US embassy cable - 04VILNIUS1526

UNCLAS SECTION 01 OF 02 VILNIUS 001526 
 
SIPDIS 
 
STATE FOR EUR/NB (MGERMANO) AND EB/IFD 
 
E.O. 12958: N/A 
TAGS: EINV, ECON, LH, HT22 
SUBJECT: IMF'S RECOMMENDATIONS ON HOW TO PROLONG THE 
LITHUANIAN ECONOMIC MIRACLE 
 
 
------- 
SUMMARY 
------- 
 
1.  An IMF delegation, concluding an Article IV 
Consultation mission to Lithuania December 10, praised 
Lithuania's impressive structural improvements and the 
country's complete transition to a market economy.  The IMF 
delivered an overall positive assessment of the country's 
economic prospects for 2005 and several short-term policy 
prescriptions to ensure continued growth.  The IMF 
delegation warned that the economy risks overheating, 
however, and also advised attention to remaining fiscal and 
other structural reforms.  Congratulating the GOL on the 
economy's performance, the mission was optimistic that 
Lithuania would speedily adopt the euro and attain the 
living standards of more advanced European countries.  The 
IMF's policy prescriptions provide an agenda for the new 
GOL's Ministry of Finance and guideposts for our advocacy 
and reporting of their progress.  End Summary. 
 
2.  An IMF delegation under the leadership of the Fund's 
European Department Assistant Director Ashoka Mody 
concluded an Article IV consultation on December 10.  The 
mission's overall analysis lauded Lithuania's structural 
reforms.  The delegation congratulated the GOL on the 
economy's strong performance since the last IMF 
consultation in June 2003, Lithuania's accession to the EU, 
and the country's entry into the ERM-II currency mechanism. 
The mission noted Lithuania's continued robust, non- 
inflationary growth in 2004, declining unemployment, and 
predicted GDP growth of 6.5 percent in 2005, and annual 
growth of five to six percent in the medium term. 
 
------------------------- 
IS LITHUANIA OVERHEATING? 
------------------------- 
 
3.  The IMF cautioned that Lithuania's fast growth rates 
would stimulate aggregate demand to grow above potential, 
leading either to destabilizing inflation or greater 
borrowing, with higher current account deficits and 
external debt.  They noted that inflation, expected to be 
just under 1.5 percent in 2004, will likely exceed 2.5 
percent in 2005, and remarked several early signs that 
point to a risk of overheating of the Lithuanian economy: 
 
- High capacity utilization; 
- Continued robust growth of credit, driven by low interest 
rates; 
- Declining unemployment; 
- Acceleration in wage growth; 
- Increases in property prices; 
- Rapid growth in the current account deficit; and 
- Output exceeding potential. 
 
The mission stated that supply-side shocks are exerting 
inflationary pressures, noting that recent increases in oil 
prices had raised domestic prices because of the high 
energy-intensity of Lithuania's production.  It noted, 
however, that domestic demand is equally inflationary, 
pointing to the sharp increase in real estate prices, and 
added that there is a continuing risk of price increases in 
utilities and other non-traded goods. 
 
--------------------------------------- 
URGES TWO PERCENT FISCAL DEFICIT TARGET 
--------------------------------------- 
 
4.  The IMF noted that Lithuania's current account deficit 
has widened sharply.  The mission recommended the GOL 
closely monitor external debt obligations, take measures to 
raise the private savings rate, and reduce the fiscal 
deficit, since the latter contributes significantly to the 
demand pressures underlying the current account deficit. 
 
5.  Commending the GOL for accepting the fiscal discipline 
of the Maastricht criteria in order to achieve early 
adoption of the euro, the mission encouraged the GOL to 
adopt an even more ambitious fiscal deficit target for 2005 
of two percent of GDP, rather than the current 2.5 percent 
target.  It suggested the GOL could reduce the fiscal 
deficit by taking advantage of the high projected revenue 
in 2004 and transferring domestic co-financing funds to 
2005, since these will not be needed in 2004 due to the 
delay in the utilization of EU funds.  The mission observed 
that a conservative fiscal policy would prevent 
overheating, while allowing the GOL the flexibility to 
increase the deficit in the future in order to stimulate 
demand, should domestic confidence fall unexpectedly. 
 
------------------------------------------ 
URGENT: REFORMS TO ENSURE LONG-TERM GROWTH 
------------------------------------------ 
 
6.  The IMF urged the GOL to implement fiscal and other 
structural reforms to ensure a stable revenue base and 
create incentives for private entrepreneurs to increase 
employment, invest in upgrading the quality of the labor 
force, and better enable their enterprises to compete 
against lower-wage economies in international markets.  The 
mission recommended the following reforms: 
 
- More effective collection of VAT revenues to remedy the 
shortfall in 2004, and reforming the VAT tax administration 
system; 
 
- A significantly lower and unified single personal income 
tax rate that would maintain the current exemption 
threshold and would be appropriately phased in to limit 
disruption to revenues, along with greater efforts at 
achieving tax compliance; 
- Institution of a more wide-ranging property tax, to both 
increase revenues and provide incentives to municipalities 
to invest in education, infrastructure, and public 
services; 
 
- Greater transparency and control in the design and 
management of public expenditures, to include detailed 
documentation of government expenditures and cash flows, 
identification of buffers to deal with contingencies, and 
institution of modern cash control methodology; 
 
- a more financially viable social security system 
featuring accelerating increases in the retirement age; 
 
- Expansion of the social safety net, by devising a means- 
tested targeting system for income support, but not by 
raising the minimum wage, since the latter is already high 
relative to other countries and a further increase would 
only serve to discourage employment; 
 
- Introduction of a Fiscal Responsibility Act in parliament 
which would contain GOL commitments to targets, procedures, 
and transparency of budget revenues, expenditures and debt, 
and would provide a comprehensive and transparent framework 
to ensure long-term fiscal reforms; and 
 
- Additional microeconomic reforms to increase the 
attractiveness of Lithuania's business environment, such as 
decreasing complex and time-consuming regulations facing 
small and medium enterprises, increasing private 
initiatives in the health and education sectors, and 
implementing World Bank recommendations on the knowledge 
economy. 
 
The mission concluded that a GOL focus on these short-term 
policy prescriptions would ensure early adoption of the 
euro and rapid improvement of living standards to match 
those of more advanced European countries. 
 
------- 
COMMENT 
------- 
 
7.  The IMF prescriptions are timely, coming just as a new 
Government takes office.  The IMF framed the challenge 
well: Lithuanian elites must now decide how quickly 
Lithuanian income levels will converge with those in 
Western Europe.  To catch up quickly, this Government and 
Parliament will have to forget about the populist platforms 
that helped elect many of them and adhere instead to the 
IMF's recommendations. 
 
MULL