On the Convergence Programme for Lithuania


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Official

translation



 



GOVERNMENT

OF THE REPUBLIC OF LITHUANIA



RESOLUTION

No 54



 



of

21 January 2005



 



on

the Convergence Programme for Lithuania



 



Vilnius





 



 



 



 



Acting pursuant to Article 7 of Council

Regulation (EC) No 1466/97 of 7 July 1997 which lay down a multilateral surveillance

procedure of the European Union Member States carried out in the form of

stability and convergence programmes, the Government of the Republic of Lithuania has resolved:



1.     

To approve Convergence Programme for Lithuania

(appended);



2.     

To charge the Ministry of Finance with the task

of submitting the Convergence Programme for Lithuania approved hereby to the

European Commission;



3.     

To repeal Government Resolution No 568 of 11 May

2004 on Convergence Programme for Lithuania of 2004 (Valstybės žinios

(Official Gazette) No 79-2793, 2004).



 



 



 



Prime Minister                                                                     Algirdas

Brazauskas



 



 



Minister of Finance                                                             Algirdas

Butkevičius









 



APPROVED:



by Resolution No. 54



of January 21, 2005



of the Government



of the Republic of Lithuania



 



 



 



 



 CONVERGENCE PROGRAMME FOR LITHUANIA



 



 



 



 



INTRODUCTION



 



Lithuania’s economic policy serves the goal of ensuring a rapid real

convergence and approximation to the high level of productivity and subsistence

within the Economic and Monetary Union, to be achieved through a full-fledged

participation in the Economic and Monetary Union. Lithuania pursues to

introduce the euro on 1 January 2007. The Convergence Programme for Lithuania

(hereinafter – the “Programme”) outlines the Government‘s economic policy

commitments aimed at ensuring that Lithuania’s economic performance satisfies,

in a sustainable manner, the convergence criteria.



 



The entire set of reforms is geared towards the development

of measures aimed at achieving the above-mentioned goal over the medium term.

These measures include:



a rapid and sustainable real convergence and a

stable macroeconomic environment;



favourable conditions for business development

and a successful implementation of structural reforms;



a transparent state governance and a political

consensus regarding the reforms to be carried out;



a stable and predictable legal environment; and



a deeper economic integration into the EU.



 



Despite temporary difficulties related to extra tensions on the

budget, Lithuania has undertaken, by adopting the Convergence Programme, to

pursue the fiscal and monetary policy that ensures the stability of prices and

government finances  as to maintain the strong confidence in the continuity of

the currency board arrangement in Lithuania and successfully participate in the

Exchange Rate Mechanism II (hereinafter  the “ERM II”).



The Programme consists of seven chapters, giving an

overview of recent economic developments in Lithuania, a projection of a

medium-term monetary and fiscal policy, an assessment of risks and the quality

of government finances, and a description of Lithuania’s readiness to overcome

the effects of its ageing population, as well as an outline of the main

structural reforms underway.



The Programme examines and assesses the preconditions for

the achievement of the declared economic policy goals. The economic development

projections given herein are based on the assumption that Lithuania’s external

economic environment will essentially remain stable during the period

concerned. Other assumptions used herein are close to those made by the EU

Commission. The critical assumption underlying in the projections of economic

indicators and the fiscal deficit is that parliamentary parties will sign a

framework agreement ensuring the implementation of the measures outlined in the

Convergence Programme, which is a requisite for the implementation of the

commitments under the Stability and Growth Pact and for the introduction of the

euro in 2007.



As a

result of re-pegging the national currency to the euro under the currency board

arrangement, inflation remained low, i.e. 0.3% in 2002, in 2003, with the

appreciation of the euro vis-à-vis the U.S. dollar and the stronger competition

in the telecommunications market, the average level of prices temporarily fell

by 1.2%. Lithuania’s participation in the Exchange Rate Mechanism II marks the

stage of a close economic cooperation between Lithuania and the EU, built on

harmonisation of economic policies, which is necessary in ensuring a

sustainable and deeper integration of Lithuania into the EU single market.



Lithuania has successfully formed a flexible market

economy. With the appreciation of the effective nominal exchange rate, the

competitiveness of the economy was maintained due to the moderate growth of the

nominal wages and the stability of prices. The rapid growth of Lithuania’s

exports and investment had an upward effect on the GDP and was bringing the

level of unemployment down at the highest pace in the EU. The orientation of

Lithuania’s fiscal policy towards the achievement of the goals under the

Stability and Growth Pact has strengthened the market players’ expectations

related to the approaching membership in the Economic and Monetary Union and

reduced the degree of risks associated with investment in Lithuania. A rapid

growth of investment will ensure Lithuania’s long-term competitiveness and

increase the import of investment goods and the current account deficit in the

short run.



The tight fiscal policy pursued since 2000 and the prudent

re-pegging of the litas to the euro in 2002 have aroused market expectations

about an early membership in the EMU, thus reducing the gap between interest

rates on loans in the litas and in the euro (see Fig. 1) and making

euro-denominated-loans more popular. With the drop of interest rates, the

private demand financed by the rapidly expanding financial intermediation

sector has served to expand production capacities and to improve the

utilisation of the existing ones.



 



Figure 1. Quarterly differences between the annual Vilibor and Euribor



 







 



Changes in Lithuania caused by the membership in the EU

will bring about certain economic concerns to be addressed by taking timely

precautions. The domestic demand will be boosted, to a record extent, by three

factors: firstly, by favourable conditions of borrowing; secondly, by a growth

of net inflows from the EU by 4.4 percentage points of GDP; and thirdly, by

higher government spending until 2005. Government sector is to allocate

additional funding for: growing payments to the EU budget, co-financing of the

EU structural policies, the costs of the pension reform, personal income tax

reliefs that are increasing in the volume due to the extensive housing lending,

and the national expenditure on the support to agriculture approaching the EU average

in this area.



The fiscal policy faces the challenge of keeping control

over the impact of the changes in the demand on the economy. Price stability in

sectors related to construction would help to prevent an unsustainable jump of

real estate prices that might have a downward effect on the potential GDP. The

rise in agricultural prices after the accession to the EU and after the jump of

oil prices imposes a task of maintaining consumer expectations about the

stability of prices and a sustainable satisfaction of the price-related

convergence criterion. The stabilisation of consumer and housing prices would

help to preclude negative social consequences and strengthen the confidence in

long-term saving institutions.



The rapid growth of demand under the conditions of a fixed

exchange rate of the litas inspires a rapid growth of imports and Lithuania’s

balance of payments current account deficit. Lithuania’s current account

deficit was primarily financed by foreign direct investment. Thus, to ensure

the continuity of foreign capital inflows, the government should further

improve business and investment environment, give maximum support to investment

that is promoted statutorily, and create particularly favourable conditions for

"green field" investments, as well as maintain the market players’

confidence in an early integration of the country into the euro zone.



With a view to preventing any adverse social and economic

effects and to weaken cyclical fluctuations of the economy, the Convergence

Programme provides for a set of measures aimed at controlling the growth of

demand. A number of measures will be taken to increase government revenue,

allowing to do without any further expenditure cuts. The expansion of the real

estate tax base, the balancing of capital and personal income taxation, and the

reduction of the shadow economy will facilitate the implementation of fiscal

deficit targets, prevent an unsustainable jump in real estate prices, provide a

basis to expect stable consumer prices and interest rates, and help to keep the

confidence in macroeconomic stability.



The planned improvement of the tax system will help to

achieve a better balance between labour and capital taxation. Efforts will made

to continue re-directing a portion of labour taxation over to capital taxation

in the medium term.



The EU Broad Economic Policy Guidelines set a commitment

for Lithuania to use any extra government revenues that might be collected

above the plan due to a business cycle or a better collection of taxes, for a

further reduction of the fiscal deficit and to refrain from pursuing a

pro-cyclical policy. The Convergence Programme reaffirms the commitment to use

above-the-plan budget revenue and unspent co-financing monies for the reduction

of the fiscal deficit. Strict fiscal policy measures will ensure sustainable

private investment and consumption that will speed up the real convergence.



 



1.

OVERVIEW OF RECENT ECONOMIC DEVELOPMENTS



1.1 REAL

SECTOR



In recent years, Lithuania’s economy has been

growing at an increasing pace. In 2003, Lithuania was one of the

fastest-growing economies of the world, with its GDP growth of 9.7% during 2003. This is a testimony of  success in

implementing structural reforms, effective investment, and competitive exports.











 



Figure

2. Real GDP growth,

2000-2004 (in %)







 



Over

the first three quarters of 2004, GDP grew by 6.7%, according to preliminary

estimations by the Statistics Department under the Ministry of the Republic of

Lithuania (hereinafter – “Statistics Department”). The economic growth was

driven by the growth of domestic demand surpassing the growth of GDP and by

unused capacities that existed in the economy.



 



Figure 3. Utilisation of production

capacities of the industry (in %)



 







Favourable

conditions of borrowing were among the key factors that promoted the growth of

investment, household consumption, and thus the gross domestic product.



 



 



 



 



 



 



 



 



 



 



Figure 4. Quarterly growth of loans

extended to private and corporate persons (in GDP %)



 







 



According

to the data of the Bank of Lithuania, lending by banks grew by 52.4% over 2003.

This trend continued in 2004. Over the year since 1 October 2003, lending by

banks grew by 50.1% or LTL 5.1bn. Loans to private customers dominated by housing loans

remained among the fastest-growing items of banking assets. Over the year since

1 October 2003, bank loans to private customers nearly doubled having grown by

LTL 1,913M, of which housing loans alone grew by LTL 1,417M or 91%. This rapid

growth in housing loans was driven by lower interest rates and a personal

income tax relief effective from 2003 that allowed to reduce taxable income

with the interest paid on a housing construction or

acquisition loan. Despite the faster growth of real estate prices in viable

locations, the growth of construction volumes has contributed to the growth of

GDP (see Fig. 5).



 



Figure 5. Construction volumes at 2000

prices, by quarter and in thou litas







 



In 2003-2004,

a rapid growth of demand and a shortage of production capacities had an upward

effect on prices of immovable items (housing, land) and on importation of

movable goods and services.



The EU

structural support, Lithuania’s personal income tax relief on housing

construction or acquisition, the EU and national direct payments to

agriculture, have all boosted the demand for land and construction capacities

and increased the value of the existing property. Lithuania’s accession to NATO

and the EU inspired the redistribution of property: land and real estate owners

had an opportunity to benefit from the appreciation of their property. Bearing

in mind that appreciation of property is, to a certain extent, driven by

insightful investor expectations, the government plans to propose to expand the

real estate tax base, thus pursuing to ensure the sustainable development of

real estate market and an evener redistribution of property.



The

structural reforms have stimulated a rapid growth of labour productivity. According

to calculations made by the Statistics Department which has used such estimates

as the gross value added generated in individual types of the economic activity

and the number of actual working hours, labour productivity in the economy grew

by 22% in 2000 as compared to 2003 and by 4.9% in 2002 as compared to

2003. The fastest growth of productivity and added value was observed in

production and consumption sectors. Productivity growth rates were higher in

industry, construction and productive services than in overall the economy. The

growth of productivity in the past three years exceeded the growth of wages

thus enabling to maintain competitiveness under the conditions of appreciation

of the nominal litas exchange rate: during 2001-2003, wages grew by 11.5%, and labour

productivity grew by over 20%.



Lithuania

has, in recent years, witnessed a drop of unemployment. According to the data

of an employment survey, the average annual level of unemployment dropped from

13.8% in 2002 to 12.4% in 2003. In the second quarter of 2004, unemployment stood at 11.3%. A particularly

high growth of employment was recorded in the construction sector.



 



Figure

6. Employment in the construction sector







 



1.2

INFLATION



After almost two years of deflation,

positive inflation (1%) was recorded in May 2004 and it continued  going up  to reach 2.2% in August and

3.1%

in September, as calculated by using the harmonised index of consumer prices

(HICP). These changes in inflationary trends were mainly inspired by

skyrocketing world oil prices (in LTL) in April 2004, rising food prices, and

changes in administered prices and indirect taxes attributable to the accession

to the European Union. The increase of food prices in August 2004 was

accountable for the annual inflation of 1.7 percentage points as compared to

0.8 percentage points in May and -0.1 percentage points in January. The

increase in prices concurred with the introduction of a tighter trade regime

upon accession to the EU and with the rise of fuel prices effected by the

lengthy boom of oil prices. The two factors combined have an upward effect on

costs, but their individual impact is difficult to assess. It is projected,

however, that changes in administered prices and indirect taxation will be

accountable for 0.33% of the annual inflation during 2004.



 



Table 1. Key factors of the HICP change, (in

percentage points)



 









Year and month





2001





2002





2003





2004 01





2004 02





2004 03





2004 04





2004 05





2004 06





2004 07





2004 08









HICP*





1.3





0.4





-1.0





-1.2





-1.2





-0.9





-0.7





1.0





1.0





1.8





2.2









Liquid and other

fuel, lubricants





0.2





-0.1





0.2





-0.1





-0.2





-0.2





0.0





0.5





0.7





0.6





0.6









Foodstuffs and

alcohol beverages





1.2





-0.1





-0.9





-0.1





-0.1





0.1





0.1





0.8





0.6





1.5





1.7









* Yearly change in per cent.



Sources:

Eurostat, Bank of Lithuania‘s calculations.



 



 



Figure 7. The HICP (yearly change in per cent) and key factors of the HICP

change (in percentage points)







Sources:

Eurostat, Bank of Lithuania‘s calculations.



 



Import prices have been falling in the past three

years, mainly as a result of appreciation of the litas. However, the jump of

oil prices and the higher stability of the U.S. dollar vis-à-vis the euro

reversed this trend in the second quarter of 2004, making the yearly increase

of import prices positive (0.4%). A rise of prices of imported mineral products was accountable for

2.0 percentage points of the yearly increase in import prices. The import

prices were largely influenced  by the fall of prices of imported machinery and

equipment which slowed down the yearly increase of import prices by 1.3

percentage points in the second quarter of 2004.



 



Table 2. Unit value indices of imports and exchange rates, yearly change in

per cent









 





2001





2002





2003





2004 1Q





2004 2Q









Unit value index

of imports (UVII)





-3.3





-4.9





-2.9





-5.0





0.4









UVII, less

mineral products





-0.9





-3.9





-2.7





-2.2





-1.9









U.S. dollar rate

vis-à-vis the euro





-3.1





5.3





19.8





16.7





6.3









Sources:

Statistics Department, Bank of Lithuania, Bank of Lithuania‘s calculations.



 



Figure 8. Import prices and exchange rates, yearly

change in per cent







Sources:

Statistics Department, Bank of Lithuania, Bank of Lithuania‘s calculations.



As far as supply trends are concerned, the

upward movement of unit labour costs recorded in the past quarters demonstrated

similar rates of growth of the cost of labour (compensation per employee) and

labour productivity. The yearly increase of compensation per employee accounted

for 7.7% in the past four quarters on average, with

the increase of productivity accounting for 8.3%. This had a slight downward effect on unit labour

costs (1.4%) during the year.



 



Table

3. Cost of labour, unit

labour costs, and productivity, yearly change in per cent









 





2001





2002





2003





2004 1Q





2004 2Q









Average monthly

wages and salaries





1.2





3.2





4.1





-5.1





6.6









Compensation per

employee





4.8





1.7





7.3





4.9





8.5









Productivity





9.9





0.2





6.9





5.4





10.1









Unit labour

costs





-4.6





1.4





0.3





-0.5





-1.4









Sources:

Statistics Department, Bank of Lithuania‘s calculations.



Figure

9. Cost of labour, unit

labour costs, and productivity (negative), yearly change in per cent







Sources:

Statistics Department, Bank of Lithuania‘s calculations.



 



 



 



1.3.

Monetary and Exchange Rate Policy



 



The implementation of the fixed exchange

rate mechanism supported by a currency board arrangement has played an

important role in ensuring a non-inflationary and stable macroeconomic

development. This has served to stabilise inflationary expectations, to lower

country and currency risk premiums, and to boost confidence in the economic

policy of the country.



Note. From 1 April 1994 to 2 February 2002, the litas

was pegged to the U.S. dollar. On 2 February 2002, the litas was re-pegged to

the euro, chosen as the anchor currency, at the official exchange rate of

3.4528 litas to 1 euro (calculated by multiplying the U.S. dollar exchange rate

vis-à-vis the euro (0.8632 US dollar to 1 euro) announced by the European

Central Bank on the date of re-pegging (1 February 2002) by 4 (the former

official litas exchange rate vis-à-vis the U.S. dollar)), which remained

unchanged even after joining the ERM-II on 28 June 2004.



Upon the accession to the EU, Lithuania

has committed to replace, in the prescribed manner, the litas with the euro in

the future. One of the conditions for this replacement is the participation, at

least for two years, in the ERM-II, maintaining a stable exchange rate of the

national currency to the euro. In Lithuania’s case, a number of economic

considerations also spur the introduction of the euro:



 a historical success in maintaining a

tight, fixed exchange rate;



Lithuania has unilaterally pegged its currency to

the euro; however, it does not make full use of the advantages of the single

national currency: economic entities suffer exchange losses in converting

currencies to/from the euro and pay higher risk premiums, and a deeper

integration of trade and finances with the EU is precluded;



 the introduction of

the euro will speed up Lithuania’s economic convergence with EU states.



Lithuania is successfully participating

in the ERM-II, with a unilateral commitment of maintaining the existing fixed

exchange rate regime and a fixed national currency exchange rate vis-à-vis the

euro until the introduction of the latter. Accordingly, litas-denominated liabilities

of the Bank of Lithuania must be fully backed by foreign reserves (as of 30

September 2004, they were backed by over 150 per cent).



Pursuing a disciplined fiscal policy and

having eliminated legal unconformities set out in convergence reports by the

Commission of the European Union and the European Central Bank, Lithuania seeks

to be ready for the introduction of the euro in early 2007.



 



Table 4. Interest rates, 1996-2003 (in per cent)









 





1996





1997





1998





1999





2000





2001





2002





2003





2004 I half









Average interest

on bank loans in litas





21.3





13.9





12.0





13.0





11.9





9.3





6.6





5.8





5.7









Average interest

on litas deposits with banks *





13.8





8.2





6.7





7.7





7.3





5.3





3.2





2.5





2.3









* Average interest on deposits with maturity of over

1 month









Source: Bank of Lithuania.









                           









Table 5.

Interpolated yield of RoL euro-denominated euro-bonds and the difference

between the latter and the basic euro yield*

(end

of period)









 





Time before redemption









 





Y1





Y2





Y3





Y5





Y10









 





Yield





Difference





Yield





Difference





Yield





Difference





Yield





Difference





Yield





Difference









2001-12





-





-





5.0





+1.3





5.3





+1.4





5.6





+1.2





-





-









2002-12





2.9





+0.3





3.2





+0.5





3.5





+0.6





4.2





+0.8





5.1





+0.9









2003-12





2.5





+0.3





2.9





+0.3





3.2





+0.4





3.9





+0.3





4.8





+0.5









2004-06





2.4





+0.2





2.8





+0.1





3.2





+0.1





3.8





+0.2





4.6





+0.3









2004-09





2.4





+0.1





2.7





+0.2





3.0





+0.2





3.5





+0.1





4.4





+0.3









*The yield (%) is expressed as the average of buying

and selling prices quoted in the secondary market, and the differences in the

yield are expressed in percentage points. The yield of RoL euro-bonds has

been calculated according to actual yield curves.

Sources: Bank of

Lithuania, Bloomberg.









 



 



 



 



 



 



 



 



 









 Table 6.

Yield of RoL government securities and the difference between the latter and

the interpolated yield of RoL euro-denominated euro-bonds*

(end of

period)









 





Time before redemption









 





Y1





Y2





Y3





Y5





Y10









 





Yield





Difference





Yield





Difference





Yield





Difference





Yield





Difference





Yield





Difference









2001-12





4.8





-





5.4





+0.4





5.7





+0.4





6.0





+0.3





-





-









2002-12





3.2





+0.2





3.8





+0.6





4.0





+0.5





4.7





+0.5





5.2





+0.1









2003-12





2.3





-0.2





3.4





+0.5





3.7





+0.5





4.1





+0.3





4.9





+0.1









2004-06





2.2





-0.2





2.9





+0.1





3.3





+0.1





3.6





-0.2





4.7





+0.0









2004-09





2.3





-0.2





2.8





+0.1





3.3





+0.3





3.8





+0.3





4.6





+0.2









*The yield (%) is expressed as the average of buying and selling

prices quoted in the secondary market, and the differences in the yield are

expressed in percentage points. The yield of RoL euro-bonds has been

calculated according to actual yield curves.









Sources: Bank of

Lithuania, Bloomberg.









 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



 



1.4

EXTERNAL SECTOR



 



In the first half of 2004, the current account

deficit was increasing further, to reach 9.9% relative to GDP, compared to 6.2 per cent in the

corresponding period of 2003. This change in the volume of the current account

deficit was largely caused by the increase of foreign trade deficit by up to

10.3% relative to GDP.



 



Table 7. Components of the current

account balance, relative to GDP( in per cent)









 





2001





2002





2003





2004 1 st half









Current account

balance





-4.7





-5.2





-6.9





-9.9









Goods





-9.2





-9.4





-9.2





-10.3









Services





3.8





3.8





3.4





3.2









Income





-1.5





-1.2





-2.7





-3.9









Current

transfers





2.1





1.6





1.6





1









Sources: Bank of Lithuania.



 



Figure 10. Components

of the current account balance, relative to GDP (in per cent)







Sources: Bank of Lithuania.



 



In the first half of 2004, Lithuania’s total

export and import of goods increased by 16.2% and 15.6%, respectively, as

compared to the corresponding period of 2003. Lithuania’s foreign trade was

further oriented towards EU countries (including the new Member States). In the

first half of 2004, export and import of goods to the EU (hereinafter – “EU -

25”) increased by 15.1% and 13.6%, respectively, as compared to the corresponding period of

2003. The share of export of Lithuanian goods to the EU accounted for 62.4% of total exports (cf. 61.3% in 2003); and imports, for 64.5% of total imports (cf. 56.3% in 2003). Export of Lithuanian goods to Commonwealth of

Independent States (hereinafter – “CIS countries”) fell from 17% to 15.7% of total exports in the first half of 2004, while

the share of imports (by the country of origin) hardly changed and accounted

for 25.3% of total imports.



 



Table 8. Changes in exports and imports of the main categories of goods, and

factors causing the changes in the first half of 2004 as compared to the first

half of 2003, in per cent.











 





Exports





Imports









 





Change





Impact of factors





Change





Impact of factors











All goods





16.2





16.2





15.6







15.6











Investment goods







-18.6





-2.3





13.6





2.6









Interim

consumption goods





21.6





10.7





17.2





9.7









Consumption

goods





16.0





4.4





24.2





4.0









Petrol





83.7





4.5





28.9





0.0









Cars





-22.2





-1.1





-0.6





0.1









Other goods





30.0





0.0





-45.9





-0.8









Sources: Statistics Department,

Bank of Lithuania‘s calculations.



 



The largest increase in exports

over of the period concerned was recorded in the machinery and equipment sector

(43.7%). Driven by a continuous supply of crude oil

and an uninterrupted operation of AB “Mažeikių Nafta” (Oil Refinery

Company) as well as the rise of oil prices in international markets, export of

mineral products grew rapidly (a growth of 41.1% was recorded over the period concerned), with its share

growing from 19.2 to 23.3% of total exports. A

very slight drop was recorded in the volumes of export of textiles and textile

articles; its share in the total export, however, fell from 14.8 to 12.7%.



The growth of import of goods was driven by the

growing domestic demand. In the first half of 2004 as compared to the

corresponding period of 2003, the largest growth was recorded in the import of

consumption goods (24.2%), of which the import of long-term consumption goods (household

appliances, TV-sets, refrigerators, etc.) increased by as much as 51% over the period

concerned. The growth of import of these goods was attributable to a more

extensive borrowing prompted by more favourable borrowing conditions. It is

evidenced by an almost threefold increase in the volume of bank loans to

natural persons for the acquisition of consumption goods. The removal of

customs duties on foodstuffs and alcohol beverages imported from the EU

significantly reduced the prices of these products and increased their

consumption in the second quarter of the year. In the second quarter of 2004

the rapid growth of construction volumes entailed a growth of import of certain

goods (paints and other finishing materials, plumbing equipment).



The higher domestic demand also had an impact on the

balance of services. In the first half of 2004 as compared to the corresponding

period of 2003, export and import of services to EU-25 grew by 11.9% and 25.5%, respectively.

The total positive balance of services amounted to LTL 910.1M (cf. LTL 1bn in

the first half of 2003). The change in the total export and import of services

was determined by the developments in the transport and travel services.



In the total exports of services, the share of exports

to EU countries (25 states) accounted for 48.3%, and that to CIS

countries, 43.3%. Export of transport services to EU countries accounted for 50.5%, and that to

CIS countries, 42.7% of the total export of transport services. Export of travel

services to the EU accounted for 44.1%, and export of other services, 62.3%.



As far as the current account deficit is concerned,

foreign direct investment remained its main source of financing, which in the

first half of 2004 accounted for 42.1% relative to the CAD, or 4.2% relative to

GDP. Privatisation proceeds classified as foreign direct investment accounted

for below 10% of the total flows of direct investment in Lithuania. This ratio

reveals a weak sensitivity of FDI flows in Lithuania to the privatisation

process and thus a low risk of the drop in FDI after the completion of the

privatisation process.



 



Table 9. Sources of financing of the current account deficit,

relative to GDP(in per cent)











 





2001





2002





2003





2004 1st half











Foreign direct

investment





3.6





5.0





0.8





4.2









Other investment







2.5





1.8





7.8





4.4









Capital account





0.0





0.4





0.4





0.1









Official

international reserves





-2.7





-3.1





-2.9





0.8









Errors and

omissions





1.3





1.1





0.9





0.4









Sources: Bank of Lithuania.



 



Figure 11. Sources of financing of the current

account deficit, relative to GDP(in per cent).







Sources: Bank of Lithuania.



 



Analysis of the current account factors

according to the balance of savings and investment reveals that the widening of

the current account deficit was largely caused by the declining share of

savings that accounted for 11.6%

relative to GDP in the first half of 2004 as compared to the average of 14.7% relative to GDP in the period from 2000

to 2003.



 



Table 10. Gross savings and gross domestic investment relative

to GDP (in per cent)









 





2002   I





2002  II





2002 III





2002 IV





2003   I





2003  II





2003 III





2003 IV





2004   I





2004  II









Gross savings





16.0





14.2





15.4





15.5





15.4





14.4





14.1





14.3





12.2





11.1









Gross domestic

investment





20.9





19.9





19.9





20.8





19.7





22.3





22.4





21.0





21.3





21.9









The season adjusted data.



Sources: Statistics Department, Bank of

Lithuania’s calculations.



 



Figure 12. Gross savings and gross domestic

investment relative to GDP(in per cent)*







*The season adjusted data.



Sources: Statistics Department, Bank of Lithuania’s

calculations



 



To be sure

about the medium- and long-term development and sustainability of the external

sector, it is important to analyse the level and dynamics of the total foreign

debt. As of 30 June 2004, Lithuania’s total debt to foreign entities accounted

for 43% of GDP. Its upward movement is not a concern: the total debt to

foreign entities accounted for 43.6% of GDP in the end of 2001, and 41% of GDP in the

end of 2003.



2.

MEDIUM-TERM MACROECONOMIC SCENARIO



 



2.1

ASSUMPTIONS UNDERLYING THE FORECASTS



The

below forecast of Lithuania’s economic development (see Table 11) is based on

the recent trends of economic development and assumptions of economic growth,

most important of which are a stable monetary and fiscal policy, an active

labour market policy aimed at a higher employment and a flexible labour market,

and an investment and business promotion policy favourable for the economic

development.



 



 



 



Table 11. GDP growth and growth factors











 





2003





2004





2005





2006





2007











GDP growth at

constant prices, %





9.7





6.5





6.5





6.2





6.0









GDP at current

prices, LTL M





56179





61027





66526





72424





78686









GDP deflator,

change in %





-0.83





2.02





2.31





2.51





2.50









CPI (average

annual), change in %





-1.2





1.2





2.9





2.5





2.9









Growth of

employment, change in %





2.2





1.5





0.5





0.5





0.6









Productivity

growth, change in %





9.8





6.1





6.1





6.3





6.0









 





 





 





 





 





 









 





 





 





 





 





 









Sources of growth: change in % (at constant prices)









1. Household

consumption expenditure





12.4





8.5





6.9





6.6





6.7









2. Government

consumption expenditure





4.0





9.4





3.7





3.0





2.5









3. Gross fixed capital

formation





14.0





10.5





16.7





13.2





6.5









4. Change in

inventories and acquisitions less disposals of valuables, % of GDP





2.2





1.8





2.0





1.9





1.5









5. Export of

goods and services





6.9





9.8





8.8





8.6





7.5









6. Import of

goods and services





10.2





13.2





11.6





10.0





6.7









Contribution to real GDP growth









7. Final

domestic demand





11.5





9.5





9.0





8.2





6.6









8. Change in

inventories and acquisitions less disposals of valuables, % of GDP





0.6





-0.2





0.3





0.0





-0.3









9. Balance of

goods and services





-2.40





-2.79





-2.69





-1.97





-0.30









Assumptions









Short-term

interest rates





2.4





2.3





2.5





3.2





3.6









Long-term

interest rates





5.3





4.6





5.1





5.7





6.0









USD/EUR exchange

rates





1.13





1.23





1.24





1.24





1.24









EU-25 GDP

growth, %





1.0





2.5





2.3





2.4





2.4









Global imports

(excl. EU-25), change in %





4.2





5.7





4.8





4.6





4.6









Oil prices

(Brent, USD per barrel)





28.5





39.3





45.1





40.1





40.1









 



An

important assumption underlying in the forecast of the period of 2004 to 2006

is related to the membership in the EU and the use of structural funds and

other financial assistance from the EU. The assumption regarding the absorption

of EU financial support was made on the basis of a historical average level of

absorption of such funds in the European Union.



 



Figure 13. EU net support (in % of GDP)







 



 



 



Figure 14. Annual increase of EU net

support compared to previous years( % of GDP)







 



The key

assumptions about the external economic environment in implementing the EU

fiscal monitoring procedure and in seeking to ensure the comparability of

economic forecasts correspond to the external environment assumptions announced

by the European Commission (EC’s Autumn 2004 Forecast). It is expected that the

improved geopolitical position, favourable financial conditions, the flexible

macroeconomic policy and the implementation of structural reforms will foster a

faster development in the EU in the coming years: the economic growth of the 25

EU Member States is projected to reach 2.5% in 2004, 2.3% in 2005, and

2.4%

in 2006. It is also projected that the global economy (excl. EU-25) will grow

at a rate of 5.7% in 2004, 4.8% in 2005, and 4.6% in 2006. The average economic growth in the euro zone will reach

2.1% in 2004, 2% in 2005, and 2.2% in 2006. Another important assumption underlying the forecasts of

economic development for 2004 to 2007 is the stability of exchange rates and

oil prices.



The

assumptions about the external environment and the data published by the

Statistics Department support the projection that Lithuania is capable of

maintaining, in the medium term, a sustainable annual economic growth of about

6 per cent. GDP would grow at a rate of 6.5% in 2004, 6.5% in 2005, 6.2% in 2006, and 6% in 2007.



The assumption underlying in the projections of economic

indicators and the fiscal deficit is that parliamentary parties will sign a

framework agreement ensuring the implementation of the measures outlined in the

Convergence Programme, which is a requisite for the implementation of the

commitments under the Stability and Growth Pact and for the introduction of the

euro in 2007.



 



2.2

RISK-RELATED ASPECTS OF ECONOMIC DEVELOPMENT



The accession to NATO and the EU has strengthened the expectation

that direct foreign investment per capita will reach the level of other EU

Member States and that the growth of GDP will accelerate, meaning,

unfortunately, a correspondingly higher current account deficit.



The highest threat for the growth in the short run would be posed by

a potential decline of national disposable income and solvent demand, owing to

persistently high oil prices. According to the European Commission’s

calculations, a rise of oil prices by 10 dollars would mean a slowdown of GDP

growth in a developed economy by 0.4 percentage points. A rise of oil prices by

50%

would slow down GDP growth of the euro zone  by 0.6 percentage points in the

first year, 0.2 percentage points in the second year, and 0.1 percentage points

in the third year. Given the fact that Lithuania’s economy consumes over six

times more energy to generate GDP than developed economies, the impact would be

higher for Lithuania. However, the depreciation of the U.S. dollar and the

ongoing growth of the volumes of consumption loans in 2004 have, in part,

compensated the impact of changes in oil prices and keep the growth of GDP on a

fast track.



A number of structural reforms are implemented to tackle the issue

of dependency on imported energy sources: a set of legal acts passed in 2004

will speed up the process of housing renovation, enabling households to cut

their expenses on heating by 25 to 70 per cent. At the end of the medium-term

period, economic indicators will not be so much sensitive to energy product

prices.



A higher than expected growth of consumer credits and wages in the

period of 2004 to 2005 would serve to boost consumption and import of interim

and final consumption goods, and would accordingly influence the growth of GDP,

Lithuania’s balance of payments current account deficit, and the consumer price

index. The continued rise in oil prices would slow down the growth of GDP, and

unreasonable consumer expectations about the overall price boom are likely to

affect consumer behaviour and procyclically affect the economy, thus

accelerating the growth of the nominal GDP. Automatic stabilisers will

hopefully handle the increasing demand for loans and the accelerating

inflation: interest rates will rise, real GDP growth will approximate the

potential GDP growth, and the current account deficit will be stabilised. The

fiscal deficit reduction scheme laid out in Lithuania’s Convergence Programme

is aimed at securing confidence in the macroeconomic stability of the country.



The decommissioning of Unit I of the Ignalina Nuclear Power Plant in

2005 will mean a loss of one-third of energy generated by the Plant, which will

result in the drop of exports by about 1 percentage point and a slowdown of GDP

growth by about 0.3 percentage points.



A successful absorption of  EU support is a sufficient means to

offset the factors that slow down the GDP growth: higher expenditure on oil,

loss of revenue as a result of the decommissioning of Unit I of the Ignalina

Nuclear Power Plant, and a cyclical fluctuation of the economy after the

record-high growth of credits. In the period of 2004 to 2007, EU support-driven

demand will increase the GDP by over 3 percentage points. DGP growth will

additionally be stimulated by the improved economic infrastructure and

production capacities. The average growth of GDP over the period concerned will

remain on the fast track, accounting for over 6 per cent.



The forecasts of the rapid growth of GDP are based on the assumption

that Lithuania will phase out its national currency and introduce the euro in

2007. To make this assumption true, corresponding fiscal policy goals have been

formulated.



 



2.3

MARKETS FOR GOODS AND SERVICES



Over the period of 2004 to 2007, a rapid growth

in investment and consumption is projected, and Lithuania’s export performance

will remain on a positive track. New trends in 2003-2004 suggest that the

domestic demand will continue to have a heavy impact on the economic growth.



The demand for loans in the beginning of the

projected period will be driven up by favourable interest rates and

expectations about a rapid growth of income associated with Lithuania’s

membership in the EU, a successful absorption of EU funds, an early

participation in the ERM-II, and integration into the euro zone.



New opportunities for domestic lending as well

as EU structural support to investment projects will facilitate a more active

investment process. Investment will be furthered by the increasing investor

confidence in the stability of the economy. It is projected that investment

will grow at a higher rate than GDP and account for an increasingly larger

share of GDP. The largest impact of EU financial support will be felt in 2005,

when gross capital formation will grow at a rate of 16.5%, to reach 26.1% of GDP in the end of the projected period.





In the period of 2004 to 2006, the development

of different sectors of the economy will be supported by EU structural funds.

The primary impact of structural funds would primarily enliven the

constructions sector, as well as industry and education to a certain extent.

New jobs would serve to increase the consumption of interim products, which

would have a secondary impact to be most intensively felt in three sectors of

services (trade, transportation and warehousing, and communications) and in

industry to a certain extent. About 80% of this

increase would be shared equally by the following sectors: services to businesses

(trade, transportation and warehousing, and communications), constructions, and

industry. The remaining share of the increase would be spread between education

and other sectors. The structure of the increase would hardly change over the

entire period of 2004 to 2006. Changes might occur only if a certain sector

fails to absorb structural funds in full.



A new positive impetus to consumption in the

projected period will be provided by the overall economic upswing, decreasing

unemployment, opening EU labour markets, increasing income and positive

consumer expectations about the economic development. Average final consumption

rates will account for 6.6% in the period of

2004 to 2007. The rapid growth of the domestic demand will be underpinned by a

moderate increase in government consumption expenditure. This moderate increase

in government expenditure over the projected period is attributable to higher

expenditure associated with the membership in the EU and by the objective to

balance public finances.



Export-intensive industries will remain the key

contributor to the long-term economic growth. The overall economic development

will mostly be stimulated by the construction sector. A more active consumption

will facilitate the growth of wholesale and retail trade.



 



2.4

STABILITY OF PRICES



 



The macroeconomic impact of inflation in 2004 will be revealed by

the average annual inflation ratio: the drop of prices in the communications

sector due to the higher competition in the beginning of the year have

partially offset the increase in prices of foodstuffs, and transport and

health-care services recorded in May and June; thus, the general price level

will go up by about 1.2 per cent on average in 2004. The 2004 December

inflation of 2.9% anticipates trends that will prevail in 2005 when the annual

inflation will average at 2.9%. The upward movement of prices associated with the accession to the

EU is likely to fade in 2005, resulting in a slowdown of the rise in prices in

2006.



There is a threat, however, that price changes in the construction

and food-exporting sectors will distort the expectations about Consumer Price

Index (hereinafter –“CPI”) inflation in 2005 and 2006. In 2003, real estate

prices started to swell (see Fig. 15). The second and third quarter of 2004

witnessed a rapid increase in the export deflator, the construction price

index, and the consumer price index (see Fig. 16 to 18). The boom of consumer

and construction prices, the rise in oil prices, and the anticipation that the

accession to the EU will entail an indefinite increase of inflation might cause

a sudden jump of inflation in the future.



Figure 15. Yearly changes in real estate prices in Vilnius



 



 



Figure 16. Yearly change in construction prices













 



Figure 17. CPI inflation







The

liberalisation of the trade in foodstuffs with the EU has allowed to raise meat

and dairy export prices and to import certain goods more cheaply, free of

duties.



 



Figure 18. Inflation of the exports and services deflator and of the unit

value of exported items







The appreciation of the litas that has continued for several years,

the stronger competition in the telecommunications sector, and the continued fall

of food, clothing and footwear prices, have all served to form certain

expectations about price stability. These factors are likely to exert quite an

effect in the medium term, too. Competition in the market economy of Lithuania

and consumer awareness will bring inflation performance well within the

Maastricht criteria.



Inflation would be the strongest in those groups of consumption

goods and services where services account for a relatively higher share. The

annual inflation would average at 2.5% in 2006 and 2.9% in 2007. A more effective

use of the economic potential and the growth of productivity, which will partly

set off the growth of the average monthly wages, will subdue the rise in

prices.



 



2.5

LABOUR MARKET



Over the period of 2004 to 2007, the situation in the labour market

is set to be improving further. The increase in the number of the employed

population in 2002 and 2003 shows that enterprises have used the available

labour force resources in full and will have to hire additional staff to be

able to further increase their production volumes. Financial support from the

EU will stimulate a further growth of employment. The number of the employed

population will grow in the entire period covered by the forecast, thus

increasingly contributing to the growth of production.



The growth of foreign direct investment will contribute to higher

productivity and mitigate the impact of the growth of wages on the remuneration

for work. Corporate profits that have demonstrated a growth in recent years

will also have an upward effect on wages, without losing competitiveness. A

moderate growth in wages (up from a relatively low level) will contribute to

the sustainability of the current account.



 



2.6. THE

CURRENT ACCOUNT OF THE BALANCE OF PAYMENTS



 



The current account deficit is set to shrink in the second half of

2004, acted on by several factors. Firstly, EU advance payments to be

transferred to the treasury will have an upward effect on the positive balance

of current transfers. In the second quarter of 2004, the balance of current

transfers fell owing to the fact that Lithuania had to contribute to the EU

European Communities (hereinafter – “EC”) Own Resources before receiving the EU

support as an advance. In the first quarter of the year, before the EU duty

regime became applicable, use was made of the opportunity to import raw

materials more cheaply (this process particularly boomed in April); therefore,

the import of these raw materials is likely to drop in the second half of the

year. The deficit of the first half-year additionally broadened owing to

unreasonable consumer expectations about a rapid growth of prices, leading to a

buying rush and higher volumes of import of consumption goods. The abolition of

duties on foodstuffs and alcohol beverages imported from the EU significantly

reduced their prices and increased their consumption in the second quarter of

2004. The excitement about imported goods that have so suddenly became cheaper

will fade eventually and normalize. In this context, the growth of imports is

likely to slow down. Since non-resident investment income (paid in the form of

dividends) is typically higher in the first half-year, the negative balance of

income will shrink in the second half-year. With all these factors in mind, the

current account deficit is set to stand at 8.4% of GDP in 2004.



The stability of the real effective litas exchange rate and the

recovery of the EU domestic demand are likely to secure positive export

performance for Lithuania. Exports grow at a high pace, thus testifying the

continued competitiveness of Lithuania’s economy. The long-term outlook

suggesting the improvement of productivity and export performance is an

assurance of the sustainability of Lithuania’s current account of the balance

of payments: in the coming years, more plant and machinery will be imported so

as to ensure a rapid growth of exports and productivity in later years.



However, the EU support and higher foreign investment in the first

half of 2004 that will keep consumption and investment at a high level will

promote the importation of goods and services, which will worsen the current

account deficit. The buoyant domestic demand will serve to increase imports and

postpone the improvement of trade and current account deficit to later periods.

On the other hand, the medium-term growth of demand might be subdued by

potentially deteriorating terms of borrowing and fiscal policy measures aimed

at achieving a balanced structural budget. Therefore, it is expected that these

trends will serve to stabilise the current account deficit in the medium term.



Clear perspectives about the integration into the euro zone

stimulate consumers to spend a portion of their future income today. The rapid

expansion of financial markets create favourable conditions for borrowing and

spending before the money is earned. The tight fiscal policy is adjusted so as

to respond to market players’ expectations and ensure the sustainability of the

current account.



The fiscal deficit reduction policy is set to sustain the current account

deficit at a healthy level in the medium term. A positive impetus to the

current account will be provided by the future EU current transfers and the

projected growth of domestic savings. The current account deficit would be

mainly financed from debt-neutral sources such as foreign direct investment and

EU transfers. The GDP-relative share of final consumption expenditure is

projected to shrink from 83.4% in 2003 to 82.2% in 2007, meaning a corresponding growth of the savings rate and a

more extensive financing of investment by domestic resources.



Structural reforms that will ensure a more economical use of energy

resources will reduce the country’s requirement for oil and oil products

imported for domestic use.



Higher volumes of cash transferred by Lithuanian residents working

abroad can improve the position of the current account of the balance of

payments to a larger extent than projected so far. 



The stable flow of foreign direct investment in Lithuania in recent

years and the favourable external and internal environment support the

expectation that the flow of foreign direct investment in Lithuania will not go

off track in the period of 2005 to 2007 and will be drawn on to finance up to

50%

of the current account deficit. The EU support is another stable source of

financing of the current account deficit of the balance of payments. A

successful absorption of EU support funds will be equally important for the

current account deficit as foreign direct investment: funds to be transferred

by the EU are projected to account for 3.6% of GDP in 2007.









 



3.    

PUBLIC FINANCES



 



3.1

POLICIES



3.1.1  Objective



The key objective of the medium-term fiscal policy is the

approximation to a cyclically balanced general government budget by ensuring a

successful implementation of economic policy goals. Efforts will be made to

sustain the general government deficit below 3% of GDP in the period of

2004 to 2007 and to adhere to the balance deficit.



The medium-term fiscal policy will aim at implementing the following

priorities of the macroeconomic policy:



to ensure macroeconomic stability by pursuing an anti-cyclic fiscal

policy: to seek to maintain low risk premiums above the benchmark interest

rate, and a low inflation;



to create favourable conditions for the improvement of labour

efficiency and to improve the competitiveness of the economy: to attract more

foreign direct investment and to successfully implement EU structural policies;



to further stimulate important factors in continuing energy,

agriculture, and budget management reforms;



to continue the pension reform ensuring a long-term general

government financial sustainability;



to match the fiscal policy with the priorities of social policy.



Seeking to join the euro zone with the first wave of enlargement,

Lithuania will improve, as part of its fiscal policy, the institutional

conditions for a long-term saving and for a higher labour efficiency, and will

ensure a successful completion of structural reforms, improve tax

administration, promote investment, create favourable business and private

investment environment, and ensure an effective use of public funds allocated

for investment. Through the use of tax measures, Lithuania will try to balance

the too-high growth of the demand that is currently financed by bank loans and

by the increasing EU support. Any additional general government revenue or

unspent expenditure allocations will be used for the implementation of fiscal

deficit plans or for a further reduction of the deficit. By introducing new

taxes, the government will seek to cut speculative investment and to ensure

sustainability of the current account.



 



3.1.2       

ACTIONS PLANNED FOR 2004 TO 2007



 



By way of

implementing the new tax legislation, a share of the tax burden has been

shifted over from labour to capital. In the medium term, efforts will be made

to ensure the continuance of this trend. The government also seeks to introduce

a real estate tax chargeable on residents, by taking measures to protect

socially vulnerable groups of population from additional taxation and slowing

down the rise of housing and land prices, and to suggest to increase indirect

taxation of capital, by raising land and real estate taxes chargeable on

companies. If housing prices stabilise as a result of a change in the economic

environment and if fiscal deficit targets are secured by other measures, the

introduction of a real estate tax for residents will be postponed to a later

period. Efforts will also be made to promote an efficient use of property, in

particular land, by discouraging speculative investment and barring

unsustainable rises in real estate and land prices. Furthermore, a set of tax

measures will be suggested aiming to partially offset revenue losses associated

with the abolition of the turnover tax on the use of roads: several options of

an additional tax on vehicles are being considered.



A better balance between taxation of capital and employment-related

income will be sought in the medium term, by reducing the burden of personal

income tax and streamlining capital taxation and by promoting the development

of labour-intensive sectors of the economy and the creation of new jobs.

Efforts will be made to make sure that the balance between labour and capital

taxation is achieved without adding to the fiscal deficit, that it promotes a sustainable

economic development and creates conditions for businesses to enhance their

competitiveness and profitability.



The government is considering to put forward the following

proposals:



to use general government revenues collected in excess of the plan

owing to a business cycle or a better collection of taxes, for the reduction of

fiscal deficit;



to re-allocate general government budget allocations that might

remain unspent due to delays in co-financing the EU support or for other

reasons, for the reduction of fiscal deficit;



to amend the Law on the Approval of Financial Indicators of the

State Budget and Municipal Budgets to ensure the achievement of the fiscal

deficit target by cutting down expenditure, should it emerge in the second half

of 2005 that co-financing will require more funds than allocated in the state

budget for this purpose.



Further effort will be made to improve public financial management

and the quality of general government finances.



 



3.2

ACTUAL BALANCES AND IMPLICATIONS OF THE FORTHCOMING BUDGET ON MEDIUM-TERM GOALS



 



3.2.1  Overview



The rapid economic development is a proof of the pragmatic character

of the sustainable fiscal policy pursued in recent years, which has ensured the

stability of public finances and helped to win confidence of local and foreign

investors.



In

2000, the direction of fiscal policy was radically changed with a view to

achieving fiscal consolidation. General government

budget deficit amounted to 2.5% of GDP in

2000, followed by a drop to 2% of GDP in 2001. The

2003 general government fiscal deficit accounted for 1.9% of GDP. With debt servicing costs

of 1.3% of GDP, the primary deficit of 0.6% of GDP was recorded in

2003. The increase of the general government budget deficit in 2003 is

attributable to higher than expected (0.4 p.p. of GDP) expenditure for the

restitution of depreciated savings.



On account of the carry-forward to 2005 of the unspent funds that

had been allocated for co-financing the EU support in 2004 and a faster growth

of the nominal GDP, general government deficit is expected to fall below the

target (2.7% of GDP) and to account for 2.5% of GDP.



As the budget burden imposed by the membership in the EU eases over

the medium term, efforts will be made to reduce general government deficit from

2.5%

of GDP in 2004 to 1.5% of GDP in 2007, thus keeping it  below the ceiling of 3%. General

government finances will change in the structure during 2004 to 2007 compared

to that in 2003, mainly due to the payments to the EC Own Resources and the

co-financing of the EU support funds, the costs of the pension reform that is

being successfully implemented, and the harmonisation of taxation with relevant

EU polices. The following budget indicators are projected for the period of

2004 to 2007:



 



Table 12. General

government budget (S13) projections, for 2004 to 2007 (% of GDP)



 











% GDP





ESA





2003





2004





2005





2006





2007









code











Net borrowing (B9)









1. General

government*





S13





-1.9





-2.5





-2.5





-1.8





-1.5









2. Central

government





S1311





-2.38





-2.69





-2.55





-1.82





-1.51









3. State

government





S1312





 





 





 





 





 









4. Local

government





S1313





0.03





0.05





0.02





0.02





0.02









5. Social

security funds





S1314





0.50





0.11





0.03





0.00





0.00









General government budget (S13)









6. Total

receipts





ESA





32,29





32,95





34,41





34,70





34,48









7. Total

expenditures





ESA





34,14





35,49





36,91





36,50





35,98









8. Budget balance





B9





-1.9





-2.5





-2.5





-1.8





-1.5









9. Net interest





D41





0.4





0.5





0.6





0.6





0.6









10. Primary balance





 





-0.6





-1.5





-1.4





-0.8





-0.5









Components of revenues









11. Taxes





D2+D5





19.9





19.8





20.4





20.4





20.5









12. Social

security contributions





D61





8.7





8.7





8.6





8.5





8.4









13. Interest

income





D41





0.9





0.6





0.5





0.4





0.4









14. Other





 





2.8





3.8





4.9





5.4





5.2









15. Total

receipts





ESA





32,29





32,95





34,41





34,70





34,48









Components of expenditures









16. Collective

consumption





P32





7.9





7.1





7.1





6.6





6.3









17. Social

transfers in kind





D63





10.8





10.8





10.8





10.3





9.9









18. Social

transfers other than in kind





D62





9.2





9.3





9.2





9.2





9.0









19. Interest

payments





D41





1.3





1.1





1.1





1.0





1.0









20. Subsidies





D3





0.8





0.9





0.9





0.9





0.8









21. Gross fixed

capital formation*





P51





3.0





3.4





4.9





5.2





5.0









22.  Other





 





1.1





2.9





2.9





3.4





3.8









23. Total

expenditures





ESS





34,14





35,49





36,91





36,50





35,98









* ESA – European System of Accounts



** Figures marked

with the asterisk will be lower if EU support is absorbed more slowly than

assumed.



 



As a result of the carry-forward to 2005 of the unspent funds that

had been allocated for co-financing the EU support in 2004, the 2004 fiscal

deficit could be 0.3 percentage points lower than that given in the Table 12

above.



The updated Convergence Programme fundamentally changes general

government financial projections due to the following five factors: more funds

allocated for the formation of fixed capital; Eurostat general recommendations

for the disclosure of the EU support; a faster growth of GDP causing the “base

effect”; assumptions adjusting the co-financing of the EU support; and tax

measures aimed to control the cyclical growth of the economy..



In the medium term, general government revenues (as a percentage of

GDP) that accounted for 32.3% of GDP in 2003 will grow to 32.9% in 2004, 34.4% in 2005, and

34.7% of GDP in 2006. The pre-accession aid will be finished in 2007; as

a result, lower current and capital transfers will bring the general government

revenues down to 34.5% of GDP in 2007. As recommended by Eurostat, the updated Convergence

Programme excludes the EU support to the private sector from the category of

general government revenues.



The GDP share of tax revenues will grow throughout the medium-term

period. Although the abolition of the road tax in 2005 will bring revenue

losses of around 0.4% of GDP, additional tax measures will serve to increase tax revenues

by about 0.6 p.p. of GDP to 20.4-20.5% of GDP.



The updated assumptions about co-financing of the EU support suggest

that EU commitments will continuously increase, until 2006, current and capital

transfers shown in Table 12 under “Other”. EU payment commitments to Lithuania

have been included in the calculations not on the basis of cash flows approved

by the Copenhagen Council but on the basis of historic average rates of

absorption of the EU support in the new Member States.



By way of implementing the fiscal deficit strategy, total general

government expenditures were brought down to 34.1% of GDP in 2003. Absorption

of the EU support funds resulted in a rise in the GDP-relative share of

expenditures to 35.5% in 2004 and will further grow to 36.9% in 2005. To be able to

implement fiscal policy objectives matched to the economic cycles, general

government expenditure should shrink to 36.5% of GDP in 2006. General

government consumption efficiency and the phasing-out of the pre-accession aid

will bring general government expenditure down to 36% of GDP in 2007. The

contraction of general government expenditure will not essentially affect the

projection in the updated Convergence Programme about a rise in expenditure on

investment by about 2 percentage points of GDP. The implementation of the

commitment under the Stability and Growth Pact to achieve a budget balance

should help to improve the quality of government finances.



General government expenditures include estimated payments to the EU

budget, which will account for 0.7% of GDP in 2004, 1.2% of GDP in 2005, and 1.1% of GDP in 2006

and 2007.



A number of factors, such as payments to the EU budget, the need to

co-finance the EU support, the increase of support to agriculture to 55% of the EU level

in 2004 (to 60% in 2005), and compensations for real estate and private savings

restituted, will call for additional funds. The target to keep the fiscal

deficit below 3% of GDP would be achieved by cutting down collective consumption

expenditure from 7.9% of GDP in 2003 to 6.3% of GDP in 2007. Support to agriculture

financed from national resources that is set to be increased from 40 to 55% of the EU

average accounted for over 0.3% of GDP in 2004 and is set to account for over 0.5% of GDP in 2005.

The   Programme lowers the amount of subsidies by 0.6 percentage points of GDP,

as direct payments to agriculture are attributed, according to the new Eurostat

methodology, to the private sector rather than to the general government

sector. The decision to top up towards the EU level in making direct payments

to agriculture was adopted by Resolution No. 1391 of 8 November 2004 of the

Government of the Republic of Lithuania on the directs payments to the

agricultural entities of Lithuania in 2005 (Valstybės žinios (Official Gazette) 2004, No

164-5982), which sets that direct payment to agriculture for

agricultural holdings shall reach 60% of the EU average in 2005.



The successful implementation of the borrowing policy will lead to

the reduction of the GDP-relative share of interest payments from 1.3% in 2003 to 1% in 2007.



As part of the pension reform in the period of 2004 to 2007, a part

of social security contributions are being transferred to privately-funded

pension schemes. Capital transfers to privately-funded

pension schemes will be increasing gradually from 0.3% of GDP in 2004 to 0.7% of GDP in 2007.

Due to the favourable demographic structure of employment in the projected

period and the increase of the retirement age, social security payments will

account for an increasingly lower share of GDP; however, social benefits that

were raised in 2004 will keep this expenditure close to the level of 2003.



Gross fixed capital formation is expected to grow, due to absorption

of EU support, from 3% of GDP in 2003 to 5.2% of GDP in 2006. As the pre-accession aid will

be finished in 2007, gross fixed capital formation will drop to 5% of GDP. The

rapid growth of investment will improve the quality of public finances.



General government budgetary expenditure on the restitution of

private savings and for compensations for restored ownership of real estate

will account for 0.6% of GDP in 2003, 1.1% of GDP in 2004, 0.4% of GDP in 2005, 0.8% of GDP in 2006, and 1.2% of GDP in 2007. These figures are subject to

changes, should the economic cycle require a more dramatic reduction of the

fiscal deficit.



 



3.3

STRUCTURAL DEFICIT AND SUSTAINABILITY OF FISCAL POLICY



For the calculation of the structural

deficit, the updated Convergence Programme uses stricter assumptions about the

cyclic character of current expenditures: it is assumed that current

expenditures are not responsive to cyclical fluctuations. Figure 19 shows that

the highest cyclic fluctuation of general government deficit was -1% of GDP in

2000-2003. Cyclical fluctuation of general government deficit is projected to

go beyond 0.6% of GDP in the projected period. By a determined continuation of the

expenditure-down and revenue-up policy, efforts will be made to bring the

cyclically-adjusted general government deficit down by 1 percentage point over

2004-2007 to 2.1% of GDP by the end of the projected period. The reduction of the

cyclically-adjusted deficit will activate automatic stabilisers in the economic

cycle.



Figure 19. Implications of the GDP cycle on general

government cyclic fiscal deficit, in %







 



Estimation of the output gap. Having

collected additional statistical data, the Statistics Department has

recalculated GDP estimates for 2002 and 2003. The GDP cycle was recalculated

following the recalculation of actual data of national accounts and the update

of medium-term projections.



The GDP cycle was estimated by applying the Hodrick Prescot

(HP) filter. The results of this estimation suggest that Lithuania’s economy is

currently in the upswing.



Since 2003, real economic growth has been exceeding the potential

GDP growth. The output gap will be 1.86% in 2004, 1.94% in 2005, 1.94% in 2006, and 2% in 2007.



 



Table

13. Cycles of the economy (% of GDP )









 





 ESA





2003





2004





2005





2006





2007









code









1. GDP

growth at constant prices





B1g





9.7





6.5





6.5





6.2





6.0









2. Actual

balance





B9





-1.9





-2.5





-2.5





-1.8





-1.5









3. Interest

payments





D41





1.3





1.1





1.1





1.0





1.0









4. Potential GDP

growth





 





6.3





6.4





6.4





6.2





6.0









5. Output gap,

HP filter





 





1.75





1.86





1.94





1.94





2.0









6. Cyclical

budgetary component





 





0.51





0.55





0.59





0.59





0.61









7.

Cyclically-adjusted balance (2-6)





 





-2.36





-3.09





-3.09





-2.39





-2.11









8.

Cyclically-adjusted primary balance (7-3)





 





-1.06





-1.99





-1.99





-1.39





-1.11









 



However, due to short time-lines under the Hodrick Prescot

filter approach or under the production function approach (using NAIRU),

the estimation of Lithuania’s output gap is not completely accurate.

Conclusions obtained under the production function approach (based on the NAIRU

conception) are, for the time being, not acceptable due to short

time-lines, a lack of reliable data and a plenitude of structural breaks. The Hodrick

Prescot filter approach has a disadvantage, lying in the fact that it

smoothes structural changes even when they show an obvious shift in the output.

Moreover, this approach suffers from the so-called “end-point bias”. Thus, the

weaknesses of the two approaches must be taken into account if they are to be

used to estimate the structural deficit.



 



3.4 BUDGET SENSITIVITY TO GDP CHANGES



In the period of 1995 to 2003, only

one-third of the cyclical GDP fluctuation would turn into general government

deficit. This characteristic of general government finances can be explained by

low elasticity of revenues in the face of GDP fluctuations and historically

very low expenditure associated with unemployment in Lithuania.



Relying on the actual quarterly figures

of general government budget revenues for the period of 1995 to 2002 (period of

observations: 7 years), elasticity was estimated for customs duties, value

added tax, excises, revenues, profit taxes, and current expenditure.



 



Table

14. Lithuania’s general government budget revenue

elasticity estimates









ESA 95 code





 





Cyclical elasticity estimates









D.212





Duties





0.84









D.211





VAT





0.97









D.214





Excise





1.36









 





Of which:





 









 





on alcohol





1.09









 





on tobacco





0.0









 





on fuel





1.57









D5





Income and profit taxes





1.03









D61





Social contributions





0.98









 





Current expenditure





0









 



As the Table 14 shows, revenue from tobacco

has a zero elasticity. It has been estimated that revenue from fuel is most

elastic, i.e. fuel is a commodity the consumption of which is very much

sensitive to income fluctuations. These elasticity estimates would have been

more accurate, if their quality has not been affected by numerous changes in

tax legislation. The Programme calculates deficit by making stricter

assumptions about cyclical fluctuations of current expenditures: the elasticity

figure has been reduced from 0.97 to 0. If the historic link between general

government current expenditures and a slowdown of GDP growth persisted, the

share of the cyclical deficit would make as little as one-tenth of the output

gap in the medium term.



 



 



 



 



 



Figure 20. The dynamics of general government structural and cyclical budget

deficit, 2004-2007







The cyclically-adjusted general government

deficit has been estimated by taking account of the macroeconomic and budgetary

projections described in this Programme. The results are presented in Table 13.





Table 15 shows that the structural deficit would shrink to 0.9% of GDP in 2004

and 0.3% of GDP in 2005, if euro-integration expenditures and costs of

structural reforms were excluded. Structural deficit

shows the likely difference between general government revenue and expenditure

if the actual GDP equalled the potential GDP. Structural deficit is estimated

by eliminating the effect of the business cycle.



Line 9 of Table 15 shows a successful implementation of structural

measures for 2004-2006, which serve to reduce general government deficit by 3,0

percentage points of GDP in the total or by 0.8 percentage points of GDP a

year.



 



Table 15. General

government structural and cyclical fiscal deficit projections, and the

additional financing requirement associated with the EU accession (in % of GDP)











 





2003





2004





2005





2006





2007











1.





General

government fiscal deficit target





-1.9





-2.5





-2.5





-1.8





-1.5









2.





Cyclical fiscal deficit (-)





0.51





0.55





0.59





0.59





0.61









3.





Structural fiscal deficit





-2.36





-3.09





-3.09





-2.39





-2.11









4.





EC Own Resources





0.00





0.72





1.15





1.10





1.10









5.





Co-financing requirement





0.24





0.33





0.50





0.79





0.76









6.





Expenditure on

the pension reform





0.00





0.29





0.45





0.53





0.65









7.





One-off effects:

loss of revenue as a result of the new procedure for paying VAT on imports

from the EU introduced in 2004 (regain of the revenues since 2005); the

growth of personal income tax underpayments in 2003; refunds of profit tax

overpayments in 2003-2004.Continuous effect: the abolition of the road tax in

2005-2006





0.17





0.45





0.35





0.66





0.61









8.





Structural

deficit reduced by the amount of payments to the EU Own Resources,

co-financing requirement and loss of revenue





-2.0





-1.3





-0.6





0.7





1









9.





Structural

measures implemented annually in the general government sector, to fulfil the

commitments under the Stability and Growth Pact





 





-0.7





-0.7





-1.3





-0.3









 



 



3.5

STOCK OF DEBT AND ITS DYNAMICS



By

preliminary data, the general government debt as estimated according to the

Excessive Deficit Procedure (EDP) requirements accounted for 21.4% of GDP as of

the end of 2003 as compared to the permissible ceiling of 60% under the

Maastricht criteria, and was one of the lowest among EU Member States.



 



Table 16. General

government debt according to EDP









 





1999





2000





2001





2002





2003









General government debt as of year-end (in LTL M)





9,963.30





10,841.63





11,100.54





11,591.08





12,032.51









% of GDP





23.0





23.8





22.9





22.4





21.4









 



The government borrowing volumes are strictly regulated by the Law

on Approval of Financial Indicators of the State Budget and Municipal Budgets,

which sets annual limits on net borrowings by the Government and on newly

contracted government guarantees. The net borrowing limit for 2005 is set at

LTL 1700M, and no new guarantees are planned at all, except of the repayment of

existing government-guaranteed loans.



 



3.5.1 Goal



The key

objective of national debt management is to ensure a full and timely financing

of public expenditures and a timely implementation of debt liabilities at the

lowest possible cost and with acceptable risks, without exceeding the limits placed

on the national debt and on new borrowing and in line with the requirements

placed on the EU Member States seeking to join the Economic and Monetary Union.



 



3.5.2 Actions Planned



The strategy of financing the government borrowing

requirement has not changed from that of the previous year.



The

largest share of the borrowing requirement in the coming years will be

necessitated by the repayment of foreign and domestic debt and budget deficit

financing.



The

Government has accumulated over LTL 1.4bn in the Stabilisation Fund. In case of

unfavourable developments in financial markets, the Government is authorised to

draw on these resources to cover its debt liabilities.



In the

medium term, the Government has envisaged to implement the following borrowing

policy measures:



to finance the major share of the

government’s borrowing requirement by issuing government securities in the

domestic and foreign markets;



to borrow in litas and euros or other

currencies to be converted to litas or euros through derivatives;



to gradually clear government liabilities

denominated in those foreign currencies, the fluctuations of exchange rate of

which vis-à-vis the litas and the euro can potentially increase debt servicing

costs;



to seek that government securities

denominated in foreign currencies accounted for an increasingly larger share of

the foreign debt portfolio.



 



 



 



3.5.3. General Government Debt Projections



 



General

government debt (acc. to EDP) (S.13) is projected to shrink by over 1

percentage point of the projected GDP, due to the good collection of taxes and

the rapid growth of GDP. In the medium term, the stock of general government

debt should settle at 20% of GDP.



 



Table

17. General government debt projections









% of GDP





ESA





2003





2004





2005





2006





2007









code









 General government debt as of

year-end





 





21.4





20.1





20.9





20.3





20.1









 Change of

general government debt





 





-1.0





-1.3





0.8





-0.6





-0.2









Factors Influencing the Change of National Debt









 Interest





D41





1.3





1.1





1.1





1.0





1.0









 Primary balance





B9





0.6





1.5





1.4





0.8





0.5









 Nominal GDP

growth





B1g





-1.9





-1.9





-2.0





-1.9





-1.8









Other factors 

influencing the debt ratio





 





-1.0





-2.0





0.3





-0.5





0.1









 Of which:

privatisation proceeds: (-) positive proceeds (+) negative proceeds





 





-1.5





-0.7





-0.8





-0.2





-0.2









 p.m. 

implicit interest rate on national debt (%)





 





5.5





5.4





5.2





5.1





5.1









 



3.5.4 Economic Impact



In the end of 2003 and the beginning of 2004, three leading rating

agencies raised credit ratings for Lithuania on account of the positive

dynamics of Lithuania’s macroeconomic indicators and the tight fiscal deficit

reduction policy pursued until 2002. Over the medium term, the Government of

the Republic of Lithuania expects to further improve its sovereign credit

ratings, which would not only serve to reduce government borrowing costs, but

would also have a positive impact on borrowing by the private sector.



 



3.6

BALANCE BY SUB-SECTORS OF GENERAL GOVERNMENT



In 2003, budgets of social security funds continued to run

surpluses: a preliminary surplus of 0.5% of GDP was recorded.

Social security funds have fully cleared their arrears in 2003: by the data as

of 1 January 2004, the social security sub-sector was clean from arrears.



Better administration of collection of municipal revenues and the

reduction of arrears (by the data as of 1 January 2004, local government

sub-sector had arrears of 0.4% of GDP), as well as a strict control over municipal borrowing, all

have served to form a slight overall surplus of municipal budgets in 2003

(about 0.03% of GDP).



As a result of the structural and tax reforms carried out in recent

years, the major share of the total deficit consisted in the central government

budget deficit which accounted for 2.4% of GDP in 2003.



It is

projected that a close-to-balance municipal budget will be achieved in the

medium term. As the costs of the pension reform will be increasing with time,

the budget surplus of social security funds will grow rather slowly; however,

the growth of employment and wages will sustain the social sub-sector surplus

at about 0.1% of GDP.



The general government deficit mainly consists in the central

government deficit. Therefore, the reduction of the central government deficit

will accordingly exert a downward pressure on the general government deficit

over the medium term.



Should a portion of the allocations for co-financing of the EU

support be unspent in the current year (e.g. owing to incomplete absorption of

the EU support), the general government deficit projection of the current year

would be adjusted down accordingly. The pace at which the general government

deficit will approach the balance will be dictated, in the medium term, by the

EU support absorption indicators, the performance in repaying debt and

discharging other government commitments, the cost of structural reforms,

better administration of taxes, and the economic growth.



The

downward movement of the general government deficit is shown in Table 12.



 



3.7. FISCAL RISKS



It is projected that the main sources of fiscal risks will be

deposit insurance, restitution of real estate ownership rights, debt of

state-owned enterprises to banks, savings restitution, and the decommissioning

of the Ignalina Nuclear Power Plant.



Deposit insurance. As of 1 September

2004, the total amount of insured deposits was LTL 15,598.9M or 25.6% of GDP.



Savings restitution. As of 1 December

2004, these commitments stood at LTL 1,640M or 2.7% of GDP.



Restitution of real estate ownership rights. The financing requirement for compensations to be paid for the

land, forest area and water bodies repurchased by the state totalled LTL 1051M

or 1.7% of GDP as of 1 December 2004.



As of 1 December 2004, the financing requirement for the restoration

of ownership rights for citizens to surviving residential houses, parts thereof

or apartments, and for compensations to be paid to religious communities for

the real estate repurchased by the state totalled LTL 291M or 0.5% of GDP. Another

0.63% of GDP of liabilities will be covered by issuing securities.



Article 8.2 of the Law on the Amounts, Sources, Terms and Procedure

of Payment of Compensations for Real Property which is Bought-Out by the State

as well as on Government Guarantees and Privileges Provided in the Law on the

Restoration of the Rights of Ownership of Citizens to the Existing Real

Property (No VIII-792 of 16 June 1998) provides for compensations to be paid to

citizens in the current year shall be adjusted each year for inflation of the

previous year.



Decommissioning of the Ignalina Nuclear Power Plant. The operation of the Ignalina NPP and foreign financing for the

termination of its operation entail certain risks. A share of the costs of the

decommissioning of the Ignalina Nuclear Power Plant will be covered by the EU

which has allocated EUR 315M for 2004-2006 for this purpose. It has been

estimated that the technical and socio-economic expenditures will require EUR

950M in the period of 2007 to 2013. The financing of these expenditure will

depend on the outcome of negotiations about the EU financial outlook for

2007-2013.



Budget arrears. As of 1 October

2004, the stock of municipal budget arrears (including personal income

tax, social security contributions, and loans) totalled LTL 218.4M or 0.4% of GDP.

Compared to the data as of 1 January 2004, it has shrunk by LTL 44.4M (16.89%). The municipal

budget arrears have been continuously reduced in the past years.



A number of measures aimed at the reduction of budget arrears are

envisaged: information about municipal budget arrears will be published in the

press on a monthly basis; no loans or guarantees will be extended to those

municipalities which fail to respect borrowing limits and to reduce their

budget arrears; the commission formed by Resolution No 621 of 7 May 2002 of the

Government of the Republic of Lithuania will be further supervising the

financial position of municipalities.



Government

guarantees. One of

the Government’s medium term borrowing policies is the reduction of the stock

of government guarantees (no new government guarantees are extended starting

from 2003, except on the repayment of the existing government-guaranteed

loans).



As of 1 November 2004, government-guaranteed loan portfolio

accounted for about 2% of GDP. This figure is expected to drop to 1.2% of GDP over the

medium term.



On-lending the loans taken on behalf of the state, and government-guaranteed

loans. With the view to improving credit risk

management, loans issued or guaranteed by the state are classified into 5 risk

groups (employing commercial bank practices). The risk group is determined by

taking account of the borrower’s status evaluated with reference to the

regularity of repayments, instances of debt restructuring or refinancing, the

status of the borrower’s financial and economic activities, and the actual

implementation of the investment project concerned.



As of 31 September 2004, the stock of outstanding loans on-lent by

the state to Lithuanian economic entities in which the state held over 51% of shares

totalled LTL 241M or 0.5% of GDP.



As of 30 June 2004, borrowers of the fifth risk group collectively

had LTL 586M (0.9% of GDP) worth of outstanding loans on-lent to them by the state and

about LTL 157M (0.26% of GDP) worth of outstanding government-guaranteed loans.



 



4. SENSITIVITY ANALYSIS AND

COMPARISON WITH PREVIOUS UPDATE



 



Sensitivity and risk assessment. The degree

of sensitivity of general government budget deficit to GDP fluctuations is

rather low. In the period of 1995 to 2003, only one-third of cyclical

fluctuations in GDP would turn into general government deficit. This feature of

general government finances can be explained by a low elasticity of revenues in

the face of GDP fluctuations and a historically very low level of expenditure

associated with unemployment in Lithuania. The Programme calculates deficit by

making stricter assumptions about cyclical fluctuations of current

expenditures: the elasticity figure has been reduced from 0.97 to 0. If the

historic link between general government current expenditures and a slowdown of

GDP growth persisted, the share of the cyclical deficit would make as little as

one-tenth of the output gap in the medium term.



A medium-term growth of variable and fixed market interest rates by

one percentage point would mean an increase of the interest payable on the

central government debt (including new borrowing) of LTL 52M in 2005, LTL 56M

in 2006, and LTL 62M in 2007, or about 0.1% of GDP.



 



Sensitivity of budgetary projections to different assumptions. Assumptions made in forecasting macroeconomic indicators are close

to the assumptions about the external environment made by the EU Commission in

the 2004 Autumn Forecast.



Lithuanian forecasts are based on the assumption that the absorption

of EU support will not deviate much from the historic

average EU support absorption rates (not according to payments approved by the

Copenhagen Council). A lower absorption would mean a 1 percentage point lower

growth of GDP. An almost 100% absorption of the EU

pre-accession support allows to expect that the actual absorption will surpass

the average rates, thus creating the conditions for GDP to grow at a higher

pace than projected in this Convergence Programme.



 



Comparison with the previous update. GDP

projections have been adjusted to reflect the

actual figures of the first 9 months of 2004 announced by the Statistics

Department and the new assumptions about oil prices. The revision of the 2003

actual figures have accordingly adjusted general government deficit

projections.



The

projections below have been made according to ESA’95.









 



Table

18. Dynamics of general

government fiscal deficit and debt projections (% of GDP)









% of GDP





ESA code





2003





2004





2005





2006





2007





















Real GDP growth

Previous update**





B1g





9.0





7.0





7.3





6.6





6.3











Latest update





 





9.7





6.5





6.5





6.2





6.0











Difference





 





0.7





-0.5





-0.8





-0.4





-0.3











Actual budget

balance

Previous update**





B9





-2.4





-2.7





-2.5





-1.8





-1.5











Latest update





 





-1.9





-2.5





-2.5





-1.8





-1.5











Difference





 





-0.5





-0.2





0.0





0.0





0.0











General

government debt

Previous update**





 





21.5





22.4





22.2





21.4





21.0











Latest update





 





21.4





20.1





20.9





20.3





20.1











Difference





 





-0.1





-2.3





-1.3





-1.1





-0.9











* Preliminary actual data.



** Lithuania’s Convergence Programme of May 2004



 



5. QUALITY OF GENERAL GOVERNMENT

FINANCES



 



Policy strategy. As part of the

budgeting reform, off-budgetary funds have been incorporated into the state

budget and a number of legal amendments were passed to enable the accumulation

of public funds in the Reserve (Stabilisation) Fund, with the Privatisation

Fund being its primary source of income, to be drawn on in extreme situations

and economic threats so as to ensure a smooth functioning of the economy. As of

1 October 2004, the Reserve (Stabilisation) Fund had LTL 1,031.8M (1.7% of GDP).



 



5.1 GENERAL GOVERNMENT EXPENDITURE



General government expenditure policy. The dynamics of general

government expenditure was directly determined by the changes in the economic

situation and fiscal policy objectives.



 



Table 19. General

government expenditure, 1998-2003, by ESA’95 (% of GDP)*









Indicators





ESA Code





1999





2000





2001





2002





2003









Total expenditure





 





42.9





38.4





35.1





34.3





34.1









    Collective consumption expenditure





P32





8.7





9.5





8.0





7.8





7.9









    Private consumption expenditure





P31





13.5





12.1





11.8





11.6





10.8









Capital depreciation





K1





-2.0





-2.0





-1.8





-1.5





-1.4









Social transfers other than in kind





D62





11.4





10.7





10.6





9.3





9.2









    Interest payments





D41





1.5





1.7





1.6





1.4





1.3









    Subsidies





D3





1.1





0.8





0.9





0.8





0.8









    Gross fixed capital formation





P51





2.6





2.4





2.2





2.8





3.0









    Other





 





6.1





3.2





1.8





2.1





2.5









Budget balance





B9





-5.6





-2.4





-2.1





-1.5





-1.9









*data from the Statistics Department



 



Over the period of 1999 to 2003, the GDP-relative share of general

government expenditure has been continuously falling: from 42.9% of GDP in 1999

to 34.1% of GDP in 2003 (by preliminary data reported by the Statistics

Department). This downward trend was the outcome of the strict fiscal deficit

reduction policy and the increasingly lower involvement of the government in

the goods and services market. A steady reduction was recorded in private

consumption expenditure (from 13.5% of GDP in 1999 to 10.8% of GDP in 2003)

and in collective consumption expenditure and social transfers (from 11.4% of GDP in 1999

to 9.2% of GDP in 2003). The decreasing interest rates on Government of the

Republic of Lithuania securities and the favourable conditions on the

international securities market have served to reduce interest payments on

general government debt. Government subsidies stayed at around 0.9% of GDP during

1999 to 2003 and continued to be on a downward track.



General government expenditure on gross fixed capital formation has been

decreasing since 1999 to reach 2.2% of GDP in 2001, followed by an increase in

2002 to reach 3% of GDP in 2003.



With a view to improving public financial management, a set of legal

acts were passed in the period of 2000 to 2003 to set out budget publicity

requirements, essential principles of strategic planning, and the inclusion of

most off-budgetary funds into the budget.



The municipal budgeting procedure has been reformed. Efforts are

being made to ensure equal and stable financial opportunities for

municipalities to form their own budgets in accordance with statutory standards

on the levels of long-term revenue. Since 2002, municipalities have been funded

from the state budget for the implementation of functions delegated to them by

the central government and for the “student’s basket”. This has helped to

significantly consolidate municipal finances and create real conditions for

municipalities to reduce their arrears.



In the effort to improve the financial position of municipal budgets

and encourage municipalities to streamline the use of state budget funds, the

Law on the Budget Structure was amended to allow the possibility of using the

unspent targeted appropriations for the purposes specified in the law on the

approval of the financial indicators of the state budget and municipal budgets

of the year concerned, instead of returning them back to the state budget.



By Resolution No. 345 of 26 March 2004, the Government adopted

municipal borrowing rules that are in line with the methodological requirements

of the European System of National and Regional Accounts ESA’95, and with the

provisions of the Law on the National Debt and the Law on the Budget Structure.

According to these rules, municipal debt shall include liabilities assumed by a

municipality under loan agreements, leasing (financial lease) contracts and

other binding debt instruments. The rules also lay down the procedure for

issuing short-term loans from the state budget to municipalities. Loans issued

to municipalities from the state budget shall be interest-bearing loans.



The Government of the Republic of Lithuania has also revised the

consultation procedure to be followed by the Ministry of Finance and the

Association of Local Authorities in Lithuania in discussing relevant indicators

and data that are used for the calculation of financial indicators of the state

budget and municipal budgets of the year concerned.



Starting from 2005, there is a possibility to negotiate for the

covering of under-collection of municipal revenues.



As part of the budget reform, a strategic planning and program-based

budgeting mechanism was introduced. It has created possibilities to direct the

activities of appropriation managers towards the achievement of the priorities

set by the Government. The strategic budget planning is coordinated with the

principles applied in the EU.



With a view to ensuring a more efficient use of EU support, the 2004

Law on Approval of Financial Indicators of the State Budget and Municipal

Budgets authorises the Government of the Republic of Lithuania, or another

institution authorised by the Government, to reallocate the EU support and

national co-financing funds allocated for programs and projects among

appropriation managers, areas of investment, governmental functions and items

of economic classification, and to cover a temporary shortage, if any, of funds

for EU co-financed programs by  budget of the republic of Lithuania operating

funds or borrowed resources. These provisions are also incorporated in the new

Law Amending the Law on the Budget Structure of the Republic of Lithuania

passed. The 2004 Law on Approval of Financial Indicators of the State Budget

and Municipal Budgets also allows to reallocate the balance of allocations that

remained unused (as planned) for EU-funded programs and projects as of the end

of 2003 and to use it for co-financed projects as unused funds of special

programs, as well as to use the balance of allocations approved for 2004 in

excess of the appropriations approved by the above mentioned Law. 



The government investment strategy is reflected in the Public

Investment Program (hereinafter referred to as the PIP) which defines the

financing requirement for investment projects implemented as part of

government-supported programs, as well as the sources of financing and the

timeframes for implementation of the investments projects concerned. The PIP

attributes higher priority to those investment projects that are co-financed by

the EU and that are in line with the EU requirements as well as to those that

aim at developing national defence as a part of the collective security and

defence system.



Since the accession to the EU, Lithuania has been receiving support

from the EU Structural Funds and the Cohesion Fund, the strategy and measures

of usage whereof are outlined in the Single Programming Document (SPD) for

2004-2006 and in the Cohesion Fund Strategy for 2004-2006, respectively. The EU

Structural Funds and the Cohesion Fund are financial instruments of the EU

structural policy that are employed to co-finance projects in priority areas in

Member States. Lithuania’s SPD for 2004-2006 defines the strategy, priorities

and measures of the use of the EU Structural Funds and the respective national

co-financing, and the Cohesion Funds Strategy for 2004-2006 defines the

strategy of the use of the Cohesion Fund and the respective national

co-financing as well as the projects financed.



 



Objectives. In Lithuania, budgetary

expenditure targets and priorities are defined in a number of policy papers

that are interrelated and form a single integrated set. The key national budget

expenditure targets and priorities are defined in the

Government Long-Term Development Strategy, (which is in line with Lisbon

strategic goals), the Single Programming Document (SPD), the Government of the

Republic of Lithuania Program, regional development plans, and the documents on

the accession to the EU and NATO. The medium-term budget for the period

until 2007 is planned and relevant programs are prepared in line with the

following strategic goals (priorities) approved by Resolution No. 330 of 18

March 2003 of the Government of the Republic of Lithuania:



to strengthen

Lithuania’s say in forming the economic policy of the European Union and in

making decisions on issues relevant to the country;



to develop the

national defence system as a part of NATO’s collective security and defence

system;



to seek

sustainable development, ensure further improvement of the conditions for

business development, and boost the development of a competitive agricultural

sector;



to reduce

unemployment and poverty;



to ensure the

development of education, science and national culture, and the promotion of

healthy life-styles;



to develop

information and knowledge society;



to ensure public

security and public order; and



to ensure the

development of public transport infrastructure.



The

expenditure policy is strongly influenced by the EU integration process. Since

2000, expenditure associated with the EU integration has become a priority.

Every effort is being made to ensure maximum implementation of EU-related

projects. In the post-accession period, this policy direction is pursued with

still stronger effort. The key directions of this policy are agriculture, the

development of transport and environmental protection, business promotion,

investment not only in infrastructure but also in the development of human

resources.



 



Actions Planned. In the period from 2004

to 2007, the following actions are planned:



to complete the transposition to a program-based budgeting;



to restructure general government budgetary expenditures, i.e. to

allocate funds by priorities and by the need to co-finance the EU financial

support;



to build institutional and administrative capacities to ensure a

maximum absorption of EU budget allocations;



to improve financial management in municipalities;



to improve financial management in the health-care system;



to further develop the Reserve Fund, and to complete the

privatisation of state-owned property; and



to enhance the efficiency of management of general government

financial flows, thus seeking to ease the extra burden on the budget that can

potentially be placed by extra expenditures related to the membership in the EU

and NATO.



 



Public financial management will be further improved by adopting the

methodology applied in the EU Member States in public financial accounting and

in assessing and forecasting financial performance, by improving the technical

base and by enhancing labour skills.



As part of the budget reform, the scheme of coordinating budgetary

resources with the EU support is being improved. In the planning area, this

scheme of coordination combines the preparation of the SPD, the budget cycle,

and investment planning.



Also, the Strategic Planning Methodology was updated to facilitate

the coordination of strategies and budgeting process of different cycles.



A new version of the Law on the Budget Structure was passed in

December 2003. The Law defines new budgetary aspects brought about by the

membership in the European Union. Lithuanian’s membership in the EU

necessitates amendments to Law on the Budget Structure of the Republic of

Lithuania in two aspects: firstly, the Republic of Lithuania has committed to

ensure an effective and efficient use of the European Union financial support

funds and to make payments to the European Union budget; secondly, the European

Union system of accounts has to be introduced in administrating national

budgetary funds and cash flows.



It is planned that general government expenditure allocations that

might remain unused due to delays in co-financing the EU support or for other

reasons will be used for further reductions of the fiscal deficit.



 



5.2 GENERAL GOVERNMENT REVENUE



Government budget revenues declined from 37.3% of GDP in 1999

to 32.3% of GDP in 2003. The decrease was determined by lower income from

levies, assets, dividends, interest and other income inherently linked with the

possession of assets or government operations. The decline was also stimulated

by the implementation of the tax reform (a number of corporate profit tax and

personal income tax benefits and exemptions): tax revenues fell from 23% of GDP in 1999

to 19.9% of GDP in 2003. Despite a better than planned tax collection in

2003, general government revenues accounted for an increasingly lower share of

GDP due to the rapid GDP growth.



 



Table

20. General government revenue in 1999-2003, by ESA’95 (% of GDP)*









 





ESA code





1999





2000





2001





2002





2003









Total revenue and grants





ESA





37.3





35.8





33.0





32.8





32.3









    Taxes





D2+D5





23.0





21.0





20.1





20.0





19.9









    Social contributions





D61





9.3





9.4





9.0





8.7





8.7









    Other receipts and grants





 





5.0





5.4





3.9





4.1





3.7









*data from the

Statistics Department



 



A new Law on Income Tax of Individuals that came into force on 1

January 2003 (No. IX-1007 of 2 July 2002) sets two rates of the personal income

tax: 15 and 33 per cent. From 2003, individuals enjoy a higher non-taxable rate

on all income (raised from 250 to 290 Litas per month); the disabled, families

with three and more children, single parents as well as people employed in

farmers’ farms and agricultural entities are entitled to still higher

non-taxable rates determined individually; and parents with one or two children

may make use of an additional non-taxable share of income. The Law also allows

a 25% reduction of the taxable personal income (for the purpose of

calculating the taxable income, the total income may be reduced with life

insurance contributions, contributions to pension funds, interest paid to banks

or other credit institutions on loans taken for the construction or acquisition

of housing, tuition fees for studies at a higher school). After the approval of the first Convergence Programme, the Law on

Income Tax of Individuals was supplemented with the provision allowing to

reduce the taxable income with the expenses on the acquisition, once in the

period of three years, of a personal computer with software and/or on the

installation of an Internet access together with the costs of acquisition of

the required hardware, of up to LTL 4000.



The Law also introduces a full-scale declaration of income and

income tax.



A set of secondary legislation was passed in April 2004, as a means

to ensure the implementation of the provisions of the Law on Profit Tax of the

Republic of Lithuania and the Law on Income Tax of Individuals of the Republic

of Lithuania obliging the taxpayer to transact at arm’s length and, in the

failure to do so, entitling the tax administrator to adjust transaction values,

as provided in the relevant European Union and OECD guidelines.



On 13 April 2004, the Seimas of the Republic of Lithuania passed a

Law on Tax Administration to improve the regulation of legal aspects of tax

administration. The Law defines basic principles of legal regulation of

taxation procedures applicable to all tax legislation; regulates, with higher

precision and consistency and in more detail, taxation procedures on the

statutory level, by using the best practice of foreign states; adjusts the

focus of activities of the tax administer, by attaching a priority to the promotion

of voluntary payment of taxes and to every possible assistance to the taxpayer

in the field of legal compliance. The new Law on Tax Administration has

transposed the EU Council Directive on taxation of savings income in the form

of interest payments.



In

2003, the Seimas of the Republic of Lithuania passed a Law on the Provision of

Assistance to and the Receiving of Assistance from Institutions of the European

Union Member States for the Recovery of Claims Relating to Certain Levies,

Duties, Taxes and Other Measures, which created legal preconditions for the

effective co-operation between Lithuania and other EU Member States in the

field of recovery of tax debts. The Law came into force on 1 May 2004.



In 2004,  new pieces of legislation were passed and came into force

on 1 May 2004: an amendment to the Law on Value Added Tax and a new version of

the Law on Excise Duties, followed by a set of secondary legislation for the

implementation of the two laws. This new set of legislation has transposed the

provisions necessary for the actual membership in the EU, i.e. laid down, in

line with the EU acquis, the rules of taxation of transactions between

economic entities of different EU Member States.



To facilitate the fulfilment of taxpayers’ obligations, tax administrators

have taken over certain functions of social security administrators as from 1

January 2004.



From 1 May 2004, no VAT on imports will be collected on the

Lithuanian-EU border. It has been estimated that as the result the budget lost

0.4%

of GDP worth of VAT receipts in 2004.



 



Measures

to improve the tax system. In the future, tax legislation will be amended

to take into account any changes in the EU tax policies, practices of the

European Court of Justice, results of activities of the European Commission

working groups and the world’s best practice in the field of taxation.



The Council Directive on a common system of taxation applicable to

interest and royalty payments made between associated companies of different

Member States had to be transposed starting from 1 May 2004; for this purpose,

the Law on Profit Tax has been amended and supplemented accordingly.



Taking into account the fact that the transposition of the

above-mentioned Directive would adversely affect the level of general government

revenues collected as the profit tax and that the principles laid down in the

Directive are essentially contrary to those which Lithuania has been

consistently applying in recent years in concluding double taxation avoidance

agreements, Lithuania was allowed a transitional period for the transposition

of the Directive: during this transitional period of six years, the rate of

profit tax chargeable on payments of royalties at source shall not exceed 10%, and that

chargeable on payments of interest shall not exceed 10 % during the first four

years and 5 % during the final two years.



Capital taxation will be increased indirectly, by revising the rates

of land and real estate taxes charged on companies and by promoting an economic

use of property, particularly land, by discouraging speculative investment and

taking measures to prevent a rapid unsustainable rise in real estate and land

prices. As part of the corporate real estate taxation reform, there are plans

to introduce a market value approach in valuating real estate for tax purposes.





Plans include the introduction of a real estate tax on individuals,

with the view to preventing an unsustainable rise in real estate prices and

discouraging speculative investment. A real estate tax law will provide levers for

socially vulnerable social groups against the increase of the tax burden. If housing prices stabilise as a result of a change in the economic

environment and if fiscal deficit targets are secured by other measures, the

introduction of a real estate tax for residents will be postponed to a later

period.



The medium-term plans include the reduction of disbalances between

capital and labour taxation, which will be achieved by reducing taxation of

marginal employees and increasing taxation of capital, by promoting the

development of labour-intensive industries and the creation of new jobs.

Efforts will be made to ensure that a balance between labour and capital

taxation is achieved without adding to the fiscal deficit and that is

contributes to a sustainable economic development and higher competitiveness

and profitability of businesses.



Since 1 May 2004, excise rates applicable in Lithuania have been

adjusted to match the minimum EU rates, except the excises on the products for

which Lithuania has been allowed a transitional period (such as petrol,

gasoline, coal, coke, lignite, electricity, orimulsion, and cigarettes).



In the future, excises on cigarettes and energy products will be

gradually raised to reach the minimal EU rates by the end of the transitional

period. Coal, coke and lignite will not be taxed until 1 January 2007, and

electricity, until 1 January 2010.



To mitigate the impact of oil prices on the consumer price index, no

increase in the excises on petrol and gasoline is planned in 2005.



There are plans to eliminate, starting from 1 July 2005,

the deductions from gross corporate income to the Road Program, to be replaced

by alternative sources of financing.



 



 Financing. It is projected that the implementation

of the new tax legislation and the envisaged measures will have the following

direct impact on the general government budget:



the provisions of the new Law on Income Tax of Individuals that came

into force in 2003 brought revenue losses to the general government budget in

the amount of approximately 0.23% of GDP in 2004;



according to preliminary calculations, the harmonisation of the VAT

Law of the Republic of Lithuania with EU requirements has cost the  budget of

the Republic of Lithuania approximately 0.16% of GDP, which could have

been received as additional revenue in 2004; the change in the procedure for

payment of VAT on imports caused a loss of revenue of approximately 0.31% of GDP in 2004;



the introduction of a real estate tax on individuals will bring

additional revenues of about 0.2% of GDP a year;



the raising of the real estate tax on companies will bring

additional revenues of about 0.3% of GDP a year;



the changes in the land tax are expected to bring additional

revenues of up to 0.1% of GDP a year;



the road tax will be partially replaced by a tax on vehicles;



the reduction of the personal income tax that is currently under

consideration as a means of achieving a balance between labour and capital

taxation in the medium term will cost the general government budget about 0.4

percentage points of GDP. Efforts will be made to match this reform with

economic cycles and compensate revenue losses through other tax measures.



Economic Impact. The changes in land and real estate taxation will serve to discourage

taking the profit out of the increase in land and real estate prices. Although

the successful implementation of Lithuania’s foreign policies had an upward

effect on land and real estate prices, over-high expectations about the rise in

land and real estate prices inspire unsustainable price increases, curtail the

use of land and real estate for productive and social purposes, create unequal

opportunities for land and real estate owners to gain, and create preconditions

for a financial instability caused by a “price bubble”. The change of real

estate taxation at the point where the economy reaches the peak of activity

would help to secure economic stability in 2005 and facilitate the reduction of

the personal income tax rate over the medium term.



The implementation of the new tax legislation

has served to attain a better balance of labour and capital taxation burden.

The redirection of a portion of the tax burden from labour onto the capital

will be continued in the medium term.



The application of higher non-taxable rates of personal income and the possibility

to reduce the taxable income with expenses on education, interest on housing

loans, life insurance contributions and payments to pension funds will reduce

the amount of taxes to be paid by individuals by up to 3 per cent, depending on

the individual deductions applied. In 2003, the expansion of the profit tax

base already yielded additional revenue in the amount of around 1 percentage

point of GDP.



 



6.

SUSTAINABILITY OF PUBLIC FINANCES



Pension Reform.

The state social security

pension system set up in 1991-1995 operates on the pay-as-you-go (PAYG)

principle. The system is administrated by the Board of the State Social

Security Fund (SSSF) that has its own budget, separate from the  budget of the

Republic of Lithuania.



Before 1995, the retirement age was 55 years for women and 60 years

for men. After 1995, the retirement age has been annually increased by 4 months

for women and 2 months for men. Since 1 January 2001, the retirement age both

for women and men has been and will be increased by 6 months a year until the

targeted retirement age is reached, which is 60 year for women (by 2006) and 62

years and 6 months for men (by 2003). In 2004, the age limit for the old age

pension was 59 years for women and 62 years and 6 months for men. The rate of

the pension insurance contribution is 25.9 per cent of the wages of the person

covered by the pension insurance scheme. The State Social Security Fund budget

expenditure on pensions accounted for 6.3 per cent of GDP (LTL 3,528M) in 2003.





2004 saw the start of the third pillar of privately-funded pension

scheme. Contributions to this pillar are made by redistributing a share of the

compulsory state social security contributions. Started in 2003, the process of

concluding privately-funded pension agreements continued, attracting over 48% of persons

covered by state social security for the whole old age pension in 2004.



Although the redistribution of state social security contributions

to the current pension system and to the privately-funded pension scheme serves

to reduce government liabilities towards future pensioners, today it calls for

state budget grants to the social security system. Moreover, the ratio between

the average pension and the average wages (the replacement rate) currently stands

low at 42% (net); therefore, pensions are being increased faster than wages,

with the goal of reaching the net replacement rate of 60% in 2010.



The increase of the retirement age to 65 years would ease the

financial burden on the employed population who make social security

contributions. If the retirement age were not increased, 10 social security

contributors would support 8 pensioners in 2025, and 11 pensioners in 2050 (see

Table 21). Similarly, if the retirement age is increased to 65 years, 10 social

security contributors will support 7 pensioners in 2025, and 9 pensioners in

2050, and spending on old age pensions will be below 7% of GDP in 2050.



 



Table 21. Projection of the ratio of pension recipients and

contributors











 





2002





2025





2050











Population, in thou (beginning of

year)





3475





3202





2555









Ratio of

population aged 60+ and 18–59, %





34.1





46.3





74.6









Ratio of pension

recipients and contributors, if the retirement age is 60/62.5 years,%





86.1





81.3





113.1









Ratio of pension

recipients and contributors, if the retirement age is gradually increased to 65/65 years, %





86.1





65.3





88.5









 



The pension reform will serve to reduce direct financial liabilities

of the state towards future pensioners. This will help to prevent a crisis in

the pension system that could threaten in the light of demographic changes in

the long run.



 



Table 22.

Long-term sustainability of public finances











% of GDP





2000





2005





2010





2020





2030





2040





2050











 Total

expenditure





38.4





37.0





37.4





37.4





37.4





37.4





37.4









     Old-age

pensions*





5.3





5.3





5.3





5.3





6.0





7.0





7.0









     Healthcare

(including care for the elderly)





4.6





4.6





4.6





4.6





4.6





4.6





4.6









     Interest

payments





1.7





1.1





1.1





0.9





0.7





0.6





0.5









 Total revenues





35.8





34.5





37.4





37.4





37.4





37.4





37.4









 Of which:

social contributions for old age pensions





5.1





5.3





6.1





6.2





5.4





5.1





4.4









National pension

fund assets











0.8





n/a





n/a





n/a





n/a





n/a









Assumptions









 Labour

productivity growth





7.9





6.1





5.2





5.0





4.8





4.1





3.7









 Real GDP growth





3.9





6.5





5.2





4.6





3.9





3.1





2.4









 Participation

rate males (aged 20–64)





82.1





83.3





88.2





89.0





90.0





90.1





90.2









 Participation

rate females (aged 20–64)





74.2





74.5





76.7





79.0





79.5





79.8





80.0









 Total

participation rates (aged 20–64)





77.9





78.4





82.0





83.9





84.6





84.8





85.0









 Unemployment

rate (ILO definition)





16.4





11.4





8.6





6.9





6.9





6.9





6.9









* On the assumption that the pension age to 65 years

will start to be increased in 2010.



 



The third pillar of the privately-funded pension scheme started

gaining weight in 2004. It is projected that contributions to this scheme will

grow to over 0.1% of GDP in 2005. Participation in the third pillar creates the

conditions for cutting the personal income tax by 18 percentage points, which

raises expectations that the participation will be growing in later years. The

current long-term projections of the pension system are based on the data

available only about the participation in the second pillar.



Reform Goal. The main goal of the pension reform is

the setting-up and development of the privately-funded pension system,

providing a possibility for the people of the Republic of Lithuania to

privately save funds for their old-age pensions by setting aside a share of

their social security contributions for this purpose.



Reform

Measures. On 3 December 2002, the Seimas of the Republic of Lithuania

passed a Law on Pension Reform which set forth that:



the pension reform shall be started on 1 January 2004;



participation in

privately-funded pension schemes shall be voluntary;



contributions to privately-funded pension schemes shall amount to

5.5%the participants’ income on which state social security contributions are

payable (2.5%in 2004, 3.5% in 2005, 4.5%in 2006, and 5.5% in 2007). This share

of the pay-as-you-go contributions will be transferred to the privately-funded

pension schemes;



the general rate

of social security contributions (i.e. 34%) shall not be raised;



the

size of the state social security pension to be paid to participants in the

privately-funded pensions schemes for the years of their participation therein

shall be reduced proportionately to their contributions to the privately-funded

pensions schemes;



pension

schemes will be operated by life insurance companies and management companies. They will be subject, by law, to

additional requirements (licensing, capital adequacy, liquidity of equity,

separation of the ownership of participants in privately-funded pension schemes

from the equity of the company operating the scheme, investment requirements).

In 2004, 12 enterprises were engaged in providing the pension saving service.



 



Financing. It is envisaged that functioning of the

current pensions system based on the pay-as-you-go principle should be ensured

to both current and future pensioners. Over 441 thou people (36.6%) covered by social security joined the

new, privately-funded pension system in 2003, and another 115 thou people

joined it in 2004. It has been estimated on the basis of this figure that the

share of social security contributions that will be transferred to

privately-funded pension funds in 2004 will amount to around LTL 155 million.

It is expected that another 10% of

those covered by social security will join the new pension system in 2005, thus

injecting to the privately-funded pension schemes another LTL 305M in 2005 and

LTL 460M in 2006. The increase of expenditure of the State Social Security Fund

as a result of the pension reform will be financed from privatisation proceeds,

budget of the Republic of Lithuania and other sources. A portion of this

expenditure will also be covered by the surplus in the budget of the State

Social Security Fund that has accrued as a result of the short-term improvement

of the demographic situation.



 



Economic impact of the reform. It has been estimated that:



once the pension reform is implemented, a three-pillar pension

system will be set up in Lithuania, consisting of a pay-as-you-go pillar, a

mandatory privately-funded pillar (when a portion of a social security

contribution is transferred to the privately-funded pension scheme) and a

volunteer privately-funded pension pillar, resulting in the expansion of the

long-term saving and investment infrastructure;



the pension reform will increase the liquidity of financial markets

and accelerate the economic development. Although a larger fiscal deficit will

build up as a result of the reform, the resources accumulated in pension funds

will reduce the stock of direct financial commitments of the government towards

future pensioners.



Figure 21 reflects the impact of the budget balance of the pension

system on the financial liabilities of the state. Given the fact that pensions currently

account for as little as 42% of the net wages, the estimates given in the Figure below reflect

implicit general government commitments to attain a replacement rate of 60%. Assuming that

participation in the second pillar gradually increases to reach 100% by 2020 and the

retirement age reaches 65 years, the multi-yearly (until 2070) impact of the

pension system on the general government would not threaten an excessively

large impact either on the fiscal deficit or on the size of debt. The third basic

scenario shows the likely general government balance in the situation where

pensions are increased without implementing any reforms in this area. The

calculations are based on Eurostat demographic projections for Lithuania. 



 



 



 



Figure 21. Social security budget

balance (% of GDP)



 



 



 



7.

IMPLICATIONS OF STRUCTURAL REFORMS ON PUBLIC



7.1 LABOUR MARKET



Having joined the EU in 2004, Lithuania has committed to implement

the Lisbon objectives and the Employment Guidelines adopted by the European

Council in 2003. Taking into account European Council recommendations to

Lithuania, a range of national measures will be implemented to ensure the

implementation of three overarching broad objectives: full employment, quality and productivity at work, and strengthened social cohesion

and inclusion.



With

the view to achieving full employment, efforts will be made to maintain the

current high level of employment among groups of population, coupled with the

implementation of the policy promoting active economic participation and

employment among other groups of population. Measures will be taken to

approximate the level of employment to 70%, and to cut unemployment and keep it low, at no more

than 6 to 7%; however, with full account taken of the

economic potential of the country and the country’s political, social and

economic goals, this target will not be achieved earlier than within 12 to 15

years.



 



Table 23. Lisbon employment objectives









Employment

rates, %





2003





2005





2010









EU- 25





Lithuania





EU- 25





Lithuania*





EU- 25





Lithuania*









Total





62.9





60.9





67.0





63.5





70.0





68.0









Women





55.1





58.4





57.0





59.3





60.0





61.0









People aged

55-64





40.2





44.5





-





46.2





50.0





48.0









* forecast



 



Lithuania’s Single Programming Document for 2004-2006 approved by

Decision C(2004) 2120 of 18 June 2004 of the European Commission and by

Resolution No 935 of 2 August 2004 of the Government of the Republic of

Lithuania sets out a set of priority measures aimed at the implementation of

European Commission guidelines:



facilitate

the adaptability of workers and firms to changes in the labour market,



increase

labour market participation and facilitate a free choice of jobs,



more

extensively and effectively invest in human resources and lifelong learning.



 



Table 24. Consolidated financing requirement for the implementation

of  the 2003 Employment Guidelines approved by Council Decision, 2004-2006, in

LTL M 



 









Measures





Funds









Total





EU structural

funds





General

government expenditure





Private funds









Total





1,901.1





1,024.7





821.9





54.5









Guideline 1:





 





 





 





 









Promotion of employability





431.31





146.3





277.7





7.2









Development of services

infrastructure





569,6





296.0





273.6





-









Guideline 2:





 





 





 





 









Promotion of

self-employment and improvement of business environment





210.5





156.3





54.2





-









R&D and innovation in the quality of human

resources





121.8





90.4





31.4





-









Guideline 3:





 





 





 





 









Promotion of

labour competences and the adaptability in the labour market





179.4





108.7





36.2





34.5









Guideline 4:





 





 





 





 









Development of

lifelong learning





211.1





158.4





52.8





-









Guideline 7:





 





 





 





 









Prevention of

social exclusion, and promotion of social integration





122.1





56.6





65.6





-









Guideline 10:





 





 





 





 









Support to local

employment initiatives





55.3





12.1





30.54





12.8









Source: Ministry of Social Security and Labour



 



7.2

Small and Medium-Sized Enterprises



 



Lithuania attaches great importance to

the improvement of conditions for businesses, particularly small and

medium-sized enterprises (hereinafter – “SME”); direct support is allocated for

the development of existing enterprises and the establishment of new ones.

State aid is given to economic entities to support their

participation in exhibitions, preparation of various informative publications,

innovations; the state also co-finances a number of other business promotion

measures.



In addition to national funds, SMEs have been supported, since 2004,

from the EU structural funds. For the period of 2004 to 2006, over EUR 100M has

been allocated, as direct support for businesses, for enterprise development,

modernisation, innovation and other projects.



With the view to ensuring a maximum absorption of the EU structural

funds allocated for businesses, a Lithuanian Business Support Agency was

established in 2003 with the primary function of administering the European

Union and national support for the development of national industries and

businesses.



To help businesses to successfully apply for EU structural support

funds (particularly the European Regional Development Fund), small enterprises

were given assistance, in the end of 2003 and beginning of 2004, for the

preparation of project documentation.



To

provide SME with better financing possibilities in all regions, the private

limited liability company Investment and Business Guarantees

(hereinafter – “INVEGA”) established in 2001 issues guarantees in favour

of banks on a portion (up to 80%) of loans taken by SMEs and covers up to 50% of interest on guaranteed

loans. INVEGA’s guarantee liabilities are secured by the State, which reduces

credit risks and opens opportunities for more SMEs to draw on banks.



Lithuania is an active participant in the EU Multi-Annual Program

for Enterprise (particularly for small and medium businesses) and

Entrepreneurship. Within the framework of this Program, Lithuania continues a

dialogue with the European Investment Fund (EIF) concerning new instruments

aimed at improving SME financing possibilities. In the first quarter of 2004,

an agreement was signed with the European Investment Fund for

counter-guaranteeing the INVEGA’s liabilities.



INVEGA’s services are quite in demand: over the first eleven months

of 2004, it has issued 154 guarantees on LTL 39.4M worth of loans to small

businesses and covered LTL 1,286.5 thou worth of interest paid by small

businesses to banks, which was 67.5% more than over the corresponding period of

2003. The implementation of business projects for which INVEGA-guaranteed loans

were taken during this eleven-month period of 2004 will serve to create about

840 new jobs, i.e. 26% more than in the corresponding period of 2003.



 



7.3

Healthcare



With the view to improving health of Lithuanian people by ensuring

accessible, high-quality and effective healthcare, by implementing the

principle of social justice, and by creating equal access for every citizen of

the country to the required medical aid, the following measures are being

implemented:



public healthcare system is being strengthened to implement the EU

policies in this field: public health centres have been restructured by

delegating certain healthcare functions to country governors’ administrations;

a network of test laboratories has been optimised; three regional laboratories

have been certified for public health research. It is planned to reorganise

public health centres established in counties into public administration

institutions, by separating public administration from the provision of

services, and to optimise the network of institutions providing specialised

public healthcare services. The required state budget allocation for the public

healthcare reform is estimated at LTL 3.5M for the next few years;



the quality of personal healthcare services is being further

improved;



         pursuant

to the Healthcare Institutions Restructuring Strategy approved by the

Government of the Republic of Lithuania by Resolution No 335 of 18 March 2003,

healthcare institutions undergo restructuring. Restructuring plans have been

approved for 10 healthcare institutions in counties. In the process of

streamlining the personal healthcare network in terms of its coverage,

structure and layout, priority is attached to the development of the primary

healthcare and ambulatory services; the improvement of medical nursing and

long-term/palliative treatment services; the streamlining of in-patient

services and the development of alternative forms of activities; and the

preservation and improvement of children’s and youth’s health. The required

state budget allocation for the implementation of the Healthcare Institutions

Restructuring Strategy is estimated at LTL 104.3M for the period of 2005 to

2008. Funds will also be taken from the EU structural funds allocated for the

implementation of Measure 1.4 Development and Upgrading of Health Care

Institutions included in Lithuania’s Single Programming Document for

2004-2006 approved by Decision C(2004) 2120 of 18 June 2004 of the

European Commission and by Resolution No 935 of 2 August 2004 of the Government

of the Republic of Lithuania. This measure is being implemented by following

two main directions:  the development and modernisation of the infrastructure

of general practitioner services, and the strengthening and development of

cardio-healthcare services by upgrading healthcare institutions;



the development of the healthcare system is continued, in the effort

to ensure an effective healthcare by improving the administration and financing

of the healthcare system. Government capital investment is made use of in

continuing the ongoing or starting new health programmes and projects for the

restructuring of healthcare institutions implemented by counties and

municipalities,  aimed at implementing new medical technologies, upgrading and

restructuring healthcare institutions, and creating an integrative,

development-supportive information system;



the national

pharmaceuticals policy is being implemented: the goal is to ensure that

Lithuanian market offers only high quality, safe and effective as well as

affordable pharmaceuticals, and that the pharmacy sector reformed according to

the EU requirements provides only high quality services. The system of

reimbursement for medicines is being further improved by removing certain

restrictions: more reimbursable medicines are prescribed, the assortment of

reimbursable medicines is increased;



health insurance system is being improved: efforts are

made to improve the quality of healthcare services and their accessibility for

everybody, to increase the efficiency of the health system, and to implement

more efficient forms of use of the available resources. The resources of the

Mandatory Health Insurance Fund are distributed according to the statistical

demographic indicators, i.e. with reference to the number, sex and age of the

population of the respective region. The right of a patient to select a medical

institution they prefer are being implemented; competition among medical

institutions is promoted; prices of services are revised annually.



It has been estimated that state budgetary expenditure on insurance

contributions for persons insured at the state’s cost will total LTL 570.1M in

2005, which is 17.3% more than in 2004 (a contribution per person will increase from LTL

221.4 in 2004 to LTL 264.2 in 2005).



 



Table 25. Projected MHIF

budgetary receipts and expenditure, 2004-2007









Year





2004





2005





2006





2007









Receipts

           LTL M



           % of GDP





 

2,043.8

3.3





 

2,360.8

3.5





 

2,463.1

3.4





 

2,599.9

3.3









Expenditure

           LTL M



           % of GDP





 

2,043.8

3.3





 

2,360.8

3.5





 

2,463.1

3.4





 

2,599.9

3.3









 



According to the estimation of the financial impact on the budget of

the Mandatory Health Insurance Fund of the implementation of Regulation (EEC)

No 1408/71 of the Council of 14 June 1971 on the application of social security

schemes to employed persons and their families moving within the Community  and

Regulation (EEC) No 574/72 of the Council of 21 March 1972 fixing the procedure

for implementing Regulation (EEC) No 1408/71 on the application of social

security schemes to employed persons and their families moving within the

Community, after the free movement of persons is ensured, a budget allocation

has been provided for covering the costs of healthcare services provided to

those covered by the mandatory health insurance during their stay in another EU

Member State. Since 1 May 2004, the date of Lithuania’s accession to the

European Union, visitors to Lithuania covered by mandatory health insurance in

any EU state are entitled to the first medical aid and reimbursable medicines.



 



7.4. Agriculture, Food Industry, and Rural

Development



To ensure the implementation of the EU common agricultural policy,

to develop a competitive agricultural and food sector, and to promote a

sustainable economic and social development of rural areas, the following

measures are being implemented:



            strengthening

of institutional and administrative capacities;



            implementation

of the measures aimed at securing income for entities engaged in agricultural

activities, and market regulation measures (direct payments according to a

simplified scheme, quota systems, intervention buying, private storage systems,

import/export mechanisms, product marketing standards, etc.);



            implementation

of the measures set forth in the Rural Development Plan (early retirement from

commercial farming, less favoured areas and areas with environmental

restrictions, afforestation of agricultural land, environmentally friendly agricultural methods, support to

semi-subsistence farms, support for meeting EU standards), the Single

Programming Document (SPD) (investment in agricultural holdings, setting up of

young farmers, improving processing and marketing of agricultural products,

promoting adaptation and development of rural areas, forestry, LEADER+  type

measure, training, modernising fishing fleet, aquaculture);



              application

of state aid measures (state support for the promotion of production of high

quality products, for the development and implementation of a quality testing

system, for the acquisition of breeding animals, propagating material of

certified plants, for farmer's training and consultation services, etc.);



              the

process of restitution of ownership rights to land, forest and water bodies is

approaching the end, to be followed by the next stage of land management

process associated with a promotion of a rational use of land, by preserving

the ecologic stability of the landscape and by developing a required rural

infrastructure. Also, authorities are addressing the issue of authorising the

selling agricultural land  to Lithuanian legal persons and foreign citizens;



              promotion

of the development of a competitive food industry, restructuring of the food

sector, taking measures to ensure that only safe food is supplied to the

market, food control in the whole chain from the field to the table.    



Allocations to agriculture and rural development will account for

one-third of the total EU support. EU funds will be used to finance market

regulation and rural development measures. A portion of allocations for rural

development measures will be used for direct payments. Moreover, structural

support will be provided for rural development and fisheries in 2004-2006.



With the view to implementing agricultural strategic goals and

becoming equal partners in the EU market, the state budget will continue to

annually finance state support to agriculture, land reform, land reclamation,

market development, infrastructure, quality management, science and education,

information and other needs.



 



Table 26. Estimates of

measures aimed at achieving strategic agricultural policy goals, in LTL million











Measures





Funds









2004





2005





2006





2007









Revenue

           LTL M

        %

of GDP





 

619.0

1.0





 

1,076.2

1.6





 

1,345.4

1.9





 

1,061.9

1.4









Expenditure

           LTL M

        %

of GDP





 

1,422.4

2.3





 

1,739.7

2.6





 

2,047.5

2.8





 

1,715.1

2.2









Net direct budgetary impact

           LTL M

        %

of GDP





 

-803.4

1.3





 

-663.6

1.0





 

-702.2

1.0





 

-653.1

0.8









 



Once the process of restitution of ownership rights to land, forest

and water bodies is finished, a further process of land administration in

Lithuania will be associated with land consolidation, i.e. rearrangement of

land plots by changing their abbutals and location at landowners’ requests,

with the aim of consolidating land plots, forming a rational use of land,

improving its structure, setting up the required infrastructure and

implementing other goals and objectives of agricultural and rural development

and environmental policies. This process will be carried out by implementing

land consolidation projects to be co-financed by the European Union and

national funds.



 



7.5

Other Structural Reforms in Goods and Services Markets



A number of other structural reforms affecting the sustainability

of public finances in the medium and long term are continued.



Environmental policy. With the view to

ensuring an adequate quality of water in all water bodies of Lithuania,

authorities have started a reform in the field of governmental regulation of

the protection of water resources: management of water resources will be

organised by river basin districts, water supply and wastewater management

system will be reorganised. With the view to setting up a streamlined waste management system that

ensures a good quality of the environment and operates under the principles of

market economy, 10 regional waste management systems will be established in

Lithuania. By 2010, about 800 existing landfills will be closed, 10 to 12 new

regional landfills opened, and waste collection and management systems

implemented. As part of

implementation of the commitments under the Kyoto Protocol, authorities have

drafted a national allocation plan for 2005 to 2007 regulating the emission of

greenhouse gasses.



In the effort to improve the economic regulation of the

environmental protection by following the “polluter pays” principle, Lithuania

introduced, in 2003, a tax on pollution with product and packaging waste (the

Republic of Lithuania Law No IX-720 of 22 January 2002 Amending the Law on

Pollution Tax). The tax is chargeable on all types of primary, filled packaging

and certain products (such as tiers, batteries, galvanic batteries, mercury

vapour lamps, fuel and oil filters for internal combustion engines, intake filters

and hydraulic dampers for cars); the Law clearly defines producer and importer

responsibility for handling product and packaging waste.



 



Table 27. Projected revenues to the

national budget from pollution taxes, 2004-2007









Pollution taxes





Year











2004





2005





2006





2007











Water

pollution (LTL M)





14





11





11,5





12









Tax on products and packaging (LTL M)





15





15





14





13









Air

pollution (LTL M)





33





20





15





15









Total (LTL M)

% of GDP





62

0.1





46

0.1





40,5

0.1





40

0.1









 



Rates of the tax on pollutants discharged to the

atmosphere and water set in the Law on Pollution Tax for the period of 2005 to

2009 will remain unchanged during this entire period and stay at the 2004

level. Therefore, no increase in the related business sector expenditures or in

the prices of goods and services is likely in the period concerned.



As the stock of residential houses tears and wears and energy

becomes more and more expensive, the issue of a rational use of energy becomes

increasingly painful. Homeowners cannot solve this problem individually. It is

therefore being tackled by legislating: a set of legal acts passed in 2004 have

created conditions for modernising residential houses and boosting energy

consumption efficiency by drawing on commercial bank resources, public funds,

state budget support for low-income families (individuals) and homeowners’ fund

pools. The reduction of energy consumption will ease the burden on the state

budget for compensating heating and hot water costs to low-income families

(individuals) and will thus have a direct impact on the current account

deficit. As renovation will help to cut household expenditure on heating by 25

to 50 per cent, energy product prices will have less implications for the

current account deficit and for the dynamics of the demand by the end of the

medium term period.



Transport sector. One of the key

priorities of Lithuania’s transport sector is the creation of a modern

north-south transport axis that will be developed within the framework of

Pan-European transport corridor #I (Tallinn-Riga-Kaunas-Warsaw) and will

connect the Baltic States to Poland. One of the most important projects aimed

at developing the above-mentioned axis and implementing the Rail Baltica

Project is the construction of a modern railway line Tallinn-Warsaw via Kaunas.

The Rail Baltica Project appears among priority projects listed in the

Trans-European Transport Network Guidelines adopted by the European Parliament

in April 2004.



The new Long-term Transport System Development Strategy

will create favourable conditions for a further implementation of Lisbon

strategy goals. By 2025, Lithuania plans to set up a modern and balanced

multi-modal transport system that measures up, by it technical parameters,

safety and the quality of services, to the level of old member states of the

EU. Lithuanian transport sector will become an important element in the

transport system of the southern Baltic Sea region and will effectively serve,

by providing high quality services, the common needs and interests of Lithuania

and the enlarged European Union.



Knowledge society. The Government of the

Republic of Lithuania approved, by Resolution No 488 of 28 April 2004, a

Strategy for the Development of Public Administration for the period until

2010, which aims at modernising the public administration system with an

ultimate goal of developing a transparent and result-oriented public

administration focussed on providing high quality services to citizens and

other people and built on information technologies.



In pursuance of Lisbon strategy goals, the Government of the

Republic of Lithuania approved, by Resolution No 1646 of 22 December 2003, a

Long-term Research and Development Strategy accompanied by a Program for the

Implementation of the White Book on Science and Technology in Lithuania. The

Strategy sets a goal of strengthening the scientific-technical potential of the

country, seeking its most efficient use in advancing progress and increasing

competitiveness.



As an incentive for businesses to develop innovation and invest in

research and development, the state co-finances innovation projects carried out

by businesses and supports their participation in the European R&D and

Cooperation projects within the EUREKA framework. For the implementation of

innovation projects, businesses are entitled to subsidies of up to 50% of their

eligible project expenditure. The European Union structural funds open new

possibilities for supporting the development of innovation and technologies.

Businesses will be supported both directly (through subsidies to enterprises)

and indirectly (by subsidising services to businesses and improving business

climate) from the European Regional Development Fund.