A Survey of 1997 Developments in Lithuania’s Economy

Free Market readers are familiar with the economic reform issues which the Lithuanian Free Market Institute (LFMI) has addressed in its research, articles, and policy proposals. This article presents an overview of Lithuania’s main macroeconomic indicators and economic policy programmes adopted in 1997 in the areas of taxation, budget formation, social policy, finances, and international co-operation.
The Macroeconomic Environment
According to preliminary estimates, the country’s GDP rose by 5.75 percent in 1997, reaching 9550.2 million US dollars at the end of the year and placing Lithuania among the leading nations of Central and Eastern Europe in terms of GDP growth. Preliminary calculations estimate the private sector’s share in GDP at 70 percent. In 1996 the private sector produced about 65 percent of GDP, with the rest being contributed by the public sector, provided we agree that all activities are aimed at creating value added and that the officialdom, for example, also create rather than use the value produced by others. Annual per capita GDP was 2,097 US dollars if estimated according to the exchange rate approach, or 4,245 US dollars if calculated based on the purchasing power parity.
As compared to 13.1 percent in 1996, annual inflation, measured as the consumer price index, dropped to a level of 8.4 percent in 1997.
Preliminary data indicate that direct foreign investment rose by 428.2 million US dollar in 1997, topping one billion by the end of 1997. Over the first three quarters the bulk of direct foreign investment came from the United States (26.5 percent), Sweden (12.3 percent) and Germany (11.4 percent). The biggest investors are “Phillip Morris” and “Motorola”, which had invested 62.2 and 60.1 million US dollars respectively by October 1997.
Over the first three quarters of 1997 Lithuania’s exports totalled 3,737 million US dollars (at free on board prices), a 22.5 percent increase as compared to the respective period in 1996. Imports during the same period of 1997 went up by 25.6 percent to 4,365 million US dollars (at f.o.b. prices). By the end of the third quarter the country’s trade balance was negative by 628 million US dollars. The biggest share of export was to the CIS (46.6 percent) and EU (33.0 percent), regions which were also the largest importers into Lithuania (31.1 and 44.3 percent respectively).
The current account deficit was on the rise, drifting up to 10.4 percent of GDP in mid-1997 (9.3 percent in 1996). On the other hand, the Bank of Lithuania’s official foreign currency reserves rose by 31.1 percent. According to preliminary estimates by the Bank of Lithuania, the current account deficit fell to 8.0 – 8.5 percent by the end of the year.
Lithuania’s economic development received favourable assessments from international credit rating agencies. In June 1997 the US-based Standard&Poor’s granted Lithuania the first-ever investment grade rating. Lithuania received a long-term hard currency credit rating of BBB- and a BBB+ for long-term litas loans. In late 1997 Moody’s Investor Service released a new Ba1 investment rating, shifting Lithuania up one notch from the previous Ba2 rating.
Public Spending
In December the Lithuanian parliament (the Seimas) passed a fiscal 1998 budget legislation, with revenues projected at 1,722 million and expenditures at 1,895 million US dollars.
According to the Conservative-led government, the main focus in drawing the 1998 budget legislation was on social issues. Although lawmakers kept reassuring that the budget was for the first time compiled based, not on estimated revenues, but on expenditures, the principles of budget formation were not changed. This has preserved for yet another year the problems inherent in the Soviet-style budget formation, calling for changes that would ensure transparent and efficient public spending.
For one thing, the budget is not balanced. The government is to do away with the budget deficit before the year 2000, but for it to happen, the law must explicitly incorporate the principle of projecting budgetary expenditures based on estimated revenues and without increasing the tax burden.
The anticipated budget deficit is 174 million US dollars. The government concedes that the deficit constitutes 1.64 percent of GDP, but this is a misleading comparison. It confuses the society and government alike. To adequately assess the budget deficit, expenditures must be compared in absolute terms with revenues. If measured this way, the budget deficit is 10.09 percent. In other words, every tenth litas expended by the government is not backed by revenues.
Second, the budget embraces not only exclusive public functions (such as public administration, national defence, law and order, social safety), but also those which belong to the private realm (e.g. transportation and communication, agriculture, dwelling and utilities). Public funds are thus allocated to finance activities that yield products which are partly paid for by consumers. They are also used to support typical commercial undertakings.
Third, almost a quarter of public spending will go toward financing activities that are not assigned to major categories of functions.
Another concern is that the budget does not reflect all public expenditures, for there are about 20 extra-budgetary funds. Earmarked, or trust-fund, outlays must be encouraged, but they must not be detached from the budget. Extra-budgetary funds obscure the transparency of government spending, therefore a unified budget should be adopted.
The budget legislation prescribes the scope of public borrowing and repayment of loans. Revenues from borrowing will top 820.4 million US dollars, of which 503.1 million will go toward repaying loans received with state guarantees and covering domestic debt. Preliminary estimates put Lithuania’s total debt at 2,050 million US dollars (of this, 1,400 million of foreign debt and 650 million of domestic debt), which constitutes 552.7 USD per capita, or 22.5 percent of GDP.
In mid-1997 the Seimas adopted a new methodology of calculating local government revenues. Under the new rules local governments plan revenues and expenditures for three years ahead. The sources of municipal receipts were modified too. Presently personal income tax (with a 33-percent regular rate) goes to municipal budgets after no less than 30 percent of the tax have been deducted to the health insurance fund. Corporate income tax is allocated to the state budget. Previously local budgets were receiving part of personal and corporate income taxes. Differences in municipal budgets caused by demographic and social trends are now equalised with state subsidies. Such subsidies are channelled to weaker municipalities at the cost of financially sustainable ones. The size and recipients of subsidies depend on Seimas-set ratios. Lawmakers concede that municipalities are now freer to compile their own budgets, and negative effects are avoided by way of revenue equalisation.
As the new methodology is designed to combine two incompatible ends, that is, local government independence and revenue equalisation, it appears to be convoluted and eclectic. In reality, municipal revenues depend on annually approved ratios.
In late 1997 the government set up a policy-drafting group to draw new principles of budget formation. Remigijus ?ima?ius, LFMI’s Legal Expert, was invited to be a member of the group. LFMI believes that with this initiative a major budget reform will get under way.
The Social Safety Net
The year 1997 saw the introduction of mandatory public health insurance, which was initially scheduled for the beginning of the year but did not take effect until mid-1997. Contributions to the health insurance fund, which are in no way related to a person’s sickness risks, are deducted from personal income tax (no less than 30 percent of the tax) and allocated to a special fund. The state contributes for unemployed registered with the labour exchange. Medical establishments provide services under contracts with territorial sickness funds. Such services are financed at basic prices set by the health care ministry.
The changes adopted are unlikely to create an efficient system of financing health insurance. The financing of medical establishments will depend on the number of services rendered, so it is feared lest these figures be inflated artificially. The system fails to engage patients in health insurance. For one thing, patients are not obliged to participate in cost sharing. Second, the obligation to contribute to the health insurance fund is imposed on employers. Finally, compulsory medical services are provided under any circumstances and the health insurance fund covers all medical services previously financed by the state.
In 1997 the state social insurance fund underwent the first-ever international audit. As the audit conclusions stated, “in 1996 the social insurance fund sustained losses in the amount of 116.6 million US dollars, and short-term assets available were insufficient to discharge the fund’s deferred liabilities. These factors raise doubts as to the continuity of the fund’s operation.” Heads of the State Social Insurance Board (Sodra) attributed this shortfall to arrears in social security contributions accumulated over past years. Yet, the Sodra’s deficit is evident, as the fund is now compelled to take loans from banks to fulfil its liabilities.
Seeking to reduce pension outlays, the Seimas adopted amendments to the rules of providing widows’ pensions and raising state pensions, which are extended to top officials and other distinguished persons along with social insurance pensions.
Previously the government raised state pensions as it lifted the level of basic old-age pension, used as a basis for calculating social insurance pensions. Over the last year the basic pension was increased twice. In January it rose to 30.3 US dollars and in November to 33.0 US dollars. Under the new amendments, state pensions ceased to depend on increases in basic old-age pensions. However, the law provides no safeguards against increases in state pension outlays and against governmental powers to augment favours for certain segments of society.
Also, expenditures for widows’ pensions will, contrary to the desired effect, drift up.
Social security contributions are financed by a 31 percent tax on the wage bill, with 30% paid by the employer and 1% by the employee. As part of its programme, the government pledged to set the upper earnings limit on social security contributions at 2.5 to 3 times the average wage, but a final decision was put off until 1998.
In April 1997 the social welfare and labour ministry set up a policy drafting group to complete the pension fund proposal. The group comprises experts from the Securities Commission, the institution that will supervise pension fund activity, the finance ministry, and LFMI’s social policy analyst Audron? Mork?nien?. The group has finalised its work, and the proposal is scheduled for submission to the government in the near future.
For the years 1997 through 2000 the government brought forward a programme for putting all economic agents and goods on an equal tax footing, exempting reinvested profits from Lithuania’s 29 percent corporate income tax, carrying forward losses, repealing corporate income tax for a period of ten years, revising tax administration, avoiding double and forward taxation, and cutting value added tax 18 to 15 percent at the cost of a widened VAT base.
A stricter policy on tax administration was started by founding tax police and launching, as the administration put it, a “fierce action” against free riders. This undertaking involved on-site inspections and fines of 25 percent of annual turnover for wilful tax evasion (previously penalties amounted to a hundred percent of unpaid tax returns). Imposing heavy penalties as a result of over-enthusiastic inspections led to several bankruptcies, fuelled bribery and multiplied cases of settling scores with competitors by means of deliberate actions. In mid-1997 penalties were cut to 10 percent of annual turnover but no less than 12.5 thousand US dollars. A multitude of defects in tax legislation inevitably invite good faith breaches of regulations, thus calling for a major reform that will tie tax administration, not to penalties, but to rational, simple and clear-cut rules of calculating and paying taxes.
In April 1997 reinvested profits, which were subject to a 10-percent tax rate, were exempted from the corporate income tax, a prospect likely to attract investments and encourage the renewal of enterprises. However, this provision is not applicable to loans taken for investment purposes and to assets other than material and usable ones.
Given the above stipulations, the rules of exempting investments violate the principle of tax neutrality, complicate enterprises’ financial procedures and impede market entry for new businesses, adding to their competition with robust companies more expensive investments.
As of July 1997, losses sustained by companies through their economic activities may be carried forward for three financial years.
A new 10 to 15 percent tax was introduced on sources of income that foreign companies receive from Lithuanian companies, a decision which prompted a barrage of criticism from the business community. The tax covers mediation services, consulting and market research, trademarks, names, and licences. A negative response was also spurred by a retroactive decision to charge a regular 29-percent tax on all kinds of income transfers to enterprises registered in low-tax countries or zones. Taxation of incomes generated by companies and other entities registered in tax havens brought about a much wider and more elaborate tax evasion, leading to new amendments a few months later. Despite these considerations, the policy decision was not abandoned.
In spite of numerous legislative amendments (and the preparation of new draft laws), direct income taxes are still marked by costly administration coupled with complex and vague rules which inevitably invite arbitrary interpretations and decisions. However, this is only natural given that defects of direct taxes are inherent in their nature.
As 1997 drew to a close, LFMI put forward a major tax reform proposal. After several years of focused efforts LFMI worked out a conceptual framework for a pro-liberal tax reform, which was presented at a major conference, December 1997. The pivot of the proposed reform is the phasing out of income taxes following a fundamental budget reform and a shift to a single tax modelled on VAT.
The Seimas extended the government’s powers to set excise duties until 1 January 1999. Excise duties on fuel went up in the spring of 1997, and in December the government resolved to raise them again by 27 percent as of 1 April 1998. Excise duties remain a tool for government protectionism. Lithuania’s only oil refinery Mažeikiai Oil, by way of illustration, is subject to an individual tax rate, which is lower than the regular one. The competitive environment is further distorted by varying rules of calculating excise duty. Excise duties charged on imported oil products are calculated based on their price, VAT, and customs duties. For Lithuanian products the size of excise duties depends on their price only.
In 1997 Lithuania signed treaties on double taxation avoidance with five countries, Canada, Kazakhstan, France, Ukraine, and Germany. Before that treaties had been concluded with ten countries, including Norway, Finland, Sweden, Poland, the Czech Republic, Latvia, Estonia, Belarus, China, and Italy.
Two years ago Lithuania embarked on a cash-privatisation programme. Before 1996 state-owned enterprises had been sold for cash and investment vouchers. The latter were distributed to Lithuanian citizens free of charge in 1991.
The 1997 privatisation programme included 1,098 items with authorised capital worth 632.6 million US dollars. In early 1997 the government resolved to put up for privatisation 14 large energy, communication, transportation and other “strategic” enterprises, including the Lithuanian Telecom, Lithuanian Airlines, and the Ma?eikiø Nafta oil refinery.
Privatisation of the Lithuanian Telecom, which is scheduled for April 1998, provoked intense public debates. The sale may therefore be delayed and the price of the telecom, which has been forecast to reach a high of one billion US dollars, may prove twice as low. Regrettably, the project cannot be viewed as privatisation, for the telecom is to be awarded monopolist rights for a period of five years. These favours will no doubt augment the telecom’s price tag, but one should remember that privatisation is not about converting a state monopoly into a private one, but about creating market conditions.
The slow pace of privatisation is attributed mainly to small share packages offered for sale. On the other hand, privatisation is being impeded by vague, defective laws and prevailing political motivations, distorting the essence of privatisation and undermining people’s confidence in the private sector. True, in the summer of 1997 the Social Democrats failed in their attempts to take the infrastructure privatisation issue to a public referendum, which indicates a resurgence of confidence in the private sector. The “special designation” items include the B?ting?s Nafta oil terminal, the Ma?eikiø Nafta oil refinery, the Ignalina atomic power plant, the national gass supplier Lietuvos Dujos, the Lietuvos Energija national electricity and thermal energy company, municipal water supply enterprises, telecommunication and transportation companies.
In November the Seimas passed a new law on the privatisation of state and municipal property. The aim was to revoke the discretionary right of founding ministries and municipalities to retain or release property for privatisation, the right which was the main stumbling block to privatisation. Under the new legislation, a special asset management fund was created to administer state-run enterprises slated for privatisation.
Despite these improvements, the newly adopted legislation contains a number of shortcomings. The modes of privatisation-which, alongside public offer of shares and auctions, include public tender and direct negotiations-invite unlimited discretion of the government in selecting purchasers and personalised relationships between the government and potential buyers. The competence of and assignment of functions among privatisation authorities is vague and unclear. There are no conditions for private agents to participate in organising the privatisation process. All this erects bureaucratic barriers and leads to political favouritism and violations of fundamental market principles.
Consistent with its electoral platform, the government drafted a proposal on the restitution of citizens’ savings lost to rouble depreciation. The law, which was approved by the Seimas in the spring of 1997, provides that no less than two thirds of proceeds from privatisation will go toward repaying depreciated savings. In light of an array of pressing social problems, e.g. pension reform, this is hardly the optimum solution.
The government pledged to pay off compensations of up to 15 hundred US dollars. It is not clear though whether privatisation will yield enough revenues for compensations, a project that will require 860 million to one billion US dollars.
It should be noted that initial savings restitution projects proposed that the state budget and public borrowing be additional sources of funds for compensations. Yet, the government took the LFMI’s advice and abandoned such plans.
Last year there were eleven operating banks in Lithuania, three of them state-owned. As compared with the period from 1990 through 1996, the year 1997 was gratifying for the country’s banking sector. Many of the banks improved their performance, some increased authorised capital. Three of the banks expanded their activities outside Lithuania. Two received syndicated loans from abroad without government guarantees. The Polish Kredyt Bank PBI was the first bank to open a branch office in Lithuania (the French bank Societe Generale received a permit to establish a branch office on 19 February 1998).
Over the past two years 16 of Lithuania’s commercial banks went bust, so the confidence in the banking sector was badly dented. In the autumn of 1997 the Baltic Research survey agency reported that close to 80 percent of the country’s population distrusted banks.
Still, over the last year banks’ assets rose by 683.3 million US dollars (49 percent), topping 2,076 million US dollars. The same period saw an increase in deposits by 490.8 million US dollars (49.8 percent) and the total of 1,476 million US dollars. Loans increased by 540.8 million US dollars (242.6 percent), with the total peaking at 920 million US dollars.
In October the annual average interest rate was 5.2 percent on residents’ deposits in litas and 4.5 percent on deposits in foreign currency. The January 1997 figures were 9.9 and 7.0 percent respectively. Average annual interest on residents’ loans in litas was 11.5 percent, while a 10.9 percent interest rate was recorded on loans in foreign currency. The figures for January 1997 were 17.0 and 12.4 respectively.
In 1997 six out of eight private commercial banks were profitable, while two out of three state-run banks-the Lithuanian State Commercial Bank and the Lithuanian Agricultural Bank-operated at a loss. The third state-owned Lithuanian Savings Bank dod not show as good a performance as the private banks did.
In 1997 attempts were made to privatise the Lithuanian State Commercial Bank. The finance ministry announced two tenders, but both of them failed as no bids arrived. Experts say that the bank’s financial shape was the main reason behind the failure to attract investors. In late 1997 the bank’s liabilities exceeded its assets by 31 million US dollars, with bad loans accounting for 40 percent of the bank’s assets.
The state’s 86 percent stake in the Lithuanian Agricultural Bank is slated for privatisation in 1998, but there is no talk of selling the Lithuanian Savings Bank. It should be noted that, regardless of political orientations, all governments wanted to retain at least one state-run bank.
In April 1994 Lithuania installed a currency board. According to the Litas Credibility Law, cash in circulation is backed a hundred percent by hard currency and gold reserves, and the litas is pegged to the US dollar at a permanently fixed exchange rate of 4 to 1. The currency board arrangement put inflation under control and shielded the country’s economy from political pressure as it confined the central bank to strict, rule-bound policy.
In early 1997 the Bank of Lithuania (BoL) adopted a monetary policy programme for the years 1997 through 1999. According to the programme, the currency board is to be phased out and “classical” central bank functions are to be restored. The programme will be implemented in three phases. During phase I, which ended last autumn, the BoL introduced new monetary policy instruments (repo transactions between the BoL and commercial banks, deposit auctions, short-term crediting of commercial banks for government securities pledged, overnight liquidity loans by pledging government securities). Phase II will involve amending the Litas Credibility Law and repealing a hundred percent reserve system. During phase III, which will be launched not earlier than 1999, the litas will be unpegged from the US dollar and linked to a currency basket (the euro and dollar) or a single currency, the euro.
The business community voiced their distrust of the central bank’s policy right after the adoption of the monetary programme. For fear that devaluations may be in the offing, commercial banks demanded that the Bank of Lithuania remove a ban on extending loans in foreign currency, which it did.
As the press abounded with speculations about the litas exchange rate, central bank officials proclaimed that the BoL’s reserves would suffice to preserve the litas exchange rate unchanged until phase III, stressing that the reserves constitute 132 percent of cash in circulation.
According to preliminary estimates, official reserves in 1997 increased from 834.3 to 1,062.7 million US dollars (27.4 percent). Of this, foreign currency reserves rose from 762 to 999.2 million US dollars (31.3 percent) and special drawing rights from 10.2 to 10.8 million US dollars (5.9 percent). Gold reserves fell from 62.0 to 52.7 million US dollars (15 percent) after revaluing them at 238.5 US dollars for one troy ounce of gold, the lowest price fixed at the London Alloys Exchange last year. Before that the value of gold was estimated at 333 US dollars for one ounce.
LFMI came out in opposition to the removal of the currency board, stressing that strict currency board principles reduced the likelihood of money inflation and government interference in economic affairs.
The Securities Market
In 1997 the Lithuanian stock exchange saw brisk activity. Enterprises became increasingly involved in the stock market by attracting investments through new stock issues, while the sale of state-owned enterprises at the National Stock Exchange provided a basis for an objective, transparent privatisation.
Over the first 11 months the capitalisation of the stock exchange increased from 1.4 to 2.5 billion US dollars (75 percent). Calculated since April 1997, the stock exchange’s official list dropped by 11.03 percent. The blue-chip index contains five enterprises that meet strict requirements concerning authorised capital, stock issue, listing, and profitability. Despite that, the Litin-A index, comprising 54 stocks, went up by 13.6 percent, while a 13.8 percent increase was recorded for the Litin-G index, calculated for all 282 Group A and B stocks quoted on the exchange.
Last year saw an increase in the share of foreign capital registered with Lithuania’s central depository. By the end of 1997, the comparative weight of foreign capital rose from 34.0 to 58.6 percent, while the share of domestic investors slumped from 66.0 to 41.4 percent. This indicates foreign investors’ increasing confidence in the country’s enterprises.
The Lithuanian securities market is still misssing pension and investment funds. As a rule, these institutional investors accumulate large resources from small local investors, enhancing the liquidity and stimulating the growth of the capital market.
The absence of investment funds is attributed mainly to the unconducive tax treatment. Presently the income tax is not charged on personal income received from dividends and capital gains, but investment funds are subject to double taxation, thus reducing individual incomes.
The legal framework for pension funds is under preparation. However, the pension fund proposal, which is scheduled for submission to the government in the near future, provides that state social insurance will remain a monopolist in social insurance provision. This main severely impede the development of a private pension system.
As compared to 17.8 percent in early 1997, government bonds-a tool to finance budget deficits-accounted for 13.8 percent of the stock exchange’s capitalisation by the end of the year. Interest rates kept falling depending on the maturity of government bonds. Dominating the market at 54.3 percent, domestic banks were the major players in government bond transactions, while foreign buyers accounted for 1.2 percent.
LFMI has repeatedly voiced a proposal to do away with the budget deficit and the issue of government securities.
International Co-operation
The main aspects in this area were Lithuania’s agreement on free trade in agricultural products with Estonia and Latvia, free trade agreements with CEFTA, and integration into the European Union.
The free trade agreement with Estonia and Latvia, which took effect at the beginning of the year, was instrumental in terms of economic liberalisation. The results of the first quarter showed a drop in Lithuania’s export and increase in import of agricultural products with the other Baltic countries.
Over the last year Lithuania continued to seek membership in the CEFTA (Central European Free Trade Agreement). Free trade agreements with Poland went into force in January, with Slovenia in March, and with the Czech Republic and Slovakia in July. To become a member of the CEFTA, Lithuania still has to conclude a free trade agreement with Hungary, to become a member of the World Trade Organisation and to receive approval from the CEFTA nations.
In July the European Commission declared its conclusions on the readiness of Central and Eastern European countries for membership in the EU. Candidates were assessed according to three criteria: (i) institutional stability securing democracy, the rule of law, human rights, and respect for and protection of minorities, (ii) creation of a functioning market economy and the ability to handle the pressure of competition and market forces within the EU, and (iii) the ability to assume membership responsibilities. In addition to that, the EC evaluated medium-term prospects of the candidates and the reforms conducted and progress achieved to date.
Lithuania scored best in terms of democratisation. The EC conclusions reported that Lithuania is a democratic state with stable institutions protecting the rule of law, human rights and the respect for and protection of minorities.
Although the EC pointed to Lithuania’s progress in creating a market economy and stabilising the macroeconomic environment, doubts were expressed as to Lithuania’s ability to cope with the competition and market forces from the EU. Lithuania, the EC stressed, should proceed with large-scale privatisation and focus on its weakest sectors, agriculture and banking.
The EC was also skeptical about Lithuania’s ability to undertake membership responsibilities, noting that concerted efforts and investments will be needed for Lithuania to catch up with EU standards in agriculture, the energy sector and environment protection.
The ruling Conservative party was dismayed at the EC decision, arguing that some of the assessments were based on outdated indicators. The government promised to take all possible measures to persuade EU nations that Lithuania is ready to start membership talks. With this goal in mind Lithuanian diplomats visited every EU member state.
The Luxembourg EU Summit in December 1997 resolved that Lithuania, with the EC recommendation, will be able to start membership negotiations in late 1998 without formal approval from the EU Council.
Main macroeconomic indicators
Total GDP (USD mln, in current prices)
Real GDP growth (%)
GDP per capita (USD)
One-year inflation (%)
Annual unemployment (%)
Average wages (USD)
Export (USD mln)
Import (USD mln)
Trade balance (USD mln)
Current account balance (% of GDP)
Foreign direct investments (USD mln, end of year)
Budget balance (% of GDP)
Gross foreign debt (USD mln, end of year)
Source: The Department of Statistics, the Bank of Lithuania, the Ministry of Finance
* Preliminary