC's strategy in Lithuania will be to support the privatization and modernization process of domestic enterprises so that they can become internationally competitive, particularly those that are able to attract foreign technical partners in joint venture undertakings. Sectors which appear to offer some promise in this regard are wood products, construction materials and tourism. IFC will assist such firms by providing technical assistance for the privatization process, and financial support to privatized enterprises that show promise of becoming internationally competitive. IFC has received some joint venture project inquiries, but many investors are waiting for property rights to be clarified and for economic reforms to take hold before venturing in. At the request of the Government, FIAS undertook a diagnostic assessment of the environment for foreign investment and identified a number of specific areas for improvement.
Collaboration with Other Agencies
Various donors have been providing assistance to Lithuania and the G24 has been coordinating resource mobilization activities. Several European countries, either bilaterallyþparticularly the Nordic countriesþor through the EC, have initiated significant programs of assistance. EBRD has also initiated its program in Lithuania, focussing in particular on support for the energy, telecommunications, infrastructure and financial sectors. As the Bank builds up its presence in Lithuania, it can be expected to play an increasing aid-coordination role based on its multi-sectoral experience as well as the overview provided by its economic and sector work. In conjunction with the potential build-up of its lending program and a deeper understanding of Lithuania's economy, the Bank also plans to intensify its aid coordination efforts in certain sectors. Considerable effort has already been devoted to sharing information with donors, both formally in the context of meetings organized by the EC/G24, as well as meetings with bilateral donors, and informally among staff working on Lithuania. This effort is important in order to minimize the duplication of activities and to ensure complementarily of activities by various donors.
Risks to the Bank's Lending Strategy
During October/November 1992, elections for a new Parliament were held in Lithuania, and the Lithuanian Democratic Labor Party (LDLP) won a majority of the seats in the new Parliamen. It is therefore expected to head a new government. Atlthough an assessment of the likely economic policies of the new government would be premature at this time, the current Government has assured Bank management of Lithuania's commitment to continuing the reform program agreed under the Bank's Rehabilitation Loan. Nevertheless, there remain a number of risks that could cause slippage in the reform program and thus the relationship with the Bank: (i) policy slippages and related difficulties in the adjustment process itself, in particular the need for continued public support, which will depend inter alia on the establishment of a strong and financially rational social safety net; (ii) Lithuania's still limited implementation capacity, whose strengthening will require continued institutional support and technical assistance as well as more intensive than usual supervision of lending operations; (iii) continued delays in the normalization of trade relations and the establishment of adequate payment and settlement arrangements with the FSU; (iv) the availability of external financing. Slippage in the reform program could jeopardize disbursements of the rehabilitation loan, and adherence to the economic reform program will affect the composition and level of future Bank lending strategy.
To reduce the risk of considerable slippage and enhance the authorities' implementation capacity, intensive technical assistance is being provided to implement the reform program, including assistance for strengthening of the social safety net to enhance the program's social and political acceptability. On the trade side, Lithuania is continuing discussions in an effort to restore relations with its traditional suppliers as well as establishing trade ties with new partners. Finally, in order not to endanger unduly the success of Lithuania's reform, it will be crucial that already committed external financing be made available in full as quickly as possible and that international aid coordination efforts continue to proceed and result in new commitments commensurate with Lithuania's financing needs.