Report No. 25005-LT Lithuania Country Economic Memorandum Converging to Europe: Policies to Support Employment and Productivity Growth October 7, 2002 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENT UNITS Currency Unit = Litas US$1.00 = LTL 4.00 Fiscal Year January 1 - December 31 ACRONYMS AND ABBREVIATIONS AFMRA Agricultural and Food Market Regulation Agency ALMP Active Labor Market Programs BEEPS Business Environment and Enterprise Performance Survey CAP Compensatory Area Payment CEEC Central and Eastern European Countries CGE Computable General Equilibrium CIS Commonwealth of Independent States ERP Economic Rates of Protection EU European Union FDI Foreign Direct Investment FIAS Foreign Investment Advisory Services FTC Federal Trade Commission GDP Gross Domestic Product GMP Good Manufacturing Practice HBS Household Budget Survey ISPA Structural Policy Instrument for Pre-Accession MMPP Minimum Marginal Purchase Prices MNC Multinational Corporations MSL Minimum Subsistence Level NACE Nomenclature Generale des Activites Economiques dans la Communaute Europeen OECD Organization for Economic Co-operation and Development PADP Private Agricultural Development RCGF Rural Credit Guarantee Fund RTV Radio and Television SITC Standard Industrial Trade Classification SME Small-Medium Enterprises SSIF Social Security Insurance Fund SSI State Supported Income TIR Transit Intemational Routier VBK Vilniaus Baldu Kombinatas VW Vilniaus Vingis WTO World Trade Organization Vice President: Johannes Linn (ECAVP) Country Director: Roger Grawe (ECCU7) Sector Director Cheryl Gray (ECSPE) Sector Manager Kyle Peters (ECSPE) Daniela Gressani (ECSPE) Task Team Leader Ana Revenga (ECSPE) CONTENTS ACRONYMS AND ABBREVIATIONS . ......................................................II ACKNOWLEDGEMENTS .................................................................. Ix EXECUTIVE SUMMARY ...................................................... XI THE CHALLENGE OF EU INTEGRATION .................................................................. XI MACROECONOMIC FRAMEWORK: ACHIEVEMENTS AND CHALLENGES ................................. XII THE ROLE OF INTERNATIONAL TRADE AND FOREIGN DIRECT INVESTMENT .......... ............. XV AGRICULTURE AND THE RURAL ECONOMY .................................................................. xvii THE STRUCTURAL REFORM AGENDA ............................. ..................................... XXI Labor Market Reform: Enhancing Flexibility .................................................................. xxi Regulatory Reform: Improving the Business Environment ............................................. xxv Social Protection Reform: Increasing Effectiveness and Efficiency ............................ xxviii 1. MACROECONOMIC TRENDS AND CHALLENGES ................................................1 A. MAIN MACROECONOMIC DEVELOPMENTS ...................................................................2 Production ...................................................................2 Demand ..............................................................4 Government Finances ...........................................................7 Lithuania's Fiscal Sustainability ............................................................8 Savings and Investment Financing ............................................................8 Balance of Payments ............................................................9 B. TRENDS IN COMPETITIVENESS AND EXTERNAL VULNERABILITY .................................. 13 C. KEY LABOR MARKET OUTCOMES .............. ............................................. 18 Unemployment and Under-Employment ........................ ................................... 18 Sectoral Distribution of Employment ........................................................... 19 Patterns of Job Turnover ........................................................... 21 D. POVERTY AND OTHER SOCIAL INDICATORS ........................................................... 22 Household Consumption and Incomes ........................................................... 22 Poverty Profile ........................................................... 23 Non-Income Dimensions of Poverty and Other Social Indicators . . 26 E. LOOKING AHEAD: THE MEDIUM- AND LONG TERM STRATEGY ................................... 28 Long Term Sources of Growth: Lessons from History ...................................................... 28 Medium-Term Strategy for Preparing Convergence ......................................................... 30 2. INTERNATIONAL TRADE AND FOREIGN DIRECT INVESTMENT ................. 35 A. PATTERNS OF COMPARATIVE ADVANTAGE ................................. ................................. 36 Geographical Reorientation of Trade ............................................................................... 36 Increased Processing Level and Changing Pattern of Specialization .......... ...................... 37 Changing Factor Content of Trade ............................................................................... 38 Presence in Expanding Markets . ............................................................................... 41 Participation in Production Networks ............................................................................... 43 B. THE ROLE OF FOREIGN DIRECT INVESTMENT ............................. .................................. 45 C. DETERMINANTS OF EXPORT AND PRODUCTIVITY PERFORMANCE: EVIDENCE FROM FIRM-LEVEL DATA ............................................................................... 47 Are Exporters Different? ............................ ................................................... 47 To Export or not to Export? ................................. .............................................. 48 Does Exporting Increase Productivity? ............................................................................. 49 Are Firms with Foreign Capital Different? ........................................................................ 50 D. SUMMARY AND CONCLUSIONS .50 3. AGRICULTURE AND THE RURAL SECTOR ................................................. 53 A. AGRICULTURAL PERFORMANCE AND PRODUCTIVITY ................................................... 54 Sector Performance ................................................................................................. 54 Trends in Productivity and Factor Utilization ..56 B. RURAL POVERTY PROFILE .64 C. TOWARDS MoRE EFFICIENT AGRICULTURE .65 Incentives Regime ..65 Key Sub-Sectors 68 1TE ROAD AHEAD .73 Preparations for Accession into the EU .73 The Challenge of Accession .74 Enhancing Dynamism in the Agricultural Sector .77 4. LABOR MARKET REFORM: ENHANCING FLEXIBILITY . .83 A. MACROECONOMIC DIMENSION: WIDESPREAD RESTRUCTURING WITH UNDERUTILIZATION OF LABOR RESOURCES .83 Pattems of Job Turnover .................................................... 84 Determinants of Job Creation .87 Job Tumover and Unemployment .87 B. WORKER DIMENSION: LONG DURATION OF JOB SEARCH .88 Labor Flows .88 The Skills Gap .90 Job Security .91 Earnings Inequality .93 C. EMPLOYER PERSPECTIVE: CONSTRAINTS TO EMPLOYMENT AND WAGE ADJUSTMENT 93 Constraints to Employment Adjustment .94 Constraints to Wage Adjustment .95 Are the Constraints Binding .95 D. SUMMARY AND POLICY REcoMMENDATIONS .97 5. REGULATORY REFORM: IMPROVING THE BUSINESS ENVIRONMENT ... 99 A. ELEMENTS OF A FAVORABLE BUSINESS ENVIRoNmENT .100 B. OBSTACLES TO PRIVATE SECTOR DEVELOPMENT: A FIRM-LEVEL VIEW . 101 Market Expansion, Benefits from Exporting and FDI .. 102 Business Environment-Public Private Interactions .. 104 Business Registration Procedures .. 106 Access to financing ................ 107 Labor Market ..107 C. REGULATION AND ACCESSION INTO THE EU .108 The Free Movement of Goods ..108 Transport Policy ........... 110 Agriculture ....................................................... 112 Environment ..113 Energy .. 115 D. SUMMARY AND POLICY RECOMMENDATIONS. 116 6. SOCLL POLICY REFORM: INCREASING EFFICIENCY AND EFFECTIVENESS ..119 A. OVERVIEW OF THE SOCIAL PROTECTION SYSTEM .119 B. STATE SOCIAL INSURANCE PROGRAMS .120 Old-Age Pensions ..122 iv Unemployment Benefits ................................. 125 C. SOCIAL ASSISTANCE PROGRAMS ................................... 129 Cash Transfer Programs .................................. . 130 D. MERIT-BASED BENEFITS-STATE PENSIONS ................................... 136 E. SUMMARY AND POLICY RECOMMENDATIONS .......... ......................... 137 REFERENCES .................................... 139 v List of Tables Table 1 Main Economic Indicators ...................................................... xii Table 2 Dynamics of GDP, Employment, Productivity and Wages (1995=100) ............ xiii Table 3 Poverty in Lithuania, 2000 (%) ..................... ................................. xiv Table 4 Comparative Productivity Measures in Agriculture, 2000 ................................. xix Table 5 Job Creation and Job Destruction, 1996-2000 ................................................... xxii Table 6 Leading Constraints to Operation and Expansion ............................................ xxvi -Table 1.1 Main Economie- Indidators- .......................................... I Table 1.2 Capital Investments by Source of Financing (%) .9 Table 1.3 Lithuania's Central Bank's Balance Sheet .12 Table 1.4 Dynamics of GDP, Employment, Productivity and Wages .18 Table 1.5 Labor Supply, 1995-2000 .19 Table 1.6 Average Disposable Consumption and Income in 1996-2000 .23 Table 1.7 Poverty in Lithuania, 2000 (%) .24 Table 1.8 Poverty by Location, 2000 .24 Table 1.9 Population Share and Poverty Risk by Gender of Household Head, 2000 (percent) .25 Table 1.10 Poverty Risk by Highest Education Level Achieved by Household Head, 2000 .25 Table 1.11 Poverty by Employment, 2000 .26 Table 1.12 Selected Social Indicators .27 Table 1.13 Projected TFP Growth Rates for the Baltic Countries .29 Table 2.1 Geographical Distribution of Trade: Lithuania vs. Selected CEEC Countries... 36 Table 2.2 Factor Intensity of Lithuanian Trade with the EU, 1992-99 .38 Table 2.3 Presence of Lithuanian and Other Selected Country Exports in EU Sunrise Markets .43 Table 2.4 Lithuanian Participation in the EU Production and Marketing Networks, 1993, 1997-99 .44 Table 2.5 Differences in Performance between Exporters and Non-Exporters .48 Table 2.6 Average Productivity in Manufacturing Sectors .48 Table 3.1 Comparative Productivity Measures, 2000 .59 Table 3.2 Distribution of Rural Non-Poor Household Investment Expenditure .61 Table 3.3 Poverty Risk by Access to Land, 2000 .64 Table 3.4 Expenditures on Agricultural Inputs, 2000 .65 Table 3.5 Nominal (NRP) and Effective (ERP) Rates of Protection (%) .67 Table 3.6 Milk Production .69 Table 3.7 Grain Production .71 Table 3.8 Sugar Prices .72 Table 3.9 Inelastic Demand: Consumers' Real Income Change .75 Table 4.1 Job Creation and Job Destruction, 1996-2000 .84 Table 4.2 Job Turnover by Industry .86 Table 4.3 Transition Probabilities Across Labor Force States .88 Table 4.4 New Hires by Previous Labor Market Status (%), 2001 .89 Table 4.5 Unemployment by Educational Attainment and Occupation, 2000 .91 Table 4.6 Evolution of the Minimum Wage, 1994-2000 .95 Table 5.1 Constraints Preventing Firm Growth (mean score) .102 Table 5.2 Companies Trying to Reach New Markets .102 Table 5.3 Main Factors Preventing Firms from Increasing Sales in the EU (mean score) .103 Table 5.4 Assistance Received from Foreign Partner .103 Table 5.5 Leading Constraints to Operation and Expansion .104 vi Table 5.6 Main Difficulties Associated with Starting a New Business ............................. 107 Table 6.1 Structure of the Social Protection System in Lithuania ..................................... 120 Table 6.2 Financing of the Social Insurance Programs ............................................. 121 Table 6.3 Poverty Impact of the Old Age Pension Program ............................................. 123 Table 6.4 Unemployment Support Program Indicators ............................................. 126 Table 6.5 Social Assistance Program Expenditure (as % of GDP) ................................... 130 Table 6.6 Impact of Means Tested Social Assistance Programs on Poverty ..................... 133 List of Figures Figure 1 Lithuanian Export Specialization Indices ....................... ...................... xvi Figure 2 Nominal and Effective Rates of Protection (%), in 2000 ................................. xviii Figure 3 How Problematic Are These Areas for Your Business? .................................. xxvii Figure 4 Categorical Benefits Are not Pro-Poor .................... ......................... xxix Figure 1.1 Real GDP Growth and Factors of Production .............................................. 2 Figure 1.2 Structure of Gross Value Added by Economic Activity ........................................3 Figure 1.3 Employment Level by Sector ..............................................3 Figure 1.4 Productivity by Sector ..............................................4 Figure 1.5 Composition by Expenditure ..............................................5 Figure 1.6 Imports and Exports ..............................................5 Figure 1.7 Share of Exports by Country (or Union) of Destination ........................................6 Figure 1.8 Share of Imports by Country (or Union) ..............................................6 Figure 1.9 Inflation and GDP Growth in Lithuania and Estonia ............................................7 Figure 1.10 Aggregate Fiscal Balance .7 Figure 1.11 Gross National Savings as % of GDP .9 Figure 1.12 The Current Account Deficit and its Components .10 Figure 1.13 Decomposition of the Goods Trade Balance .1 Figure 1.14 The Financial Account.1 Figure 1.15 Evolution of the Real Exchange Rate Indices of the Litas (June 1993 = 100) .... 14 Figure 1.16 Lithuania's Exports Market Shares in Key Trading Partners' Imports Markets. 15 Figure 1.17 Exports and Imports Prices Indices and TOT Indices (1996 = 100) .16 Figure 1.18 Current Account, FDI, and Gross External Debt .17 Figure 1.19a Employment Composition in 1993 ...................................... 20 Figure 1. 19b Employment Composition in 2000 ...................................... 21 Figure 2.1 Lithuanian Export Specialization Indices ...................................... 37 Figure 2.2 Cummulative FDI Inflows Per Capita 1993-2000 ...................................... 46 Figure 3.1 Animal Yields ...................................... 57 Figure 3.2 Crop Yields ...................................... 57 Figure 3.3 Land and Labor Productivity in Agriculture ...................................... 58 Figure 3.4 Tractor Fleet ...................................... 60 Figure 3.5 Agriculture as a Share of Total Foreign Investment ...................................... 61 Figure 3.6 Rural Household Investrnent ...................................... 62 Figure 3.7 Change in Real Producer Prices 1996-2000 ...................................... 66 Figure 3.8 Dairy Producer Prices ...................................... 69 Figure 3.9 Domestic Grain Use ...................................... 71 Figure 4.1 Job Creation by Firm Size, 2001 .............................. 85 Figure 5.1 How Problematic Are These Areas for Your Business? .................................... 106 Figure 6.1 Expenditure of Social Insurance Programs ...................................... 121 Figure 6.2 Unemployment Benefit: Lithuania vs. Other Transition Economies ................ 127 Figure 6.3 Perverse Work Incentive in the Proposed New Benefit Structure ..................... 128 Figure 6.4 Categorical Benefits Are not Pro-Poor ............................................... 134 vii List of Boxes Box 2.1 Moving Up the Value Chain in the Apparel Industry .......................................... 40 Box 2.2 Vilniaus Baldu Kombinatas ................ ....................................... 42 Box 2.3 Vilniaus Vingis ....................................................... 45 Box 5.1 Over Regulation and Unpredictability of Legislation ........................................ 105 Box 5.2 The Effects of Participating in the Internal Market on the Achema Compar y. 109 Box 5.3 The Impact of Adjusting to the EU Quality Standards in the Pharmaceutical Industry ................................................... 110 Box 5.4 The Impact of EU Membership on International Road Haulage Carriers ......... 111 Box 5.5 The Impact of Adjustment to the Quality Norms in the Milk Production Sector .................................. 112 Box 5.6 The Impact of Adjusting to Veterinary Standards ....................... ........... 113 Box 5.7 The Adjustment to the EU Emission Norms . ............................. 113 Box 5.8 The Adjustment to the Volatile Organic Components Emission Norms ........... 114 Box 5.9 The Impact of Implementing EU Norms on Security of Supplies ..................... 115 Box 6.1 Revised Pension Reform Proposal: the Voluntary Funded Pillar ..................... 124 Box 6.2 Minimum Subsistence Level (MSL) and State Supported Income (SSI) .......... 132 viii ACKNOWLEDGEMENTS This report was prepared by a team led by Ana Revenga, and comprising Richard Burcroff, Anne del Castillo, Severin Kodderitzsch, Brian Kopp, Clestin Monga, Francis Ng, Lodovico Pizzati, Davide Rodogno, Jan Rutkowski, Beata Smarzynska, Diane Steele, Giedre Tarbuniene, Henrik Tiete, Vilija Kostelnickiene, Ramunas Vilipisauskas, and Xiaoqing Yu. Duilio Pighi provided invaluable assistance with the production of the report. The report also benefited from the constructive inputs provided by the peer reviewers, Pedro Alba and Christine Jones, and by Bernard Funck, Celestin Monga, Mantas Nocius, Seppo Ensio Tiihonen, Laura Tuck and Jos Verbeek. Sector managers Kyle Peters and Daniela Gressani provided guidance to the report at various stages. The work was carried out under the general direction of Michael Carter, Country Director for Lithuania, and subsequently under that of Roger Grawe. The staff of the Resident Mission in Vilnius provided invaluable assistance in organizing the missions and meetings. The team would also like to thank the Government of Lithuania, and especially officials from the European Committee, Statistics Lithuania, the Office of the President, the Office of the Prime Minister, the Ministry of Labor and Social Security, the Bank of Lithuania, the Ministry of Agriculture, the Ministry of Economy, and the Ministry of Finance, for the excellent cooperation received, and for the written comments provided on an earlier draft. The team also wishes to thank the many academics, NGO members, representatives from business and business associations, parliamentarians, and representative of other international donors, who met with the report team, for their productive discussions and inputs. This report was prepared in conjunction with a series of background papers. These background papers, which represent the views of their individual authors, are available upon request from The Econornic Management and Poverty Reduction Department of the Europe and Central Asia Region. ix EXECUTIVE SUMMARY THE CHALLENGE OF EU INTEGRATION Lithuania's leading political, economic and social objective for the coming decade is integration into the European Union. Underlying this objective lies not only a desire to be an active participant in the construction of a common Europe, but also the goal of delivering to Lithuania's population the standards of living of its richer, Western European neighbors. To a large extent, the success of Lithuania 's integration into the EU over the next two decades will be measured by its ability to converge over time towards EU-levels of income, and to spread the benefits of such convergence across all segments of the population. I. Integration into the EU will not automatically translate into income convergence and human development, but it does open the opportunity for such convergence to occur. As evidenced by the experience of several countries that joined the EU before 1990-Portugal, Spain, and especially Ireland-formal economic integration into the EU can provide the stimulus for fast and sustained economic growth that rapidly translates into rising incomes. However, in all three countries mentioned, the choice of domestic policies pursued during the period leading up to and immediately following accession proved to be critical. The much less favorable experience of Greece further highlights this point. 2. The main challenge for Lithuanian policy makers vis a vis the integration process is to put in place a policy framework that will ensure successful integration: one that will foster greater competitiveness and higher productivity, while at the same time supporting job creation and employment growth. The challenge for policy is twofold. On the one hand, policies need to encourage modernization and restructuring throughout the economy; not only at the enterprise level but also among market-supporting institutions and in the public admninistration. At the same time, policies need to ensure that the benefits of integration are spread broadly across different parts of society. This means dampening, when necessary, the potentially negative impact of integration in some less competitive sectors and among certain vulnerable groups. Balancing these two challenges is a complex task that requires strong movement forward on key structural reforms (in agriculture; in the labor market; and to improve the business environment), and the simultaneous strengthening of the social safety net. 3. It is important from the start to draw a distinction between formal accession into the EU, which requires compliance with a set of given legislative, regulatory and institutional requirements, and economic integration into the EU which is a much longer process. The integration process has started already with the significant reorientation of the Lithuanian economy and of its trade flows towards the EU. More importantly, given that the EU is already Lithuania's main trading partner, integration is arguably a process which would have to happen independently of formal accession. It is this process of economic integration, and not formal accession per se, that is the main concern of this study. xi MACROECONOMIC FRAMEWORK: ACHIEVEMENTS AND CHALLENGES Lithuania has put in place a stable macroeconomic foundation from which to approach EU integration. During the last decade, Lithuania has achieved macroeconomic stability and positive GDP growth. In this regard, the country approaches EU integration with a strong track record of budget management. Nevertheless, the process of integration is likely to bring about new fiscal pressures, which could create long-term vulnerabilities if not managed adequately. The main macroeconomic challenges are (i) how to sustain high GDP growth, and (ii) how to ensure that this growth translates into new employment opportunities. Success in both dimensions will depend on the country's ability to implement the necessary structural reforms. 4. From an aggregate perspective, Lithuania's macroeconomic performance since transition has been very successful. With the exception of a temporary recession in 1999 as a result of the Russian crisis, GDP growth has been positive and has averaged 4 to 5 percent per year. Macroeconomic performance has improved remarkably in recent years. The strong growth record has been accornpanied by relatively modest fiscal deficits, low inflation and a stable currency (Table 1.1). Growth has been driven mainly by growth in services and manufacturing, the latter aided by a strong expansion in exports of labor-intensive goods. The growth in services and manufacturing has come about mainly through the growth of small and medium firms, which by 1998 represented 60 percent of total value added and nearly 80 percent of total value added in the non-financial sector. Table 1 Main Economiic Indicators 1997 1998 1999 2000 2001 Nominal GDP (million litas) 38340 42990 42655 45148 47968 Real GDP Growth, 1995 prices 7.3 5.1 -3.9 3.8 5.9 Inflation rate (of CPI) 8.9 5.1 0.8 1.0 1.3 Consolidated General Govemrnent Fiscal Balance (% of GDP) -1.8 -5.9 -8.5 -2.8 -1,9 Unemployment rate (labor survey) 14.1 13.3 14.1 15.4 17.0 Current Account Deficit (% of GDP) -10.2 -12.1 -11.2 -6.0 -4.8 Foreign direct investrnent (million litas) 1418 3702 1946 1516 1783 External debt, (% of GDP) 34.0 34.8 42.5 43.0 43.9 Source: Lithuanian Department of Statistics, IMFstaff reports 5. Exports have been a major contributor to Lithuania's good economic record. Total exports grew by 12 percent per year in dollar terms during 1996-2001. After a short setback in the wake of the Russian crisis, Lithuania's exports have made a strong recovery since early 1999, growing at almost 20 percent per year. However, for much of the period, imports have increased at a faster pace than exports, leading to a widening trade deficit. Reflecting the underlying trade imbalances, the current account deficit has remained persistently large, at above 10 percent of GDP until the year 2000. In the past two years, expanding exports have reduced it to single digits. It remains to be seen whether this improvement is temporary, or sustained over the long- term. 6. Although Lithuania has been successful in achieving overall macroeconomic stability and in minimizing the impact of adverse external shocks, not all sectors have enjoyed the benefits of reform and of a successful transition. The existence of underlying imbalances and structural problems is most evident in the low productivity level and low growth rate of agriculture, which still employs some 18 percent of the labor force (28 percent including agro-processing). Two other manifestations of these underlying structural problems are the rising unemployment rate, and the existence of large (and persistent) pockets ofpoverty in rural areas. xii > Macroeconomic stability and GDP growth have not translated into new employment. Lithuania faces a growing unemployment problem, which affects mainly the less-skilled. 7. Lithuania's labor market is characterized by a very low level of utilization of labor resources. Despite strong economic growth, which Lithuania has enjoyed since the mid-1990s, employment has remained largely stagnant. By end-2001, unemployment reached 17 percent of the labor force. The employment rate, arguably a more general measure of labor market conditions, has also deteriorated, dropping by 4 percentage points over the- 1995-2000 period. Only 58 percent of persons of working age are employed in Lithuania, as compared to 66 percent in the OECD. This means that a sizeable fraction of working-age Lithuanians who could be employed are not. This is a considerable economic loss, which translates into lower than potential GDP. Table 2 Dynanics of GDP, Employment, Productivity and Wages (1995=100) Average annual rate 1996 1997 1998 1999 2000 2001 of growth (1996-2001) in % GDP 105 112 118 113 118 125 3.5 Employment 101 102 101 100 96 92 -1.8 Productivity 104 111 117 113 122 136 6.3 Realwages 103 119 136 143 144 145 7.1 Note: real wage growth is based on gross earnings. Source: Statistics Lithuania, 2001. 8. One possible reason for this 'jobless" growth is a strong increase in real wages, which have outpaced productivity growth, and led to an increase in labor costs (Table 2). Another contributing factor is the nature of labor market institutions in Lithuania, which favor productivity and wage growth over employment growth, and in particular work against the creation of low-skill jobs. The relatively high minimum wage appears to be binding at the bottom of the wage distribution, greatly reducing employment opportunities for low-skilled workers. 9. Despite stagnant aggregate unemployment, firm-level data on job turnover suggest that the Lithuanian labor market is actually quite dynamic, and characterized by high job flows. Job creation rates are much higher than in neighboring countries such as Slovakia or Poland, but so are job destruction rates. Since job destruction has exceeded job creation, in net, the overall outcome has been a decline in total employment. The evidence suggests that small and medium enterprises have created many new jobs, especially in services, trade and some expanding export sectors. However, these have not compensated for the loss of jobs associated with widespread restructuring, nor for the stagnant behavior of larger enterprises. > Poverty in rural areas remains widespread. Poverty in rural areas is much higher than in urban ones. It is also deeper and more severe. There has been little reduction in poverty since 1996, despite positive GDP growth. 10. According to the UTNDP Human Development Reports, poverty in Lithuania has remainedfairly constant since 1996 (at between 16 and 18 percent of the population, using a relative poverty line of 50 percent of mean adult equivalent expenditures). Our own estimates suggest that, depending on the poverty line used, poverty in Lithuania oscillated between. 10 percent and 25 percent of the population in' the year 2000 (Table 3). This is a very large range xiii and indicates that many people are in fact concentrated around the poverty line. Small changes in the level of the poverty line can thus have a very big impact on measured poverty.' Table 3 Poverty in Lithuania, 2000 (%) Poverty Line (level) Poverty Rate (%)a All Urban Rural Below $2.15PPP expenditures per person per day 3.3 1.5 7.1 (119 litas per mo.) Below $4.30PPP expenditures per person per day 25.5 18.5 40.1 (237 litas per mo.) Below 50% median per adult equivalent 10.0 6.1 18.3 expenditures (223 litas per mo.) Below MSL income (187 litas per mo.) 8.2 4.1 17.1 Notes: a % of all individuals. See Chapter I for a detailed description of the choice of poverty lines. Source: Lithuania Household Budget Survey, 2000. Staff calculations. See Chapter 9 (Steele), The Background Papers Volume. 11. Independently of the poverty line used, poverty is much more prevalent in rural than in urban areas. In addition, the depth and severity of poverty are always higher in rural areas. Although they comprise less than a third of the population, rural areas account for some 70 percent of the poor. As in other transition economies, poverty affects the young (especially children) more then the elderly. There is also an important gender dimension to poverty in Lithuania, with individuals living in households headed by women having higher rates of poverty than individuals living in male-headed households. Individuals in households where the head has less than secondary education are at highest risk for poverty, and among these, the risk is especially high for those living in rural areas. Individuals who are unemployed have a higher risk ofpoverty than the employed, but the employed constitute a larger share of the poor. 12. Large rural-urban differences are visible also in other dimensions of well-being. In particular, private spending on education and health is much lower in rural areas than in urban ones, and these differences are often reflected in the quality of services received. Rural areas have worse health indicators, lower levels of educational attainment and less access to other public services such as transport. All in all, the evidence points to a increasingly dual economy, with an urban sector modernizing and experiencing rising incomes, and a rural sector that risks getting left behind. > Productivity is expected to drive future growth. The main lesson from international experience is that productivity growth has the greatest potential to spur growth in Lithuania in long-run. Increasing the intensity of labor use can provide an additional impetus. Taken together, these two factors callfor an acceleration of structural reforms. 13. Total Factor Productivity (TFP) projections indicate that Lithuania has the potential for rapid growth but that convergence with EU income levels will probably take time to materialize. Given Lithuania's demographic structure and already high levels of education, the main driver of convergence over the longer-term is expected to be total factor productivity growth. In this, Lithuania resembles the situation of Westem Europe in 1950-75, or that of Spain and Portugal following their 1986 accession to the European Community. However, the pace of convergence with Westem European countries can clearly be influenced by changes in the capital-output ratio ' For a nurnber of reasons, we prefer to use both an absolute and a relative line to measure poverty. Absolute lines defined in terms of PPP$ per capita allow one to carry out intemational comparisons of levels of poverty. Relative lines are more appropriate to study the characteristics of the poor in any one country, and compare them to others. Following other Bank studies, we define two absolute lines (US$2. 15 PPP per capita and US$4.30 PPP per capita), and one relative line (50 percent of median equivalent expenditure). xiv anU III L11 ULupIUyIuVLLu L4M. , uaceases in the size and quality of the capital stock could do much to accelerate growth. So could efforts to increase labor force participation and the employment rate. In this regard, continued investment in both human and physical capital is key. 14. These finding have major policy implications for the medium-term term, as the Lithuanian authorities will need to accelerate the remaining structural reform agenda and create the legal and business environment that will be most conducive to productivity growth. They will also need to ensure adequate investment ratios; stimulate domestic and foreign savings to fund the necessary investment; and undertake the labor market reforms needed to increase employment rates. 15. All in all, there is a broad consensus in Lithuania about what the key elements of a productivity-friendly economic policy strategy should be for the medium term. These include: * Maintaining a stable monetary policy under the CBA while preparing an orderly exit from it to join the EMU in due course; * Furthering fiscal consolidation in order to support extemal viability prior and after EU accession; * Increasing the effectiveness of public expenditure, including through social protection reform; * Accelerating the remaining agenda for structural reforms to improve productivity and the business environment. This includes the continued reform of the agriculture sector; completion of the privatization process; labor market reform to increase flexibility and create greater employment opportunities; and regulatory reform to improve the business environment. THE ROLE OF INTERNATIONAL TRADE AND FOREIGN DIRECT INVESTMENT Trade and Lithuania's medium-term economic development are closely intertwined During the last few years, Lithuania has made progress in reorienting its exports away from traditional trading partners and into more competitive EU markets. As a result, trade has been a critical factor of growth and of restructuringfor the Lithuanian economy. This restructuring has brought about significant improvements in productivity, and contributed to enhancing the overall competitiveness of the Lithuanian economy. Within manufacturing, productivity growth has been closely associated to exporting. 16. Exports have been and are expected to remain a driving force for the growth of the Lithuanian economy. The analysis carried out in this study suggests that during the last decade Lithuania has undergone a process of intensive restructuring, much of it trade-induced. The extent of this restructuring has been reflected in broad changes in the structure and orientation of Lithuanian exports, with a clear shift in the direction of Lithuanian exports towards EU markets and a growing importance of manufactured goods in the country's total export basket. As part of this process, Lithuania has developed a growing specialization in unskilled-labor-intensive products (Figure 1). Sectors such as apparel, textiles or furniture have seen their exports boom, and as a result have been the fastest expanding sectors in terms of employment. Exports have proven to be a critical vehicle for productivity growth, with exporting firms clearly outperforming non-exporters in terrns of both productivity levels and changes. Firms that export continuously enjoyed on average 38 percent higher productivity growth than non-exporters. They also saw their employment and sales increase 39 and 41 percent faster than did non-exporters. xv > Exports are key to future growth. But changes in Lithuania's external environment - especially the phasing out of the Multi-Fiber agreement in 2005, will pose special challenges. 17. Given the size of the Lithuanian economy, exports will continue to be a main engine of growth in the future. Sustaining export growth over the medium Figure 1 Lithuanian Export Specialization Indices term, however, will present some special challenges First, --Wood products -- Clothing - Textiles - Furniture accession to the European Union -- -A - Iron & steel Electical machinerF will increase competition in - Metal products - -- Chemical elements Lithuania's domestic market and _ Agric raw materials put pressure on many domestic producers. Second, the phase-out 4 of the Multifiber Agreement in 4 2005 will remove quotas on 3, exports of textiles and clothing / from developing countries, 2 - including China, to the EU, thus - - 6. lowering their price in EU 1 markets. Given that one-third of Lithuania's manufacturing exports o _- - - to the EU consists of textiles and 1992 1993 1994 1995 1996 1997 1998 1999 apparel, Lithuanian exporters will face increased competitive pressures. Third, more generally, as wage levels rise with economic growth, Lithuania's comparative advantage as a low-cost producer will erode and make it increasingly difficult for Lithuanian producers to compete with developing country producers in purely unskilled-labor-intensive goods.. 18. To sustain strong export growth in the medium term, Lithuania will gradually have to improve its ability to export skilled-labor- and capital-intensive exports. Recent developments in this regard, however, are not encouraging. Both categories of products experienced a decline in their export specialization indices between 1995 and 1999, and their combined share in total exports fell from 29 to 23 percent. Lithuania appears to be lagging behind many other Central and Eastem European countries in this area. In Poland, for example, the share of capital and skilled-labor intensive goods increased during a comparable period, from 31 percent of total exports to 45 percent. Lithuania also lags behind other accession countries in exports to markets with high growth potential, and in participation in international production and distribution networks. The slower progress of Lithuania in these areas can be largely attributed to lower inflows of FDI relative to other accession countries, and to the fact that they started the restructuring and trade reorientation process later than elsewhere. Lithuania can catch up in this process by accelerating restructuring and by improving its investment climate. > Improving the investment climate can mobilize FDI flows and facilitate exports. Lithuanian firms face significant costs in entering export markets. FDI can lower these entry costs andfacilitate participation in international networks. 19. A better investment climate would help mobilize domestic andforeign savings, including foreign direct investment flows. Greater FDI flows would in turn support exports and productivity growth. Foreign investors not only bring capital, but also new technologies, know- how, management techniques, narketing skills and access to international production and distribution networks. This is particularly important for Lithuanian producers trying to move into xvi new, skilled-labor or capital intensive markets, where foreign participation can greatly lower entry costs. The costs of purchasing and developing technologies that are competitive in these sectors may otherwise be prohibitive for many smaller Lithuanian finns. The lack of foreign contacts can present another insurmountable barrier to entering foreign markets. A strong positive association between presence of foreign capital (even a minority stake) and probability of a firm exporting to EU markets provides evidence of the benefits of having a foreign partner. In addition, FDI appears to have some positive regional spillover effects. > But upgrading of human capital is also critical. Firms face increasing difficulties finding skilled labor. Skill shortages are a constraint to firm expansion and productivity growth. 20. Lithuanian enterprises increasingly complain of difficulties in finding skilled workers. According to firm-level surveys, lack of skilled labor has become one of the top five constraints to firm operation and expansion. To improve its ability to export skilled-labor intensive goods, Lithuania also needs to upgrade the skills of its labor force, and better equip its workers to meet the demands of the global economy. Progress in needed in two fronts. First, in improving Lithuania's educational and vocational training system, to ensure that the new inflows of workers have the skills needed to find jobs. Unlike university graduates, who face few problems in finding employment, workers finishing their schooling after only basic or vocational education have a very difficult time finding employment. This is in large part due to the existence of a large gap between the skills they have acquired and those that are needed in today's market economy. Second, progress is needed in enhancing the flexibility and efficiency of the labor market, so that it can better match workers and jobs, and more effectively intermediate demand and supply of skills. Skills and education are a long-term investment, and the labor market needs to be able to send adequate signals, via relative wages, in order for workers to invest in the right sets of skills. 21. Jointly, a better investment clirnate, a more efficient labor market, and a better educational system can go a long way in underpinning Lithuania's future competitiveness in skilled-labor intensive and capital-intensive goods. AGRICULTURE AND THE RURAL ECONOMY Reforms in agriculture are far from complete. Agriculture lags other sectors in terms of performance and productivity. The sector is plagued by policy distortions, which have prevented the modernization of the rural economy. Policies in general have benefited agricultural enterprises at the expense of the family farm, with important distributional consequences. Poor performance and low productivity among the latter have translated into low incomes for farmers and widespread rural poverty. The modernization of agriculture requires reforms on multiple fronts, most notably a better incentive system; the removal of barriers to productivity growth; and sustained investment (both private and public) in human and physical capital, so as to bridge growing disparities between rural and urban areas. 22. Since regaining independence in 1990, Lithuania has made progress in reforming its agricultural sector. One of the most significant steps has been the privatization of vast tracts of farmlands, which has led to the creation of hundreds of thousands of small family farrns and hundieds of larger agricultural enterprises. However, adjustment to the new market environment has not been a smooth process, and in many aspects reforms remain incomplete. Although only 19 percent of all farmland is still controlled by the State, numerous restrictions on land and land use remain in place, including prohibitions against ownership by foreigners or legal entities. At the same time, limited availability of rural finance has severely inhibited sector's abilities to service the investment needs of a modernizing farm economy and agro-industrial complex. These xvii impediments have created an uncertain climate for investment. They have effectively deterred capital inflows and investment in rural economic activity, and have dissuaded modernization and dynamic efficiency. Moreover, the sector is still guided by policy induced distortions to agricultural producer incentives, which are highly detrimental to the sector's performance. 23. Sector output has declined steadily over the last decade, with agriculture's share in GDP falling from 27.6 percent in 1990 to 7 percent by 2001. Nevertheless, the sector remains very important in terns of employment. In 2001, the sector directly occupied 297,800 workers, or 17.8 percent of the labor force (27.8 percent including agro-processing). While open unemployment is lower in rural areas than in urban ones, rural underemployment is fairly widespread. Labor productivity in rural areas, and hence wages and incomes, are low. The incidence of rural poverty, at 18.3 percent in 2000, is three times that in urban areas (6.1 percent). > The incenive scheme has worked against effgciency and modernizadon. The incentive structure has deteriorated, aggravated by erratic government policies. 24. Since 1996, producer incentives have deteriorated sharply, with the farm gate price index declining 35 percent; and the purchased input price and farm wages indices increasing by 16.2 percent and 101 percent, respectively. Exacerbating these price shocks, government intervention in Lithuania's domestic producer and input markets has interfered in the transmission of the world market price equivalent to the sector and has contributed to sector instability. Government farm support has been erratic. Nominal and effective protection rates have varied greatly across products and over time. Protection rates have been negative for wheat, barley, rapeseed, beef and milk. In the cases of pork and sugar beets, government intervention has maintained positive nominal protection rates (see Figure 2). Overall, the system has benefited agricultural enterprises (for whom beef, pork and sugar beets, are important commodities), at the expense of the family farm. Figure 2 Nominal and Effectivo Rates of Protection (94, In 2COD 30 i. 20- -- --, 10' -10 |>r, ' Sugar beet Whmt Repeseed Beef Pork Bertay M k .5 ~~ ~ ~~.5 -12 18lai rINRP 33 _ 0 0 121-1'5 *ERP 54 -14 -14 5 35 11 27 Source: Tietje, 2002 update of Valdes/Kray study. xviii 25. A recent trade study2 concluded that had world prices prevailed in Lithuania in the year 2000, the farn sector, on balance, would have generated much higher total and net revenues. The gain to total and net revenue would be greater for the family farm than for the agricultural enterprise. For the sector as a whole, moving towards free trade would result in a 28 percent increase in total revenue and a 113 percent increase in aggregate value added. > Productivity levels are far below that of the EU. Land productivity is especially low, even when compared to other candidate countries. 26. As a result of the legacy of Soviet-era investment programs, a technology gap exists with respect to the European Union (EU), both on-farm and in the processing industries. Lithuanian yields per ha are consistently lower than EU average levels, and farms are much less efficient than their EU counterparts. Output per worker in Lithuanian agriculture is less than 10 percent that of an EU agricultural worker; albeit if comparable to that in Poland and in other EU candidate countries (Table 4). Land productivity measures are extremely low by any standards. The Lithuanian farmland unit productivity, measured as output value per farmland unit, is 15 percent that of the EU, and nearly half the level of other EU candidates. Factors contributing to low land productivity include: (i) small farm size, which inhibits economies of scale; (ii) pervasive uncertainty regarding domestic support programs and policies, accentuated by concerns over the implications of EU accession; and especially (iii) low levels of capital investment and complementary recurrent expenditures. Table 4 Comparative Productivity Measures in Agriculture, 2000 Labor intensity Labor productivity Farm Unit Productivity Labor/100 As % of Output/Labor As % of Output/ As % of ha EU EU Farm unit EU Lithuania 9.6 192 1,667 8.0 160 15 Estonia 5.8 116 2,869 13.7 168 16 Poland 16.1 320 1,770 8.4 285 27 EU Candidate 15.8 316 1,784 8.5 282 27 EU-15 5.0 100 20,968 100 1059 100 Source: Pouliquen, Alain, "Competitivites et Revenus Agricoles dans les Secteurs Agro-Alimenlaires des PECO J October 2001, unpublished document preparedfor the European Commission Source > EU accession poses large challenges but also opportunities for the sector. Agriculture must modernize for incomes in rural areas to increase. Accession can provide a huge stimulus to this modernization. The potential social costs of this modernization can be dampened by putting in place an adequatefarm and rural business environment, that can stimulate a strong investment response and the development of off-farm workplaces. 27. EU accession and entry into the single market holds great promise for the agriculture sector, yet also presents huge challenges. The change in the incentive regime is expected to have significant effects on farm prices, incomes, capital formation in agriculture and land values. The family farm sector as a whole will benefit, but the less productive of the existing family farms will disappear as consolidation takes hold. With the loss of domestic subsidies, many agricultural enterprises will likely disappear as well. This will result in further labor shedding, and put additional pressure on rural unemployment. To survive in the more competitive enviromnent, farms must improve productivity through capital investments, especially to upgrade herds, piggeries and flocks, as well as machinery and on-farm infrastructure. Serious bottlenecks in the 2 A. Valdes and Holgar Kray; Lithuania: "Strategy for the Pre-Accession Period: Adjustments of Agricultural and Trade Policies to the CAP"; ECSSD Rural Development and Environment, World Bank, June 1999, updated by H. Tietje., February 2002. xix industrial sector will have to addressed including obtaining sufficient EU export certifications for processed dairy and meat products. And an adequate business environment must put in place, so as to stimulate the quick investment response needed to develop off-farm employment opportunities in rural areas. These measures are discussed further in Chapters 3 and 5 of this Report. 28. Food prices are likely to increase with EU accession, as they also would were Lithuania to realign its border price parities with international prices. For the poor, higher food prices are could result in an estimated 10 percent decline in household income. Particularly affected will be the very vulnerable rural poor, especially the unemployed and those households with many children or with fixed incomes. > Policies need to support modernization. This requires reforms in all aspects of the agricultural policy framework. The current structure of incentives and protection schemes must be reviewed commodity by commodity, so as to reduce effective protection and dis-protection rates, and revised accordingly. Land privatization must be completed, and a functioning land registry put in place. The human capital gap between rural and urban areas must be gradually filled, via continued investments in agricultural extension and training servicesforfarmers and rural workers. 29. In order for the Lithuanian economy to avail of the benefits, transfer payments and rural investment funds associated with accession to the European Union, agriculture will have to modernize. Foremost among the reforms needed to support modernization are adjustments to the macro-economic framework for agriculture. Key policy areas of concern are the price and subsidies programs, rural taxation policies, land privatization, and skills and education. 30. In the realm of agri-food pricing, erratic producer support programs, through direct production and export subsidies, continue to introduce undesirable uncertainty and restrict efficient resource allocation. To reduce the extent of these policy induced distortions, the Government is urged to resume the deregulation of prices, while placing a greater reliance on decoupled income support (to the extent that it is needed beyond the direct payments, based on reference area and animal numbers, that will come about with EU accession). As a first step in this direction, the Government should review, commodity by commodity, the existent structure of incentives and protection, and design a strategy to both reduce levels of protection and dis- protection, and ensure greater stability in govemment interventions. 31. Policies should aim to increase transparency and enforcement of agricultural taxation and reduce tax preferences, which distort resource allocation between agriculture and other sectors. Government could still reexamine the efficacy of remaining tax exemptions and allowances currently in effect, including corporate tax allowances for agricultural partnerships, land tax allowances for farmers, and exemptions from full payment of social security contributions. 32. Similarly important in paving the way for Lithuania's imminent accession to the EU should be the conclusion of the land privatization process. The implementation of already approved restitution procedures-which formalize the transfer of State controlled land to the private sector, offer quit-claims and provide legal protection to owners and lessees-has been accelerated since the study mission visited Lithuania. However, the process should be completed as swiftly as possible. With accession just around the comer, there is an urgent need to formally sanction the unfettered exercise of direct and indirect tenurial rights by farm operators. Drafts of the intended Law on Land Management and Administration, or other parallel enactments should seek to facilitate same. In addition, to attract capital to the sector, restrictions on formal land xx ownership, including prohibitions against ownership by foreigners and domestic legal entities, as well as those restricting altemative uses of agricultural land must be relaxed. According to recent Seimas recommendation, in the negotiations for EU membership Lithuania will seek a transitional period of 7 years for acquisition of agricultural and forest land by foreign nationals. Government agencies will need strengthening to be able to manage EU farm programs. Much still needs to done to ensure that both public institutions and the farm sector build the institutional capacity to access the EU Structural Funds. 33. A longer term focus should be maintained as well. In anticipation of the likely impact on the production side, government needs to take measures to develop efficient rural factor markets, including product, land and credit markets, and to address critical knowledge and skills gaps in the sector. Such measures include improved farmer access to timely market information, as well as assistance to producers seeking to improve producer organization and on-farm infrastructure. Agricultural extension and training services can be extremely helpful as well. To accelerate farm consolidation and attract investment, an agile and modem land market is essential. This will require, inter alia, a completed land registry. Sound capital markets are needed to support sector modemization of the sector, both at the primary and industrial levels. To facilitate credit access, producers' collateral options, including land and movable assets, will need to be expanded and further developed. Programs concentrating on stimulating non-farm rural employment are also needed to help absorb the rural unemployed and underemployed. THE STRUCTURAL REFORM AGENDA 34. Lithuania's long-term economic strategy aims at building the foundations for achieving rapid convergence with Westem European countries. The medium-term objective of the economic policy is to meet the economic criteria for accession and to get ready for membership of the Economic and Monetary Union (EMU) after accession. This will be achieved through continued macroeconomic stability, fiscal consolidation and further implementation of structural reforms necessary for an efficiently functioning of market economy, improved productivity, and enhancement of competitiveness. 35. This report focuses on three critical elements of the structural reform agenda: (i) labor market reform, aimed at increasing labor market flexibility and improving the utilization of labor resources throughout the economy; (ii) regulatory reform and reform of the business environment, to support private sector development and growth in both urban and rural areas; and (iii) social protection reform, to improve targeting, effectiveness and efficiency. Labor Market Reform: Enhancing Flexibility A more efficient and flexible labor market is critical to reducing Lithuania's long-term unemployment, and to increasing its employment rate. A higher employment rate would stimulate GDP growth and would also allow for a broader and fairer distribution of its benefits. A more efficient andflexible labor market would better matchfirms with the types of workers they need, and workers with the types ofjobs they seek. It would better encourage investment in the types of skill that the market demands, and hence improve Lithuania 's long-term competitiveness. > High unemployment and high job turnover. High job creation and high job destruction are evidence of dynamism at the firm level. But these co-exist with a stagnant pool of unemployed. xxi 36. Despite high unemployment, job turnover rates in Lithuania are very high, indicating that there has been far-reaching restructuring and reallocation of labor. This restructuring process has been associated with substantial productivity improvements. Job creation rates in Lithuania are higher (by 3 percentage points) than in neighboring Poland, and much higher (by 11 percentage points) than in Slovakia. Job destruction rates, however, are also much higher than elsewhere (Table 5). To the extent that job losses to date have exceeded job gains, the process has led to a net fall in employment. 37. Partly as a result of high levels of restructuring, workers in Lithuania face relatively high job insecurity and difficulties in finding new employment once unemployed. Less skilled workers, in particular, are at a high risk of unemployment, which often is of a long-term nature. Low chances of escaping unemployment are associated with a mismatch in skill. Our estimates suggest that some 22 percent of the unemployed do not find a job because their skills fall short of employer needs. However, wage rigidity at the bottom of the wage distribution is another contributing factor. This combination of inadequate skills and a high minimum wage mean that once a low-skilled worker falls into unemployment, chances of escaping unemployment are low. Table 5 Job Creation and Job Destruction Rates (in % of total employment), 1996-2000 Lithuania Poland Slovakia US. 1996-97 1997-98 1998-99 1999-2000 1998-99 1997-98 1984-91 Job creation rate 14.0 14.0 13.6 10.5 9.7 2.0 13.0 Openings 5.2 4.0 3.8 3.6 4.4 8.4 Expansions 8.8 10.0 9.7 6.9 5.3 4.6 Job destruction rate 19.3 12.4 17.7 15.1 11.5 6.9 10.4 Closures 7.5 1.9 7.0 1.9 1.4 7.3 Contractions 11.9 10.5 10.7 13.2 10.1 3.1 Net employment change -5.3 1.6 -4.1 -4.6 -1.8 -4.9 2.6 Continuing establishments only -3.0 -0.4 -0.9 -6.3 -4.8 1.5 Job turnover rate 33.4 26.3 31.2 25.6 21.2 8.9 23.4 Continuing establishments only 20.7 20.5 20.4 20.1 15.4 7.7 Excess job reallocation rate 28.1 24.7 27.1 21.0 19.4 4.0 20.8 Continuing establishments only 17.7 20.0 19.4 13.8 10.5 6.2 Note: job creation equals sum of all employment gains as % of total employment at start of year; job destruction equals the sum of all employment losses as % of total employment at start of year. See Chapter 4, and The Background Paper Volume for details. Source: Lithuania: Annual survey of wages and salaries (DA-03), various years, Bank staff calculations; Poland: World Bank (2001a); Slovakia: World Bank (2001b); United States: OECD (1996). 38. Although the rate ofjob creation rate is high, it has a limited impact on unemployment. This is because employers tend to hire from the ranks of already employed (job-to-job transitions) and new labor market entrants. The unemployed account for less than one-half of all hires. Small firms hire the most workers (relative to their employment) and thus offer the best chances to find a new job for an unemployed person. At the same time however the average job tenure at small firms is short and job security is low. > A modestly flexible labor market, with scope for improvement. Small and medium firms seem to operate in a fairly flexible labor market environment. But rigidities exist in larger firms, which as a result create many fewer jobs. 39. As evidence by high job turnover, and especially by the high job destruction rates, the Lithuanian labor market is, in practice, already quite flexible. Employment protection legislation and associated dismissal costs do not seem to significantly restrict employers' ability to adjust the size and composition of their workforce, at least in practice. However, the effects of legal xxii norms seem to be unevenly distributed across different segments of the economy.. Firing seems to be much easier in small firms than in large firms. These disparities in impact of legal norms between firms of different size introduces important inequities into the Lithuanian labor market. 40. The use of flexible forms of employment is limited. Self-employment, temporary employment or part-time employment are relatively rare. At the same time, informal sector employment is sizeable, exposing many workers to working conditions and remuneration than are not in line with established norms. On the whole, Lithuanian employers face relatively stringent employment protection regulations combined with relatively lax enforcement. This combination means that in practice employers can lay-off redundant workers and adjust the size of their workforces. But from a social point of view outcomes under this framework are often less equitable than would be obtained under a more liberal framework, where fewer regulations were actually more actively enforced. 41. Overall, the Lithuanian labor market appears to have a highly dualistic nature, which cuts across several dimensions. First, there is increasing segmentation between the employed, who face high job turnover but often move from job to job, and the unemployed -especially the low skilled- who get stuck in long-term unemployment. Second, there are large disparities -in flexibility and working conditions- between small and larger firms. The former provide the labor market with a large degree of defacto flexibility, and create most of the new jobs, but sometimes at the cost of violating basic worker standards. Larger firms offer better worker conditions to those they employ, but at the cost of being much less flexible and creating many fewer jobs. > High minimum wages limit employment opportunities for low skiUled workers. The minimum wage is high relative to the median wage and to that of low-skilled workers. As a result, it discourages the creation of low-skill jobs. 42. Although there are few effective constraints to employment adjustment, the scope for wage adjustment is limited due to the relatively high statutory minimum wage. The major piece of indirect evidence on the detrimental effects of the high minimum wage in Lithuania is high unemployment concentrated among less productive workers: the youth and the low-skilled. Consistent with this is wage distribution that is cornpressed at the lower end. The minimum wage accounts for about 50 percent of the median wage, and is close to 100 percent of that-of the bottom decile of the wage distribution. The bite of the minimum wage is particularly pronounced in industries employing large numbers of low skilled workers, such as agriculture, hotels and restaurants, and trade. In these industries the incidence of minimum wage employment ranges from 20 to 30 percent. 43. While limiting employment chances of less-skilled workers, the high minimum wage in Lithuania has contributed to the fast pace of enterprise restructuring and productivity improvements. By restricting adjustment of wages to the fall in the demand for low-skilled labor, the high minimum wage in Lithuania forced employers to close low-productivity jobs implying a rise in the average productivity level The high rate of job reallocation provides support to this view. A high minimum wage would thus explain the apparent paradox that high job turnover coexists in Lithuania with a stagnant unemployment pool. Job turnover is high, because employers have to close low-productivity jobs and replace them with higher productivity jobs. The unemployment pool is stagnant since low-productivity workers are locked out of employment due to a high minimum wage. 44. Recent evidencefrom European labor markets suggests that the minimum wage can play an important re-distributive role, but at the same time can hinder job creation. Policies aimed at increasing employment growth have to balance redistribution goals with productive efficiency. xxiii For this reason, many EU countries are experimenting with measures to flexibilize minimum wages for groups at risk of unemployment (such as youth or low-skilled workers), while combining these with policies to introduce financial incentives to work at low-wages (OECD, 2000; Auer, 2000). These experiences can help guide Lithuania as it seeks to adopt more flexible forms of regulating wages and earnings. > There are a number of measures that if undertaken would improve labor market performance. 45. These measures, which are not limited to the labor market per se, include: * Improve business environment, especially for SMEs. SMEs play a critical part in both job creation and job destruction. Measures needed include actions to reduce regulatory costs and barriers, and improve the efficacy with which public agencies deal with SMEs (e.g. customs; tax authorities) (see Chapter 5 for details). * Lower barriers to entry. Business start-ups account for a large fraction of all newly created jobs. In Lithuania, business registration procedures are more complex and take longer than in many neighboring countries. Efforts to reduce the complexity and costs of registration processes can help foster the entry of new firms, and result in faster job creation. * Avoid attempts to forestall restructuring in order to protect jobs, which can be counter- productive in the long-run. Indeed, the analysis indicates that job destruction and restructuring are conducive, not detrimental, to employment growth. * Improve the skills of poorly educated workers as a means of addressing the skills gap. This can be achieved by improving access to and better quality of primary and secondary education, including vocational education, and by using targeted training schemes to improve the skills of the unemployed; * Enhance wage flexibility in order to accommodate the excess supply of low skilled workers. This can be achieved either by reducing the minimum wage as a percentage of the average wage, or by differentiating the minimum wage (e.g., by introducing the youth sub-minimum). Such measures can be combined with financial incentives to work at relatively low wages. * Promote flexible forms of employment, including fixed-term contracts, in order stimulate labor supply (e.g., part-time work by women) and labor demand; * Liberalize the use of fixed-term contracts by removing a limit on the number of successive renewals while keeping the existing limit on total duration; * Adopt the practice of annualization of working hours, i.e. calculating working time on a yearly basis, rather than having strict overtime limits per week; * Lower the cost of overtime work by allowing social partners to negotiate freely the number of hours as well as the amount and forms of compensation (monetary vs. time off), while setting the ceiling on the total number of hours (at least 200 hours) and the minimum overtime premium at 25 percent of the base salary; and * Most generally and importantly, reversing the implicit rule "strict regulations with lax enforcement" by deregulating labor relations and devolving the responsibility to shape them to social partners, and simultaneously by improving enforcement of key labor rights and standards. xxiv 46. Some of these measures are implicit in the new Labor Law recently adopted by the Seimas (see Chapter 4). The new Labor Law has been largely inspired by the need to conform to EU standards. It introduces new forms of flexible employment contracts, liberalizes firing conditions, and foresees the possibility of reducing minimum wages for specific sectors or groups. Most notably, the Law also seeks to promote social partnership in enterprises, and to build a shared commitrnent to labor standards and labor mobility among employers, workers organizations and government. The assumption is that only a collective approach can simultaneously achieve the labor market flexibility that Lithuania needs to continue its rapid structural transformation, while ensuring faimess and equity of treatment for workers across all enterprise segments. Indeed, the European experience during the 1980s suggests that such a "negotiated" approach to flexibility has a high chance of success. In this regard, the authorities are moving very much in the right direction. Regulatory Reform: Improving the Business Environment Improving the business environment and the overall investment climate is critical in many dimensions. It can help mobilize new FDIflows, which can in turn stimulate productivity and entry into export markets, setting off a virtuous cycle between exporting and productivity growth. It will foster the emergence and expansion of new entrants and smallfirms, which provide the bulk ofjob creation in Lithuania. This will help in crease employment and broaden the benefits of growth. Furthermore, an improved business environment in rural areas can do much to dampen the expected social costs of modernization in agriculture. 47. Aggregate statistics and the examination of firn-level data provide ample evidence of widespread restructuring taking place in Lithuania and point to an increasing integration of Lithuania into the global economy. The progress in these areas, however, seems to be somewhat slower in Lithuania than in other Central and Eastern European countries (CEEC). One of the reasons for slower progress is Lithuania's over-regulated business environment, which has dampened the emergence and growth of newfirms and deterred some foreign investmentflows. > Simplifying business registradon procedures, improving the legal framework and streamlining tax administration are top priorites. 48. Enterprise-level surveys undertaken consecutively in 1994, 1997 and 2001, suggest that Lithuanian firms face a numbers of sizeable barriers to their operation and expansion. Overall, different aspects of the tax system and in particular tax administration, are perceived by enterprises as the main obstacle to their business. The legal framework in general is viewed as the second most serious constraint. Enterprises also identify business registration processes, cumbersome customs procedures, corruption, lack of access to financing, and difficulties in finding skilled labor and technicians, as additional business obstacles (Table 6). Weaknesses in public administration are highlighted as an additional long-term problem. According to the evidence, small and medium firms are more affected by the regulatory burden and constraints than larger firms. xxv Table 6 Leading Constraints to Operation and Expansion (% of respondents indicating each constraint) 1994* 1997 2001 Taxation (policy, system) 48 35 40 Legal framework 18 25 Problems with payments (late payments) 8.4 21 Lack of operating capital 29 39 17 General economic crisis 3.8 15 Lack of skilled workforce 7.6 13 Bureaucracy of civil servants, corruption 9.2 13 Weak demand 18 11 Problemns with supply, raw materials 8 Lack of new mnarkets 4.6 5 Customs duties (policy, system) 5.3 5 Old technology, equipment 5 Lack of credits (high interests) 7.6 4 Instability of banking system 4.6 2 Source: Lithuanian Firn Survey, 20001. 49. Investors also complain of the unpredictability of regulations, of frequent changes and insufficient information and consultation with businesses. When asked about factors preventing them from increasing sales in EU markets, firms cite the high costs of doing business abroad. Lack of information about markets and lack of new technologies also rank high among the constraints. They were followed by high price of own products, barriers to trade, lack of experience and marketing skills. > When compared to other candidate countries, business licensing, tax regulations and administration, and labor regulations appear as the biggest problems. 50. The quality of business environment affects not only domestic firms and entrepreneurs but also the magnitude of FDI inflows. FDI inflows are to a large extent determined by how business climate in Lithuania compares to the conditions in other CEEC. According to the 1999 BEEPS survey, which presents views of domestic and foreign firms operating in each transition economy, this comparison is not very favorable for Lithuania. Lithuania ranks second, after the Czech Republic, in terms of the negative perceptions of tax regulations and tax administration. Lithuania leads the ranking as far as the perceived difficulties with business licensing are concerned. It is also in the second place in terms of labor regulations being an obstacle to business operations and development (Figure 3). The finding on labor regulations probably reflects their more binding impact on larger firms (more often the recipients of FDI). The problem could be reduced with the implementation of the "less regulation, but better enforcement" approach recommended above. xxvi Figure 3 How Problematic Are These Areas for Your Business? 4.00 3200 2 5011 2000 _ _ _ _ _ _ _ _ _ _ 10011- Czech Uthuania Latvia Romania Poland Hungary Slovakia Bufgaria Siovenia Estnla Rep | Tax regulation/administation D High Taxes 0 Business Licensing 0 Labor regulations > A better business environment requires both improvements in the overall enabling environment, and a streamlining of regulations and administrative barriers. Measures must be coordinated with the implementation of the EUacquis. 51. Improving the business climate in Lithuania requires action on two fronts. First, it is necessary to continue to improve the quality of the overall enabling environment- that is of the public policies, institutions and services that support private activity. This requires maintaining the existing stable macroeconomic framework and open trade regime, but also making progress on the remaining structural reform agenda including continuing with financial sector reform; tax reform and harmonization; completion of privatization, especially in the infrastructure sectors; and enhancement of labor market flexibility. 52. Second, it is necessary to streamline business regulation and reduce existing administrative barriers. Eliminating remaining distortions and restrictions in land, construction, labor and transit markets; rationalizing registration and licensing procedures; streamlining liquidation and bankruptcy processes; and increasing the effectiveness of public administration officials dealing with businesses, will have an important stimulating effect on the development of the private sector, and of SMEs and business start-ups in particular. An increase in the size of the SME sector should, in turn, bolster job creation and increase the growth rate of the economy. 53. The reform of the business environment, however, cannot be envisioned in isolation of requirements associated with meeting the EU acquis. While in many areas, complying with the acquis will de facto bring about an improvement in the regulatory framework; there are others, where in effect the EU could bring about an additional regulatory burden. There is a danger, for example, that adoption of some EU wide quality and process standards-especially in a setting with weak administrative capacities-may create additional barriers to market entry for small companies and erode their competitive advantages. Attracting foreign equity participation could help reduce the costs of adjusting to these increased regulatory requirements. xxvii 54. In general, the process of aligning domestic regulations with EU norms is likely to be more favorable to exporting companies, who already meet many of the EU standards, while it may create adjustment costs for those working only for the domestic market. Government regulatory policy, and its strategy for gradual adoption of the acquis, can dampen or exacerbate the adjustment costs. The focus should be on removing barriers to trade and business as quickly, and to use the adoption of the EU acquis as a stimulussforfurther reforms, rather than to attempt to reduce the impact of accession by delaying reforms or applying compensatory measures. Social Protection Reform: Increasing Effectiveness and Efficiency Strengthening the social safety net is a critical component of a successful EU integration strategy. EU accession is likely to accentuate competitive pressures on the Lithuanian economy, and will demand continued economic restructuring, especially in sectors such as agriculture which are lagging behind. In this context, it is critical to ensure that the social protection policy and programs are supportive of the development and integration process, and can address social concerns in an efficient and sustainable manner. > Lithuania's social protection system is extensive and fairly effective, but faces some important problems. The system is neither as distorted or as costly as that of many other candidate countries. But it does have some major coverage gaps, and efficiency could be improved. 55. Lithuania's social protection system is fairly extensive. It provides support to the elderly, the disabled, the unemployed, the sick, the poor, and Lithuanian families at large through a range of social insurance and social assistance programs. Comparing with many similar programs in the region, the social insurance programs (pensions and unemployment benefit) offer relatively modest benefit and are fairly redistributive. The unemployment benefit does not create significant disincentive to work. The social assistance program is characterized by a heavy reliance on categorical benefits and heavy focus on families with children and children without parental care. Income tested social benefit accounts for a small portion of the overall cash transfer programs. There are still some merit-based benefits, but they are separate from the state social insurance and social assistance programs. Over the past ten years, many modifications were introduced to make the social protection programs more efficient and affordable. 56. Major problems also emerged in the past decade, indicating the weakness of current policy and program administration. The state social insurance pensions have accumulated high deficits in recent years, despite the relative modest size of pension benefit and the increase of pension age. This trend will become even more pronounced with the aging of Lithuanian population. Financial pressures on the system are expected to mount, posing a potential long- term liability on the budget. These pressures can only be partially addressed through piece-meal measures such as an increase in the pension age or via the gradual erosion of the real value of pension benefits. What is needed is a comprehensive reform. 57. In spite of many positive features of the unemployment benefit program, it has the problem of not being able to adequately coordinate with other social protection programs. Consequently, certain vulnerable groups, notably the long term unemployed, are left unprotected in the current system. 58. Review of the social assistance program also indicates major efficiency and effectiveness problems. First, the allocation of the overall resources is not sufficiently targeted at the poor. Categorical benefits, which consumed most of the expenditure, are not designed to reach the poorest (Figure 4). Second, the income-testing threshold for targeted social benefit is very low, xxviii leaving significant portion of the poor ineligible. Third, even with this low poverty line, the income-tested benefits only reaches a small fraction of the intended population, suffering from very high exclusion error. Fourth, the current benefit structure of income-tested social benefit has high withdrawal rate, making low income jobs unattractive and creating a poverty trap. Figure 4 Categorical Benefits Are not Pro-Poor (Average benefit level by income quintile) 350 300 250 200 100 M _X Poorest Q2 Q3 04 Richest Quintle Quintile U social pension *family related categorical benefits ofamilybenefit > The Government is aware of these weaknesses and has inigiaged major reforms in all areas of socialprotection. For the most part, these reforms go in the right direction. 59. To address these problems, the Government of Lithuania has actively engaged in policy discussion and developed reform proposals in almost all aspects of social protection programs. These proposals call for a reform of the pension program by introducing a multi-pillar pension system and creating voluntary funded individual pension accounts.3 There is also a proposal to restructure the unemployment benefit program. A draft law on cash transfers suggests increasing the income-testing threshold and reducing the benefit rate. Along with reforms in benefit structure, there are proposals to modify the administration to improve efficiency. Other proposed changes include the modification of financial management of the social insurance program, changing the financing arrangement of active labor market programs, and improving income and asset declaration to enhance tax and contribution collection. Some of these changes have already taken place. 60. The active pursue of reform options indicates a good understanding of the Government regarding the problems that social protection programs face. Most of the proposed approaches represent a move in the right direction. Broadly, the reform of the social protection programs should aim at (i) improving program targeting so that the limited resources can reach the intended recipients and assist the most vulnerable in the Lithuania society; (ii) increasing policy efficiency so that it reinforce positive behaviors and support economic restructuring and productivity enhancement; and (iii) ensuring that the program is financially viable in the long term. 3 The original government proposal called for a mandatory funded scheme, but the mandatory pillar was rejected by Parliament. In response, Govemnment submitted a new proposal compnsing only voluntary funded schemes. xxix 61. In the area ofpensions, the re-enforcement and extension of a multi-pillar pension system and continued reform of the pay-as-you-go pensions would greatly improve pension coverage and adequacy. However, more is required to encourage younger workers to take a direct interest in their own pension provision. To strengthen the incentive to participate, the reform needs to adjust pension benefit parameters in the pay-as-you-go pension pillar. The introduction of the option to divert up to five percent of social contributions into the funded pension pillar will establish an even stronger linkage between individuals' contributions and pensions, and encourage individuals to play an active role in managing their retirement income. 62. The revised reform proposal relies entirely on a voluntary contribution, diverted from the current contribution to the PAYG scheme into funded schemes administered by pension or insurance providers. This measure still aims at improving old age income security through risk diversification and by increasing individual's responsibility in managing their retirement income. But making the revised proposal completely voluntary runs the risk of a very low take up, particularly amongst the younger work force. There are no incentives to join a funded scheme (other than tax exempt savings and the long term promise of a better pension build up) and encouragement to switch from the state scheme will depend entirely on the public understanding of funded schemes and public trust in private financial institutions, neither of these are particularly high. 63. In the area of unemployment benefit, the proposal of the Government to establish a traditional unemployment insurance program may not suit the need of Lithuania at this stage of development. The proposed benefit structure will imply weak incentives to work, and reduced ability of the system to redistribute to the poor. It would be more appropriate to retain the current unemployment benefit structure, but strengthen the linkage with social assistance programs when tackling the issues of long-term unemployment and the unemployment problem of those close to retirement age. 64. To improve the targeting efficiency of social assistance program, the Government needs to reduce its reliance on categorical benefits, and reallocate the resulting savings to those programs that are based on income-testing. Within the set of income-tested programs currently in place, there needs to be a gradual shift from utility compensation to social benefit. When fiscal capacity allows, the income-testing threshold needs to be modified to include more poor households. Efforts are also needed to screen out the ineligible recipients by developing a better income/asset testing mechanism and stronger income/asset verification capacity. Some public work requirement can be included as a self-selection mechanism. 65. To use the limited fiscal resource on the most needy and to improve equity of the social programs, the Government needs to gradually reduce or eliminate privileges currently provided in the form of state pensions. Some categories should be removed. For categories where some kind of state support is considered justifiable by the Lithuania society, lump sum payment as oppose to lifetime pensions could be a more effective way to reward services performed and at the same time to encourage individuals to become active participants in the competitive labor market xxx 1. MACROECONOMIC TRENDS AND CHALLENGES4 1.1 From an aggregate perspective, Lithuania's macroeconomic performance since transition has been very successful. With the exception of a temporary recession in 1999 as a result of the Russian crisis, GDP growth has been positive and has averaged 4 to 5 percent per year. Macroeconomic performance has improved remarkably in recent years. The strong growth record has been accompanied by relatively modest fiscal deficits, low inflation and a stable currency (Table 1.1). Growth has been driven mainly by growth in services and manufacturing, the latter aided by a strong expansion in exports of labor-intensive goods. Domestic absorption has increased in line with exports, so that their relative weights in GDP have remained largely unchanged. For much of the period, imports have increased at a faster pace than exports, leading to a widening trade deficit. 1.2 Despite these positive developments, the Lithuanian economy presents some signs of underlying vulnerabilities and of remaining structural problems. The current account deficit has remained persistently large, at above 10 percent of GDP until the year 2000. In the past two years, an increase in FDI flows and expanding exports have reduced it to single digits. But the underlying negative trade balance, and Lithuania's great reliance on foreign savings to finance its investment needs, imply that the economy is quite vulnerable to sudden capital outflows. On the structural side, mismatches in the labor market have pushed unemployment well into double- digits. And the weak performance of the agricultural sector, which accounts for only 7 percent of total output but as much as 18 percent of total employment, is a cause for concern. Table 1.1 Main Economic Indicators 1997 1998 1999 2000 2001 Nomninal GDP (mnillion litas) 38340 42990 42655 45148 47968 Real GDP Growth, 1995 prices 7.3 5.1 -3.9 3.8 5.9 Inflation rate (of CPI) 8.9 5.1 0.8 1.0 1.3 Consolidated General Govermnent Fiscal Balance (% of GDP) -1.8 -5.9 -8.5 -2.8 -1.9 Unemployment rate (labor survey) 14.1 13.3 14.1 15.4 17.0 Current Account Deficit (% of GDP) -10.2 -12.1 -11.2 -6.0 -4.8 Foreign direct investment (nillion litas) 1418 3702 1946 1516 1783 External debt, (% of GDP) 34.0 34.8 42.5 43.0 43.9 Source: Lithuanian Department of Statistics, IMF staff reports 4 This chapter draws on very substantial contributions by Celestin Monga, Lodovico Pizzati and Giedre Tarbuniene, as well as on the work presented in Chapter I (Pizzati), Chapter 2 (Rutkowski), and Chapter 9 (Steele) of The Background Papers Volume of this study. A. MAIN MACROECONOMIC DEVELOPMENTS Production 1.3 Supply factors. An economy's long-term growth is driven by the evolution of its underlying supply factors and by the development of total factor productivity. In Lithuania, the evolution of aggregate employment during the 1995-2001 period has been negative, indicating that it cannot have contributed positively to growth (Figure 1.1). From a supply factor approach, either growth in capital or in total factor productivity must have compensated for the employment decline. Figure 1 suggests that both have played a role. In the years preceding the Russia financial crisis, increasing real capital investment was clearly a substantial factor for GDP growth. However, since the Russia crisis, capital investment has stabilized, while the economy has strongly rebounded. This suggests that total factor productivity has been the most important source of growth since 1999.5 Given Lithuania's demographic trends, productivity growth is expected to remain the engine of growth and the key to convergence in the years to come. Figure 1.1 Real GDP Growth and Factors of Production 8000- 8 7000 . 6 6000 4 . 5000 2 c 4000 0 3000 - E 2000 +4 1000 - 1995 1996 1997 1998 1999 2000 2001 _Real Capital Investment Real GDP Growth - Employment Growth Source: Lithuanian Department of Statistics. 1.4 Composition of GDP. Lithuania's value added is mostly composed of services (which contributes nearly 65 percent of value added), and industry (with 28 percent). The share of services has increased steadily since 1994, while that of industry has remained flat (Figure 1.2). The weight of agriculture in total value added has declined sharply, while that of construction has fallen moderately. The growth in services and manufacturing has come about mainly through the growth of small and medium firms, which by 1998 represented 60 percent of total value added and nearly 80 percent of total value added in the non-financial sector. The strong performance of small and medium private enterprises is in sharp contrast with that of large enterprises, and especially with that of state-owned firms, which have seen their share of sales, value added and employment drop significantly (see Starkeviciute and Tabor, 1999; and Rutkowski, 2002). 5 These aggregate patterns are confirmed by existing research at the enterprise level. In a recent paper, Starkeviciute and Tabor (1999), find that labor contribution to growth during 1995-98 was negative in all types of enterprises, and that capital's contribution was modest, with the bulk of capital formation occurring in large, inefficient enterprises. Most of the growth in value-added was generated by small, private enterprises, and driven mainly by growth in TFP. 2 Figure 1.2 Structure of Gross Value Added by Economic Activity 100%/ 90% 80%- 70%--"- 0services 60% - o construction * agriculture 1995 1996 1997 1998 1999 2000 2001 Source: Lithuanian Department ofStatistics. 1.5 Although agriculture accounts for a very small share of GDP, its decline compared to services and manufacturing has important consequences for the labor market. As illustrated in Figure 1.3, agriculture still accounts for a much greater share of employment (about 18 percent) than its contribution to aggregate GDP would suggest. Employment in agriculture has declined since 1995, but roughly on a par with the fall in output, leaving labor productivity more or less unchanged. As other sectors (from the most capital intensive manufacturing to the most labor intensive services) have experienced an increased growth in productivity, agriculture is clearly lagging behind an otherwise modemizing economy (Figure 1.4). Figure 13 Employment Level by Sector 2000- 1500 0 1995 1996 1997 1998 1999 2000 2001 o3 SeNces 903.3 924.3 970.1 969.0 988.6 951.0 939.8 * Industry 348.5 334.0 334.4 331.1 326.4 319.6 310.3 * Agnculture 391.8 400.7 364.7 356.0 332.5 315.4 271.7 |-Agnculture * Industry 0oSeNces Source: Lithuanian Department of Statistics. 3 Figurel.4 Productivity by Sector 100 0o 80- - 60 60 U) 4 o 20 - 0 1995 1996 1997 1998 1999 2000 2001 in Total Industry Mnf/Mn/Qr - - - Ele/Gas/Wtr - - - Construction - -Agriculture -.Services Source: Lithuanian Department of Statistics. 1.6 The unique position of agriculture as a receptacle for surplus, low-productivity labor, has played a role in influencing Government's agricultural policy, which has been characterized by heavy intervention, often with counterproductive effects. Government efforts to "protect" the agriculture sector via subsidies and other distortionary policies, while motivated by legitimate social concerns, have in fact reduced incentives for restructuring, prevented the modernization of agriculture, and contributed to lowering farmer productivity and incomes (see Chapter 3, below). Demand 1.7 Gross Domestic Product by Expenditure. The breakdown of GDP by type of expenditure reveals how domestic absorption has fared in comparison with trade in Lithuania's economic expansion. Figure 1.5 shows that the growth of exports has been a major contributor to GDP in both the period leading up to 1998 and in the post-1999 recovery. Private consumption and investment have also increased steadily throughout the period, more or less in line with export growth, so that their relative shares in GDP have remained largely unchanged. In contrast, public consumption (already one of the lowest in CEECs) has decreased moderately, reflecting the gradual reduction in government expenditure experienced throughout the transition. 1.8 Figure 1.5 also shows that aggregate demand is heavily dependent on imports, and increasingly so. While this increase in imports is an evidence of the benefits of trade (with overall growth supported by increasing imports of high-skilled intensive goods from Europe), the growing imbalance between the exports and imports is also the source of an underlying structural trade deficit, which has put some strains on the current account balance. 4 Figure 1.5 GDP Composition by Expenditure 40000 30000 20000 -10000 -20000 -30000 1995 1996 1997 1998 1999 2000 2001 M Private Consurrption a Public Consurrtion c Investrnent 3 Exports * bTports Source: Lithuanian Department of Statistics. 1.9 Aggregate consumption has remained relatively flat as a share of GDP throughout the period at about 84-88 percent. Approximately three-quarters of this is private consumption, and one quarter public consumption. Gross domestic investment has declined slightly, from 24.7 percent of GDP in 1995 to 21.5 percent in 2001. This fall hides a slightly greater decline in gross capital formation, to 19.4 percent of GDP in 2001. 1.10 Exports and Imports. Since 1993, Lithuania has experienced impressive growth in its volume of trade-a trend only temporarily dampened by the Russia crisis. In dollar terms, exports have grown by 12 percent per year since 1996, with imports growing at a slightly faster rate. In 2001, the share of exports in GDP was 50.4 percent, while that of imports was significantly larger at 55.8 percent (Figure 1.6). Figure 1.6 Imports and Exports 30000- 70 25000 - _-- 60 0 ~~~~~~~~~~~50 aa20000 - 0. c 15000 - w- 0 .2flf 300 -.111111 ~~~~~20 1994 1995 1996 1997 1998 1999 2000 2001 J| 1Exports _ Imports -U--mports/GDP -U- Exports/GDP Source: Lithuanian Department of Statistics. 1.11 The destination of Lithuanian exports has shifted dramatically in the last few years, partly in response to the Russia crisis (see Chapter 2). This shift has been clearly manifested in the increase in the share of Lithuanian exports going to the EU (Figure 1.7). This share increased from only a third in 1997 to one-half in 2000. 5 1.12 What is remarkable is that this export expansion to EU markets was achieved despite a currency peg to an appreciating dollar. The domestic currency, the litas, was pegged to the dollar from April 1994 until February 2002. The decision to peg to the dollar largely reflect Lithuania's trade stance in the early 1990s. However, as the composition of Lithuania's trade basket shifted towards the EU during the 1990s, the peg with the appreciating dollar increasingly became a disadvantage. However, because the litas was initially pegged at an undervalued rate, there was some room to sustain a dollar appreciation without a significant loss in competitiveness. Figure 1.7 Share of Exports by Country (or Union) of Destination 100% 80% * Others 60% | Estonia O USA 40% ~~~~~~~~OCEFTA 20% oi 1996 1997 1998 1999 2000 2001 CEFTA: Bulgaria (1999), Czech Republic, Hungary, Slovakia, Slovenia, Poland, Romania (1997). EFTA: Iceland, Liechtenstein, Norway, Switzerland. Source: Lithuanian Department ofStatistics. 1.13 The composition of imports has not changed as dramatically as that of exports. While the EU has consistently accounted for between 40-45 percent of total imports, imports from the CIS (mainly primary goods) have also remained substantial. The peg to a strong dollar has had some implications for'the size and composition of imports, most notably that it has allowed for an increase in imports of skilled-intensive goods from Europe. This spurred aggregate expenditures with little burden on prices. Indeed, as compared to neighboring economies, Lithuania has enjoyed a lower inflation rate, particularly in light of the Russian financial crisis (Figure 1.9). Figure 1.8 Share of Imports by Country (or Union) 100% 80%- - U Others 70% - Estonia 60% - U * U - Latvia 50% * * *USA 40% * * * *DEFTA 30% * * * *OCEFTA 0% 1996 1997 1998 1999 2000 2001 CEFTA: Bulgaria (1999), Czech Republic, Hungary, Slovakia, Slovenia, Poland, Romania (1997). EFTA: Iceland, Liechtenstein, Norway, Switzerland. Source: Lithuanian Department of Statistics. 6 Figure 1.9 Inflation and GDP Growth in Lithuania and Estonia Inflation Rate Real GDP Growth 25 -20 20 15 15 10 10 ~~~~~~~~~~~~~~5 5irq 0r5 1996 1997 1998 1999 2000 2001 1996 1997 1998 1999 2000 2001 | Esjtonia g LithuaniaI |Esftonia * Lithuan:ia] Source: Lithuanian Department of Statistics and Statistics Office of Estonia. Government Finances 1.14 The achievement of low inflation and stable growth is testimony to the sound fiscal policy that was conducted during the transition period. Because of the currency board, Lithuania's monetary policy has been limited to accommodating balance of payments fluctuations. Hence, much of the burden of responding to external shocks has been left to fiscal policy. In this context, Lithuania has broadly achieved low fiscal deficits and structural changes in its government finances supporting macroeconomic stability. Figure 1.10 shows the trends in fiscal deficit for Lithuania, and the corresponding levels of general government revenues and expenditures. Despite the recessionary impact of the Russian financial crisis in the late 1990s, Lithuania's fiscal deficit remained at very stable levels, and as tax revenues moderately decreased, public expenditures were also reduced. Figure 1.10 Aggregate Fiscal Balance 13198 16552 17322 14952 15228 wn 12501 14036 13687 13707 14296 0 -1. ~~~~ ~ ~~-2.8 -. -5.9 a -8.5t 1997 1998 1999 2000 2001 Revenues _ Expenditures -U--Deficit Source: Lithuanian Department of Statistics 7 1.15 Stabilizing the revenue-to-GDP ratio, which is one of the lowest among EU accession countries, has become a government priority in order to ensure medium-term fiscal sustainability. A comprehensive package of new tax legislation was drafted and approved in 2001 and 2002. In 2001, the Seimas passed laws on excises and value added tax, which will remove exemptions and adjust taxation in line with EU requirements. Corporate income tax law, eliminating zero taxation of reinvested earnings and reducing tax rate to 15 percent has become effective in January 2002. In July 2002, a new personal income tax (PrI) was approved by Seimas. The law aims to broaden the tax base and to reduce labor taxation. It provides an increase in the minimum income tax threshold and allows a number of deductible expenses, including education, interest on loans for housing and contributions to private pension schemes. The government will consider a further increase in the minimum income tax threshold to the extent the overall revenue neutrality of the tax reform package is ensured. In addition, the government intends to extend coverage of real estate tax to residential property from January 2003. Reforms of the tax system are complemented by improvements in tax administration. Lithuania's Fiscal Sustainability 1.16 The government's medium-term goal is to maintain cyclically balanced budget. Lithuania's fiscal stance has recently reached a very promising stance, with the fiscal budget deficit at 1.9% of GDP and overall national debt at an adequate 26.9% of GDP in 2001. However, fiscal sustainability does not simply entail the government's ability to finance itself, but it requires government's fiscal and monetary policies to be consistent with the expected growth, inflation and interest rate paths. Sustainability does not necessarily require government to pay off its debt in the long-run, but it needs real debt to accumulate at a lower rate than the real interest rate paid on it. 1.17 In other words, the government is accountable for the net real interest rate (real interest rate, r, minus the real growth rate, ts) paid on the debt to GDP ratio, bo . This can be financed either with a primary surplus g - r, or with seignorage revenue, which is represented by the inflation tax paid on the money demand to GDP ratio, L(r+ir) (which is a decreasing function of nominal interest rate, r+7). This sustainability condition is represented as: g - r + L(r + 7r) = (r -iu) - bo 1.18 Is Lithuania's primary fiscal balance in line with this long-run sustainability condition? Given Lithuania's recent growth rate of 5.9% of GDP and expected average inflation rate of 3% (based on 6 year average, and projected given EU integration), it would appear that a 0.89% primary deficit would be sustainable in the long-run. Although this may be in line with Lithuania's current macroeconomic stance, it is based on rough calculations, and it assumes an optimistic growth rate. Therefore, while sustainability may not be an immediate concern, it is definitely desirable to continue reducing the fiscal deficit, as a lower growth rate coupled with unexpected higher interest rate may pose a sustainability issue in the future. Savings and Investment Financing 1.19 The persistent gap between imports and exports has been reflected in a structural trade deficit. The counterpart of this deficit is a modest rate of domestic savings that renders the country quite dependent on foreign savings for financing its investment needs. In contrast to the relatively high investment rate, gross domestic savings are modest as a proportion of GDP. In 2001, national savings as a percent of GDP stood at 16.8 percent, at about the same level as five years earlier (Figure 1.11). 8 Figure 1.11 Gross National Savings as % of GDP 20.0%° 15.0%-- : 10. 0 % -E a 5.0% IEEE.. 0.0% ..._ - -5.0%- 1995 1996 1997 1998 1999 2000 2001 | Public Savings 1.6% 0.2% 1.9% -1.1% -3.9% -0.2% 0.1 % | Private Savings 12.9% 15.2% 14.4% 13A% 15.4% 14.7% 16.6% Source: World Bank SIMA database. 1.20 As a consequence of its low domestic savings, Lithuania has had to rely on foreign savings to finance its current account deficit. In 2001, foreign direct investment alone represented nearly 77 percent of the current account gap. Unlike in many developing countries, however, Lithuania's heavy reliance on external financing of its current account deficit has not had important negative consequences regarding the country's competitiveness (see also section B below). External financing has mainly been directed to capital formation-not consumption-, and has helped modernize the country's production capacity. 1.21 Table 1.2 breaks down the financing of all capital investments in Lithuania by source. The table shows that foreign financing has accounted for between 10 and 20 percent of total capital investment. Nevertheless, the trend seems to be one towards slightly less dependence on foreign savings, and a greater reliance on domestic own sources of financing. The other notable trend is the sharp decline in budget financing of capital investment, consistent with the reduction of the role of the state in Lithuania's economic transition. Table 1.2 Capital Investment by Source of Financing (%) 1995 1996 1997 1998 1999 2000 2001 Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% National Budget 20.1% 14.3% 12.6% 10.8% 4.7% 1.9% 5.9% State 13.4% .10.6% 8.8% 5.9% 2.6% 0.7% 4.5% Municipal 6.7% 3.7% 3.7% 4.8% 2.1% 1.2% 1.4% Own sources 65.2% 62.0% 63.4% 42.5% 68.5% 72.4% 71.1% o/w foreign capital 7.2% 7.7% 7.7% 3.7% 5.4% 3.6% 4.1%. Bank loans 14.1% 20.4% 20.7% 25.9% 18.0% 17.2% 17.6% o/w foreign 10.3% 18.0% 17.8% 20.0% 13.6% 11.8% 12.2% Other sources (extrabudgetary etc.) 0.6% 3.3% 3.4% 6.1% 8.8% 8.4% 5.4% Source: Statistics Lithuania, Statistical Yearbook of Lithuania 2002 Balance of Payments 1.22 As with the other Baltic countries, Lithuania's fixed exchange-rate regime has been stable since the currency board with the dollar was established in April 1994. Keeping low pressures on a fixed exchange rate requires a stable and low current account balance. In particular, if a large current account deficit is not offset by investment flows in the financial 9 account, it will place an excessive strain on the central bank's foreign reserves. The Lithuanian's current account deficit hovered around 10 percent of GDP during much of the mid-1990s, and only in the past couple of years has it dropped to more sustainable levels. 1.23 Figure 1.12 traces the current account deficits in the past years, and shows how it is caused by a deficit in the goods balance, only to some extent balanced by a surplus in services. Figure 1.12 The Current Account Deficit and its Components 1995 1996 1997 1998 1999 2000 2001 6.00% - 4.00% . . . . . . 2.00% - 0.00% I. -2.00% 0 -4.00% 1 -6.00% -8400%- -10.00% -12.00% - - -14.00% -16.00% CA -- Goods - --- Ser4ces Income ---Current transfers Note: Other Current Account components not shown are Income and Current Transfers. Source: Bank ofLithuania. 1.24 Although Figure 1.12 suggests that the current account deficit remained largely constant at around 10 percent of GDP during 1995-1999, before improving sharply, a look at the decomposition of the goods balance suggests a much more imbalanced path. Figure 1.13 shows how during 1995-1999, Lithuania shifted from being a net exporter of agricultural products to a net importer. At the same time, the trade balance in other merchandise goods deteriorated significantly. These effects were somewhat compensated by an improvement in the trade balance in energy (due to an increase in energy exports), which prevented the CA from deteriorating further. The recent post-1999 improvement in the overall trade balance, and hence in the current account, is in large part due to a sharp reduction in the other merchandise trade deficit since 1998. This reflects the successful restructuring and re-orientation of Lithuanian merchandise exports towards EU markets following the Russia crisis (see Chapter 2). 10 Figure 1.13 Decomposition of the Goods Trade Balance 1995 1996 1997 1998 1999 2000 2001 2.00% - 0.00% -2.00% -4.00% f -6.00% ,-,- _- -8.00% - -10.00% -12.00% -A Agriculture - - - Energy- -Other Merchandise Source: Bank ofLithuania 1.25 Despite the considerable current account deficit, keeping the exchange-rate fixed has not posed a burden on foreign reserves, as other components of the financial account have stabilized the balance of payments. In particular, reserve assets have accumulated up to 1999; as direct, portfolio, and other investments have more than exceeded the current account deficit. While the trade gap placed a depreciating pressure on the exchange rate, foreign investment flows, characterized by a demand for the litas, put a counterbalancing appreciating pressure that exceeded the effects of the current account deficit. Overall, the Bank of Lithuania's foreign reserves have accumulated except for 1999 (Figure 1.14). Figure 1.14 The Financial Account 1995 1996 1997 1998 1999 2000 2001 10.00% - 8.00% - 6.00% 4.00% 2.00% - -* 0.00% - ,,,,^ , - . -t- m - -2.00% -#'0 -4.00% -6.00% Direct Investment - - - - Portfolio Inwestment - - Other Investment - Reserve Assets Source: Bank of Lithuania 1.26 Figure 1.14 shows that the direct investment balance (foreign direct investments in Lithuania minus Lithuanian direct investments abroad) peaked in 1998 (as percentage of GDP), with majority of inflows coming from the sale of state fixed line telecoms company. In 1999, the reduction in the direct investment inflows was compensated by increase in portfolio investment - mainly govemment eurobonds- to finance the current account deficit of I1% of GDP. In 2000 11 and 2001, the current account deficit declined with foreign direct investment being a major source of financing. 1.27 Table 1.3 shows the Bank of Lithuania balance sheet since 1994. This shows the accounting balance between assets (foreign and domestic) and liabilities (foreign and domestic) of the Lithuanian central bank. The bulk of changes in foreign assets of Lithuanian central bank has been associated with the movements of the government deposits. Net International reserves (excluding government deposit) dropped only in 1999. The decline in the amount of 270 million litas has occurred in the commercial banks' deposits, the capital account and the stock of currency in the economy. The remaining change accounted for reduction in government deposits, mainly associated with savings restitution payments to households. In 2001, net international reserves recovered to the pre-crisis level. Table 1.3 Lithuania's Central Bank's Balance Sheet 1996 1997 1998 1999 2000 2001 Foreign assets 3345.1 4258.7 5847.6 4976.1 5375.5 6629.0 Claims on: central government 0.0 0.0 0.0 6.8 6.8 6.8 private sector 9.9 7.6 6.9 6.1 5.5 6.4 conmmercial banks 142.0 70.3 52.3 30.2 23.8 15.4 non-bank financial institutions 3.1 19.4 6.9 20.0 0.0 0.0 Other assets 199.7 121.1 226.4 238.8 247.3 228.9 Total assets 3699.8 4477.1 6140.1 5277.9 5658.8 6886.5 Foreign liabilities 533.9 444.5 380.9 363.2 313.4 462.7 Repurchase agreements 0.0 0.0 0.0 0.0 0.0 206.3 IMF loans to the LB 527.1 441.4 378.0 360.1 310.6 253.2 other liabilities to nonresidents 6.8 3.0 2.8 3.1 2.8 3.2 o/w: in convertible currency 0.6 1.2 1.1 0.0 0.0 0.0 Domestic liabilities currency outside the LB 1998.8 2726.2 3036.1 2971.7 2904.2 3262.8 deposits of commercial banks 483.2 551.3 1 211.8 1 109.3 1 036.6 1 000.2 o/w: in convertible currency 86.4 161.3 344.0 435.6 415.9 416.7 central government deposits 66.1 269.3 906.0 302.1 781.7 1 488.2 o/w: in convertible currency 43.2 147.5 866.9 245.7 713.5 1 335.9 deposits of other residents 37.1 39.4 19.0 8.8 11.8 16.6 o/w: in convertible currency 19.8 8.2 6.5 1.5 0.1 0.1 Counterpart funds 41.9 38.1 40.8 30.8 29.2 28.2 Capital accounts 514.5 396.2 519.0 468.9 571.9 618.8 Other liabilities 24.2 12.1 26.5 23.0 10.0 8.9 Total liabilities 3699.8 4477.1 6140.1 5277.9 5658.8 6886.5 Memo items: Total international reserves 3337.1 4250.9 5839.9 4968.4 5434.6 6676.6 International reserves, excluding government deposit 3271.0 3981.6 4933.9 4666.3 4652.9 5188.4 Source: Bank of Lithuania 12 B. TRENDS IN COMPETITIVENESS AND EXTERNAL VULNERABILITY 1.28 The real exchange rate is usually the most common indicator of competitiveness. It is a measure of the evolution of relative prices and costs denominated in a single currency and is often calculated as the ratio of the price of tradable goods (exports and import substitutes) to the price of non-tradables. It provides an indication of the incentives that guide businesses to allocate resources across sectors. An increase in this ratio indicates that the production of tradables has become relatively more profitable that the production of nontradables. Alternatively, the price of nontradable goods can be interpreted as an indicator of domestic production costs. Therefore, an increase in the real exchange rate implies that the prices received for exports and import substitutes are rising faster that production costs. This section reviews the aggregate competitiveness of the Lithuanian economy over the period 1994-2001 using various real exchange rate indices, some alternative indicators of export performance, and terms of trade. 1.29 Issues with REER Estimation in Lithuania. Competitiveness is affected only when the observed real exchange rate departs significantly from its equilibrium value (ERER), which varies according to the economy's fundamentals. The ERER can be calculated either by first estimating or assuming an equilibrium current account and then computing the real exchange rate that would generate it, or by estimating a reduced-form model in which the ERER is identified with the long-run real exchange rate that is consistent with steady-state net foreign assets and current account positions. 1.30 The first of these approaches is difficult to apply to Lithuania (and to most transition economies) because it implicitly assumes a constant ERER over time and as such, does not take into account changes in capital stock, productivity, commodity prices, or even tastes of private agents which come with structural transformation'. Furthermore, it also requires a reference year for which the real exchange rate can be assumed to be in equilibrium. Since trade and capital flows were heavily restricted prior to Lithuania's independence, no year before the transition can be taken as reference. The second, alternative approach is not applicable to Lithuania either. The absence of time-series data make it impossible to estimate long-run equilibrium exchange rates and the current account and net foreign assets positions. Therefore, estimates of real exchange rate appreciation based solely on CPI measures should be interpreted with caution. 1.31 Evolution of the Real Effective Exchange Rate(RER) . A major difficulty in analyzing the real exchange rate is that direct measures of the prices of tradables and nontradables are seldom recorded and released by statistical offices. As a result, one generally relies on indirect estimates like the CPI. Since 1994, the litas has been steadily appreciating in real effective terms (CPI- based) with a cumulative appreciation of 85 percent between April 1994 and December 2001, especially with respect to EU trading partners (Figure 1.15). However, the real appreciation of the litas does not appear to have had significant effects on the ability of Lithuanian exporters to find export markets for their products. 13 Figurel.15 Evolution of the Real Exchange Rate Indices of the Litas (June 1993 = 100) 500.0 400.0 -'- - 300.0 - 200.0 - '_ 100.0 - 0 .0 - , , , , , , , I , . . . . . . . . . . . . . . All -- -- EU .-Central and East European - ClS Source: Bank of Lithuania 1.32 Several supply- and demand-side factors have affected the evolution of what could be considered Lithuania's RER over the period 1994-200 1. On the supply side, the main determinant of the RER has clearly been the faster rate of productivity growth in the tradable than in the nontradable sector (the so-called the Balassa-Samuelson effect). This differential rates of total factor productivity (TFP) growth in the two sectors have induced a RER appreciation reflecting the increased competitiveness of the Lithuanian economy. Also, empirical studies suggest that accelerated structural refonns and market liberalization during the 1990s have led to a significant relative TFP growth vis-a-vis many European economies (see Table 1.4) and contributed to the appreciation of the litas. On the demand side, the RER appreciated only temporarily as a result of increased government expenditures between 1997 and 1999 (from 34 to 41 percent of GDP). 1.33 Beyond these traditional considerations, the other factor that may have played an important role in the appreciation of the litas is the high volume of capital flows entering the country since the introduction of the new currency in 1994. In 2001, FDI flows alone financed 75 percent of Lithuania's current account deficit. The large surge in FDI is in part due to the easing of capital account restrictions, the very strong stabilization and fiscal consolidation efforts that led to lower country risk, and the increased profit opportunities created by sustained structural reforms. Empirical studies by the Ministry of Finance conclude that higher levels of capital inflows have financed the expansion and modernization of Lithuania's productive capacity leading to productivity gains in the tradable sector and a permanent appreciation of the litas, with no competitive loss for the country. The reason being that the enhanced productive apparatus of the tradable sector will permit the future trade balance to offset the servicing needs of the accumulated debt and the remittances of foreign direct investment. Contrary to what often happens in developing and emerging economies, financial inflows to Lithuania did not finance higher consumption and low-productivity investment. Therefore, they will not be repaid with a reallocation of resources towards tradables that would require a depreciation of the currency in the future. 1.34 Whether the appreciation of a currency exerted by capital inflows exceeds its equilibrium value usually depends on the performance of the domestic financial sector and its ability to intermediate foreign finance. In the case of Lithuania, external financing has mainly been directed to capital formation-not consumption-and the financial sector prudential regulations are 14 mostly consistent with international norms. The 2001 Financial System Stability Assessment (FSSA) stressed the good quality of and availability of information, the efficiency and accountability of the system, the well-functioning regulatory framework, the lack of expectations of financial bailouts and the very limited degree of exuberance exhibited by players in the financial market-even in the aftermath of the other currency board crises (i.e., Argentina). All these factors helped avoid over-optimism and the kind of "bubbles" that may have resulted in excessive short-term appreciation of the litas, and loss of competitiveness for the economy. 1.35 Alternative Indicators of the Competitiveness. While the above assessment of the underlying factors influencing the evolution of the real effective exchange rate provide a general picture of competitiveness issues in Lithuania, it is useful to examine the behavior of altemative real exchange rate indices to gain a better understanding of the forces at play. The discrimination by trading partners is relevant for an economy like Lithuania with a relatively diversified export sector. Since some of its tradable goods are not perfectly homogenous, it is necessary to analyze the country's competitive stance in light of the situation of its trading partners (from the CIS and the EU) and potential competitors (Central and Eastem Europe). 1.36 Various indicators of export performance can be used to assess the impact of the appreciation of the real exchange rate of the litas: (i) the evolution of export market shares; (ii) changes in export composition; and (iii) relative unit labor costs with respect to some competitors. 1.37 Total exports grew by 12 percent a year in dollar terms during the period 1996-2001. After a setback in the wake of the Russian crisis, Lithuania's exports have made a strong recovery since early 1999, growing at almost 20 percent per year. The evolution of export market shares in the context of currency appreciation sheds more light to Lithuania's competitiveness. Between 1994 and 2001, Lithuania increased its market shares with respect to its main trading partners and competitors (Figure 1.16). This trend reflects productivity gains which may themselves be fuelling the appreciation of the litas (or be induced by the appreciation to maintain competitiveness). Figure 1.16 Lithuania's Exports Market Shares in Key Trading Partners' Imports Markets (%) 0.30 0.25 0.20 0.15 0.10 = 0.05 - .....- - 0.00 eSa eSfl wSSwp ww p 1 AwAi p 1Nd@p -EU -CEFTA EFTA -USA Source: Bank ofLithuania 15 1.38 The recovery in exports has been fueled mainly by strong penetration into EU markets, as exports to Common Wealth of Independent States (CIS) markets first shrunk in the wake of the Russia crisis, and then stabilized. Exports shares to other major trading blocs are also on the rise, especially to the Central European Free Trade Area (CEFTA) and the European Free Trade Area (EFTA). Despite these positive trends, however, the more disaggregated analysis presented in Chapter 2 points towards some potential emerging challenges in maintaining competitiveness in unskilled labor intensive sectors vis a vis developing country producers. 1.39 Reflecting strong export performance, Lithuania's terms of trade have increased over recent years as the decline in export prices (excluding the impact of oil prices) has been more than offset by an even faster decline in import prices (Figure 1.17). In sum, the evidence from the data indicates that, in the aggregate, Lithuania's export sector has been able to cope well with the appreciation of the currency over the past decade. Figure 1.17 Exports and Imports Prices Indices and TOT Indices (1996 = 100) 130.0 120.0 - 110.0 100.0- 90.0 80.0 - 70.0 . 9t 9K\ 99' c)q 99 ) dl o° P o° N Zo, l Export price index -Import price index - - *ToT 1.40 The data on labor costs suggest that Lithuania's competitive position has remained relatively strong since 1994. Concerns have often been raised that the high relative wage growth in the Baltic countries may have weakened their competitive edge, including in attracting foreign direct investment. In fact, empirical studies by Keller et al. (1999) show that overall labor costs (calculated by dividing wages by output) have increased by 14 percent in Estonia and Latvia between 1994 and 1998, while calculations of relative unit labor costs for Lithuania suggest a gain in competitiveness during the same period compared with Latvia, and a loss compared with Estonia. However, it is important to note that the effect of a relatively rapid growth in unit labor costs on competitiveness may be offset by increases in capital productivity. Keller et al. observe that in the case of the Baltic countries, the wage bill in total output has risen, which may have resulted from improvements in operations and the utilization of capital. At the same time, profits in manufacturing decreased as a share of output, but rose in absolute terms during 1995-99. All these trends seem to reflect an increased productivity of capital. 1.41 Other Indicators of External Vulnerability. The economic approach to assess the risk of a currency crisis and external viability consists of examining a broad set of macro and financial indicators. In the case of Lithuania, a currency crisis would be said to occur if a speculative attack on the litas leads to a serious loss of foreign exchange reserves or very high interest rates, or the 16 abandomnent. of the exchange rate peg.6 In theory, such a crisis would be prompted by the inability, or by doubts by financial market major players about the ability, of Lithuania to service its external debt. In conjunction to this, a banking crisis-defined as a situation in which bank failures (or potential) leads banks to suspend the convertibility of their liabilities and the Government is compelled to address the problem-may occur. 1.42 Lithuania's performance over recent years suggests that there is no evidence of concern for a currency or financial sector crisis in the immediate future. External sector indicators are broadly satisfactory: they include the current account balance and its financing, the pace of export growth, the real exchange rate, domestic and foreign currency interest differentials, the composition of capital flows, the structure of external debt, and foreign reserves coverage (see Figure 1.18) Figure 1.18 Current Account, FDI, and Gross External Debt (in percent of GDP) 50 40 - 30 20 10 ---------- 0 - - ~~4 - --] 996 997 998 1999 000 001o -20- In Current account balance U Net FDI and portfolio investment 0 Gross external debt Source: Bank of Lithuania 1.43 Financial sector indicators such as private sector credit growth, the banking system's external debt structure, the interest rate structure, the quality of the banks' loan portfolio, the maturity and currency structure of the banking system's deposit liabilities, and the overall supervisory framework, are broadly adequate. The 2001 FSSA noted that there is no immediate threats to the stability of Lithuania's bank-dominated financial system, owing, to sound macroeconomic policies in the context of the CBA, vigorous structural and legal reforms in preparation of EU accession, and strong banking regulation and supervision. A stress testing exercise focusing on possible swings in interest rates and exchange rates (such as the euro-dollar cross rate), declines in interest margins, and downturn in real economic activity, indicate that the country's financial system should be able to cope with most shocks. 1.44 Areas that may warrant attention include bank intervention, failure resolution, and the regulation and supervision of non-bank financial institutions. The FSSA specifically recommended the adoption of some measures to more effectively address the impact of hypothetical large shocks to the financial system, including: expanding the legal powers of the central bank to intervene in, and quickly resolve the failure of bank experiencing financial distress or insolvency; strengthening supervisory cooperation with the home country supervisors 6 See Keller et al. (1999). 17 of Lithuanian banks' parent institution; establishing stringent limits on domestic bank's exposures to their parent institutions; improving the quality of borrower and bank financial statements; strengthening accountability of bank directors for risk management; and revising loan classification and provisioning rules to better reflect borrower creditworthiness and the fair value of collateral. C. KEY LABOR MARKET OUTCOMES Unemployment and Under-Employment 1.45 The Achilles heel of Lithuania's recent macroeconomic performance has been the poor evolution of employment and the consequent rise in open unemployment. Despite positive GDP growth and strong export performance, employment has remained largely stagnant, with employment in 2001 slightly below that reported in 1995 (Table 1.4). This phenomenon of "jobless growth" is not specific to Lithuania; indeed it is typical of most transition economies of Central and Eastern Europe. Table 1.4 Dynamics of GDP, Employment, Productivity and Wages (1995=100) Average annual rate 1996 1997 1998 1999 2000 2001 of growth (1996-2001) in % GDP 105 112 118 113 118 125 3.5 Employment 101 102 101 100 96 92 -1.8 Productivity 104 111 117 113 122 136 6.3 Realwages 103 119 136 143 144 145 7.1 Note: real wage growth is based on gross earnings. Source: Statistics Lithuania, 2001. 1.46 The prima facie reason for economic growth not coupled with employment growth is productivity improvements associated with intensive restructuring. As Table 1.4 documents, growth in labor productivity (measured as GDP per worker) has been quite strong since 1996, averaging 4 percent per year. Thus, economic growth in Lithuania has been achieved through more efficient utilization of labor resources rather than through an increased use of labor inputs. 1.47 A deeper reason for the jobless growth in Lithuania, and in transition economies more generally, is the process of overcoming the legacy of over-manning, inherited from the previous system. Many companies entered the transition with employment far above that justified by production requirements. Growing exposure to domestic and international competition coupled with the influx of new and more capital intensive technologies has led companies to rationalize employment and shed labor. This process has been spread over time. Although the destruction of unproductive jobs has been coupled with the creation of new and more productive jobs, job losses have exceeded job gains, causing a net fall in employment. 1.48 In the long-run, these productivity improvements will be conducive to employment growth as ceteris paribus they imply a decrease in unit labor costs and thus an increase labor demand. However, this potentially positive effect hinges on the development of wages. If wages grow faster than productivity, unit labor costs increase with detrimental effects on labor demand. That is to some extent what has been happening in Lithuania. Since 1996 real wages have grown 18 by 7.6 percent per year, outpacing labor productivity growth by a large margin. This implies an increase in labor costs and may have contributed to jobless growth.7 1.49 Lack of employment growth is only one manifestation of Lithuania's underlying labor market problems. Unemployment is another very visible manifestation. In 2000, unemployment as measured by the labor force survey stood at 15.4 percent of the labor force, and by 2001, it had increased further to about 17 percent. The employment rate, arguably a more general measure of labor market conditions, has also deteriorated over the 1995-2001 period, dropping by 6 percentage points (Table 1.5). The labor force participation rate has declined even more, to reach only 58.9 percent in 2001. In addition, unemployment tends to be of long duration as over 50 percent of the unemployed have been jobless for more than a year. Table 1.5 Labor Supply, 1995-2001 1995 1996 1997 1998 1999 2000 2001 Labor force participation rate 66.9 65.4 61.5 61.7 61.9 60.4 58.9 Employment rate 65.2 64.6 65.2 65.0 63.2 61.0 60.1 Uneniploymentrate 17.1 16.4 14.1 13.3 14.1 15.4 17.0 Share of long-term unemnployed .. .. .. 55 38.7 52.3 59.0 Note: see Chapter 2, Vol. II for definitions. Source: Labor Force, Employment and Unemployment, 1997-2000 (Labor Force Surveys); Statistics Lithuania, 2001. 1.50 These negative trends have led to a significant underemployment of labor resources. The Lithuanian employment rate is much below the OECD average. Only 60 percent of persons of working age are employed in Lithuania, as compared to 66 percent in the OECD. This means that a sizeable fraction of working-age Lithuanians who could be employed are not, and are either unemployed or out of the labor force. This is a considerable social loss, which translates into lower than potential GDP. 1.51 Apart form high overall unemployment, two factors contribute to the low employment rate in Lithuania. The first is low labor force participation among young workers (aged 15 to 24). The second factor is low labor force participation among older workers (aged 55 to 64). For example, the Lithuanian labor force participation rate for young workers is 21 percent against the 47 percent OECD average. Similarly, labor force participation rate for older workers is 20 percent against the 49 percent OECD average. In addition, for both those worker groups unemployment rates in Lithuania are much higher than in the OECD. Sectoral Distribution of Employment 1.52 As with other economies in Central and Eastern Europe, Lithuania's transition years have been characterized by a sharp shift in employment from the public to the private sector. In 1991, the private sector employed less than 30 percent of the working population. By 2000, it employed nearly 70 percent. Much of the growth in private employment has taken place in small and medium enterprises, which in 1998 represented over 55 percent of total employment. (twice their level just five years earlier). 7 It is important to note that the effects of rapid growth in unit labor costs on employment and competitiveness can be quite different. While the effect on competitiveness may be offset by increases in capital productivity, as seems to be the case in Lithuania (see section B above), the impact on low productivity (low skill) employment is unambiguously negative. 19 1.53 In terms of the sectoral distribution of employment, there has been a clear gradual shift into services and a decline in employment in industry and construction, with agriculture playing a buffer role. In the first half of the 1990s, employed flowed out quickly from manufacturing (and construction) and into services. Between 1991 and 1994, the share of employment in industry dropped from nearly 30 percent, to 23 percent, while that of services expanded from 42.7 percent to 47.6 percent. Many of the workers laid off in industry, however, faced difficulties finding reemployment in urban areas, and moved to rural areas to take up farming. A large fraction of these migrants were elderly, low-skilled workers (Kassiaouni, Gomiak, and Lazutka, 2000). This urban-to-rural migration was reflected in an initial increase in agricultural employment between 1991 and 1994, from 17.8 percent of the workforce in 1991 to 23 percent in 1994. Since 1994, employment has continued to shift from industry into services, but agricultural employment has declined as well. The share of employment in agriculture dropped to 18 percent in 2001, while that of industry fell to 20 percent during the same period. In contrast, the share of services in total employment increased to 56 percent in 2001 (Figures 1.1 9a and 1.l19b). Figure 1.19a Employment Composition in 1993 Constructbns Wholesale and 7% retail tradel 0% -btels and restaurants1% Transport6% Industry Financiall % 25% R on.' . I bal estate2% --- RRblic3% Education8% Agriculture 23% *ii* 23% - -=; itw Y - *1\ H~~~~~Fealth5% Other9% Source: Lithuanian Department of Statistics 20 Figure l.19b Employment Composition in 2001 Constructions Wholesale and 6% retail tradel 50/ _.btels and ,,'':restaurants2% Transport6% Financial1% Real estate4% _Pblic4% Education1 1% .- -'- ---=- 1 Hesalth7% Other5% Source: Lithuanian Department of Statistics.. 1.54 The decline in industry's share of total employment reflects the effects of widespread restructuring, as firms searched to reduce over-manning and increase productivity in the face of new competitive pressures associated with the transition to a market economy. While the process has created many new, higher productivity jobs (as discussed in the next section), in net job destruction has exceeded job creation, with a consequent overall fall industrial employment. 1.55 In agriculture, the bulk of the decline in employment can be attributed to layoffs of workers from previously state-owned agricultural enterprises. Many, if not most, of these laid-off workers have remained attached to the rural sector -either in open unemployment, or more often, as underemployed family labor. These patterns point to the role that agriculture has played as a "safety net" of last resort for laid-off workers. Although it accounted only for 7 percent of GDP in 2001, the sector still comprised 18 percent of total employment. Open unemployment rates in agriculture are relatively low, but underemployment is widespread and reflected in very high labor to land ratios, and very low labor productivity. Patterns of Job Turnover 1.56 These aggregate patterns and the prevalence of high unemployment would tend to suggest that the Lithuanian labor market is stagnant and not creating many jobs. However, detailed analysis of firn-level data on employment and wages points to a slightly different picture at the microeconomic level. Firm-level data on job turnover, in fact, indicate that the Lithuanian labor market is characterized by high job flows, including a very high rate of job creation and job destruction. -Since job destruction has exceeded job creation, in net, the overall outcome has been a decline in total employment. 1.57 This apparent disparity between stagnant aggregate figures and very dynamic job turnover rates at the firm level is not specific to Lithuania, but characterizes other transition economies as well, most notably Poland (see World Bank, 2001). In such a context of extreme "creative destruction", where old jobs have to be destroyed as new ones are created, examining only the aggregate figures can yields a very misleading pattern of what is actually happening in the labor market. 21 1.58 In fact, Lithuania has one of the highest rates of job turnover among both transition and more mature market economies. Job creation rates are higher than in neighboring Poland, and much higher than in Slovakia. Job destruction rates, however, are also much higher than elsewhere. Taken together, these job turnover trends suggest that Lithuania has been undergoing a process of fast and very intensive restructuring. This finding is very consistent with the picture portrayed by changing trade orientation and structure, which indicated that many Lithuanian producers have been able to restructure their production process so as to compete effectively (in terms of quality and price) in EU markets. 1.59 The firm-level analysis reveals a very important link between job creation and trade. The fastest expanding industries-those in which job creation is much faster than job destruction- include services and trade, but also those manufacturing industries which are highly export- oriented: apparel, furniture, wood products, and manufacturing of RTV and communication equipment. These are the same sectors that have undergone most significant restructuring in terms of improving productivity and the quality of their products. This suggests that job creation and restructuring can go hand-in-hand, and points to the importance of trade, and in particular of exports, to employment growth and job creation. 1.60 How can these apparently diverging trends-high, stagnant unemployment and high job turnover consistent with intensive restructuring-be reconciled? The picture seems to be one of a dualistic economy, with very dynamic behavior within certain sectors-mainly services and export-oriented industries. These sectors are characterized by high job destruction but also by high job creation, and by strong productivity growth. In contrast, less dynamic sectors (especially agriculture, but also those where state presence remains large such as utilities) have undergone less restructuring, but as a consequence have been less able to create jobs Since for most years job destruction has exceeded job creation, in net employment has fallen. This duality is paralleled in the labor market, where some workers-mainly those with a certain level of skills- benefit from new job opportunities and wage growth, and where many labor-market transitions are job-to-job (e.g., new jobs are taken up by people who were already employed). On the side, there seems to be a large pool of unemployed who lack the skills to reenter jobs; and who may be priced out of the market by increases in real wages in excess of productivity gains and by a relatively high minimum wage. D. POVERTY AND OTHER SOCLAL INDICATORS Household Consumption and Incomes 1.61 The impact on households of rising unemployment and of the changing structure of employment is visible in the level and composition of household consumption and income. Reflecting the delayed impact of the Russia crisis, household consumption dropped by 5 percent in 2000, to a level below that of 1998 (Table 1.6). Like consumption, income also dropped in 2000 and 2001, after having risen steadily since 1996. The evolution of the different components of income, however, differed significantly. While income from wage employment increased by over 35 percent in this six-year period, reflecting mainly the increase in real wages; income from self-employment decreased by 25 percent. The main source of decrease in self-employment income comes from agriculture, with a decrease of almost 25 percent. Another noticeable increase in household income is the rising share of retirement and other pensions benefits in average disposable income. 22 Table,1.6 Average Disposable Consumption and Income in 1996-2001 1996 1997 1998 1999 2000 2001 Total household consumption 348.1 382.6 426.8 425.4 '404.4 411.4 Total household disposable income 326.7 368.9 422.5 428.0 415.4 409.5 Income from wage employment 159.7 191.8 222.7 227.9 216.3 219.4 Income from self employment 61.8 55.7 62.7 52.2 50.5 46.1 - Income from agriculture 40.1 39.3 41.9 33.4 31.4 30.6 - Income from business, handicrafts, free 19.9 14.3 18.7 17.6 17.9 14.0 professional activity - Income from other activities (non-business) 1.9 2.1 2.1 1.1 1.2 1.6 Income from property 0.9 3.6 0.8 1.3 0.3 0.4 Income from rent 0.6 0.5 0.9 0.5 1.2 0.3 Retirement pensions 36.6 48.4 55.3 63.6 62.0 57.2 Unemnployment benefits 1.1 1.0 1.5 1.5 1.6 1.7 Other benefits, pensions 18.0 24.9 33.1 36.2 37.4 40.0 Other income 48.1 42.9 45.4 44.7 46.1 44.4 Note: Litas per capita per month. Source: Statistical Yearbook of Lithuania, 2000, Economic and Social Development in Lithuania, 2002/02. 1.62 Urban and rural households have very different consumption patterns. In 2000, rural total per capita expenditures (370.37) were over 100 litas per month less than the corresponding urban levels (484.88). Rural households spent as much as 57 percent of their total monthly per capita expenditures on food, and 12 percent on housing, water, electricity, gas and other fuels. Urban households spent only 40 percent on food and 16 percent on housing, water, electricity, gas and other fuels. Expenditures on health, education, leisure and other human development needs represented only 5.7 percent of the total spending of rural households, as opposed to 9.3 percent of that of urban ones. 1.63 As with consumption, urban and rural households had markedly different sources of income. In 2000, the per capita monthly income for urban individuals was 501.33 litas, while it was only 348.88 for rural individuals. Urban dwellers received 54 percent of their monthly per capita income from employment and only 6 percent from self-employment. The second largest source of income for urban dwellers was retirement pensions which accounted for 18 percent of per capita monthly income. There are not large differences in this pattern or the percentages between those who reside in the five largest cities and those that reside in other towns. Rural dwellers, however, draw only 24 percent of their income from employment and draw 24 percent of their income from self-employment, primarily in the agricultural sector. The largest source of income for rural households is retirement pensions, which accounts for 28 percent of per capita monthly income. Poverty Profile8 1.64 According to the UNDP Human Development Reports, poverty in Lithuania has remained fairly constant since 1996. Using a relative poverty line equal to 50 percent of mean equivalent expenditure, the UNDP estimates that some 16.6 percent of the population was poor in 2000. This represents a slight increase over 1999 (15.8 percent), but below the levels observed in 1996 (18 percent). However, as is well-known, the exact level of poverty is very sensitive to the definition of the poverty line, and thus one should not put too much weight on any one number. Our own estimates suggest that, depending on the poverty line used, poverty in Lithuania oscillates between 10 percent and 25 percent of the population (Table 1.7). This is a very large range and indicates that many people are in fact concentrated in the lower part of the consumption See Chapter 9 (Steele) in The Background Papers Volume for a detailed poverty profile, and a discussion of the methodology and data used. 23 distribution. Small changes in the level of the poverty line can thus have a very big impact on measured poverty.9 Table 1.7 Poverty in Lithuania, 2000 (%) Poverty Line (level) Poverty Rate f/)a All Urban Rural Below $2.15PPP expenditures per person per day 3.3 1.5 7.1 (119 litas per mo.) Below $4.30PPP expenditures per person per day 25.5 18.5 40.1 (237 litas per mo.) Below 50% median per equivalent expenditures 10.0 6.1 18.3 (223 litas per mo.) Below MSL income (187 litas per mo.) 8.2 4.1 17.1 Notes: a % of all individuals. Source: Lithuania Household Budget Survey, 2000. Staff calculations. See Chapter 9 (Steele), Volume. 1.65 Although these poverty rates are based on consumption, one can also use income to examine whether a family or an individual is poor. Indeed, this is the approached used by Ministry of Labor and Social Security in order to establish eligibility for means-tested state benefits. The Ministry has established a minimum eligibility threshold or minimum subsistence level (MSL), and only families with incomes below that level are eligible to receive means-tested benefits. According to the data from the 2000 Household Budget Survey, about 8 percent of the population had incomes below the MSL in 2000. A simple comparison of this figure with the overall consumption-based poverty rates mentioned above suggests that some individuals who are poor in terms of their consumption levels may not be eligible for support under the MSL. 1.66 Unlike the measures of the levels of poverty, the characteristics of the poor are usually not very sensitive to the definition of the poverty line. This makes the profile of poverty a much more useful tool for policy making than the poverty rate per se. Our analysis of the profile of the poor reveals the following main features of poverty in Lithuania (which hold irrespective of the poverty line used):'0 * Poverty is much more prevalent in rural than in urban areas. In addition, the depth and severity of poverty are always higher in rural areas. Rural areas comprise some 70 percent of the poor, even though they represent only about a third of the population (Table 1.8). Table 1.8 Poverty by Location, 2000 * As in other transition Urban Rural economies, poverty Share of Total Pop (%) 67.8 32.2 affects the young Less than US$2.15 ppp per capita per day (especially children) Share of Poor Pop (%) 30.4 69.6 more then the elderly. Poverty Risk 1.5 7.1 The risk of poverty Less than 50 percent median per equivalent expenditures Share of Poor Pop (%) 41.3 58.7 onreases with number Poverty Risk 6.1 18.3 of children, and Is Notes: Individuals especially high for Source: 2000 LHBS families with three or 9 For a number of reasons, we prefer to use both an absolute and a relative line to measure poverty. Absolute lines defined in terms of PPP$ per capita allow one to carry out intemational comparisons of levels of poverty. Relative lines are more appropriate to study the characteristics of the poor in any one country, and compare them to others. Following other Bank studies, we define two absolute lines (US$2.15 PPP per capita and US$4.30 PPP per capita), and one relative line (50 percent of median equivalent expenditure). '° See Chapter 9, The Background Papers Volume for details. 24 more children. * There is a gender dimension to poverty in Lithuania, with individuals living in households headed by women having higher rates of poverty than individuals living in male-headed households (Table 1.9). Table 1.9 Population Share and Poverty Risk by Gender of Household Head, 2000 (percent) Male Female Total Urban Rural Total Urban Rural Share of Total Population 56.1 55.7 57.0 43.9 44.3 43.0 Less than US$2.15 ppp per capita per day Share of Poor Population 45.8 31.3 52.1 51.2 68.7 47.9 Poverty Risk 2.7 0.8 6.5 4.1 2.3 7.9 Less than 50 percent median per equivalent expenditures Share of Poor Population 49.8 43.9 53.9 50.2 56.1 46.1 Poverty Risk 8.9 4.8 17.3 11.5 7.7 19.6 Notes: Individuals Source: 2000 LHBS * Although the percentage of individuals who are elderly is not large, the elderly are at high risk of poverty when they live alone or in households made up only of elderly people. * Individuals in households where the head has less than secondary education are at highesi risk for poverty, and among these, the risk is especially high for those living in rural area, (Table 1.10). In total, some 20 percent of the population lives in households where the head of household has less than secondary education (17 percent in urban areas and 4( percent in rural areas), but they represent between 30 and 40 percent of the poor. Table 1.10 Poverty Risk by Highest Education Level Achieved by Household Head, 2000 Less than $2.15 PPP per capita Less than 50% median per per day equivalent expenditures Total Urban Rural Total Urban Rural None 5.4 0.0 7.1 25.0 16.6 27.5 Basic 3.4 1.8 4.7 13.6 12.1 14.5 Primary 5.7 1.3 11.2 16.7 10.3 24.8 Secondary 5.1 2.8 9.6 14.0 9.5 23.0 Higher 2.1 1.2 4.6 6.0 4.0 12.3 University 1.0 0.0 0.4 1.0 0.5 1.5 Notes: IndividuaIs Source: 2000 LHBS * Individuals who are unemployed have a higher risk of poverty than the employed, but th4 employed constitute a larger share of the poor (Table 1.11). The unemployed in rura areas face an especially high risk of poverty: at the US$2.15 PPP line, the poverty rate fo the rural unemployed (18.2 percent) is nearly four times that of the urban unemploye( (4.7 percent); at the 50 percent of the median line, the corresponding poverty rates arn 34.7 percent for the rural unemployed, and 15.1 percent for urban unemployed. 25 Table 1.11 Poverty by Employment, 2000 Employed Unemployed Not in Labor Retired Force Share of Total Population (%) 59.3 8.6 14.4 17.7 Less than US$2.15 ppp per capita per day ShareofPoorPopulation(%) 53.7 22.8 15.8 7.8 Poverty Risk 2.4 7.1 2.9 1.2 Less than 50 percent median per equivalent expenditures Share of Poor Population(%) 52.3 16.9 15.8 15.0 Poverty Risk 8.3 18.5 10.4 8.0 Notes: Individuals 14 years and older Source: 2000 LHBS * Access to land reduces the risk of poverty, but because of the pervasive nature of poverty in rural areas, many rural individuals with access to land are still at high risk of poverty. * More generally, poverty in rural areas seems to be associated with very low agricultural productivity, linked in part to inadequate access to complementary inputs and services Non-Income Dimensions of Poverty and Other Social Indicators 1.67 Material deprivation, whether it be measured as low income or low consumption, is only one dimension of poverty. Lack of access to education and health care services; unnecessary morbidity or premature mortality; vulnerability to crime, corruption or the arbitrary use of power; lack of access to leisure and culture; geographical isolation and lack of mobility, are other equally important dimensions of poverty and deprivation. These multiple dimensions of poverty tend to reinforce each other -for example, with children from poor families being less able to continue their education beyond the basic level- creating the potential for the emergence of intergenerational cycles of poverty and poverty traps. 1.68 According the UNDP Human Development Reports, on many of these dimensions the livening standards of poor Lithuanian households deteriorated significantly between 1996 and 2000, even as overall poverty rates remained fairly flat. Access to education and health care services has deteriorated among the poor, and there are growing disparities in human development related expenditures between poor and non-poor. Spending on education and health among poor households is only about a third that of non-poor households, and less than a tenth than of the richest 10 percent (Steele, 2002; UNDP, 2000). There are also signs of growing disparities between urban and rural areas, which given the concentration of poverty in rural areas, partially mirror those observed between poor and non-poor. Nevertheless, by middle-income country standards, educational access for poor and rural households in Lithuania remains good. 26 Table 1.12 Selected Social Indicators 1993 1995 1997 1999 Health: Maternal Mortality per O00,000 births 30 29.3 23.0 16.6 Infant mortality per 1,000 live births 15.7 12.5 10.3 8.6 Beds per 10,000 population 123.6a 108.5 98.4 93.9 Doctors per 10,000 population 39.9a 39.7 39.8 39.45 Education: Enrolled at all levels 633 665 713 767 Drop outs, % of total enrollment 0.9 1.3 0.9 0.9 % pupils finishing basic and continuing -- 97.0 98.9 99.7b % pupils finishing secondary and continuing -- 86.9 84.5 85.2b Crime: Registered crime 60,378 60,819 75,816 77,108 Crime per 10,000 population 162 164 205 208 Notes: a 1990. 2000. Source: Lithuania Statistical Yearbook, 2001. 1.69 Education. Enrollment in basic education (10 years) is practically universal. Some 99.7 percent of pupils finish compulsory basic education and continue on studying. About 85 percent of pupils finish the additional two years of secondary education and continue on to either vocational schools, specialized secondary education or higher education. Nationwide, some 46 percent of students continue on to higher educational institutions (UNDP, 2000 and Statistical Yearbook of Lithuania, 2001). 1.70 There are large urban-rural differences in spending on education, with rural households spending only about 17 percent that of the average urban family (Steele, 2002; UNDP 2000). Much of these disparities reflect differences in access to and use of higher-level education. A significantly lower fraction of secondary school graduates continue on to higher education in rural areas than do in urban ones, mainly for financial reasons (UNDP, 2000). All higher education institutions are located in cities, which renders the expense of attending higher education significantly higher for rural families. 1.71 Rural-urban differences in education start at the pre-school level. In 1998, 52 percent of pre-school age children in towns and cities attended pre-school; in rural areas, only 12 percent did. At the basic and secondary school level, rural-urban differences are more qualitative than quantitative, reflecting the fact that urban schools tend to have better teachers and better equipment. For example, approximately 90 percent of secondary schools and 31 percent of basic schools in urban areas had computers; as compared to 70 percent of secondary schools and 9 percent of basic schools in rural areas. Teachers with higher education made up 90 percent of all teachers in urban areas, but only 77 percent of those in rural areas. 1.72 Health. There are significant rural-urban differences in health indicators and health expenditures. Rural households spend on average 72 percent less than urban ones on the purchase of health services. Mortality rates, at 11.7 percent per 1,000 population, are higher in rural areas than urban ones, a gap which may be ascribed in part to a more elderly rural population, but also to differences in incomes and lower access to health care. The main causes of death at the national level are diseases of the cardio-vascular system (54.8 percent of all deaths) , malignant tumors (19.6 percent), and external causes (13.2 percent). But again, rural- urban differences are pronounced, with inhabitants of rural areas dying from diseases of the respiratory system three times more often than in urban areas. Non-medical causes of death are 1.8 times more prevalent in rural areas. Average life expectancy has increased steadily throughout the 1990s, and reached 72.3 years in 1999; but life expectancy in rural areas is about 5 27 years lower than in urban ones (UNDP, 2000). The incidence of tuberculosis decreased in 1999, most noticeably in urban areas. However, it continued to grow among rural inhabitants. 1.73 Infant mortality rates have been declining, and reached a record low of 8.6 percent per live births in 1999 (as compared to 15 in Latvia, and 9.3 in Estonia). However, here too, there are significant rural-urban disparities, with infant mortality equal to 7.6 per 1,00 live births in urban areas as compared to 10.3 in rural ones. Immunization coverage for basic childhood diseases is high nationwide (93-97 percent). 1.74 Crime. After falling in 1999, the registered crime rate increased quite sharply in 2000. The number of premeditated murders and incidents of serious bodily injuries increased by 16 percent, while that of theft increased by 11 percent. The crime rate is higher in cities than in rural areas. However, the rate of violent crime is higher in rural areas. The number of premeditated murders per 10,000 population in rural areas exceeds that in urban areas by 30 percent, while the rate of premeditated serious bodily harm in rural areas in 1998-199 exceeded the indicator for urban areas by 20 percent. E. LOOKING AHEAD: THE MEDIUM- AND LONG TERM STRATEGY 1.75 Lithuania has achieved significant progress in macroeconomic stabilization and structural reforms, and greatly improved its prospects for EU membership in the first wave of expansion. Yet, convergence to EU income levels will take time. Supply factors will determine economic growth in the long term whereas demand factors will dominate movements in economic activity in the short-run. This section outlines the long-term prospects for Lithuania and the medium-term economic strategy that would accelerate the convergence process before and after EU accession. Long Term Sources of Growth: Lessons from History 1.76 Deterninants of Growth. The prospects for the real sector in Lithuania will determine the appropriate policy framework before and after EU accession. Therefore, it is important to identify the key factors likely to shape the pace and sources of growth in the medium- and long-term. The historical evidence from European and Asian growth (Japan and also the so-called East Asian Tigers) in 1950-1975 shows that the sources of growth can vary enormously: while total factor productivity (TFP) dominated the growth in Westem Europe and Japan, increased factor inputs seem to be the predominant factor in East Asia. 1.77 Four factors usually explain these diverging patterns:1' (i) the differences in initial income levels. Westem countries had a much higher per capita GDP relative to the US in 1950 than the East Asian countries in 1960; (ii) demographic trends; East Asia experienced a rapid rise in the labor force-this was not the case in Westem Europe where the demographic transition was completed prior to the postwar golden age; (iii) the quality of the labor force (measured by average years of education) was much higher in Westem Europe than in East Asia; (iv) Westem Europe had already established a well-functioning market system in 1950 whereas Asian countries relied on large integrated enterprises, with the state playing a major role in economic policy. 1.78 Lessons for Lithuania. From this historical experience, it appears that Lithuania (and many transition economies) resembles Westem Europe at the outset of its golden age in all the four policy areas identified above: " See Peter Doyle et al. (2001 ) 28 * Lithuania's income level relative to the US (at current international prices) was 22 percent in 2001, below the range of Western European countries in 1950 (from 32 in Italy to 59 percent in the United Kingdom). This initial income level means that the scope for growth from increased capital is likely to be as important as it was the case for East Asian countries; * The average number of years of education in Lithuania is relatively high, close to levels prevailing at the outset of Western Europe's growth spurt (11 years).12 This means that the labor force may be better able to assimilate and use new technologies and make productivity gains than was the case for East Asian labor at the outset of the convergence process; and * Finally, Lithuania has already achieved significant progress in establishing many of the type of market institutions that were essential in the economic development of Western Europe in the 1950s. Though the relative merits of different institutional frameworks in supporting economic remain subject to debate, empirical studies have shown that the systems in East Asia have been less effective in promoting efficiency and innovation. 1.79 Thus, the main lesson from the international evidence is that TFP, rather than mobilization of factor inputs, has the greatest potential to spur growth in Lithuania in the medium- and long-run. 1.80 Growth Scenario in the Long Term. Empirical research has highlighted the role of the income gap and the level of education in the convergence process. Using a methodology developed by Benhabib and Spiegel (1994) and already used by Doyle et al. (2001) for a panel of transition economies, we can estimate Lithuania's TFP growth rate for the next decade. At the steady state, Lithuania's capital output ratio will remain constant. As a result, per capita GDP growth at the steady state will be TFP growth over the labor share plus changes in the quality of the labor force. Projected TFP growth is presented in Table 1.13 below. Table 1.13 Projected TFP Growth Rates for the Baltic Countries Average years of schooling Gap with US Projected TFP growth Labor force growth 1999- 2010 average Lithuania 12 4.6 4.2 0.2 Latvia 12 4.6 4.5 -0.4 Estonia 13 3.2 3.4 -0.2 Poland 9.5 3.8 3.0 0.2 Sources: Calculations using the equation from Benhabib and Spiegel (1994), which is: [.0007*Schooling*Gap + .0014*Gap]. Ga is the ratio of the US per capita GDP to that of the country concemed in 2000 at current intemational prices from the World Bank Development Indicators. Labor force growth is average annual growth rate over 1999-2010 calculated from World Bank Development Indicators. Data for Poland is from Doyle et al. (2001) 1.81 These projections indicate that Lithuania has the potential for rapid growth but that convergence with EU income levels will probably take time to materialize. The projections also assume that the capital-output ratio remains constant-which is an important assumption given the uncertainties surrounding the capital stock inherited by Lithuania from the former Soviet Union. The pace of convergence with Westem European countries would clearly be influenced by any substantial change in the capital-output ratio. This has major policy implications for the 12 Source: 2001 World Development Indicators CD-ROM, World Bank. According to P. Doyle et al. (2001), average years of schooling in Westem Europe in 1950 varied between 4.9 in Italy to 9.4 in the United Kingdom. It should be noted that the quality and nature of schooling in transition countries during the socialist period, even for highly educated workers, has been subject to debate. 29 medium-term term as the Lithuanian authorities will need to ensure adequate investment ratios; stimulate domestic and foreign savings to fund the necessary investment; and implement measures to create the legal and business environment that will be most conducive to TFT- intensive growth. Medium-Term Strategy for Preparing Convergence 1.82 Accession to the EU and to NATO has consistently been the major national medium-term goal supported by Lithuania's political leaders across the political spectrum in spite of the country's fragmented political market. The authorities have made rapid progress in their EU accession negotiations which were initiated in 2000. They are aiming to close all chapters of the EU Acquis Communautaire by end-2002, hoping to join the EU in the first enlargement wave in 2004. As of June 11, 2002, 28 out of the 31 negotiation chapters and appendixes have been closed. Lithuania's long-term economic strategy aims at building the foundations for achieving rapid convergence with Westem European countries. The medium-term objective of the economic policy is to meet the economic criteria for accession (the so-called Copenhagen criteria) and to get ready for membership of the Economic and Monetary Union (EMU) after accession. This will be achieved through continued macroeconomic stability and further implementation of structural reforms necessary for an efficiently functioning of market economy, improved productivity, and enhancement of competitiveness. 1.83 There is a broad consensus in Lithuania about what the key elements of the country's economic policy strategy in the medium-term should be:'3 * Maintain a stable monetary policy under the CBA while preparing an orderly exit from it to join the EMU; * Further fiscal consolidation in order to support external viability prior and after EU accession; and increase the effectiveness of public expenditure; and * Accelerate the remaining agenda for structural reforms to improve productivity and the business environment (this includes the completion of privatization and continued reforms in agriculture; labor market reform to increase flexibility and create greater employment opportunities; regulatory reform to improve the business environment and support productivity growth; and social protection reform to increase its effectiveness and dampen the social impact of additional restructuring).'4 (i) Maintaining a stable monetary policy under the CRA while preparing an orderly exitfrom it to join the EMU 1.84 On February 2, 2002, the litas was repegged from the dollar to the Euro at the official exchange rate of LTL 3.4528 for EUR 1. The decision was made on the grounds that the Lithuanian economy has become increasingly integrated with the economies of the European Union and other candidate countries. With the development of the relevant foreign trade and investment structure, the new litas exchange rate fixed against the euro will reduce the 13 Lithuania's economic policy for the medium-term is presented in the following documents: the Medium Term Economic Strategy of Lithuania in the Context of its Accession to the EU; the Programme of the Government outlining general guidelines of Government policy; the National Programme for Increasing Employment in 2001-2004; the National Development Plan; the Medium-term Industrial Development Programme and Strategy for its Implementation; and the Programme for the Development of Small and Medium Sized Enterprises. See also Technical Memorandum of Economic Policies (June 2001), Lithuania's Letter of Intent and Supplementary Memorandum of Economic Policies (December 2001), Memorandum of Economic Policies (June, 2002). 14 This Country Economic Memorandum focuses on point (iii) of Lithuania's medium-term strategy. 30 movements of the litas exchange rate against the currencies of the major trading partners and will serve as a firm basis for stable medium-term economic growth. Also, in the context of economic and political integration, the peg of the litas to the euro is a logical step to promote further co- operation with the European Union. 1.85 The peg to the euro will facilitate the CBA exit strategy, which aims at participation in the Exchange Rate Mechanism (ERM2) and ultimately EMU participation. The currency board arrangement will remain an essential element of Lithuania's macroeconomic policy. It will ensure a stable monetary environment and contribute to keeping low inflation rates. This will also create favorable conditions stable interest rates. The projected strong balance of payments position for the period 2002-05 and sustained confidence in the banking system should lead to a further monetization of the economy. Broad money is expected to grow by at least 10 percent a year over the medium-term. Credit growth would increase at the same pace, as recent privatizations in the banking sector lead to greater competition and interest rates decline further, reflecting strong confidence and low interest rates in the euro area. (ii) Pursuing fiscal consolidation in order to support external viability prior and after EU accession; and increase the effectiveness ofpublic expenditure 1.86 The main goal of Lithuania's fiscal policy in the medium-term will be to further reduce the Govemment deficit and achieve a balanced budget by the time of accession to the EU. Continued fiscal adjustment will boost the credibility of the CBA and lead to further reductions in borrowing costs for the public and private sectors. Higher savings generated by the general govemment will also make significant contributions to national savings, liberating resources for investment and strengthening Lithuania's extemal position. 1.87 Specific policy measures envisaged by the authorities include: First, streamlining the tax structure according to the EU requirements. There is an ongoing reform of the tax system aiming at the harmonization of tax laws with the EU requirements, the elimination of the existing VAT preferences contravening the requirements of the Sixth Directive of the EU, and the elimination of the excises on goods, taxation of which is not required in the Acquis. Tax reforms must be consistent with the pace of the targeted deficit reduction, taking into account the need to accommodate new expenditure commitments while maintaining an adequate level of social expenditures. According to the Memorandums of Economic Policies of 2001 and 2002 released by the MOF, the authorities intend to introduce changes in the tax system, with the aim of easing the tax burden to promote employment-generating growth and investment, eliminating loopholes to make the system transparent, and implementing municipal taxes to strengthen municipal finances. In 2001 and 2002, new laws on excises, value added tax (VAT), corporate income tax (CIT), personal income tax (PIT) and changes to law on fees were approved. Other tax reform measures will include extending the coverage of the real estate tax and a further increase in the minimum income tax threshold to the extent the overall revenue neutrality of the tax reform package is ensured. Reforms of the tax system will continue to be complemented by improvements in tax administration. 1.88 Second, restructuring the composition of public expenditures (inter- and intra-sectoral allocations) according to Govemment priorities and sources of financing. The authorities must face a number of priorities and new commitments: the costs of EU and NATO accession, the closure of the Ignalina nuclear power station, environmental remediation, pension reform, improvements to social expenditure, and clearance of remaining expenditure arrears. The public" investment program will be geared towards infrastructure, environmental and other projects necessary for EU accession, and further improvements in education. There is little immediate scope for further reductions if essential services and social expenditures are to remain adequate; 31 however, the government should pursue expenditure rationalization and seek gains in efficiency across the board. 1.89 Third, improving municipal finances. Measures to strengthen municipal finances will focus on defining more clearly the functions of municipalities, strengthening expenditure management, and finding new sources of revenue. These measures will address the structural causes of municipal expenditure arrears, thereby helping clear outstanding arrears by end-2002 and preventing their reemergence. A special government commission has been established to define local governments functions, including those mandated by the central government, and their financing sources. A set of comprehensive measures to overhaul municipal finances was adopted in 2002. The Law on amendment of the Law on the Methodology of Establishment of Revenues of Municipal Budget, which establishes more precise and adequate principles for balancing revenues of municipal budgets with regard to the implementation of state mandated functions and the procedure for allocating funds, was adopted by Seimas in 2001. Furthermore, the Cabinet-level commission on expenditure arrears will continue its monthly monitoring of the clearance of municipal arrears. The State Control will be asked to conduct a performance audit of municipalities and to provide recommendations on how to resolve the problem of expenditure arrears. In this context, municipalities which incur arrears due to insufficient administrative capacity and weakness in expenditure management will be provided with technical assistance. The government is planning to adopt a new law on real estate tax, which would allow municipalities to set tax rates on residential property, exceeding the limit of minimum living space. In 2002, Seimas approved the changes to the law on fees, which regulates local fees accruing to local budgets. This should lead to greater predictability in revenue and flexibility in the financial management of municipalities. In addition, the central government will not undertake any unconditional bail-outs: any financial transfers to municipalities to clear expenditure arrears will be part of a comprehensive financial restructuring plan. Transfers from. the central government to municipalities earmarked for arrears clearance will be made in separate tranches; with each tranche conditional on the fulfillment of scheduled plans for the reduction in the outstanding stock of arrears. As a general principle, the general government will strictly refrain from recourse to mutual debt cancellation or other netting or offset schemes, including with suppliers and tax payers. (iii) Accelerating the remaining agenda for structural reforms to improve productivity and the business environment 1.90 The authorities are committed to adopting the necessary legislation, and aims at quickly establishing a track record of successful implementation in all areas, thus strengthening the capacity of the economy to withstand increased competition and reap the full benefits of EU accession. In this regard, efforts will focus on continuing financial sector reform; improving the business environment; enhancing labor market flexibility; reforming social protection; and completing the privatization program. 1.91 Financial sector reforms under implementation draw on recommendations from the reports and assessments of the joint missions of the World Bank-IMF Financial Sector Assessment Program (FSAP). Reforms will aim to further enhance the resilience of the financial system and to foster a broadening and deepening of the range of financial products and services available. Specific areas of attention in the banking system include enhancing the use of risk assessment and management techniques, improving disclosure by banks, enhancing the quality of borrower financial statements, including via adoption of national accounting standards, and continuing cross-border supervisory cooperation. In housing finance, policies will aim to better target public support and to focus on the development of instruments, rather than new institutions. In leasing, consideration will be given to regulatory and tax changes to remove conditions that 32 presently discourage leasing vis-a-vis bank finance. Finally, in insurance, efforts will target improvements of corporate governance and market oversight, including by strengthening the independence and capacity of the insurance supervisory agency. 1.92 Improvements to the business environment remain the key to enhancing the climate for investment, attracting foreign direct investment, and strengthening competitiveness. The government is putting in place measures to streamline company registration and liquidation procedures, including through the establishment of a new company registry (2002). The government will also use support available through the EU PHARE program to: (i) ensure the effective implementation of new insolvency laws adopted in July 2001, through the provision of formal training for administrators and judges on new bankruptcy procedures, and preparation of a manual on bankruptcy and restructuring procedures; and (ii) assess the competitiveness of Lithuanian businesses. 1.93 The authorities remain committed to further reducing unemployment, through enhanced labor market flexibility and the provision of well-targeted training opportunities, while at the same time protecting the most vulnerable sections of society. The govermment is continuing to provide job training programs that are targeted towards the projected future employment needs of the private sector. The new labor code is expected to introduce flexibility in the setting of the minimum wage, with provisions for lower minimum wages for specific groups, certain classes of unskilled workers and possibly certain regions. With passage of the new labor code, expected in the first half of 2002, laws on Works' Councils and on Lockouts will be proposed to Seimas in the second half of 2002. The Unemployment Insurance Law, which strengthens the insurance element in the payment of unemployment assistance, will be submitted to Seimas by end-June 2002. 1.94 All in all, the Government is well aware of the need to reform social protection programs to increase both their efficiency and effectiveness. In addition, to the reform of the unemployment insurance system, the Government has advanced an ambitious pension reform plan, to allow for a multi-pillar system. The government is also committed to maintaining social cohesion by ensuring that the social safety net provides the necessary support to the most vulnerable groups, and will seek to improve the targeting of social assistance programs in this regard. The law on Social Assistance in Cash, which will be submitted to Seimas by end-June 2002, will change eligibility norms and replace the current general reduction in housing bills with cash payments targeted to the long-term unemployed. 1.95 The development of an efficient and competitive energy sector remains a key policy objective, and the government is proceeding with plans to restructure and privatize the Lithuanian Power Company (LPC) and Lithuanian Gas (LG). More generally, the privatization program, which has been a key part of efforts to increase efficiency and promote the overall restructuring of the economy, is nearing completion. Lithuanian Airlines is expected to be restructured and privatized by April 2003. The cargo business of Lithuanian Shipping Company (LISCO, the rest of which was privatized in early 2001) will be offered for sale in 2003. The government is also committed to the privatization of Lithuanian Railways (LRR), following a comprehensive reorganization of the company over the next two years along the lines approved by the government in May 2001. The government plans to continue with the rapid sale of over 3,000 and remaining 4,000 or so small residual state shareholdings and land plots, and the State Property Fund is preparing an inventory of such assets to facilitate this process. 33 2. INTERNATIONAL TRADE AND FOREIGN DIRECT INVESTMENT15 2.1 The competitiveness of a country's exports is an important factor in determining foreign exchange and investment flows into the country. As such, is a critical link between international markets and domestic incomes and standards of living. In Lithuania, exports have been and are expected to remain a driving force for the growth of the economy. Indeed, the analysis carried out in this study suggests that during the last decade Lithuania has undergone a process of intensive restructuring, much of it trade-induced. The extent of this restructuring has been reflected in broad changes in the structure and orientation of Lithuanian exports, with a clear shift in the direction of Lithuanian exports towards EU markets and a growing importance of manufactured goods in the country's total export basket. As part of this process, Lithuania has developed a growing specialization in unskilled-labor-intensive products. Sectors such as apparel, textiles or furniture have seen their exports boom, and as a result have been the fastest expanding sectors in terms of employment. Exports have proven to be a critical vehicle for productivity growth, with exporting firms clearly outperforming non-exporters in terms of both productivity levels and changes. 2.2 Given the size of the Lithuanian economy, exports will continue to be a main engine of growth in the future. Sustaining export growth over the medium term, however, will present some special challenges First, accession to the European Union will increase competition in Lithuania's domestic market and put pressure on many domestic producers. Second, the phase- out of the Multifiber Agreement in 2005 will remove quotas on exports of textiles and clothing from developing countries, including China, to the EU, thus lowering their price in EU markets. Given that one-third of Lithuania's manufacturing exports to the EU consists of textiles and apparel, Lithuanian exporters will face increased competitive pressures. Third, more generally, as wage levels rise with economic growth, Lithuania's comparative advantage as a low-cost producer will erode and make it increasingly difficult for Lithuanian producers to compete with developing country producers in purely unskilled-labor-intensive goods. 2.3 This chapter is structured as follows. First, we examine different aspects of Lithuania's trade, including pattems of revealed comparative advantage, using aggregate and sector-level statistics. Then, we discuss inflows of foreign direct investment and the impact they may have had on trade pattems and exports. Finally, we use firm-level data to examine the microeconomic links between exporting activity, productivity and foreign direct investment. t5 This section is based on the work reported in Chapters 3 (Smarzynska) and 4 (Smarzynska) of The Background Papers Volume. Francis Ng prepared all the tables. 35 A. PATTERNS OF COMPARATIVE ADVANTAGE Geographical Reorientation of Trade 2.4 Over the past several years, Lithuania's foreign trade has undergone a radical geographical reorientation . The 1998 financial crisis in Russia, which resulted in the depreciation of the ruble and the devaluation of many CIS currencies, led to a dramatic decline in Lithuanian exports to the region. In 1997, 61 percent of Lithuania's exports went to either the Commonwealth of Independent States (CIS) or to other EU accession candidate countries (the CEEC-10). By 1999 this figured had dropped to 40 percent. The loss of these eastern markets acted as a stimulus forcing Lithuanian companies to look for export opportunities in other markets, and especially in the EU. In many cases, goods that had been exported east were not competitive in EU markets, thus forcing Lithuanian exporters to restructure and improve the quality of their products. That the restructuring has been successful is evident from the changes in aggregate trade patterns: the share of Lithuanian exports going to the EU increased from only a third in 1997 to one-half in 2000 (Table 2.1). Table 2.1 Geographical Distribution of Trade: Lithuania vs. Selected CEEC Countries Country 1992 1993 1994 1995 1996 1997 1998 1999 2000 Share of EU-oriented exports in total exports (%) Poland 62.3 69.3 69.2 70.1 66.5 64.2 68.3 70.6 71.3 Estonia 86.8 48.3 47.9 54.7 51.0 48.6 55.1 62.8 68.5 Latvia 50.4 32.1 39.3 44.2 44.1 48.8 56.6 62.6 64.6 Slovak Republic na 29.6 35.0 37.4 41.3 47.1 55.7 59.5 54.6 Bulgaria 46.8 47.0 46.3 38.6 40.0 45.0 51.5 54.2 51.7 Lithuania 88.5 66.9 30.1 36.4 33.4 32.5 38.0 50.1 47.9 Share of CEEC and CIS-oriented exports in total exports (%) Lithuania 7.3 24.9 65.0 57.0 61.3 61.1 53.7 39.6 na Slovak Republic na 60.6 55.3 54.6 51.3 46.3 39.0 33.6 na Estonia na 45.2 45.7 38.5 40.8 42.3 36.1 27.0 na Latvia 43.5 56.4 53.8 50.6 50.1 43.4 33.4 26.9 na Bulgaria 15.5 15.8 24.1 35.3 34.2 29.1 26.9 23.5 na Poland 14.3 12.5 14.8 18.2 21.2 25.0 22.4 18.3 na Note: CEEC = Central and Eastem Europe Candidate Countries. Source: IMF Direction of Trade Statistics 2.5 The comparison with the other accession countries indicates, however, that Lithuania relies less on EU markets than any other country in the group. Only about 48 percent of Lithuania's exports were directed to the EU in 2000 as compared to 64.6 percent in Latvia, 68.5 in Estonia and 71.3 in Poland. Therefore, it comes as no surprise that Lithuania occupies the top position in termns of the share of exports directed to the CEEC and the CIS. Preserving strong ties with the region will provide benefits in the long run since as these countries grow they will provide expanding export markets. However, the region may not experience a rapid growth in the short run, and thus it is important for Lithuania to be able to export to the EU in addition to keeping its regional ties. While Lithuanian exporters face stronger competitive pressures in EU markets, they face lower risks than in the CIS. Many exporters that failed to receive payments for their products after the Russian crisis are wary of returning to the eastern markets. 2.6 The volume of Lithuania's exports to the EU is smaller than that of the other counties in the region. Together the CEEC-10 accounted for 9.4 percent of EU external imports in 2000. Poland being the largest supplier in the group enjoyed a 2.2 percent share in total EU external 36 imports. The corresponding figures for the Baltic states are 0.31 percent for Estonia, 0.21 percent for Lithuania, and 0.18 for Latvia. Increased Processing Level and Changing Pattern of Specialization 2.7 Changes in the geographical patterns of trade have been accompanied by an increased processing level of exports and a change in export specialization. The developments in Lithuania's trade with the EU in terms of "end-use" categories suggests a clear expansion of trade in processed goods. The share of consumer goods, capital goods and automotive parts in both exports and imports has increased sharply. Their share in total exports rose from 57 percent in 1995 to 68 percent in 1999. At the same time, trade in less processed goods (foods, feeds and beverages, industrial supplies and materials) has dropped, with their combined share in exports dropping from 30 percent in 1995 to 22 percent in 1999. 2.8 The changes in Lithuania's basket of traded goods in terms of end-use categories is one manifestation of the ongoing industrial restructuring. Indeed, during the last decade Lithuania's trade has become more similar to thai of the EU in terms of end-use classification, indicating a significant shift in the structure of production and some degree of "convergence" towards that of the EU. Another sign of an ongoing restructuring is an increase in the share of capital goods in total imports, from 22.5 percent in 1995 to 27.1 in 1999. Nevertheless, this figures remains below the EU average of 33.5 percent. 2.9 Consistent with the observed increased processing Figure 2.1 Lithuanian Export Specialization Indices level of Lithuania's exports is --Wood products --Clothing the increase in share of - Textiles - Furniture - -A - Iron & steel ?A Electical machinery manufacturing products sent to Metal products - Chemical elements the EU. While in the early - Agric raw materials 1990s they constituted less than 5 a third of EU-oriented sales, they now represent close to 70 4 - percent. Much of this is due to growth in exports of clothing 3- _ and textiles, as well as in furniture and wood products- 2- Lithuania's two emerging areas e7 - _ of specialization. Lithuania - specialization indices in o - - _ - _ _ _ _ _ _ clothing (4.3) and in textiles 1992 1993 1994 1995 1996 1997 1998 1999 (3.4) are both very high (Figure 1.3), as is its specialization index in furniture, (3.5). All three categories can be thought of as highly unskilled-labor-intensive. Lithuania also has a very high specialization index in wood (5), a natural-resource-based sector. In contrast, Lithuania's specialization indices in capital and skilled-intensive sectors are all below 1. 2.10 How does Lithuania's export specialization compare to that of the other CEEC-10? In general, the three Baltic countries occupy the lowest ranking in terms of specialization in manufacturing products. They are the only three economies in the group for which the specialization index does not exceed unity. Lithuania's pattern of specialization is also similar to that of Latvia and Estonia in other respects. All three countries exhibit high and growing specialization in wood products and furniture, clothing and textiles, as well as in agricultural raw 37 materials. However, Lithuania has the highest specialization index in textiles and fabrics of all three, and in fact of all the CEEC-l 0. Other CEEC- 10 are also specialized in the areas mentioned above, but additionally they exhibit comparative advantage in such skilled-labor-intensive categories as metal products, electrical machinery and transport equipment. Changing Factor Content of Trade 2.11 Table 2.2 below further examines the factor content of Lithuania's trade. Lithuania has become much less reliant on natural-resource-based exports than in was in the past. While petroleum, agricultural raw materials and wood still play an important role in the country's trade, the share of natural-resource-based products decreased from three-quarters of total exports in 1993 to less than 37 percent in 1999. In contrast, unskilled-labor-intensive exports have gained rapidly in importance with their share rising from slightly over 11 percent in 1993 to 40 percent in 1999. Their export value almost doubled between 1995 and 1999, and their specialization indices have risen sharply. Clothing, textiles and furniture are the main products accounting for this change. As for capital- and skilled-labor-intensive exports, not much change has been registered between 1995 and 1999. While the combined value of exports in these categories increased by 5 percent, their combined share in total exports declined from 29 to 23.5 percent over the same period. Both categories of products experienced a decline in their export specialization indices. Table 2.2 Factor Intensity of Lithuanian Trade with the EU, 1992-99 Index in 1999 Factor intensity 1992 1993 1994 1995 1996 1997 1998 1999 (1995=100) Exports to EU ($ million) atural resource based 497 653 666 647 678 629 545 648 100.2 Uskilled labor intensive 37 98 196 322 438 541 648 701 217.5 Capital intensive 61 84 127 265 325 295 346 297 112.0 Skilled labor intensive 12 28 49 131 77 81 100 120 91.4 Capital and skilled labor int. 73 112 176 396 402 376 445 417 105.2 Composition of Exports to EU (%) Natural resource based 81.4 75.5 64.0 47.3 44.4 40.7 33.2 36.6 77.3 Unskilled labor intensive 6.1 11.4 18.8 23.6 28.7 34.9 39.5 39.6 168.0 Capital intensive 9.9 9.7 12.2 19.4 21.3 19.0 21.1 16.8 86.4 Skilled labor intensive 2.0 3.2 4.7 9.6 5.0 5.2 6.1 6.8 70.6 Capital and skilled labor int. 11.9 12.9 16.9 29.0 26.3 24.3 27.1 23.5 81.2 Export Specialization Index aturalresource based 2.3 2.2 1.9 1.4 1.4 1.3 1.2 1.3 93.9 nskilled labor intensive 0.4 0.8 1.3 1.7 2.1 2.5 2.7 2.8 158.6 Capital intensive 0.3 0.3 0.4 0.5 0.6 0.5 0.5 0.4 75.8 Skiled labor intensive 0.1 0.2 0.3 0.7 0.4 0.4 0.4 0.4 63.0 Composition of Imports from EU (%) Natural resource based 48.9 35.5 27.7 25.5 23.0 21.5 18.5 18.0 70.7 Unsldlled labor intensive 9.7 15.8 16.7 18.1 17.1 16.5 17.9 21.4 118.5 Capital intensive 25.8 24.7 29.0 30.9 33.3 31.7 33.5 36.3 117.5 Skilled labor intensive 12.8 23.7 26.4 24.2 26.0 29.5 26.3 22.1 91.3 Source: Based on the EUas a reporterfrom the UN COMTRADE Statistics 38 2.12 To put these finding into perspective, we compare them with the corresponding figures for Poland. During the last decade, Poland experienced an impressive increase in exports of capital- and skilled-labor-intensive products, with their share rising from about 31 percent of total exports in 1993 to 45 percent in 1998. The export specialization index for skilled-labor-intensive products increased from 0.75 in 1993 to 1.05 in 1999. In the case of Lithuania the index decreased from 0.7 in 1995 to 0.4 in 1999. As for capital-intensive products, the values of the specialization indices for the two countries remain more or less comparable. However, Poland is experiencing an upward trend while Lithuania is facing a downward drift. One reason for Poland's higher success in shifting its export composition towards skill and capital-intensive goods may be that is has received much higher FDI flows. These have brought along not only new capital investment, but also access to new technologies, and have greatly contributed to rising productivity among Polish foreign-earned firms. 2.13 More disaggregated trade statistics tend to reinforce these findings. If we examine Lithuanian export products to the EU at the four-digit Standard Industrial Trade Classification (SITC) level and rank them by their importance, we find that clothing (SITC 8411 and 8414) represents the top two categories accounting for almost 26 percent of total exports in 1999. Another unskilled-labor intensive product, furniture (SITC 8210), occupies the fifth place with 4 percent of total exports. The other top five products include natural-resource-based groups. Capital- and skilled-labor-intensive products are not prominent among the top export categories. There are only four capital-intensive categories among the top 15. These are nitrogenous fertilizers (SITC 5611), other fertilizers (SITC 5619), insulated wire and cable (SITC 7231) and transistors (SITC 7293). Together these groups account for 12.6 percent of the total. Skilled- labor-intensive products are represented by only three product groups in the list, namely, bicycles (SITC 7331), domestic electric equipment (SITC 7250) and iron and steel structures (SITC 6911). Together, they constitute only slightly more than 3 percent of all EU-oriented exports. 2.14 By all evidence, Lithuania has not been very successful at shifting its exports into skilled- labor and capital-intensive sectors, and it lags other EU accession candidate countries (except Latvia) in this regard. However, Lithuania started reorienting its trade towards EU markets later than the other accession countries. It has also received less FDI than other candidate countries, and has had relatively low private investment to GDP ratios. Thus, it simply may be slightly behind in its process of restructuring and transforming its trade patterns. If Lithuania manages to increase investment flows (both foreign and domestic) in the future, it is likely to experience a boost in exports of skilled-labor and capital-intensive goods similar to that experienced by Poland. Many Lithuanian firms have older machinery and equipment and lack access to cutting- edge technologies, which makes it difficult for these firms to compete in markets for skilled- labor-and capital-intensive goods. Since their in-house R&D capacities are often limited, their best strategy may be to receive foreign direct investment, which is often association with technology transfer. An alternative strategy may be to become suppliers of parts and components to multinational corporations. 2.15 There are some promising individual examples of firms which have managed to break into new export markets. For example, the furniture producer Vilniaus Baldu Kombinatas has been very successful breaking into international distribution networks via an association with IKEA. Similarly, Vilniaus Vingis, a large manufacturer of electronic components, has become a global exporter of TV tubes and parts. In both cases, links to international corporations have proved critical in gaining export markets. 2.16 For producers of apparel and clothing, two sectors in which Lithuania has a high comparative advantage, a promising avenue for maintaining competitiveness in the face of lower cost producers would be to take advantage of proximity to the EU to reposition themselves in a 39 higher value added segment of the industry. This would require moving towards shorter production cycles, more flexibility in meeting time-sensitive fashion requirements, and greater speed of delivery (Box 2.1). Such a shift certainly requires some investment in both human and physical capital, but this is clearly not beyond the reach of Lithuanian companies as the successful examples cited above demonstrate. Box 2.1 Moving Up the Value Chain in the Apparel Industry Competition from cheap producers in developing countries in textile and apparel industry has been increasing the pressures facing firms in industrialized countries. While relatively low wages currently assure competitiveness of transition economies in these sectors, preserving the competitive edge may become increasingly difficult as wages in continue to rise. Thus rather than fighting an uphill battle o competing purely based on costs, transition economies would benefit from repositioning themselves into a higher value added segment of the industry. The apparel industry can be thought of as consisting of three tiers: (i) lowest value added segment -standard products, such as for instance, generic white dress shirts; (ii) middle value added segment- time-sensitive products with some fashion content; and (iii) highest value added segment-top fashion designer clothing. The highest profits are to be made in designing and marketing rather than in apparel production. However, it may take a while for producers in transition economies to build up reputation that will allow them to supply the second tier of the market under they own brand names. Thus, an alternative strategy for these producers is to move from supplying the lowest value added segment to supplying foreign retailers in the middle tier. One of the recent developments in the middle tier of the apparel industry is product proliferation and shorter product cycles, which are reflected in quickly changing styles and product differentiation. These developments have contributed to general demand uncertainty for both retailers and manufacturers, therefore making demand forecasting and production planning more difficult. In a world where producers must supply an increasing number of products containing time- sensitive fashion elements, speed and flexibility have become crucial. Instead of making planning and production decisions based on forecasts and guesses made months in advance of a selling season, firms now received ongoing orders reflecting actual consumer purchases. Thus suppliers must be able to provide frequent deliveries, in smaller quantities and of more diverse products. Moreover, suppliers are expected to do it with a far greater level of accuracy in fulfilling orders and meeting delivery standards than in the past. In short, the retail revolution has altered the basic rules of global competition for the apparel and textile industry. In order to participate in this new system, a supplier must be able to: * Label, track and respond to product orders in real time on the basis of style, color, fabric, and size; * Exchange (send and receive) information concerning the current status of a retailer's products on an electronic basis; and * Provide goods to a retailer's distribution center that can be efficiently moved to stores-that is, containers marked with bar codes concerning contents; shipments of products ready for display in retail stores. The proximity to the European Union places transition economies at a great advantage and makes them primary candidates for becomning suppliers to middle-tier apparel retailers. Moving up this route certainly requires some investment in both physical and human capital. Yet as the example of the furniture producer Vilniaus Baldu Kombinatas indicates (see Box 3.2), this is not beyond the reach of Lithuanian comnpanies. While following this route carries some risks, not doing so may be an even more uncertain path. Source: Based on Abernathy et al. (1999) 40 Presence in Expanding Markets 2.17 What export categories have been the most dynamic in recent years and hence are likely to offer the best prospects for the near future? Among Lithuanian exports to the EU, those categories experiencing the fastest growth include (not surprisingly) clothing and textiles; furniture, and footwear. All these are unskilled-intensive goods. There are also a number of natural-resource based categories, including silver and platinum ores, oil seeds and a number of wood-related categories. However, two other groups deserve attention: insulated wires and cables, and television receivers, both of which are capital-intensive products and are examples of Lithuania's emerging integration into global production and distribution networks through FDI. For example, Ekranas, a company with foreign capital since 1996, is the largest TV exporter in the country accounting for 4 percent of Lithuania's total exports to the EU. The insulated wires and cables category includes exports of Baltijos Automobiliq Technika, a former subsidiary of Siemens AG, which manufactures cable harnesses for cars produced by Volkswagen, Renault and Seat. Recently the factory has been acquired by Japan's Yazaki, and has opened new facilities for producing cable harnesses for Renault Megane. 2.18 It makes a difference whether a country specializes in products for which import demand is growing or in products for which the import demand is either stagnant or contracting. The former, often referred to as sunrise sectors, offer greater room for expansion, whereas in the latter (sunset sectors) competitive pressures are on the increase. Therefore, prospects for expanding exports are likely to be better in sunrise than in sunset sectors. 2.19 For the purpose of this study, we defined sunrise markets in the EU as the four-digit SITC product categories in which the value of EU external imports was at least US$50 million in 1997 and the average annual growth rate over 1997-99 was equal to at least 10 percent. There are 101 product groups that fulfill these criteria. Fifty-five of these products are skilled-labor--or capital-intensive accounting for EU external imports worth almost US$213 billion in 1999. For comparison, there are only 46 unskilled-labor-intensive or natural-resource-based sunrise markets accounting for US$34 billion of imports. Thus, countries aiming to expand their exports to the EU markets might have a better chance of doing so in the skilled-labor- or capital-intensive products. 41 Box 2.2 Vilniaus Baldu Kombinatas As the case of Vilniaus Baldu Kombinatas (VBK) demonstrates, establishing commercial ties with a multinational corporation may be a successful strategy for integrating into a global distribution network. VBK had been established as a small workshop over a hundred years ago and since then it has become one of the largest furniture producers in Lithuania. The company produces both home and office furniture. It has its own retail network selling about 7 percent of the output. Since the Lithuanian furniture market is too smnall to support a company of the size of VBK, the firm has to rely on exports. About 93 percent o VBK production is exported to Sweden, Germany, Belgium, Great Britain, Canada, US and France. About 90 percent of output is sold to the Swedish company IKEA, which in 1999 named the VBK its best supplier in the Baltics. The relationship between VBK and IKEA began in 1998 and the cooperation between the two companies has been very close ever since. IKEA has provided support to VBK in terms of technology, production organization and personnel training. VBK is connected to the IKEA's computer system through which invoices as well as payment and delivery information are being processed. Currently, VBK is upgrading its computer system so that in the future it will be able to receive daily information on sales of its products in IKEA stores abroad. Thanks to the upgraded system, orders will be placed daily rather than every few weeks as is currently the case. While relying so strongly on one customer may be perceived as a risky strategy, VBK is not very concerned as it is one of the top 25 IKEA suppliers (out of 2000 companies producing for the Swedish concern). Moreover, closer technological integration with IKEA will make VBK more competitive vis-a- vis other IKEA suppliers. VBK is the only company in Lithuania to be so closely integrated in the IKEA system. Source: Chapter 3, The Background Paper Volume. 2.20 To examine in which of the EU sunrise markets Lithuania has been successful, we restrict our attention to products categories in which Lithuania exported at least US$1 million worth of goods in 1997 and for which the average annual growth rate of exports was above 5 percent during 1997-99. Fourteen products fulfill these criteria, accounting for 11.5 percent of Lithuanian EU-oriented exports in 1999 (Table 2.3). Among these product categories we find only two natural-resource based categories (SITC 2218 Oil seeds and SITC 6321 Boxes and Crates). There is also a clear under-representation of light industries in the list. Only two textile categories (SITC 6533 Linen and SITC 6566 Blankets) are among sunrise markets in the EU. None of the clothing categories enjoyed a dynamic enough growth rate in the EU external imports to qualify for the name of a sunrise sector. However, one important Lithuanian unskilled- intensive category is indeed on the list. This is SITC 8210, Furniture, which is one of the sectors with a very positive outlook for the future (Box 2.2). Exactly one half of these sunrise sectors are skilled-labor and capital-intensive. Insulated wire and cable (SITC 7231), ranks second in terms of export volume in 1999. Other products in the group include television receivers (SITC 7241), medical instruments (SITC 8617) and telecommunication equipment (SITC 7249). 2.21 To put Lithuanian performance in perspective, we applied the same criteria to Estonia, Latvia and Poland. The results presented in Table 2.3 are consistent with our earlier findings. In terms of export performance in EU sunrise markets, Lithuania ranks higher than Latvia but lags behind Poland and Estonia. In 1999, Lithuanian exports in sunrise markets accounted for 11.5 percent of total EU-destined sales; the corresponding figures were equal to 34 percent for Poland and 22.4 for Estonia. Latvia's performance is less impressive with only 9 percent of exports falling into the sunrise category. 42 Table 2.3 Presence of Lithuanian and Other Selected Country Exports in EU Sunrise Markets EU SunriseProduct/a (SITC-4Rev.1) 1992 1993 1994 1995 1996 1997 1998 199 Latvian Exports Value of sunrise exports to EU (US$ million) 17 32 28 38 36 51 105 148 Share of EU-destined total exports (%) 3.3 3.5 2.2 2.3 1.9 2.7 5.9 9.2 Growth rate of sunrise exports -%) 89.2 -13.7 38.7 -5.4 42.0 105.0 40.8 Lithuanian Exports Value of sunrise exports to EU (US$ million) 11 18 32 68 94 128 164 204 Share of EU-destined total exports (%) 1.7 2.1 3.1 5.0 6.2 8.3 10.0 11.5 Growth rate of sunrise exports (%) 73.0 78.3 108.6 39.3 35.6 28.5 24.0 Estonian Exports Value of sunrise exports to EU (US$ million) 30 26 71 118 165 246 423 452 Share of EU-destined total exports (%) 8.7 8.4 9.6 9.0 10.4 13.1 20.8 22.4 Growth rate of sunrise exports (%) -13.9 174.0 66.6 40.2 49.0 72.2 6.9 Polish Exports alueof sunrise exports to EU (US$ million) 1719 2104 2496 3804 3951 4188 5398 6365 Share of EU-destined total exports (%) 16.6 21.1 20.7 23.7 25.2 25.8 29.5 33.8 Growth rate of sunrise exports (%) 22.4 18.6 52.4 3.9 6.0 28.9 17.9 Notes: See Chapter 3, The Background Paper Volume for details on calculations. Source: Based on EU as a reporter from the UN COMTRADE Statistics. Participation in Production Networks 2.22 International trade over the past decade has been characterized by fragmentation of production and creation of distribution networks spanning across continents. Thanks to technological progress and information revolution it has become possible to divide the industry's value chain into smaller functions that can be contracted out to independent suppliers. This fragmentation of production offers a unique opportunity for producers in small countries to move from servicing small local markets to supplying large multinational firms and indirectly their customers all over the world. This phenomenon is accompanied by an evolution in the nature of competition with its growing emphasis on customization of products, rapid innovation, flexibility and fast response to changing demand. In many cases, managerial and technological skills required to successfully compete in global markets make it impossible to rely on the resources of one country. Under these circumstances, integration into the production and marketing arrangements of the multinational corporations (MNCs) has become the most efficient way of taking advantage of growth opportunities offered by the global economy. 2.23 Incorporation of local producers into production and marketing networks could extend significant benefits to both Lithuania and MNCs. For the latter, it would offers a wider menu of choices in the strategies to expand their position in global markets and the option of lowering costs by moving some production segments to the region. For Lithuania, this arrangement could also yield several advantages. Presence of MNCs is usually accompanied by transfer of technology and managerial know-how with potentially significant demonstration effect. Ties with MNCs could give Lithuanian firms direct access to larger markets and thus bring benefits of economies of scale. They could boost exports without local firms having to incur marketing expenses and provide greater stability in earnings thanks to a global reach of a "parent" company. 43 The expansion in network-driven trade could contribute to boosting productivity and integrate the national economy into global markets. 2.24 To capture this kind of trade, Kaminski and Ng (2001) identify parts, components and final products in three networks usually organized around MNCs-automotive network; 'information revolution' network (telecommunication equipment, office equipment and automatic data processing machines); and furniture network. These networks have played a growing role in trade between the 10 accession candidate countries (CEEC-10) and the EU. 2.25 A comparison of CEEC-10 in termns of their participation in the international division of labor suggests that Hungary and Slovakia are the most integrated economies, with shares of network related exports in total non-chemical exports of 42 percent in 1998. Estonia and Slovenia follow with shares of 34.2 and 32.5 percent, respectively. The corresponding figure for Poland is 30 percent.'6 Lithuania is ranked 7' out of ten countries, with less than 10 percent of non-chemical manufacturing exports being network-related. It lags far behind Estonia but it is ranked above Latvia. 2.26 To learn more about Lithuania's participation in the international division of labor, we examine the development of each network over the recent years. Table 2.4 indicates that Lithuania has been focusing on the furniture and information revolution network, which accounted respectively for 6.8 and 4.6 of non-chemical manufacturing exports in 1999. Participation in automobile network has been less impressive, even though insulated wires and cables produced within the network are among one of the most dynamic export sectors in the country. The overall importance of networks in Lithuanian trade has been increasing. Their combined export share has risen from 8.6 percent in 1993 to almost 10 in 1997, and to 12.6 in 1999. For case studies of firms involved in the international production and distribution networks see Box 2.2 and Box 2.3. Table 2.4 Lithuanian Participation in the EU Production and Marketing Networks, 1993, 1997-99 Automobile Information Revolution /a Furniture Total Product (Value in million of$): 1993 1997 1998 1999 1993 1997 1998 1999 1993 1997 1998 199 1993 1997 1998 1999 Final goods exports 2.5 1.2 3.0 9.9 0.3 6.8 7.4 10.6 9.6 24.1 33.4 52.9 12.4 32.1 43.8 73.4 arts & Components exports 0.5 0.8 1.0 1.7 0.4 37.5 35.6 38.3 0.6 9.6 13.3 18.9 1.5 47.9 50.0 58.8 Parts & Components imports 15.2 88.8 44.9 32.3 6.3 45.4 38.6 44.1 1.3 6.2 8.9 8.0 22.8 140.4 92.4 84.3 Final goods imports 80.3 228.5 227.0 94.0 7.4 72.9 85.7 51.4 8.2 18.9 19.5 16.6 95.8320.4332.3 161.9 Final goods exports minus -12.7 -87.7 41.9 -22.4 -6.0 -38.5 -31.2 -33.5 8.3 17.9 24.5 44.9 -10.4 108.3 -48.5 -11. parts & comp. imports Memo: Shares of final goods, parts & components in trade with EU: % in manufacture exports /b 1.8 0.2 0.4 1.1 0.4 5.4 4.4 4.6 6.4 4.1 4.8 6.8 8.6 9.8 9.6 12. /o in manufacture imports /b 27.3 18.7 15.1 8.4 3.9 7.0 6.9 6.4 2.7 1.5 1.6 1.6 33.9 27.1 23.5 16.4 Notes: /a Includes office machinery and telecommunication equipment/b Exclude chemicals. Source: Based on EU as a reporter from UN COMTRADE Statistics 16 For more details on the Hungarian case see Kaminski and Riboud (2000). The case of Poland is discussed in Kaminski and Smarzynska-(2001). 44 Box 23 Vilniaus Vingis Vilniaus Vingis (W) is an example of a Lithuanian company that has been successful at integrating into the global production and distribution networks. W is one of the largest manufacturers of electronic components in Central and Eastern Europe. The company's main products include deflection yokes for color picture tubes and flyback transforners for TV sets and monitors. Yokes account for about 85 percent of total output. The company was established in 1959 as a state-owned enterprise producing radio components. Manufacturing of deflection yokes began in 1976. Ten years later the company acquired the technology and equipment for manufacturing deflection yokes from the American concern RCA. In 1993 the company was privatized and three years later it became a supplier of Samsung, Germany. 1998 marked the beginning of production of deflection yokes for 21 " screen color picture tubes for Philips Components. A year later, mass production of mini neck deflection yokes for Philips and Chunghwa Picture Tubes commenced. In 2000, mass production of 29" deflection yokes was introduced. Samsung purchases about 37 percent of yokes produced by VV. The yokes are used by Samsung in the production of TV tubes which in turn become part of TV sets assembled by Sarmsung and Philips. Another 30 percent of yokes are sold to a Lithuanian comnpany, Ekranas, where they become part of assembled TV sets sold abroad. Ekranas itself accounts for 4 percent of Lithuania's total exports to Western Europe. Ten percent of VV's output is exported to Philips, Barcelona and 7 percent to Philips, England. Another 10 percent is shipped to Thomson Polkolor in Poland where it becomes part of TV tubes sold all over the world through Thomson's distribution network. VV is growing rapidly, with its sales increasing from 28 million Litas in 1994 to 63 million in 1997 and 135 mnillion in 2001. The company's profits have also been growing from 0.8 mnillion Litas in 1996 to 3.3 million in 1998 and 9.1 million in 2000. Production of TV comnponents is a very competitive businesses where achieving the international quality standards is crucial. To remain competitive W purchases foreign technology licenses as well as performs in house R&D. The company holds nu-merous quality certificates, including ISO 9001, ISO14001, BSI (UK), UL (USA) and VDE (Germany). It also places strong emphasis on training. In 2001 about a third of its employees received some kind of training. Source: Chapter 3, The Background Paper Volume. B. THE ROLE OF FOREIGN DIRECT INVESTMENT 2.27 One reason why Lithuania may have been less involved in global production networks than other CEEC-10 may be FDI. Unlike in other accession countries, significant FDI inflows did not take place until late 1990s, and while FDI activity picked up during 1998-2000, in total Lithuania has received less FDI than the other accession countries. In terms of cumulative FDI inflows per capita during the period 1993-2000, Lithuania ranks eighth above Bulgaria and Romania with 658 dollars per person (see Figure 2.2 below). The corresponding figures are 2,085 dollars per capita in the Czech Republic, 1,580 in Estonia and 1,015 in Latvia. In terms of the value of cumulative FDI inflows, Lithuania ranks above Slovenia, on par with Latvia and slightly above Estonia. 2.28 In terms of the sectoral distribution of FDT, much of it originally was in manufacturing (44 percent in 1996). After large inflows into telecommunications and financial sector, this figure decreased to 32 percent in 2000. When the number of projects is taken into account, manufacturing accounted for 20 percent of projects in 1996, and 21 percent in 2000. Within manufacturing, food products, beverages and tobacco have attracted the largest share of investment (12 percent of total FDI stock), followed by textiles and leather products (4 percent), and refined petroleum and chemicals (4 percent). Electrical machinery and optical instruments as well as wood products also received significant foreign investments. As for service sectors, wholesale and retail trade accounted for a quarter of FDI stock in 2000, telecommunications for 18 percent, and financial intermediation for 14 percent. While FDI projects in services will not directly contribute to an increase in Lithuanian exports, the presence of foreign service provides 45 is likely to improve competition'7 and the quality of services provided, thus contributing to lower cost of doing business in Lithuania and attracting further investments in manufacturing sectors. Presence of MNCs in service sectors may signal improved business climate to potential investors. Figure 2.2. Cummulative FDI Inflows Per Capita 1993-2000 2,500 - 2,000 _ 1,500 F *FDI percapita ; 1,000 * * _* 500 1111111 2.29 As far as the ownership structure of FDI projects is concerned, on January 1, 2000, about 31 percent of investment stock was comprised of projects fully-owned by foreign investors, 46 percent of majority-owned, and in only 23 percent of cases foreign investor held no more than half of the shares. An increasing share of fully-owned projects is a positive development as according to recent research (Smarzynska 2000) such projects present a greater potential for transfer of cutting-edge technologies to a host country than projects with shared ownership. 2.30 FDI recipients, defined as firms with at least 10 percent share of foreign capital, have been increasingly involved in exporting activities. In 2000, they accounted for by 56.5 percent of Lithuanian exports, up from 41.6 percent in 1996. They were also responsible for 52 percent of total imports in 2000, a significant increase from 40 percent in 1996. In 15 out of 47 two-digit NACE sectors, enterprises with foreign capital were the source of more than half of total exports (see Chapter 3, The Background Paper Volume). In computers and electrical machinery, such firms were responsible for 86 percent of foreign sales. They accounted for almost three-quarters of exports in radio, TV and communications equipment and over 60 percent in machinery and transport equipment. These are precisely the sectors in which intemational production and distribution networks are prevalent. Firms with foreign capital can also be found in unskilled- labor-intensive and natural-resource-based sectors, such as textiles or food and beverages, where they are the source of 60 percent of exports. In the apparel sector, which alone accounts for a quarter of Lithuania's sales to the EU, firms with foreign capital are responsible for 49 percent of foreign sales. The apparel industry is also the sector with the largest volume of exports coming from firms with foreign capital (US$210 million in 2000). 7 With the exception of sectors where foreign investors enjoy monopolies, as for instance is the case in provision of fixed telephone lines. 46 2.31 Since participation in international production and distribution networks is also associated with significant flows of imports, it comes as no surprise that FDI recipients account for large shares of imports in radio, TV and communications equipment, transport equipment, computers and machinery. The same is true for textiles and wearing apparel. 2.32 There is no significant difference between foreign and domestic companies as far as the geographic composition of exports is concerned. Enterprises with foreign capital sold 47 percent of their exports to the EU, as compared to 49 percent for domestic firms. For both types of companies the share of EU-destined exports has been growing reflecting the overall developments in Lithuanian exports. A more detailed discussion of the contribution of enterprises with foreign capital to Lithuania's export performance, based on micro-level data, is presented in the following section C. DETERMINANTS OF EXPORT AND PRODUCTIVITY PERFORMANCE: EVIDENCE FROM FIRM-LEVEL DATA 2.33 The previous section used aggregate and sector-level data to document the profound changes that have taken place in the composition of Lithuania's trade. The purpose of this section is to use information on individual enterprises to gain a better understanding of the factors influencing firm productivity and the exporting process. The data used for this purpose come from the Annual Enterprise Survey conducted by the Lithuanian Statistical Office. A random sample of firms is surveyed annually with the sample size varying from year to year (from over 12,000 in 1996 to 21,000 in 1999). The survey coverage is extensive, as firms accounting for about 85 percent of output in each sector are included in the sample. These data constitute an unbalanced panel spanning over the period 1996-2000. The 1999 coverage is the most extensive, as in that year the survey was supplemented with the information obtained from other sources (e.g., enterprise registry, tax records). In addition to standard financial statements, the dataset contains information about the share of exports in a firm's turnover, which allows us to compare exporting firms with non-exporters. There is also information about the amount of foreign capital, if any, that has been invested in each firm.'8 Are Exporters Different? 2.34 Consistent with earlier findings, the largest number of exporting firms can be found in the labor-intensive and natural-resource-based sectors. These are wood products, food and beverages, apparel, furniture and textiles. Not surprisingly, we find that 61 percent of all firms in the textile industry are engaged in exporting. This is also true of almost half of the firms in the wood sector. 2.35 We find that exporters tend to be much larger than non-exporting enterprises. Exporters' sales, fixed assets and total capital are more than sevenfold these of non-exporters. Not surprisingly, exporting firms also tend to be larger in terms of employment. Further, the presence of foreign capital is greater among exporters. Almost a quarter of exporting firms in 2000 received some foreign investment as compared to only 8 percent in the case of non-exporters. IS See Chapter 4, The Background Papers Volume for a detailed discussion of data, methodology and results. 47 2.36 Differences between exporters and non-exporters are robust to controlling for industry and regional differences. In 2000, for example, controlling for industry and region, an exporting firm had on average a 130 percent larger employment size than a non-exporter. Controlling for firm size, industry, and region, we find that exporters have larger sales and a higher capital-labor ratio than non-exporters. On average, exporting firms are 43 percent more productive than non- exporters. Exporters also tend to pay higher wages with a wage premium of over 40 percent (Table 2.5). These findings are consistent with those observed in the US, however, the differences between exporting and non-exporting firms are more pronounced in Lithuania. Table 2.5 Differences in Performance between Exporters and Non-Exporters (exporter premium, in %) Without controls forfirmn size: With controls forfirmn size: 1996 1998 2000 1996 1998 2000 Employment 170 155 130 Sales 317 280 244 62 62 55 Average wage 55 52 52 45 46 40 Capital-labor ratio 67 75 77 47 56 51 Productivity 47 45 46 46 46 43 Note: The values are based on coefficients on an export dunmny in a regression of the following forn: In X(i) = a + b*Export(i) + clndustry + d*Region + e(i) in colurnns (a)-(c) In X(i) = a + b*Export(i) + c*Industry + d*Region + f*ln(Employment) + e(i) in columns (d)-f) Source: Chapter 4, VoL 11. 2.37 The likelihood of exporting increases with firm size. In 2000, for instance, 72 percent of large firms made sales abroad, as compared to 49 percent of medium-sized and 36 percent of small enterprises. Not surprisingly, only 13 percent of micro firms were engaged in exporting. However, we cannot attribute these findings to differences in productivity, since productivity does not seem to vary systematically with firm size (Table 2.6). The relationship between firm size and the probability of exporting may be due rather to the high cost of entering foreign markets. Smaller firms may not have enough resources to invest in expanding their sales abroad. They may also be too small to become viable trading partners for foreign customers. Larger firms, on the other hand, not only have the necessary resources but they can often rely on contacts and knowledge acquired while exporting before 1991. Table 2.6 Average Productivity in Manufacturing Sectors Number of Employees 1-10 11-50 51-100 101 ormore All firms 1996 0.81 0.70 0.69 0.72 0.74 1997 1.52 1.33 1.31 1.27 1.38 1998 1.55 1.30 1.20 1.24. 1.36 1999 1.28 1.26 1.25 1.16 1.26 2000 1.33 1.36 1.42 1A9 1.37 Total 1.31 1.21 1.20 1.16 1.24 Source: Annual Enterprise Survey. Statistics Lithuania. Bank staff calculations. To Export or not to Export? 2.38 What factors determine a firm's decision to export? To investigate this we estimate an econometric model with the dependent variable reflecting a firm's exporting behavior. Since the literature emphasizes high costs of becoming an exporter, we would expect that firms which made sales abroad in the previous year are more likely to do so in the current period. Further, since the existing studies show that more productive firms are more likely to export, we also 48 control for a firm's productivity.19 Additionally, we add controls for firm size as measured by employment. Since recent studies show that FDI recipients are more likely to export than fu-ms without foreign capital (Kraay et al., 2001), we also control for foreign capital participation. Finally, we add year and industry dummies. Year dummies capture changes in economic conditions of export markets, which affect demand for exports. They also capture movements of exchange rates and changes in barriers to trade. Industry dummies control for the fact that trade barriers (e.g., anti-dumping proceedings) and demand fluctuations may vary by industry. 2.39 The results of this exercise demonstrate that firms which exported in the previous period are 59 percent more likely to make sakes abroad in the current year. We also find that larger and more productive firms are more likely to engage in exporting. More specifically, there is a significant positive relationship between firm productivity in the previous period and the probability of exporting in the current year. The latter observation confirms the findings from other countries that firms with superior performance become exporters (Bernard and Jensen, 1999). Further, the results indicate a positive relationship between foreign investment and exporting. FDI recipients are 6 percent more likely than purely domestic firms to engage in exporting.20 Both minority and majority foreign ownership have a statistically significant positive impact on the probability of exporting, but the impact is larger in the case of minority stake. When the. controls for industry effects included, only minority ownership matters for the decision to export. Based on these results, we conclude that it is the presence rather than the extent of foreign capital that matters for the exporting decision. Even firms with minority foreign stake may benefit from their foreign partner's contacts abroad. Does Exporting Increase Productivity? 2.40 The results so far indicate that more productive firms become exporters. But, conversely, is a firm's productivity growth enhanced by the exporting experience? There are several reasons to believe that this may be the case. For example, firns may learn about new technologies from their foreign buyers who share their product designs and production techniques. Foreign buyers may also have higher quality requirements, thus forcing suppliers to invest in technology upgrading.2' 2.41 Indeed, the econometric analysis shows that exporting has a beneficial impact on productivity growth. We find that firms that have either continued to export or have begun exporting during the period in question enjoyed on average a 38 percent higher annual productivity growth than non-exporters. However, we do not find any difference between firms that ceased their exporting activity and the base category of non-exporters. Further, continuous exporters saw their employment and sales increase 39 and 41 percent faster than non-exporters. For new exporters (starters), the corresponding figures were 40 and 44 percent, respectively. As for the changes in average wage, firms in all three categories seem to have done better than non- exporters. In sum, exporting has a significant beneficial impact on growth of enterprise productivity, sales and employment. The results also suggest that firms that received FDI by the end of 1996 have outperformed those without foreign capital in 1996.22 '9 See Roberts and Tybout (1997) and Bernard and Jensen (1999). 20 The term FDI recipients is defined broadly as it also encompasses filly owned greenfield investments made by multinational corporations. 2" Clerides, Lach and Tybout (1998) present empirical evidence of learning by exporting. 22 Note, however, that we are not controlling for the fact that multinationals may have invested in firms with better prospects to begin with. 49 2.42 All in all, the evidence points to the existence of a virtuous cycle between exporting and productivity. More productive firms are more likely to export and continuous exporting leads to faster increases in productivity. Thus, making the business environment more conducive to exporting can have a positive impact on the productivity growth in Lithuania. Are Firms with Foreign Capital Different? 2.43 In terns of distribution of foreign capital across firms of different sizes, we find that large firms were most likely to receive FDI. In 2000, firms with foreign capital accounted for a third of large enterprises, as opposed to one-fifth of medium-sized companies and 11 percent of small firms. Only 6 percent of micro companies were FDI recipients. However, when we restrict our attention to firms with foreign equity participation, we do not observe large differences in the average share of foreign capital between different enterprise groups. 2.44 FDI may be a source of numerous benefits to a host economy. Foreign investors not only bring capital, but also new technologies, know-how, management techniques, marketing skills and access to international production and distribution networks (see Blomstrom and Kokko, 1997). Thus, it is not surprising that numerous studies have found that firms with foreign capital enjoy higher productivity than domestic firms (see Aitken and Harrison, 1999; Djankov and Hoekman, 2000; Evenett and Voicu, 2001). Lithuania is no exception. Econometric analysis on our sample of firms shows that those with foreign capital are more productive than purely domestic firms. Further, we find that the benefits of majority foreign ownership exceed those from minority stakes. The latter finding is not surprising in the light of recent findings for transition economies, which suggest that wholly-owned subsidiaries present a greater potential for technology transfer than investment projects with partial foreign ownership (Smarzynska, 2000). 2.45 Other benefits often attributed to FDI are the so called spillover effects, or in other words benefits accruing to local firms from presence of multinational in their sector or region. Spillovers may take place through several channels. Local companies may learn about the existence of new technologies from observing activities of foreign firms. Foreign firms may offer sales of products and services embodying new technologies that were not previously available in the country. Local firms may also benefit from hiring workers previously trained by multinationals. Finally, local suppliers may benefit from technical assistance and management advice provided by their multinational customers. We do not find evidence of spillovers from FDI in the same sector. However, we do find evidence of spillovers from FDI presence in the same region. In other words, the results suggest that, controlling for other factors, domestic firms located in regions with larger foreign presence tend to be more productive. D. SUMMARY AND CONCLUSIONS 2.46 During the past five years, Lithuania has made significant progress in geographic reorientation of exports from its traditional trading partners in the East towards more competitive markets of the European Union. This process was accompanied by changes in the product composition of trade with increasing share of manufacturing exports. However, in terms of the factor content of trade, recent developments have been less encouraging. While the share of natural-resource-based exports has declined dramatically, it has been replaced solely by unskilled-labor-intensive products. Little change has been registered in skilled-labor-and capital-intensive exports. Lithuania appears to be lagging behind many other Central and Eastern European countries in this regard. It also lags behind in exports to markets with high growth potential, and in participation in international production and distribution networks. The slower progress of Lithuania can be largely attributed to low inflows of FDI relative to CEEC-10, and to 50 the fact that they started the restructuring and trade reorientation process later than other countries. 2.47 Firm-level evidence suggests there exists a virtuous cycle between productivity and exporting. More productive fi-ms are more likely to export and at the same time exporting contributes to a faster productivity growth. Exporting thus provides an excellent vehicle for long- termn expansion and growth. However, the costs for an individual firm of becoming exporter are quite high, as significant investment in gathering information about new markets, advertising and reputation building is required. Moreover, the costs of purchasing and developing technologies that are competitive may be prohibitive for many smaller Lithuanian finrs. In this context, measures aimed at reducing the costs of entering export markets, and at facilitating exporting may have large payoffs. 2.48 Attracting FDI may be another way to support exports and increase productivity growth. As our analysis shows, firms with foreign equity participation are more likely to export than firms with purely domestic capital. Moreover, firms with foreign capital also tend to be more productive, which makes them more likely to enter foreign markets. In addition, FDI appears to have some positive regional spillover effects. Lithuania's export performance could thus be greatly enhanced by larger FDI inflows, which would contribute to the restructuring of the economy and allow the country to catch up with the leaders of the CEEC-lIO group. 2.49 More broadly, Lithuania can support its exports by creating an environment that is conducive to rapid productivity growth. A favorable business environment, with low barriers to entry and operation for SMEs is critical (See Chapter 5). But so are govemnment efforts to increase the quality of public services necessary to support private sector development: an adequate legal framework; good quality infrastructure and communication services; and solid education, health and social protection systems. Measures to ensure that the labor market functions efficiently and allows labor to flow freely to higher productivity uses; and policies to equip workers with the skills demanded by a competitive, open economy are also essential (Chapter 4). 2.50 In addition to these broad measures, some more specific policy interventions could help reduce exporting costs for small and medium firms. These could include: Measures aimed at increasing information flows to SMEs. Since high costs of gathering information about foreign markets often prevent small and medium-sized enterprises from exporting, well functioning government programs subsidizing participation of SMEs in international trade fairs and business shows can reduce this burden and thus contribute to increase export participation of SMEs. It is important that such programs be widely advertised and not be associated with excessive administrative costs on the part of SMEs; * Another possible policy initiative aiming to boost foreign trade is to create an internet portal for potential foreign customers, which would list information about Lithuanian SMEs and their products available for exports. All the information would be presented in English and possibly other languages. Ideally, the portal would be created in cooperation with foieign business associations or chambers of commerce whose intemet sites would include links to the Lithuanian portal. This initiative could be carried out by a government agency or a Lithuanian business association given the necessary govermment funding. The service would be available to Lithuanian SMEs for a nominal fee; 51 * As the analysis has shown, only more productive firms are able to sell abroad, thus policies aimed at enhancing productivity will have a positive impact on exporting. Subsidies covering part of the cost of obtaining ISO 9000 quality certifications (for instance, consulting fees) may be very beneficial, especially if aimed at SMEs. Such a program, however, must not be associated with a large administrative cost for the applicants. 52 3. AGRICULTURE AND THE RURAL SECTOR23 3.1 Since regaining independence in 1990, Lithuania has made substantial progress in reformring its agricultural sector. One of the most significant steps has been the privatization of vast tracts of farmlands, which has led to the creation of hundreds of thousands of small family farms and hundreds of larger agricultural enterprises. However, adjustment to the new market environment has not been a smooth process, and in many aspects reforms remain incomplete. Although only 19 percent of all farmland is still controlled by the State, numerous restrictions on land and land use remain, including prohibitions against ownership by foreigners or legal entities. In addition, limited availability of rural finance has severely inhibited sector's abilities to service the investment needs of a modernizing farm economy and agro-industrial complex.24 These impediments have created an uncertain climate for investment. They have effectively deterred capital inflows and investment in rural economic activity, and have dissuaded modernization and dynamic efficiency. Moreover, the agricultural sector is still guided by policy induced distortions to agricultural producer incentives, which are highly detrimental to the sector's performance. 3.2 Government farm support has been erratic, inhibiting efficient resource allocation and adding to the sector's uncertainty. Since 1996, producer incentives have deteriorated sharply, with the farm gate price index declining 35 percent; and the purchased input price and farm wages indices increasing by 16.2 percent and 101 percent, respectively. Most family farms are not efficient compared to their European Union (EU) counterparts, and for many, small farm size limits investment potential and productivity gains: Also, hindering the family farm's modernization is its additional social burden as a rural safe haven for the aged and the underemployed. At the same time, hundreds of agricultural enterprises, saddled with high labor costs and outdated facilities have fallen into bankruptcy. As a result, more than 50,000 salaried farms workers have lost their jobs. 3.3 EU accession and entry into the single market holds great promise for the agriculture sector, yet also presents huge challenges. The change in the incentive regime is expected to have significant effects on farm prices, incomes, capital formation in agriculture and land values. The family farm sector as a whole will benefit, but many of the existing family farms will disappear as consolidation takes hold. With the loss of domestic subsidies, many agricultural enterprises will likely disappear as well. This will result in further labor shedding, and put additional pressure on rural unemployment. The social consequences of this process could be large. Rural poverty in Lithuania is already high, and much of it is concentrated in low-skilled workers with scarce prospects of finding employment elsewhere. The rural population is also aging, and a sizeable fraction lives on fixed-incomes (pensions). As food prices are expected to increase with EU accession, many of these fixed-income households could experience sharp drops in real income. 23 This is a summary of the work carried out by Anne Marie del Castillo (C) and presented in Chapter 8, The Background Papers Volume of this study. Richard Burcroff (C) assisted with the final version. See also Chapter 1, and The Background Papers Volume, Chapter 9 (by Diane Steele). 24 A law on Land Management and Administration in under preparation, which will remove some of the above- mentioned rigidities. Amendments to Article 47 of Lithuania's Constitution also are being considered, to enable national legal entities and, eventually, foreigners to acquire agricultural land. 53 Some of the poorest rural households could see their real incomes decline by as much as 10 percent. 3.4 Over the longer term, the success Lithuania will ultimately realize while addressing these issues largely depends on how two seeming contradictory roles are managed for the agricultural sector and rural industries. On the one hand, their soon-to-come role as income generating sectors in the Lithuanian economy, fully integrated into the EU's "single market", essentially self- sustaining and contributing positively to overall economic growth, requires as sine-qua-non sustained increases in productivity. But the mandates of an effective technology transfer and modemization in Lithuania's agricultural complex involve continuing investment and capital formation in these sectors, backstopped by technical and management education for farm and enterprise managers, the upgrading of farmer and worker skills and an expanded use of modem inputs. On the other hand, their current role as de facto guarantor of the social safety net for pensioners and other emigrants from urban areas in the 1990s has funneled household (and enterprise) savings - needed for modemization - into essentially consumption activity, in order to top off and sustain household members in poverty or who depend on statutorily fixed incomes.. .incomes that have witnessed substantial erosion. 3.5 But agriculture must modernize. Indeed it will have to modemize for the Lithuanian economy to avail of the benefits, transfer payments and rural investment funds associated with accession to the European Union. As modernization wili foster the uptake of essentially labor saving techniques, one result will be a fairly profound shedding of labor, while the rural "sector" adjusts to the Community's price structure and supports for primary and processed commodities.25 In the absence of a rapid increase in investments in rural-based industries and other employment generating activities, a large pool of rural un(der)employed could emerge fairly quickly following accession, unless the farm and rural business environment can be set right in the meantime, thereby stimulating a fairly quick and strong investment response for the development of off-farm work places in rural areas. This will not be an easy task, but it is an essential one. With sufficient political will, it also is a quite doable task as most of the policy, legal, regulatory and institutional requisites already are known A. AGICULTURAL PERFORMANCE AND PRODUCTMITY Sector Performance 3.6 In the Soviet era, Lithuania's agricultural production was stimulated by the familiar combination of fuel and input subsidies, low apparent labor costs, excessive investment in vintage farm machinery as well as agro-processing facilities (also mostly embodying obsolete technology), non-existent capital charges, and guaranteed markets - internal and well as external - the latter mainly to CMEA countries. By the time Lithuania declared independence from the FSU, the agricultural sector had expanded well beyond any financially sustainable size. Following the shift towards a market driven sector in the 1990s, a literal implosion has occurred in agriculture, as the sector sought more sustainable levels of output and more efficient input combinations. 3.7 During the last decade, the agricultural sector's contribution to GDP has declined from 27.6 percent in 1990 to 7 percent in 2001 Within the sector, adjustments equally profound also occurred. By 2000, three commodities represented 64 percent of total value of production: grains (28.7 percent); meat, including beef, pigs and poultry (17.8 percent); and milk (17.7 percent). 25 In particular by upgrading quality and improving cultivation, handling and processing technologies to satisfy the EU's stringent phytosanitary requirements. 54 Other important activities included: potatoes (13.0 percent); fruit and vegetables (8.8 percent); and sugar beets (3.4 percent). 3.8 With the advent of scarcity pricing, or at least of prices determined more by market conditions and less by overwhelming command and control, there also was an adjustment in the commodity composition of value added. In the early 1990s, the share of value added in the output value of milk, meat and other animal products was much higher than were corresponding shares of wheat and other food and industrial crops. By the end of the decade, however, the situation had reversed. In the year 2000, value added in milk production accounted for only 6 percent of the total value of production, compared with fully 46 percent for wheat.26 This kind of adjustment accords with intuition. It reflects a weakened consumer preference for commodities having higher income elasticities of demand, such as animal products, and the resultant switch towards staples such as bread, pastas and other wheat products. Such shift was the inevitable consequence of income declines in the 1990s and the adjustment of purchasing (or of reservation demand in semi-subsistence households) to the new scarcities shown in the evolution of price relatives since Independence. 3.9 There were similar shifts in the role and patterns of agricultural foreign trade, which plays a relatively important role in the economy of Lithuania. A small and open economy, Lithuania's total foreign trade flows in 2000 amounted to more than 80 percent of GDP. The country is highly exposed to the influence of border prices and their attendant volatility, which is even more the case in the agricultural sector. Statistically, the Lt value of net merchandise trade in agricultural and food products experienced growth in the mid-1990s, then contracted in 1998- 2000, before turning marginally positive again in 2001. The agri-food trade balance as a percent of GDP during the period fell from 6.5 percent in 1994 to insignificance (0.02 percent) in 2001, even turning slightly negative in 1998-2000following the onset of the Russian financial crisis. Behind these trends was a mild increase in agri-food exports (increasing by about 15 percent [in total] between 1994-2001), and more than a doubling of agri-food imports.27 CoMmodity-wise, prepared foodstuffs and beverages prevailed in the export structure of 1994, but starting with 1995, these two items gave way to animal products On the import side, the lion's shares of agrifood imports was taken by prepared foodstuffs, beverages and tobacco products .(39 percent in 2000) and vegetable products and oils (31 percent in 2000). 3.10 The 1990s witnessed a major shift in the destinations for exports and the origins of commodity imports. In 1994, nearly 60 percent of Lithuania's agri-food exports were sold to CIS countries. Only 28 percent were exported to the EU, with an additional 8 percent going to the Baltics. (Exports to EFTA and CEFTA accounted for most of the remainder. By the year 2000, however, the CIS' share had more than halved, to only 26 percent of total exports, while the EU absorbed 35 percent. Another significant development was rapid expansion of exports to the Baltic states, especially Estonia, whose combined share in 2000 had risen to 19 percent of the total. Agri-food imports also registered a shift away from the CIS countries in favor of, especially, the CEFTA and Baltic States. The share originating in CIS countries fell from 21 percent in 1994 to only 14 percent in 2000. The European Union's share remained almost constant (declining marginally from 42 to 41 percent). 3.11 Despite a near calamitous contraction, the sector remains important in terms of employment. In 2000, the sector directly occupied 272,000 workers, or 17.8 percent of the labor force (27.8 percent if one includes agro-processing). 26 Thus the ranking of the importance of various production activities by value added differs significantly from a ranking based on revenue (gross value of production), the latter being a common practice 27 Details can be found in Chapter 8 of The Background Papers Volume to this report. 55 3.12 Oi balance, these trends, (i) in sectoral value and its composition, (ii) in the direction and composition of Lithuania's agri-food trade, and (iii) as a locus for job creation indicate that the sector has shown both resilience and flexibility in rapidly adapting to changing circumstances. It was able to endure two massive shocks in the 1990s: the post-Independence implosion and the Russian financial crisis, yet successfully reorient both the content and the direction of external trade to take advantage of emerging opportunities in the foreign sector. In doing so, it continued to provide employment opportunities on a scale far in excess of the sector's contribution to the overall economy. While the challenges facing the sector are quite sobering, the results of the past decade provide grounds for confidence, considering the adjustment pangs and disruptions that rural Lithuania has had to endure in the past 10 years. Trends in Productivity and Factor Utilization 3.13 Land, Livestock and Labor Productivity. As part of the re-establishment of a market- oriented agricultural sector, the government moved swiftly following independence to privatize land holdings and restitute land ownership. Up to June 2002, over 720,00 applications had been submitted for restitution of land ownership rights, covering 4.2 million hectares. Most have been processed, and as a result, ownership has been restored to 81.2 percent of the land.28 About 53 percent of all agricultural land is private. However, and despite this early start, the effective privatization of agricultural land remains incomplete. Numerous restrictions on land and land use are still in effect, including prohibitions against ownership by foreigners or legal entities. And, as noted above, the limited availability of rural finance has severely inhibited sector's abilities to service its investment needs, though land administration-type legislation and amendments to Lithuania's Constitution are presently being considered, which -if framed appropriately- could relieve existing constraints on more efficient land use. Of the total state land, about a third is in low-productivity household plots; 8 percent is leased to agricultural enterprises; 27 percent is leased to farmers; and the remainder is idle. 3.14 In early 2001, there were a total of 321,000 family farms, with an average area of 12.6 ha;29 and 963 agricultural enterprises, with an average farm area of 344 ha. The family farm produces most of agricultural output, with their harvests representing 80 percent of crop and 73 percent of livestock production. By all measures, resources have been shifting into the family farm sub-sector: between 1995 and 2000, cultivated area under family farms, as a share of total cultivated area, increased from 65 percent to 88 percent.30 However, the small size of the average family farm limits the scope for productivity improvements. On the positive side, there is some evidence that consolidation of small family farms into larger units is underway. As of 2000 only some 15 percent of all family farms had more than 20 hectares. By 2001, however, 25 percent had more than 20 hectares. 3.15 As a result of the legacy of Soviet-era investment programs, a technology gap exists with respect to the EU, both on-farm and in the processing industries. Lithuanian yields per ha are consistently lower than EU average levels (Figures 3.1 and 3.2). Yields of cereals, sugar beet, 28 Most of the remaining 18.9 percent requires additional supporting documentation, proving rights to the land and/or kinship, before it can be fully processed. 29 This estimate is extrapolated from the Farners' Farm Register as of January 1, 2001, which listed 67,5 thousand farmers' farms. They owned 853,0 thousand hectares of land. The average size of these fanner's farms was 12,6 hectares. These farms represent 21 percent of the land used by family farms. Some consolidation was reported during 1991. The number of registered farmer's farm declined to 29.6 thousand, i.e. by more than 50 percent, while land used in farming on farmers farm declined less rapidly, to 509 thousand hectares. As a result, average farm size (on so-called farmer's farms) increased from 12.6 ha. in 1991 to 17.2 ha. in 2002. 30 The number of agricultural enterprises declined nearly three-fold from 1995-2000, with a commensurate decrease in area farmed. 56 and apples are less than half those of EU, but are slightly higher than yields of Estonia. Rapeseed yields are just more than half those of the EU. Cow milk yields in Lithuania are comparable to those of Australia and New Zealand, but only 65 percent of EU levels. Nevertheless, milk yield have increased dramatically since the mid-1990s, even if the share of value-added has not (cf. ff 4). A combination of the high cow/milk yields and low cow/land ratios give the family farm a productivity advantage in dairy production over agricultural enterprises, and make the sector competitive in intemational terms. Although, beef yields per animal in Lithuania are 90 percent the EU average, yields per animal obscure the relatively inefficient fattening regime. In Lithuania, cattle require twice as much feed and time as their EU counterparts to reach slaughter weight. Poultry output per animal is 30 percent the EU average, reflecting very limited use of hybrid broilers and layers. Figure 3.1 Antiml Yields Lithuania and Estonia as a share of the EU level 100 8 0 --- g 60 - j.< *._>t--tm -- -J-Lithuania 2i 0 - 4 w9sa%fZ)t<.- 7-*Esoi O I milk/cow beef kg/animal pig kg/animal poultry kg/bird Source: Lithuania Statistical Department, Vilnius, 2001 Figure 3.2 Crop Yields Lithuania and Estonia as a share of the EU level 60 50 ~-- 40 - Q:rrt- -40 - O~~~~~~~~~~~~~~~~~~A,1Lithuania1 30i-i7 U-Etoi a20.1 ~ -- 0n - cereals soft wheat rape sugar beet apples Source: Lithuania Statistical Department, Vilnius, 2001 3.16 Crop yields on the agricultural enterprise are moderately better in grains and sugar beets than those of the family farm. But the family farm obtains higher yields in rape and flax seed. In milk, yields per cow of the two farm types are equivalent. However, because the costs of manufactured feeds and feed concentrates have escalated, animal productivity on family farms now exceeds those in the state sector by several orders of magnitude. For example, average milk yields per hectare on the smaller family farm, which employs a grazing and forage based system of husbandry for large ruminants, milk yields per 100 ha on the family farm are 733.8 kg as compared to 198.5 kg in the agricultural enterprises - which relies on more intensive system of husbandry, centered around stall and feedlot feeding. 57 3.17 Between 1995 and 2000, agricultural output and labor input declined by 10 percent and 21 percent, respectively. As a result, labor productivity increased very gradually. At the same time, land input increased slightly, by 0.6 percent, while land productivity was more or less stagnant (Figure 3.3). Figure 3.3 Land and Labor Productivity in Agriculture 140- 120 100- g 80 - Land Producivityi - LaborProductivity 60- 40- 20 - 1995 1996 1997 1998 1999 2000 Year 3.18 The initial factor response to the sector's contraction was the reduction in the number of salaried workers. Between 1995 and 2001, labor engaged in agriculture as a share of the total labor force fell from 23.8 percent of the total labor force to 17.8 percent. In absolute numbers, between 1995 and 2000, total agricultural employment declined from 391,800 to 297,800. The layoff was attributable to the decline in the number of salaried workers (the majority of whom had worked for the agricultural enterprises), which contracted by 52,000. Non-salaried family farm labor level remained unchanged at 250,000 workers. 3.19 During the same period, not only did farmland area increase slightly, but area used for less productive purposes increased as well. The combined effect of the area expansion and less intensive cultivation contributed to the decline in land productivity. Responding to deteriorating incentives, farmers reduced production intensity by either allowing more land to go fallow or applying fewer purchased inputs. 3.20 When held against EU measures, labor and land productivity in Lithuania are low, though labor intensity is high. In Lithuania, there are 9.6 workers per 100 ha, nearly twice the EU level, but less than the 16.1 workers per 100 ha in Poland. Output per worker is low. The Lithuanian worker's output is less than 10 percent the output of the EU worker; but comparable to that in Poland and the average level for the other EU accession candidates. Comparative land productivity measures are also low. The Lithuanian farmland unit productivity, measured as output value per farrnland unit, is 15 percent that of the EU, and nearly half the level of other EU candidates. 3.21 Several farmer education and extension type programs were implemented in the 1990s to augment labor productivity and farmer technical and business skills. In time, these will help to close the productivity gaps. In conjunction with the Private Agricultural Development Project (PADP), a five year rural finance project assisted by the World Bank and several bilateral 58 agencies,3' four specialized agricultural advisory agencies were established or strengthened to provide training and information for farmers and agro-processors and their managements. A large part of the assistance, mainly from the EU-PHARE program and the Governments of the UK, Denmark and Finland, was earmarked for the Lithuanian Agricultural Advisory Services (LAAS), an Agribusiness Training Center (ATC), the Lithuanian Agricultural International Trade Agency (LAITA), and the Rural Business Development Center (RBC). Table 3.1 Comparative Productivity Measures, 2000 Labor intensity Labor productivity Farm Unit Productivity Labor per As % of Output/Labor As % of Output/ As % of 100 ha EU EU Farmunit EU Lithuania 9.6 192 1,667 8.0 160 15 Estonia 5.8 116 2,869 13.7 168 16 Poland 16.1 320 1,770 8.4 285 27 EU Candidate 15.8 316 1,784 8.5 282 27 EU-15 5.0 100 20,968 100 1059 100 Source: Pouliquen, Alain, "Competitivites et Revenus Agricoles dans les Secteurs Agro-Alimentaires des PECO)> October 2001, unpublished document preparedfor the European Commission Source. 3.22 The provision of fanner extension services by LAAS was strengthened, in particular for plant production and animal husbandry, and for farm financial accounting. Farmers have been willing to pay for LAAS' services. It has become a successful technology advisory agency with 40 offices around the country. The ATC was newly established under the PADP's TA component, and now provides training for marketing and export promotion at the farm level and for producers and distributors of agricultural products. Also under the TA component, the LAITA was set up to collect and disseminate trade information, and assist producers and distributors with export promotion and development. It's activities include assistance with producing export promotional material and assistance in participating in international trade fairs. In 2001, LAITA was liquidated and its functions were transferred to the Agricultural and Food Market regulation Agency (AFRMA). 3.23 The RBC was established under the Project in 1996 to develop rural entrepreneurship by identifying and developing business opportunities for un(der)employed rural workers. An important objective was to help farmers and would be entrepreneurs develop business plans that could serve as a basis for loan applications to acquire start-up capital. Unfortunately RBC suffered from a shortage of funding and staff from the start, and its initial management was quite weak. It has since been transformed into a data collection agency for the Government. A need for RBC's intended advisory services still exists, however, which needs to be fulfilled sooner rather than later, whether from within the financial sector, or by specialised public agencies or quasi- public institutes, else on a fee-for-service basis by private sector consultants. 3.24 Investment & Working Capital: A Binding Constraint. Factors contributing to low productivity on Lithuanian farms include (i) small farm size, which inhibits economies of larger farm size, (ii) pervasive uncertainty regarding domestic support programs and policies, accentuated by concerns over the implications of EU accession, and (iii) low levels of capital investment and complementary recurrent expenditures. Another major factor contributing to low productivity levels is the low level of capital investment, and the difficulty of financing working capital. The low levels of investment appear to stem more from constraints on the supply of investible funds rather than a lack of effective demand. This conclusion is borne out by the likelihood of positive direct fiscal transfers in support of agricultural and rural development 3' The PADP was closed June 30, 2001. See Report No. 23011 (ICR for the Project), December 6, 2001. 59 (discussed below). The analysis of the determinants of rural incomes shows a strong and positive relationship between farm incomes and expenditures in infrastructure, services and intermediate goods. The impact of expenditures in services (mainly agricultural assistance and veterinary services) is the strongest. For every 100 Lts invested in agricultural and livestock services, rural incomes increase by 15 percent. For both infrastructure and intermediate goods, the impact is smaller, but nevertheless significant. Every additional 100 Lts spent on infrastructure or intermediate goods increases rural income by 6 percent. 3.25 Using changes in the tractor fleet (Figure 3.4) as a crude proxy for capital flows to the sector, suggests that an increasing share of credit is reaching the family farm. Between, 1995 and 2000, the national fleet grew by 20 percent, an increase entirely accountable to the increase in fleets of the family farms. During this period, the family farm fleet grew by 87 percent, with the number of tractors per 1,000 ha, increasing from 30 tractors to 43 tractors. In contrast, for the agricultural enterprises, the tractor fleet fell by 61 percent, causing the tractor/land ratio to decline from 47 tractors to 38 tractors per 1,000 ha. 3.26 The movement of the tractor fleet points to the likely overall decapitalization of the agricultural enterprises, though to some extent, the decreasing numbers have been offset by purchases of more powerful units. For the family farm, the increase in the fleet size indicates that family farm has access, albeit limited, to certain investment funds, through banks, government investment programs or tied credit from farm equipment manufacturers. Figure 3.4 Tractor Fleet 50.00- 45.00 . -- 40.00 c - 35.00 - -I 30.00 i c 25 00i ly Fanns 20 00- ,. *Ancul mral Enterpnses 15.00- g 5.00 0.00 . . , 1995 1996 1997 1999 2000 3.27 In 2000, family farms received long-term loans with an average size loan value of 19,000 Lt. Farms, which cultivated crops and cereals, received the smallest loans, having an average size of 11,000 Lt. While larger loans, having an average value of 70,000 Lt, were extended to the more specialized dairy and pig operators. The significant difference in loan size is a reflection, among other things, of better collateral, with the dairy and pig operators able to secure loans with farm infrastructure, equipment and processing plants. 3.28 Foreign investment as a source of capital for the sector is very limited. In 2000, foreign investment in agriculture was equivalent to less than one percent of total foreign investment, and represented 0.89 percent of agricultural output (Figure 3.5). Most investment was concentrated in 60 a few, mostly industrial sectors, especially sugar and tobacco. Restrictions on foreign land ownership land and cumbersome bureaucratic requirements dampen investments. 3.29 The analysis of household data (cf. The Background Paper Volume, Chapter 9) suggest that many farms face significant financing constraints in engaging in these types of expenditures. The problems in accessing working capital to finance these inputs is clearest for poor rural farmers. Not only did non-poor households invest significantly more than poor; but that the discrepancy between the non-poor and poor household investment levels is greatest with respect to capital investment (Table 3.2). Applying the $2.15 purchasing power parity (PPP) poverty line, the poor household's overall investment level is 33 percent that of the non-poor. However, capital investments levels are significantly lower, representing only 7 percent of the non-poor levels. This is indicative of the lumpiness of capital investment, i.e. capital investment cannot normally be made in small increments, but require, relative to services and recurrent expenses, the amassment of larger sums of money. Also, capital investments generally are associated with better access to credit sources and a more commercially oriented farm operation. The extremely Figure 3.5 Agriculture as a Share of Total Foreign Investment 1.50% < ... ' I100% . ~,,' 050% X 0.00% 1998 1999 2000 Source: Lithuania Statistical Department, Vilnius, 2001 low level of poor household capital investment is illustrative of a type of poverty cycle, in which the poor rural household is unable to make the investments needed to improve productivity. Table 3.2 Distribution of Rural Non-Poor and Poor Household Investment Expenditure (LTslmonth) Capital Recurrent Services Total Overall 228.1 210.6 116.2 554.9 Poverty Line US$2. 15PPP per cap Not Poor 229.8 213.6 117.1 560.5 Poor 18.3 103.2 66.7 188.2 Poverty Line US$4.30PPP per cap Not Poor 268.8 230.3 128.7 627.8 Poor 77.9 160.9 80.1 318.9 Poverty Line 50% mean expenditures Not Poor 252.7 223.3 125.1 601.1 Poor 74.7 162 79.7 316.4 Source: Steele D., World Bank, 2002 61 Figure 3.6 Rural Household Investment Non-Poor and Poor (under $2.15 PPP) Households 600 500 0 Services | 300°1o Recurrent E! 200 0~~~~~~~~~~~~~~~~i Capital 100 ' 3 , Not Poor Poor 3.30 An important impediment to agricultural lending was the reluctance and lack of capability of the state-owned Agricultural Bank of Lithuania (ABL) to intermediate investment loans and working capital credits for farm operators and other rural agents. This remnant of the Soviet system proved singularly unable to implement the lending component of the PADP, even though it used to be the only bank in Lithuania with an extensive branch banking network in rural areas. It was in poor financial condition during most of the last decade.32 More recently, ABL has reoriented itself into a commercial operation offering all range of financial services, and in 2002, the bank was sold to foreign investor - Norddeutsche Landesbank Girozentrale. 3.31 The PADP also revealed private banks' reluctance to lend to the farmers due to the widely held perception of agriculture as a high-risk sector. Factors contributing to this view included: (i) the general downturn in world market conditions, (ii) uncertainty regarding the eventual modality of the EU alignment; (iii) late payments to farmers by buyers and processors- frequently with delays of up to one year-which, in tum, hindered farmers' ability to meet financial obligations; and (iv) farmers' poor business accounting practices, making it difficult for banks to monitor their cash flows. 3.32 To mitigate their exposure, banks require large collateral, often equivalent to the loan value. However by law, banks and other legal entities cannot own land; therefore they will not accept land, as collateral. Many farmers lack altemative collateral and as a result cannot access credit. In 1999, the EU-Phare funded Rural Credit Guarantee Fund (RCGF) was established to guarantee, up to 100 percent of the loan value, to banks for investment loans made to farmers. The RCGF, while criticized as introducing market distortions, was intended to compensate farmers for being unfairly penalized by restrictions against the use of land as collateral. When other factors came into play, with increased security, bank lending to the sector was moderately stimulated. 32 During part of 1998, the ABL's status as a project financial intermnediary in the PADP was suspended by the Bank of Lithuania due to non-compliance with BOL prudential regulations. 62 3.33 Many regard the EU SAPARD funds as a panacea to sector's financial needs. However, the fund may fail to live up fully to these expectations. In 2001, Lithuania received 7.4 million Euros of SAPARD funds while first projects were selected in 2002. Beginning in 2002, over 30 million Euros in grant fund will be offered to Lithuania help the sector finance investments related to alignment. To be eligible, a farmer must have: (i) fully registered the farm and herd; (ii) full project documentation; and (iii) sufficient counterpart funding. Recent experience in rural credit programs in Lithuania indicates that these requirements may limit access to SAPARD funds for many farmers. To date, only a small fraction of family farms are registered under the less stringent national farm registry. Explanations vary, but a combination of tax avoidance as motive and unclear leasehold seem to be the main reason farmers are reluctant to satisfy the registration requirements, or are simply unable to register. Many will have difficulty in fulfilling administrative requirements, especially project documentation preparation. With limited possibilities for own-financing, without access to credit sources; most will lack sufficient counterpart funding. It remains to be seen the extent to which commercial banks and other financial institutions will be able and willing to provide such financing. 3.34 Fiscal Transfers. Net fiscal transfers, direct and indirect, could partly substitute for the lack of investible funds and working capital offered by the financial sector. The array of direct transfers, into and out of the rural economy, include subsidies and income support (mainly procurement subsidies and direct payments to farmers, and pensions);33 and an array of taxes and fees (including the land tax; VAT reductions on some agricultural products ; profit tax on processing industries; employee income tax on agro-enterprises etc). 3.35 A full quantification of these fiscal transfers is not possible at this stage. However, a review of the criteria governing these transfers suggests that there has been a net positive transfer of funds into the rural economy. For example, budgeted public sector expenditures do not carry user charges or other forms of partial repayment. Also, producer subsidies and payments to rural pensioners are not subject to taxes. On the remissions side of the ledger, little effective taxation seems to take place. While in theory the annual agricultural land tax amounts to 1.5 percent of assessed land value, in practice municipalities can and do reduce the tax rate by as much as 100%, thereby obviating the need to squeeze tax revenues from a reluctant and politically influential farm population. The new VAT regulations reduce the effective VAT on meat and meat products, and on food products which meet ecological standards, to 5 percent of revenues. The minimum income tax thresholds for workers of agro-enterprises also has been set higher than thresholds in other sectors. As wages tend to be lower in rural areas, the net effect is that very few worker income taxes are remitted by the rural processing and farming enterprises. This preference will be eliminated in the new law on Personal Income tax, passed in July 2002. It is also worth noting that the profit tax on the processing industries is zero percent whenever agricultural activities account for more than 50 percent of sales. Otherwise the "normal" profit tax of 15 percent applies. As most processors appear to specialize in agri-based products, tax remittances from this source would be limited 3.36 There are also indirect transfers, mainly via the trade regime. As no duties on agri-food exports are collected, the collection of customs duties, through the usual very complex schedule(s) of commodities, countries of origin, and the enforcement of NTBs, licensing and the like all mitigate in favor of a positive monetary inflow, even if the global effects of trade restrictions probably represent a net loss to the overall economy. Of course this monetary inflow is not earmarked for the rural economy, thus interventions at the border likely create a net 13 Unlike several other countries in transition, Lithuania does not provide off-budget support for agriculture and agro- industries via Treasury-backed disbursements through state-owned banks 63 opportunity cost (or indirect outflow) from the agricultural sector, to the benefit of more heavily protected sectors. B. RURAL POVERTY PROFILE 3.37 Poverty in Lithuania is concentrated in rural areas. In 2000, nearly one in every five rural households lived in poverty (see Chapter 1).34 The incidence of rural poverty, at 18.3 percent, was three times that in urban areas (6.1 percent). Rural areas, with less than one-third of the total population, comprise more than one half of Lithuania's poor. Moreover, of the country's extremely poor, those living on less than US$2.15 PPP per capita per day, nearly 70 percent live in rural areas. 3.38 Those more likely to be poor in rural areas include households headed by an individual with less than secondary education, and households with a large number of children. Employment, by itself, offers little protection against poverty: 16.7 percent of employed rural persons are poor, a rate four-times higher than that among the urban employed (only 3.7 percent poor).35 This is indicative of low rural wages and high rural under-employment. Among the rural employed, workers in low-skill occupations-primarily manual and field workers-face the greatest risk of being poor. 3.39 Access to land is universal among the rural Table 3.3 Poverty Risk by Access to Land, 2000 population, and does not Urban Rural distinguish the poor from the non- Less than US$2.15 ppp per capita per day poor (Table 3.3). Some 89 Access to Land 1.2 6.9 No Access to Land 1.7 10.1 percent of the non-poor in rural Less than 50 percent median per equivalent expenditures areas and 87 percent of the poor Access to Land 5.3 18.0 had access to land. But land size No Access to Land 6.7 22.0 does matter: the average land size Notes: Individuals of a poor rural household is only Source: 2000 LHBS 2.56 ha, less than 40 percent the average land size of a rural non-poor household. The type of land plot also seems to have an impact. Regression analysis of the determinants of rural incomes suggests that while additional hectares of agricultural land lead to increases in income (and hence lower poverty risk), garden plots (very small plots used for small-scale production) and personal plots (used exclusively for home consumption) have either a zero or a negative impact on household incomes. The latter reflects the role that personal plots play in providing food for self-consumption, as an altemative to other income-eaming uses of labor. 3.40 There are important differences between poor rural households and non-poor rural households in the amounts they are able to spend on complementary agricultural inputs. As illustrated in Table 3.4, poor households spend only a fraction of that spent by non-poor households in infrastructure, services and other recurrent expenditures (seeds, feed, fertilizer etc.). Lower expenditures on complementary inputs are associated with lower farm productivity and revenues, and hence with lower household incomes (see Chapter 8, The Background Paper Volume for details). Differences in rural investment pattems between the non-poor and poor households are shown above in Figure 3.6. 3 With a poverty line equal to 50 percent of median per adult equivalent expenditures. 3 Poverty defined according to the 50 percent of median per equivalent expenditures line. 64 Table 3.4 Expenditures on Agricultural Inputs, 2000 Purchase of Recurrent Purchase of Services Infrastructure Expenditures Overall 228.1 210.6 116.2 LT $2PPP Not Poor 229.8 213.6 117.1 Poor 18.3 103.2 66.7 LT50% median expenditures Not Poor 240.0 221.8 120.1 Poor 62.3 116.6 81.4 Notes: Rural households only. Infrastructure = land, building materials, drainage, machinery and equipment, vehicles, production inventory; Recurrent = purchases of seeds, fertilizer, livestock, feed, fuel and oil etc. Services = production services, veterinary services. Source: 2000 Lithuania Household Budget Survey 3.41 The rural population is much older than the urban population, and is getting older. The rural index of aging (the number of persons 60 years and older per 100 children under 15) increased from 69 percent in 1970, to 106 percent in 1999. It is 25 percent higher than the corresponding urban index. A quarter of the rural population has reached the retirement age of 60years and older, as compared to only 18.3 percent of the urban population. According to Kassiaouni, Gorniak, and Lazutka (UNDP, 2000), one of the reasons behind the aging of the rural population is increased migration of older people from urban to rural settlements since independence. As a result of this aging, fixed-incomes and transfers (mainly pensions) constitute a larger share of total household income in rural areas than they do in urban ones. This has implications for the mobilization of household savings to modernize farm operations. It also will bear on the expected impact of increases in food prices resulting from EU accession. C. TOWARDS MORE EFFICIENT AGRICULTURE Incentives Regime 3.42 During the past decade Lithuania's transition from a low-price low-wage economy to market mediation largely led to the replacement of planners' price norms with more realistic, but much higher product prices and factor costs. These price movements have affected agriculture profoundly. Since 1995, producers' incentives have deteriorated; with output prices declining significantly relative to production costs. Between 1996 and 2000, real producer prices for barely, rye, rapeseed, and beef fell between 5 and 20 percent (Figure 3.7). Prices for sugar beet, milk, pork and poultry were higher than their 1996 levels, but the increases did not keep pace with increases in input prices. In real terms, wages increased by 72 percent over the 1996-2000 period, with other inputs increasing between 33 and 104 percent (see Chapter 8, The Background Paper Volume). 65 Figure 3.7 Change in Real Producer Prices 1996 - 2000 (%) 25 /; . ; . , -,A 20 -15__ . -15 a, -- - -E - -. Wheat Barley Rye Rapeseed Beef Milk Pork Poultry Notes: constant 1995 Litas. Source. FAO, 2002. 3.43 The family farm and the agricultural enterprise have responded differently to the deteriorating incentive structure. The family farm has persisted by relying upon household labor and producing less intensively. The agricultural enterprise sector adjusted by eliminating hundreds of financially unviable enterprises and shedding redundant labor. Between 1995 and 2000, the number of agricultural enterprises fell from 2,611 to 963; some 52,000 workers lost their jobs. 3.44 Erratic Intervention. Exacerbating these price shocks, govemment intervention in Lithuania's domestic producer and input markets has interfered in the transmission of the world market price equivalent to the sector and has contributed to sector instability. Since 1990, price subsidies and govemment acquisitions have been applied to support farm income. In 1993, as a result of price liberalization, farm prices and profitability plummeted. The following year, in response to pressures from the farm sector, the Law on State Regulation of Economic Relations in Agriculture (the Agricultural Law) was established to set minimum marginal purchase prices (MMPP) for food grains, milk, livestock, flax and rape. Since then, the MMPP system, with minor interruptions, has remained in force. To defend these price levels, the Agricultural and Food Market Regulation Agency (AFMIRA), the official agricultural procurement agency, was established in 1995 to purchase, store and market farm commodities in the domestic and export markets. These operations have proven to be fiscally burdensome. 3.45 In 1997, the government, sought to dismantle the price support system But the 1998 Russian financial crisis, which dramatically reduced export demand and nearly crippled the Lithuanian farm sector, weakened government's ability to introduce more transparent farm sector support measures. Recent efforts to remove or reduce producer price subsidies have been limited. After a brief hiatus, producer price subsidies for grains, both food and feed, were re-introduced for the 2001-2002 marketing season. This has been criticized for being inconsistent with the official policy process of aligning the incentive structure with that of the EU. The program includes an unprecedented 20.6 million Lts authorization to finance direct area payments for grain farmers. The program would provide 40 It/ha area payments for 0.5 million ha, covering food 66 grains, and, for the first time, feed grains, as well. For the 2002-2003 season, the announced wheat intervention price of Lt 400/mt would be 11 percent higher than the EU level of 36OLt/mt. A controversial sugar price subsidy and export scheme for 2001, 2002 and 2003 seasons was also announced. Subsidies continue for flax and rapeseed production. 3.46 As evidenced in nominal and effective protection rates for different products, government intervention has been erratic and increased uncertainty in the sector. As a result of government intervention, producer prices for many commodities are far from world markets. Protection rates have been negative for wheat, barley, rapeseed, beef (with a negative nominal and a positive effective) and milk. In the cases of pork and sugar beets, government intervention has maintained positive nominal protection rates (see Table 3.5). Table 3.5 Nomninal (NRP) and Effective (ERP) Rates of Protection (%) 1997 2000 NRP ERP NRP ERP Wheat 12 2 -8 -14 Barley -32 -58 1 -11 Rapeseed 0 19 -6 -14 Sugar beet 22 43 33 54 Milk -50 -94 -15 -27 Beef -1 -32 -12 5 Pork -5 108 16 35 Source: Valdes/Kray/Tjiete. 1999 and 2002 3.47 The Lithuanian government is reviewing a proposed Law on Agriculture and Rural Development to consolidate and update existing agricultural legislation into a single coherent law. The Law would be more consistent with the EU guidelines concerning its common agricultural policies and rural development programs. By replacing the former agricultural and price laws, the government's authority to regulate agricultural prices would be reduced. Greater emphasis would be placed on producer compensation payments. The proposal would also contain a separate chapter dedicated to the national rural development program, designed to be consistent with the EU structural funds programs. 3.48 With protracted negotiation for EU accession, candidate countries, like Lithuania, could consider applying subsidies to increase production levels and help secure higher EU historical production levels. But caution is advised in pursuing such a strategy as it would not only divert scarce public investment funds, but could reduce productivity and weaken the sector's ability to compete internationally. 3.49 A recent trade study36 concluded that had world prices prevailed in Lithuania in the year 2000, the farm sector, on balance, would have generated much higher total and net revenues. The gain to total and net revenue would be greater for the family farm than for the agricultural enterprise. For the sector as a whole, moving towards free trade would result in a 28 percent increase in total revenue and a 113 percent increase in aggregate value added. Aggregate value added gain is significantly greater than the total revenue gain as the aggregate value added reflects, not only the change in producer prices, but also the change in the price of inputs. The dairy sector would be most affected. Total revenue for the diary sub-sector would double at the world price equivalent. In terms of value added, which computes inputs at their world market 36 A. Valdes and Holgar Kray; Lithuania: "Strategy for the Pre-Accession Period: Adjustments of Agricultural and Trade Policies to the CAP"; ECSSD Rural Development and Environment, World Bank, June 1999, updated by H. Tietje., February 2002. 67 price equivalent, the gain would be even greater. Beef gross revenues would decline slightly, while value added, because of decreased production costs, would increase. In the case of barley, both revenue and value added would increase under world prices. Pork, sugar beets, rapeseed and wheat would experience losses under world price equivalents. While pork revenues would decline by 2 percent, value added would fall by as much as 55 percent. 3.50 Because of differences in cropping patterns, value added for agricultural enterprises would increase only by 2.5 percent. However, for the family farms value added would increase by 168 percent. This points to the fact that the current farm policy regime is skewed in favor of the agricultural enterprise. The farm program supports prices for pork, beef and sugar beets, commodities which are relatively important to the agricultural enterprise crops. At the same time, the farm price of milk, an important family farm commodity, is depressed relative to the world market levels. Key Sub-Sectors 3.51 Dairy Products. In terms of dairy farm prices, Lithuania can be considered one of the world's most efficient milk producers (Figure 3.8). Lithuanian producers receive the equivalent of half the world market border price. This does not imply, however, that the milk industry in its present configuration in Lithuania is highly productive and dynamically efficient. To the contrary, despite modest cow milk yields, the family farm is able to produce milk at relatively low cost thanks mainly to their high animal/land ratios and low labor and feed costs. By relying upon family labor and applying relatively low rations of purchased concentrate, the family farm has been effective at containing costs. 3.52 As a result of the way that farm privatization was carried out, and given the existence of barriers to land consolidation, dairy operations remain mainly very small and fragmented. About 90 percent of the national dairy herd is distributed among the 223,000 individual family farms and plots. Most farms, over 78 percent, have less than two cows, with only 0.5 percent having more than ten. The production of these small farms provides about 90 percent of the national milk production. Such small farm sizes limit the scope for improvements in productivity and efficiency. 68 Figure 3.8 Dairy Producer Prices 70 Japan Swit Norway Fr., Gar., UK Bosnia, Bulgaria. Estonla, Argentina, NZ. Cnmatia, US Slowakia Lahva, Podand Uthuania Source: FAQ, 2001. 3.53 About 70 percent of dairy output, or 1.2 million tons, is marketed for processing (Table 3.6). Of the marketed supply, the vast majority, 84 percent, is collected from the output of widely dispersed small farms. The supply structure is cumbersome for processors, complicating the collection and insurance of a steady supply of high quality. For the producers, a structure with mnany, individual and small producers and a few, relatively large processors, depresses producers prices by compromising their ability to negotiate. High collection costs, which can represent as much as 10 percent of final dairy product costs, erode margins for both producers and processors. Table 3.6 Milk Production ('000 metric tons) 1990 1995 1996 1997 1998 1999 National PYoduction 3,157 1,819 1,831 1,950 1,930 1,714 Marketed 2,885 1,216 1,332 1,416 1,477 1,209 Small Farm Production 1,304 1,466 1,531 1,671 1,677 1,507 Marketed 1,186 886 1,030 1,110 1,225 1,018 Agricultural Enterprises Production 1,853 353 300 278 253 207 Marketed 391 93 100 92 78 82 Source: Lithuania Statistical Department. 2001 69 3.54 The dairy sector, both at the primary and the industrial levels, has shown to be resilient and responsive to market signals. Beginning in 1995, minimum milk procurement prices were set to ensure profitability levels; with the standards for the highest milk grade set to correspond to the EU quality requirements. The quality-denominated price supports induced marked quality improvements, as the share of highest and first grade milk increased from 28.9 percent to 62.7 percent of total deliveries between 1995 and 2000. Since the beginning of 2000, higher requirements have been introduced for the quality of milk; requirements set to the best quality milk are now in line with EU requirements. 3.55 In recent years, the industrial milk processing sector has been concentrating. In 2000, there were 38 dairy processors, 3 of which accounted for 70 percent of milk processed. By the end 2001, the number of enterprises had decreased further to 24. 17 producers possess certificates allowing them to export to the EU. 3.56 Exports of dairy products are among the most dynamic in the agriculture sector. In 2000, dairy product exports constituted 30 percent of agricultural and food exports. The main export markets are the EU, USA, Baltic States and CIS. Some of the dominant dairy producers plan to negotiate with potential strategic investors after the accession negotiations are completed. There are also plans to expand production into neighboring CIS markets. 3.57 Dairy appears to be an agricultural activity in which Lithuania enjoys a definite comparative advantage. In the world market where subsidies are expected to play a decreasing role in trade, the price of dairy industry's basic raw material will be the principal factor deciding the competitiveness of dairy products over the longer termn. According to FAO, as a rule of thumb, at current market prices, producer prices of less than US$0.20 per kg would be the dividing line between those countries that can export dairy products without the use of export subsidies and those that cannot.3 Despite its modest yields per cow, Lithuania, whose milk production costs are under US$0.15/kg, is one of the world's least cost producers (Figure 3.8). 3.58 Grains. About 85 percent of the national crop area is dedicated to the production of grains, most of which is produced on family farms, and represents 60 percent of family farm income. Most wheat cultivation, about 60 percent, is concentrated in country's fertile central region, with the rest grown in the western areas, where heavy rains and inadequate drainage systems can reduce production. Lithuanian wheat yields, at 2.7t/ha, compare favorably with yields obtained in Estonia, Latvia, and Belarus, but are significantly below the levels in EU countries (which exceed 7.0 t/ha). Factors cited for the relatively low yields include the use of traditional low yielding varieties, outdated technologies and low use of complementary inputs. 37 Griffen, Michael," Overview of Developments in the World Dairy Market", Food and Agriculture Organization, speech delivered in Santiago, Chile, April 1999. 70 Table 3.7 Grain Production '000 Mt 1995 1996 1997 1998 1999 2000 Wheat 928.6 1,308.3 1,593.9 1,480.5 1,188.6 1,632.4 Winter 902 1,222.3 1,429 1,307.5 982.7 1,410.1 Spring 26.6 86 164.9 173 205.9 222.3 Barley 887.1 1,168.9 1,189.3 1,098.4 740.1 856.9 Rye 239.3 286.8 348.2 348.7 260.9 311.9 Leguminous grains 47.5 87.4 106.4 104.1 63.8 73 Total 2,102.5 2,851.4 3,237.8 3,031.7 2,253.4 2,874.2 Source: Lithuanian Statistical Department, Vilnius, 2001 3.59 Only less than 25 percent of the total grain harvest is marketed. Feed use accounts for 60 percent of total consumption, of which about 80 percent is fed directly and unprocessed to the animals (Figure 3.9). Most wheat is processed in large-scale highly inefficient facilities. Figure 3.9 Domestic Grain Use 1800,; ; 1600;i . 1400-- 1200 =X 0 1 ;|Animal Feed ° 600 z _ _- U T>|Lt Human Consumption 4200° -f6r .. , 1995 1996 1997 1998 1999 2000 Source: Lithuanian Statistical Department, Vilnius, 2001. 3.60 The 2001 grain farm package announcement appears to represent movement away from closer alignment to EU policies. In August 2001, the MMPP system for grains was re-introduced, with support levels varying between 390 Lt/mt for first-class wheat, and 670 Lt/mt for buckwheat. The first class wheat intervention price is above the EU of level of Lt 360 but below the world market price level of approximately of 448 Lt/mt. In addition, the Ministry of Agriculture was authorized 20.6 million Lt provide direct area payments to grain farmers on the basis of the area under grains declared in 2001. The program would entail paying an estimated 40 LtVha over an area of 0.5 million ha. Feed grains and legumes, excluded from earlier programs, were to be covered under the new program. For the 2002 season, the intervention price set of 400 Lt/mt for food grains continues to be above the EU level of 360 Lt/mt. 3.61 According to official forecasts, during the next five years wheat production, faced with growing international competition and declining domestic consumption, will continue to decline, becoming increasingly concentrated in the more favorable central regions. Only the cultivation of leguminous crops is expected to grow as demand increases for balanced feed. Grain farm size is expected to increase, with the number of grain farms between 50 and 100 ha, doubling. As result, 71 labor input will decline, with the number of agricultural workers in grain production forecasted to decline by as much as 47 percent (Lithuanian Institute of Agrarian Economics). 3.62 Sugar Beets and Sugar Production. In 2001, over 3,500 farmers produced 880,000 tons of sugar beets. Family farms accounted for 62 percent of total output and agricultural enterprises accounted for the balance. Sugar beet production represents more 10 percent and 5 percent of the value added of production of agricultural enterprises and family farms, respectively. Cultivation is concentrated in the country's central region in areas, close to processing plants. 3.63 There are four major refineries in the country; of which there is Danish participation in three. The fourth, owned by a local investor and growers, is facing serious financial problems. While refinery capacity has been expanded, many appear to be waiting to assess the EU accession's impact on the industry before making additional investments. 3.64 Sugar production is subsidized. Subsidies are financed with revenues generated by the sugar excise tax and there has been a commitment on the part of Government to maintain a self- financing sugar regime. But recent increases in the production quota could jeopardize this commitment. Production quota levels have risen from 112,000 tons in 2000 to 122,000 tons in 2002. Surplus production has resulted in substantial carryover stocks, which in 2002 could represent more that 50 percent of domestic consumption. Table 3.8 Sugar Prices (Constant 1995 Lita/Mt) 1996 1997 1998 1999 2000 Sugarbeet with subsidy 119 143 140 125 175 Subsidy 70 56 82 Average sugar content (%) 9 10 10 10 0 Sugar (white) (without tax) 1,608 1,963 1,137 1,116 0 with excise tax 0 0 1,895 1,860 0 Source: FAO, 2002 3.65 In late 2001, to bolster the sugar industry the government set the ex-plant sugar price about 9 percent higher than the prevailing domestic price (equivalent to US$290/mt). This is the price refineries are obliged to sell to buyers (wholesalers, retailers and other processors). It is estimated that the higher sugar prices could increase the wholesale sugar prices by 10 percent, thereby increasing the production costs for all sugar-containing products. With the elimination of the export subsidy, the refinery would export at the world price of US$215/ton and recoup losses (US$75/mt) from domestic sales, representing an effective income transfer of an estimated Lt 21 million from the domestic consumers to the refineries. 3.66 Although intended to be temporary stop-gap measure, this policy could be in violation of Lithuania's commitments with the World Trade Organization. The program also places in jeopardy the government's resolve to maintain a sugar regime entirely financed through sugar excise revenue. While excise revenues are expected to decline, the sugar regime costs are likely to increase. Already, the 2001 end-of-season stocks are equivalent to 50 percent of domestic consumption. With an expected increase in the regime's tonnage eligibility, the regime's storage costs are likely to increase substantially. 72 D. THE ROAD AHEAD Preparations for Accession into the EU 3.67 Preparations in the agricultural sector for accession to the European Union are fairly well advanced. Scheduled to formally accede in 2004 with 9 other candidate countries, the European Commission recently concluded that "overall, Lithuania has continued reforming its structures in the agricultural field in order to be able to implement the acquis".38 In terms of the mechanics of accession, Lithuania seems well on its way towards satisfying requirements of the acquis by 2004. However, important steps remain to be taken. 3.68 In regards to land reform, the Commission would like to see a completion to the restitution process, as well as the adoption of a constitutional amendment that would abolish the restriction on sales of agricultural land to foreigners. The progress report makes note that further work is needed to align government agencies in the sector with EU requirements. Special note was made of the need to fully develop an integrated administrative control system, especially to bring the land and bovine registration systems up to EU requirements as well as Lithuania's farm accounting network.39 Concerning the administration of general CAP requirements, the report notes that training is still needed for the market regulation agency. Furthermore, as the current national support schemes (i.e. incentives) differ considerably from the CAP mechanisms, the report concludes that new administrative structures will need to be set up to administer the CAP. But so far, "little attention has been paid to, and few actions taken, to develop these structures". 3.69 The report found that the creation of an institutional framework and necessary administrative structures for the design and implementation of rural development projects has advanced at a satisfactory pace. Some efforts are still needed to establish proper monitoring procedures in accordance with EC rules. 3.70 Framework legislation in the veterinary sector has been approved by the Lithuanian Parliament and is in place. Considerable progress is being made towards transposing EU requirements and implementation rules. The same is true in the phytosanitary area. While the rules are being implemented in the latter area, little progress has been made implementing the new veterinary regulations. As regards the agri-food industries, the Commission notes that meeting the EC's quality standards *emains a major challenge, especially for small establishments in the meat industry and the processing of canned fruits and vegetables. Only limnited progress has been made in strengthening border controls. In this regard, Lithuania's system of import permits will have to be abolished as part of the process of harmonizing Lithuanian legislation with the acquis. In sum, there has been good progress to date but quite a bit remains to be done between now and 2004. Perhaps the most difficult task will involve dismantling the existing agricultural support system, and rather quickly at that, while implementing the CAP. This may have to be done with deliberate haste in order to have the CAP operational in Lithuania in time for accession. 38 See Commission of the European Communities: "2001 - Regular Report on Lithuania's Progress Towards Accession", SEC (2001) 1750, Brussels November 13, 2001, page 56 39 The government advised (September 2002) that action plans for implementing an integrated administration and control system to EU standards have recently been submitted to the European Commission for review. 73 The Challenge of Accession 3.71 Operating essentially within the context of a small, open economy, the course of Lithuanian agriculture will be strongly influenced by changing incentives linked to the country's accession to the EU's single market. The European Commission's proposals for reforming EU institutions and regulations are summarized in the Agenda 2000: For a Stronger and Wider Union. These proposals for reform of the CAP are driven both by a changing world environment for agriculture, and by the need to accommodate the planned enlargement of the EU and control its potential financial burden on the CAP budget. Agenda 2000 is a further development of the earlier 1992 reforms rather than a radical turn towards full market liberalization (see Chapter 8, Volume 2 for details). Simulations of the impact of moving to the Agenda 2000 scenario, suggest that overall Lithuanian agriculture would benefit from EU accession, even more than it would from full market liberalization. Again, however, it is the family farm, and not the agricultural enterprise, that would reap the greatest gains. 3.72 Producer Income Implications. Accession under Agenda 2000 would induce a significant increase in the income of primary producers, and in particular of family-owned farms. The differential impact on agricultural enterprises and family farms reflects differences in output mix and technologies, as well as differences in economic rate of protection levels (ERP) for various activities. The highest increases in value added would be achieved for beef cattle, followed by milk production and rapeseed. A high proportion of the increase in farm income from milk production would accrue to family farms, while the impact on beef would be similar for both farm types. The CAP compensatory area payment for rapeseed would contribute significantly to income growth for this activity. 3.73 Pork an activity important for agricultural enterprises, would not benefit at all from the alignment to the CAP. Nominal protection for pork is lower in the EU than exists in Lithuania, and hence under the CAP pork prices would decline by about 15 percent. Furthermore, the higher prices for grains and milk would translate into higher input costs in hog production, since milk and grains are used in the feeding of pigs. 3.74 Comparing the impact of moving to the Agenda 2000 scenario to that of simply moving to world prices reveals that outcomes are similar under both scenarios for most products. However, beef producers clearly benefit more under the Agenda 2000 scenario than under world prices (since the Agenda 2000 prices for beef are 165 percent of world price levels). With respect to dairy, about three-quarters of the price increase realized under Agenda 2000 can be accounted for solely by the move towards world price levels. 3.75 Consumer Real Household Income Implications. Rural households, on average, spend 57 percent of their disposable income on food and beverages. For the poor, this share is closer to 70 percent. Thus, policy reforms that affect food prices will have an impact on consumers' real income, at least in the short-term. 74 Table 3.9 Inelastic Demand: Consumers' Real-Income Change Relative change in real income (percent] Type of household all by residence I by income quintile averagel urban I niral I. I II. III. IV. I V. Scenario B: Agenda 2000 t Change in household's real income -7.71 J -7.20 | -9.03 -9.67 | -9.37 -8.67 -8.12 -6.15 real income effect of: 7 1 1 7 1 1 1 _ Food, beverages and tobacco -13.24 -13.22 1-13.27 -13.51 -13.44 -13.35 -13.25 -12.97 Food and non-alcoholic beverages -13.79 -13.79 1-13.79 -13.79 1-13.79 -13.79 -13.79 -13.79 Source: Chapter 8, Volume 2. 3.76 The largest expenditure increases in household consumption would occur in beef and dairy products. Conversely, the effect of price changes for grains appear to have only a minor effect on consumers' real'income. Under the Agenda 2000 scenario, average real household income would be reduced by about 8 percent. The impact on real household incomes would be greater for rural households than for urban ones, and the overall effect would be regressive (Table 3.9). The impact of food price increases on the poorest quintile would be nearly 60 percent higher than on the wealthiest quintile. In the longer run, however, these effects would moderate as consumers would adjust their consumptions patterns to the new prices.40 3.77 Trade Implications EU accession will increase in tariffs for imports from non-EU countries and eliminate those on imports from the EU. Recent trade negotiations, however, had already been reducing trade barriers between the EU and Lithuania. By virtue of the 1999-2000 trade agreement on new reciprocal agricultural concessions, effective January 1, 2001, EU and Lithuania already allowed unlimited and free access to the least-sensitive agricultural products. The agreement also placed on the "double zero" list such products as pig meat, poultry, sausages, cheese, eggs, tomatoes and apples. The double zero approach allowed for the reciprocal elimination of import duties within tariff quotas as well as the elimination of export refunds. Tariff quotas were increased, especially for the cheese sector. The Lithuanian cheese quota was increased from 1,750 tons to 6,000 tons. In addition, for a certain number of products, such as milk powder and butter, Lithuania has been unilaterally granted duty free tariff quotas on the imports to the EU. 3.78 The EU has quickly become Lithuania's strongest trading partner in agricultural and food products. Between 1995 and 2000, agricultural exports shipped to EU as a percentage of total agricultural exports increased from 28 percent to 36.7 percent. During the same period, agricultural imports from the EU as a percentage of total agricultural imports also increased from 44.5 percent to 52.2 percent. At the moment, nearly 30 percent of the value of EU imports consists of farm commodities not produced in Lithuania, including grapes, citrus fruits and coffee. To date, unlimited access is allowed to these commodities, which pose little threat to local producers. In contrast, many of the more sensitive agricultural and food items, which are produced locally, continue to be relatively protected. However, with complete EU alignment, 4 A simple approach was used to sketch out the magnitude of possible impacts of demand response. To better capture the medium- to longer-term response in consumption to price changes, price demand elasticities for each separate product group were introduced. For Lithuania, no empirically estimated elasticities were available. Thus, they were assumed to be -0.05 for bakery products, -0.15 for vegetable oils and fats, and -0.25 for dairy products, meat products and sugar products. Compared to what has been estimated or assumed for other studies under a single price change, these elasticities are rather low. However, considering that we are dealing with a simultaneous change in many prices, we expect these parameters would be lower than those which apply under a single price change. 75 these patterns will change. Domestic producers of these more protected commodities will face more intense competition from EU imports. At the same time, some export sectors (especially processed dairy and animal feed sectors) may lose a part of their comparative advantage, which comes from access to lower cost primary materials such as milk. 2000 Agriculture and Food Trade Lithuanian Exports to the EU Hbrses Oilsreeds Fishf il et Aninre fted VegeIablesfrozen\/ Dairy produLcs 3.79 Fiscal Impact Expectations are that EU accession will provide very sizeable inflows of funds into the sector via EU Structural and Cohesion Funds. According to some estimates, in 2004-2006 Lithuania's potential gains from Structural Funds could reach some 881 million euro 2000 Agricultural and Food Trade Major Imports from EU (by value) Mat Fish pncessed A fel feed Prepaued hoft in annual payments (i.e., some 3.2 billion Lt or 7.6 percent of the 2000 GDP). Under the Cohesion Fund, Lithuania could receive up to 574 million euro (i.e., almost 2 billion Lt). These estimates, however, are likely to prove overly optimistic for a number of reasons. First, the numbers reflect the EU's potential share in project funding; it order to be realized they would require a sizeable co-financing share from the national budget. Given the need to maintain fiscal discipline, such co-financing may be limited. Second, access to certain funds (e.g., SAPARD) require completion of some specific measures, which may take time to implement, including: (i) 76 the strengthening of the National Paying Agency to be in conformity with EU standards and procedures; (ii) improving the land registry and completing the parcel digitalization; and (iii) completing animal herd registration. Third, the sheer magnitude of the potential fiscal transfers, without the proper management mechanisms both centrally and in the field, could quickly overwhelm Lithuania's administrative and the sector's absorptive capacities. Such administrative bottlenecks could seriously constrain the flow of resources into the sector, and more importantly, limit the effectiveness with which new resources are used. 3.80 In general, while participation in the EU agricultural program is expected to benefit the sector, the actual impact of Agenda 2000 may be well below the estimates presented above. Our analysis was grounded in prices prevailing in the year 2000. As a result of renewed intervention in 2001, and subsequent movements in world commodity prices, the gap between domestic and border prices has widened, thereby skewing the analysis for some important commodities. That said, the directions of adjustment are likely the same under updated price relatives as it was in 2000, only orders of magnitude may have changed. 3.81 Our analysis also assumes 100 percent participation and actual participation, at least in the early stages, could be much lower for a number of reasons. First, marketed volumes as a share of harvests varies greatly with commodities. For example, only a quarter of the grains and half of the milk produced ever enter market channels. But only those commodities commercialized would receive EU support prices. Second, only a very small fraction of total family farms are properly registered in compliance with EU. A minimum eligibility criterion for a farmer to participate in the EU programs is the registration of farm and herd. In Lithuania, up to 80 percent of the family farms have not registered their farms under the relatively simple and far less stringent national farm registry system, perhaps owing to fear of taxation, but also because title on leased lands is still not clear. Perhaps with the promise of the EU benefits, farmers would be encouraged to proceed with the necessary registration procedures. But it remains to be seen how quickly and effectively farmers can meet such EU administrative requirements. 3.82 It is worth noting that the mix of supports and payments offered by the EU to member agriculturalists would again stimulate expansion in some part of the sector beyond levels that would be realized were border prices to govern across the board. However, the EU's Agenda 2000 and associated CAP policies and investment supports would by no means approach the extremely distorted scale of production and unbalanced mix of commodities that characterized Lithuanian agriculture under central planning, Enhancing Dynamism in the Agricultural Sector 3.83 After adjusting to the dramatic changes caused by the break-up of its Soviet-style production and marketing systems, the Lithuanian farm sector is now preparing for EU accession. To this end, the sector must become more competitive, ensure compliance with EU guidelines, as well as safeguard against economic shocks to the more vulnerable rural social groups. 3.84 Every segment of the rural population will be affected by EU accession. In light of the expected increases in farm prices, especially dairy prices, the family farm sector will benefit, with farm incomes and land values rising. However, the process will also impose substantial costs. Many of the 175,000 small, family farms are expected to consolidate and disappear, and as a result rural un(der)employment will likely increase. With the loss of domestic subsidies, more agricultural enterprises could disappear as well. This too will result in labor shedding. To survive in the more competitive environment, farms must improve productivity through capital investments, especially to upgrade herds, piggeries and flocks, as well as machinery and on-farm 77 infrastructure. Serious bottlenecks in the industrial sector will have to addressed including obtaining sufficient EU export certifications for processed dairy and meat products. 3.85 Food prices are likely to increase with EU accession, as they also would were Lithuania to realign its border price parities with international prices. For the poor, higher food prices are could result in an estimated 10 percent decline in household income. Particularly affected will be the very vulnerable rural poor, especially the unemployed and those households with many children or with fixed incomes. 3.86 Foremost among the recommended reforms are adjustments to the macro-economic frameworkfor agriculture that would be consistent with the overall economic framework. Key policy areas of concern are the price and subsidies programs, agricultural foreign trade, rural taxation policies and the completion of land privatization. The ultimate objective is to create an essentially distortion free, efficient and internationally competitive agricultural sector. 3.87 In the realm of agri-food pricing, erratic producer support programs, through direct production and export subsidies, continue to introduce undesirable uncertainty and restrict efficient resource allocation. Major reform of price support systems reduced the number of products covered by minimum prices and initiated the shift toward direct payments, with an emphasis on support of higher quality products. A new agriculture strategy and related legislation, initiated in early 2000, introduced new market regulation and income support policies for the short and medium terms, including such mechanisms as intervention and direct payments to farmers. Nevertheless, a highly distorted sugar regime was announced in late 2001. The new regime relies on a de facto export subsidy financed by the domestic consumer and threatens the commitment to finance the sugar support program with sugar excise tax. In addition, the 2001 grain subsidy package re-introduces the minimum support prices, with first class wheat intervention prices set higher than the EU levels. In addition, the program has authorized direct area payments for food and feed grain growers. 3.88 To regain the high ground and reduce the extent of policy induced price distortion, the Government is urged to resume the deregulation of prices, while placing and greater reliance on income support, decoupled, and on direct payments that would be based on reference area and animal numbers and targeted to promote quality and efficiency improvements. Related are needs to (i) develop a consistent policy strategy for agriculture that provides a stable and long term planning environment for private and public decision makers and shifts agricultural support toward a focus on quality and efficiency enhancement and structural adjustment, (ii) increase support for improved market institutions including market information systems, and (iii) adopt a consolidated Agricultural Law, now under consideration, which follows EU guidelines regarding producer compensations and rural development programs. 3.89 Trade Policies: Negotiations for WTO accession and for a new trade agreement with the EU have been completed and the legal and institutional frameworks as well as the trade regime are in compliance with WTO requirements. The EU negotiation results, effective January 2001, provide for unlimited free access to both EU and Lithuania markets of the "least sensitive" agricultural products (those for which the previous EU import duty was less than 10 percent, products imported from the EU and not cultivated in Lithuania, such as citrus fruit and olives). The agreement also provides a double zero list, which includes pig meats, poultry, sausages, cheese, eggs, tomatoes and apples. In addition, tariff quotas have been increased, especially in the cheese sector. For certain products, such as milk powder and butter, Lithuania has been unilaterally granted duty free tariff quotas on imports to the EU. However, de factor export subsidies have been applied to sugar exports, the cost of which is primarily borne by the domestic consumer. 78 3.90 While a flexible, efficient trade policy framework is largely in place, the Government should ensure that Lithuania undertakes new WTO liberalization commitments as these emerge frohi the Millennium Round of trade negotiations, especially with respect to the prohibition on the use of export subsidies It could also profitably improve the country's agricultural foreign trade information systems. 3.91 Taxation: Policies should aim to increase transparency and enforcement of agricultural taxation and reduce tax preferences, which distort resource allocation between agriculture and other sectors. The Government has included a few measures in the new tax laws which brings taxation of agricultural activities closer to those of other sectors, namely: (i) personal income tax exemptions for persons engaged in agricultural activities will be eliminated since January, 2003; and (ii) land tax allowances for farmers and other rural populations will be reviewed in line with a new law on real estate tax. However, Government could still reexamine the efficacy of remaining tax exemptions and allowances currently in effect, including (i) corporate tax allowances for agricultural partnerships; (ii) legislation, approved in 2000, that exempts economically weak farms from full payment of social security contribution; and (iii) the excise tax on sugar and sugar containing products was introduced in 1998 as part of the new sugar market regime. 3.92 Similarly important for paving the way for Lithuania's imminent accession to the EU should be the conclusion of the land privatization process. The implementation of already approved restitution procedures-which formalize the transfer of State controlled land to the private sector, offer quit-claims and provide legal protection to owners and lessees-has been accelerated since the study mission visited Lithuania; however the process should be completed as swiffly as possible. With accession just around the corner, there is an urgent need to formally sanction the unfettered exercise of direct and indirect tenurial rights by farm operators. Drafts of the intended Law on Land Management and Administration, or other parallel enactments should seek to facilitate same: In addition, to attract capital to the sector, restrictions on formal land ownership, including prohibitions against ownership by foreigners and domestic legal entities, as well as those restricting alternative uses of agricultural land must be relaxed. According to recent Seimas recommnendation, in the negotiations for EU membership Lithuania will seek a transitional period of 7 years for acquisition of agricultural and forest land by foreign nationals. Govemment agencies will need strengthening to be able to manage EU farmn programs, especially the SAPAR'D fund program, and use of Structural. Much still needs to done to ensure that the farm sector can access SAPARD funds, including farm and herd registration; document preparation; and identification of sufficient counterpart funding sources. 3.93 A longer term focus should be maintained as well. In anticipation of the likely impact on the production side, government needs to take measures to develop efficient factor markets, including product, land and credit markets. Such measures include removal of policy induced distortions, improved farmer access to timely market information, assistance to producers seeking to improve producer organization and on-farm infrastructure. To accelerate farm consolidation and attract investment, an agile and modem land market is essential. This will require, inter alia, a completed land registry. Sound capital markets are needed to support sector modernization of the sector, both at the primary and industrial levels. To facilitate credit access, producers' collateral options, including land and movable assets, will need to be expanded and further developed. Programs concentrating on stimulating non-farm rural employment are also needed to help absorb the rural unemployed and underemployed 3.94 Competitive Agro-processing and Services for Agriculture: Considerable progress in has been made in the privatization of agro-industries, but additional domestic and foreign investment is needed to bridge the technology gap with EU producers. Foreign participation in 79 marketing and agro-processing has been very limited to date. In order to attract new investment, the overall business environment in agriculture and agro-processing needs to be improved. 3.95 To foster the creation of efficient, privately owned agro-business firms, subject to market forces, and agro-processing industries with high quality products that can compete in world markets, Lithuania would be well advised to (i) create and promote a policy and market enviromnent that attracts new investment, especially foreign investment that brings new agricultural and agro-processing technology, including the adoption of draft amendment to eliminate the special status of farmers' shares in agro-processing companies, (ii) adopt measures to facilitate the relocation of excess labor, (iii) strengthen and enforce legal measures to protect producers and processors from payment arrears, (iv) strengthen farmer/processor market information systems, and (v) support the modernization of transport, storage, and communications facilities. Furthermore, to expand exports of processed meats to the EU, considerable attention is needed to ensure that that a greater share of meat packing and processing plants meet EU sanitary and veterinary requirements. 3.96 Rural financial markets. The creation and development of a sound financial system is under way, but rural financial markets still need focused attention. Burdensome bank collateral requirements and the exclusion of land as a form of guarantee reduce farmers' access to credit. 3.97 Viable financial institutions serving the agricultural and rural sector efficiently represent an urgent need. To facilitate and stimulate capital investment, the Government is urged to: (i) complete the registration farm and herd registration, in compliance with the EU guidelines; (ii) develop financial arrangement to facilitate sector access, especially among smaller farmers, of sufficient funding to meet SAPARD counterpart funding requirements and document preparation; (iii) permit land ownership by'legal entities and the use of land as collateral; (iv) develop innovative methods for farmers to guarantee loans; (v) facilitate the development of financial services and retail banking services in rural areas; and (vi) provide training to farmers on preparation of business plans needed for loan applications. 3.98 The development of an institutional framework for agriculture is primarily driven by EU integration requirements. In this regard, (i) the National Paying Agency continues to prepare to be able to implement SAPARD programs, (ii) regulations were approved in 2000 regarding compulsory quality standards for food and agricultural products, and other technical regulations, (iii) milk quality control system and standards came into effect January 1, 2000, a step in converging to EU milk standards, while (iv) considerable progress has been made in the area of legal provisions concerning livestock breeding and veterinary medicine. 3.99 To continue the development of an efficient and effective public sector administration and support for private agriculture, it will be necessary for Government to (i) continue to strengthen the research system and increase focus on competitiveness of products, quality control and management of standards, (ii) continue reform of the national and regional agricultural administration, including the subordination of the regional agricultural officers to the Ministry of Agriculture and adoption of EU-required planning, accounting, and control procedures for national programs as well as for SAPARD, and (iii) complete implementation of the National Acquis Adoption Program for the development and implementation of quality requirements and the restructuring of the food quality control system. 3.100 Rural safety net: The anticipated farm consolidation and resultant labor shedding will require measures to facilitate the movement of labor from former agricultural activities to new employment, both within and outside the sector. A key instrument will be the strengthening of safety nets for the poor and for pensioners, and their adaptation to the needs of vulnerable 80 populations who reside in rural areas. The burden of diverting potentially investible funds from farm earnings to sustain livelihoods of the poor and vulnerable, though laudable as an act of human kindness, is simply inconsistent with the need for modernization investments in the sector. As the sector adjusts to EU and CAP mandates, it must be relieved of the burden of guaranteeing adequate income for pensioners and the "structurally" unemployed and poor. Though safety net programs are beyond the scope of this chapter, the providing and strengthening of same would seem to be legitimate mandates for the Govemrnent. We therefore strongly urge that the rural safety net should be redesigned, reinforced and expanded fairly quickly along lines proposed elsewhere in this report. 81 4. LABOR MARKET REFORM: ENHANCING FLEXIBILITY41 4.1 Labor market flexibility means the ability of the labor market to adjust swiftly to changing economic conditions and, in particular, the ability to absorb external "shocks" with limited adjustment costs. From the view point of macroeconomic performance flexible labor markets tend deliver better outcomes.42 Labor market flexibility is particularly important for Lithuania since operating a currency board it cannot use monetary and exchange rate policy to accommodate external adverse shocks (such as the 1998 Russia crisis). 4.2 There are three dimensions to labor market flexibility. From the macroeconomic dimension a flexible labor market gives rise to full utilization and efficient allocation of labor resources. This entails high labor force participation, low unemployment, and labor mobility resulting in an efficient structure of employment. The prerequisite of the latter is a process known as "creative destruction", that is the reallocation of jobs from declining firms and industries to expanding ones. From the worker dimension a flexible labor market means the ability to find gainful employment easily and without too much cost. This entails availability of information on job opportunities, low mobility costs, and a short duration ofjob search. From the employer dimension, a flexible labor market is one that does not unduly constrain the employer's ability to adjust the size, composition and remuneration of his workforce in response to changes in product demand. Each of the next three sections evaluates the performance of the Lithuanian market from the corresponding dimension. A. MACROECONOMIC DIMENSION: WIDESPREAD RESTRUCTURING WITH UNDERUTILIZATION OF LABOR RESOURCES 4.3 Lithuania's labor market is characterized by a low level of utilization of labor resources. Despite strong economic growth, which Lithuania has enjoyed since the mid-1990s, labor market slack has not diminished. One possible reason is a strong increase in real wages, which have outpaced productivity growth, thus leading to an increase in labor costs. Despite high unemployment, however, job turnover rates in Lithuania are very high (Table 4.1). Both job creation rates and job destruction rates are markedly higher in Lithuania than in other transition countries such as Poland or Slovakia. As a result, the "excess job reallocation" rate (the extent of job turnover beyond the necessary to accommodate net employment changes) is also much higher. Such a high excess job reallocation rate is an indication of very intensive restructuring going on in the labor market. This process seems to have been underway in Lithuania since the mid-1990s, with little variation over time in total job turnover rates. 41 This section is a summary of Chapter 2 (Rutkowski) of The Background Papers Volume of this study. 42 See, for example, OECD 1994; Blanchard (2000); Bertola et al. (2001); Boeri et aL; (2000); and Garibaldi and Mauro (1 999), among others. 83 4.4 Since the mid-1990s, job destruction has for the most part exceeded job creation and, as a result, net employment growth has been negative. However, the time variation of job destruction has been higher than that of job creation-with job creation rates remaining relatively constant over time, except for a slight slowdown in 1999-2000. All in all, and despite the slowdown, the evidence suggests that intensive job reallocation continues in Lithuania. Table 4.1 Job Creation and Job Destruction, 1996-2000 Lithuania Poland Slovakia U.S. 1996-97 1997-98 1998-99 1999-2000 1998-99 1997-98 1984-91 Job creation rate 14.0 14.0 13.6 10.5 9.7 2.0 13.0 Openings 5.2 4.0 3.8 3.6 4.4 8.4 Expansions 8.8 10.0 9.7 6.9 5.3 4.6 Job destruction rate 19.3 12.4 17.7 15.1 11.5 6.9 10.4 Closures 7.5 1.9 7.0 1.9 1.4 7.3 Contractions 11.9 10.5 10.7 13.2 10.1 3.1 Net employment change -5.3 1.6 -4.1 -4.6 -1.8 -4.9 2.6 Continuing establishments only -3.0 -0.4 -0.9 -6.3 -4.8 1.5 Job turnover rate 33.4 26.3 31.2 25.6 21.2 8.9 23.4 Continuing establishments only 20.7 20.5 20.4 20.1 15.4 7.7 Excess job reallocation rate 28.1 24.7 27.1 21.0 19.4 4.0 20.8 Continuing establishments only 17.7 20.0 19.4 13.8 10.5 6.2 Note: data for U.S. are averages for the period; data on transition economies refer only to one year. Source: Lithuania: Annual survey of wages and salaries (DA-03), various years, Bank staff calculations; Poland: World Bank (2001a); Slovakia: World Bank (2001b); United States: OECD (1996). Patterns of Job Turnover 4.5 Gross job creation has taken place largely in existing firms (Table 4.1). Still, new entrants have played a significant part in job creation. For example, out of nearly 11 percent of new jobs that were created in 1999-2000, 7 percent were created owing to expansions of existing firms and close to 4 percent were due to the entry of new businesses. In contrast, job destruction occurs mainly in existing firms, while firm closures play a secondary role.43 Out of 15 percent of all jobs that were destroyed in 1999-2000, less than 2 percent were lost due to firm closures, and over 13 percent were due to reductions in employment by existing firms. However, in the aftermath of the Russian crisis (1998-1999), firm closures did account for a substantial part of job destruction. 4.6 Job turnover is substantially higher in smaller firms. In firms with up to 10 workers the job creation rate approaches 20 percent, the job destruction rate is almost 25 percent, and close to 20 percent of jobs are reallocated from contracting to expanding firms. In contrast, in the largest firns (with over 1,000 employees) the job creation rate is less than 1 percent, the job destruction rate is 10 percent and thus job turnover is much lower than in small firms. Jointly, small firms and business start-ups create the bulk of new jobs. Small firms (of up to 50 employees) create almost 40 percent of all new jobs (Figure 4.1). Small firms and business start-ups (which as a rule are small) together account for over 70 percent of new jobs. The key part played in job 43 Firm closures are usually substantially underrepresented in most surveys, however this does not seem to be the case in Lithuania, where the statistical agency takes effort to determine in each case whether a non-response is due to firm closure or to a refusal to respond. 84 creation by business start-ups and small firms has important policy implications. It points to the critical role of competitive product markets, lack of barriers to entry, favorable business and investment environment in supporting employment growth. 4.7 Where are jobs being created? The highest job creation rates are in services and trade, which were relatively underdeveloped at the start of the decade. But job creation is also high in some manufacturing industries, such as wood products and furniture and in plastic products. 4.8 The fastest expanding industries, where job creation is much faster than job destruction, include financial intermediation and other business activities, wholesale trade, and some critical manufacturing industries that are characterized by being highly export oriented: manufacturing of RTV and communication equipment; furniture and wood products, and apparel (Table 4.2). This points to the critical role played by exports in generating jobs. 4.9 Employment Figure 4.1 Job Creation by Firm Size, 2001 growth within an industrial sector is 40 strongly correlated with 3 job creation but only 30 _ weakly (negatively) associated with job 25 -7- destruction. This means $ 20 that there are industries - - where employment lo . grows despite high job 5'iJI. destruction. At the __* _l_ _ same time, there is a Start-ups Micro Small Medium Large Extra large weak but positive correlation between O Share in job creation U Share in job destruction 0 Share in employment employment growth and the excess job Source: Annual Survey of Wages and Salaries, Bank staff calculations reallocation rate. This is a counterintuitive finding which means that industry restructuring tends to be conducive (not detrimental, as usually assumed) to employment growth. 4.10 These findings have several important policy implications. First, employment policies should focus on creating favorable conditions for job creation rather than on preventing job destruction and protecting unviable jobs. Second, contrary to conmnon perception, enterprise restructuring often results in employment gains, not losses, and thus should be encouraged rather than hampered. In other words, enterprise restructuring and associated job destruction are not detrimental to employment as long as business environment is conducive to job creation. It is high job creation, not low job destruction, that is key to employment growth. 4.11 Does job reallocation in Lithuania take place mainly between or within industries? This is an important issue, which defines the nature of industrial restructuring. The dominance of the between component of job turnover would point to reallocation of labor resources from declining industries to growing ones, while the dominance of the within component would indicate that resources are reallocated from contracting toward expanding firms within an industry. Using the standard decomposition of the excess job reallocation index (Davis and Haltiwanger, 1990), we find that although inter-industry employment shifts still play an important part in Lithuania, they are dominated by much larger intra-industry shifts. Between industry job shifts account for 18 percent of the excess job reallocation index and within industry shifts account for the remaining 85 82 percent. Hence, the dominant form of restructuring in Lithuania consists of intra-industry reallocation of jobs. As in other market economies (including transition economnies such as Poland or Slovakia), restructuring in Lithuania takes place mainly at the industry level, and consists of reallocation of jobs from less to more efficient firms within the same industry. Table 4.2 Job Turnover by Industry A. Top 10 industries with highest rates of job B. Top 10 industries with highest rates of job creation destruction Job creation Share in Job destruction Share in Industry rate (%) employment Industry rate ('Io) employment Financial intermediation 60.7 1.1 Construction 19.9 12.0 Wholesale trade 22.5 6.3 Insurance & pensions 18.2 0.6 Other business activities 19.9 2.7 Mineral products 17.8 1.9 Wood 18.5 2.6 Real estate 17.5 2.4 Recreation & culture 14.6 0.9 Hotels & restaurants 17.5 2.3 Hotels & restaurants 14.5 2.3 Car sale & repair 16.9 2.9 Car sale & repair 14.4 2.9 Wood 16.0 2.6 Furniture 14.3 1.9 Leather 15.8 0.5 Retail trade 13.9 9.0 Retail trade 15.5 9.0 Rubber & plastic 13.9 0.9 Recreation & culture 15.0 0.9 C. Top 10 industries with highest excess job D. Top 10 industries with highest employment reallocation growth Excess job Share in Net employment Share in Industry reallocation employment Industy growth (%) employment (%O) Wood 32.0 2.6 Financial intermed 55.5 1.1 Wholesale trade 29.4 6.3 0th bus activities 9.8 2.7 Recreat & culture 29.3 0.9 Wholesale trade 7.8 6.3 Hotels & restaurants 29.0 2.3 RTV & comnuunic 5.2 1.3 Car sale & repair 28.8 2.9 Furniture 3.6 1.9 Retail trade 27.7 9.0 Apparel 2.7 5.0 Rubber & plastic 27.7 0.9 Wood 2.5 2.6 Insurance & pensions 25.1 0.6 Petroleum products -0.1 0.6 Metal products 23.5 1.3 Recreat & culture -0.4 0.9 Travel 22.9 1.9 Rubber & plastic -0.5 0.9 Note: ranking based on industries whose share in total employment is at least 0.5 percent. Source: Annual survey ofwages and salaries, 1999 and 2000. Bank staffcalculations. 4.12 Lithuania's regions differ with regard to job creation, but hardly differ with regard to job destruction. The most successful regions create twice as many jobs (relative to their employment) as least successful one. Specifically, the job creation rate ranges from about 6 percent in the Utena and Alytus regions, to 12 percent in the Vilnius and Kaunas regions. However, compared to the differences observed in other countries, the overall regional variation in job creation is modest . Regional variation in the job destruction rate is even smaller, ranging from just under 11 percent in the Utena region to over 16 percent in the Marijampole region. The regions that have restructured the most are those in which the job creation rate has been the highest. Thus, labor markets are most vibrant in the Vilnius and Kaunas regions, and are stagnant in the Utena and Alytus regions. Interestingly, there is no visible relationship between regional unemployment rates and either regional job creation or job destruction rates. 86 Determinants of Job Creation 4.13 The previous section looked at patterns of job turnover, and especially of job creation, and documented an association between certain characteristics and job growth. This is useful from the point of view of understanding what is happening in the Lithuanian labor market. But, in order to extract policy recommendations, we need to go a step further and look at what factors may actually cause firms to change their employment level and create new jobs. In order to do this, we carry out some multivariate regression analysis to identify the independent impact of selected variables such as FDI, access to credit, export orientation, labor costs etc. (see Chapter 2, The Background Paper Volume for details on data, methodology and results). This regression analysis yields the following main findings: * All else being equal, small firms have a bigger employment creation potential than larger firms; * The share of foreign capital has no visible direct impact on firm employment performance; * Export orientation has a significant positive impact on firm employment growth, although the magnitude of the effect is not huge. One possible reason for the small magnitude of the effect is that there are two opposite forces at work. Once is access to foreign markets with positive effect on employment. The other is a greater focus on productivity with a negative short-term effect on employment; * Access to credit is not necessarily associated with better employment performance. Small firms receive proportionately little credit, even though they are the fastest growing in terns of employment. This may reflect the difficulties and reluctance of the banking sector to lend to SMEs; * Investment brings about employment growth: capital and labor turn out to be gross complements in Lithuania. Other things being equal, more capital intensive firms have a better job creation record than less capital intensive firms; and * Labor productivity contributes to employment growth in Lithuania, invalidating fears that productivity improvements imply job cuts. Job Turnover and Unemployment 4.14 How can high job turnover and high unemployment in Lithuania be reconciled? Is high unemployment itself a result of intensive restructuring (despite the high rate of job creation)? The analysis of the relationship between unemployment and job turnover suggests that intensive restructuring may have indeed contributed to high unemployment, but has done so indirectly via the emergence of frictional and structural mismatches in the labor market rather than directly. High job reallocation per se need not be associated with high unemployment, because high turnover usually means that the unemployed have a good chance of finding a new job, and hence that unemployment spells are short. It is thus possible to have a very high job destruction rate, and yet relatively low unemployment and short duration of unemployment spells (a classic example of this is the United States). The requirement for this to happen is a high degree of labor mobility (geographical and in terms of skills). 4.15 However, in Lithuania there appear to be some severe limitations in mobility from old to new jobs. The jobs that are being destroyed differ in salient characteristics (especially skill and location) from those being created. As a result, many of the workers that have lost their jobs do not have the right characteristics to take up the new ones. This leads to longer spells of 87 unemployment, and has contributed to the build-up of a pool of long-term unemployed. Since long-duration of unemployment is often associated with loss of skills and motivation, many of the long-term unemployed may have become marginalized and even less able to benefit from the relatively high job creation rate. 4.16 In such a context, policies should not focus on reducing the job reallocation rate-which as argued earlier is likely to be counterproductive-but rather on facilitating and supporting labor mobility through measures to reduce skill and regional mismatches. Such measures include training and retraining, as well as improving the housing market or promoting commuting through lowering transportation costs (which includes better transport infrastructure). Long-term unemployment can be partially tackled by carefully targeting active labor market interventions (such as training) at persons who are at high risk of long-term unemployment." B. WORKER DIMENSION: LONG DURATION OF JOB SEARCH 4.17 From the worker's perspective a labor market is efficient if it is easy to find a job paying a decent wage. This involves high probability of avoiding unemployment, short duration of job search, and wages that adequately reflect productivity differentials and human capital. The Lithuanian labor market does not fully meet these conditions. The risk of loosing a job is relatively high; and the chances of finding a new job, once a worker is unemployed, are rather low. Unemployment spells thus tend to be of long duration. Poorly educated, low-skilled and inexperienced workers find it particularly difficult to find employment. Labor Flows 4.18 Lithuanian workers face a high risk of losing a job. Some 5.7 percent of workers who were employed in May 2000 were unemployed one year later (Table 4.3). This is a high job separation rate by standards of both transition and OECD economies (Boeri 1998). For example, the job separation rate in Poland in the mid to late 1990s varied between 2.2 and 3.4 percent (Bell 2001), which is roughly half the magnitude observed in Lithuania. Similarly, in Slovakia- another high unemployment country-the job separation rate was 2.3 percent in 1999 (World Bank 2001c). Expectedly, most of the jobs are terminated by employers, so job separations are largely involuntary. Lay-offs are the main reason for unemployment among previously employed worker (46 percent), followed by terminations of temporary jobs (22 percent). Still, voluntary quits account for a sizeable proportion-almost one-third--of unemployment among the previously employed. Table 4.3 Transition Probabilities Across Labor Force States May, 2001 May, 2000 Enmployed Unemployed Out of the labor force Same job New job Employed 82.1 5.6 5.7 6.6 Unemployed x 24.0 60.4 15.6 Out of the labor force x 5.2 4.8 89.9 Source: Lithuanian Labor Force Survey. Bank staffcalculations. 4 Tbis mnay involve changing the incentive structure faced by public employment services so that they use profiling instead of creaming (i.e. focusing on those unemployed who are easiest to place to jobs). 88 4.19 The unemployment problem in Lithuania is magnified by large numbers of new entrants to the labor market. The yearly transition rate from inactivity into unemrployment is substantially higher than in other transition economies. For example, in Poland this rate was 2.2 percent in 1997/78 (Bell 2001), about half that observed in Lithuania (4.8 percent). Despite these large influxes, however, a vast majority of the unemployed in Lithuania (86 percent) has previous labor market experience. This proportion is quite typical of transition economies and indicates that the labor market is in the state of flux, that people lose jobs mainly because of enterprise restructuring. This figure also suggests that (despite high youth unemployment, which is a common phenomenon) barriers to entry are not a dominant labor market problem in Lithuania. 4.20 Finding new employment in Lithuania is a lengthy process. Only a minority of the unemployed-24 percent-find a job within a year. This is worse than in Poland or Bulgaria (where around one-third of the unemployed find a job within a year), or in Russia (near 40 percent), but better than in Slovakia, where the yearly job accession rate is less than 20 percent. On average, it takes over three years of search before a new job is found. This long-tern nature of unemployment is very costly for both the affected individuals and the society as a whole. International experience shows that long-term unemployment often leads to disenfranchisement and social exclusion, as chances to find a job decrease with unemployment duration. This so called "duration dependence" results from the erosion of skills and motivation on the part of the long-term unemployed as well as from the employers' reluctance to hire workers who were jobless for a long time. 4.21 Some worker groups are more successful than others in finding new employment. Two groups stand out in this respect. These are young workers and workers with university education. Both these groups on average find work much faster than their older and less educated counterparts. For example, it takes younger workers (aged 15-24) half the time needed to find a job by older workers (aged 55-64). Similarly, university educated workers need about half the time necessary to find a job by workers with less than upper secondary education. Table 4.4 New Hires by Previous Labor Market Status (°i6), 2001 Previous Labor Market Status One year earlier Employed 45.9 Unemnployed 45.7 Out of the labor force 8.4 Total 100.0 New hires: persons holding job for 12 months or less. Source: Lithuanian Labor Force Survey. Bank staffcalculations. 4.22 The unemployed have to compete for jobs with new entrants to the labor market (e.g., school leavers) and also with those who already have jobs but may be perceived by employers as better matches for existing vacancies. In this competition, the unemployed seem to be at a disadvantage. Job-to-job transitions are quite significant in Lithuania: some 5.6 percent of workers change a job within a year. This is somewhat more than, for example, in Poland where the job-to-job transitions account for between 4 and 5 percent of employment (Bell 2001). Flows from inactivity to jobs are also relatively large in Lithuania, again larger than in Poland. As a result, the unemployed are a minority among the new hires (Table 4.4). The majority of vacancies are taken by persons who changed jobs (46 percent) and new entrants (8 percent). This partly explains relatively low probability of escaping unemployment. It also points to a possible problem of the skill gap or skill mismatch on the part of the unemployed. 89 The Skills Gap 4.23 The skills gap seems to partly account for the limited transitions from unemployment into jobs. On average, the unemployed, and especially the long-term unemployed, have lower educational attainment and lower skills than the employed. Unemployment is disproportionately concentrated among workers with low educational attainment and poor skills. The unemployment rate among workers with less than upper secondary education is around 25 percent compared with 6 percent among workers with university education (Table 4.5). Similarly, the unemployment rate among workers in elementary occupations (i.e., the low skilled) is over 20 percent, compared with 4 percent among professionals or 8 percent among technicians. Low or inadequate skills are thus an important factor behind high unemployment in Lithuania. 4.24 Simulations of the magnitude of the skills gap (see Chapter 2, The Background Paper Volume) suggest that about 22 percent of the unemployed do not find a job because their skills fall short of employer requirements. The problem of the skill gap-the inadequacy between skills demanded by employers and those possessed by the unemployed-seems to be more pronounced in Lithuania than in some other transition economies of Central Europe. For example, in both Bulgaria and Poland the skill gap is smaller, accounting for about 17 and 14 percent of unemployment, respectively.45 Thus, the inadequate skill level of the unemployed, especially of the long-term unemployed, are likely to be a key factor behind relatively limited outflows from unemployment to work in Lithuania. Poor skills prevent a substantial fraction of the unemployed from effectively competing for jobs. Confirming this, Lithuanian employers increasingly mention lack of skilled labor and difficulties in finding and hiring skilled workers and technicians as a constraint to their business expansion. 4.25 The apparent importance of the skill mismatch problem in Lithuania has two policy implications. First, it indicates the need for greater wage flexibility, especially at the lower end of the wage distribution, in order to encourage the creation of low skilled jobs and improve the employment prospects of poorly educated unemployed. Second, and more fundamentally, it points to the role of the educational and training systems in curbing the problem of low, narrow and inadequate skills. 4 See Rutkowski (1998) and Rutkowski (1999) for the estimates of the skill gap for Poland and Bulgaria, respectively. 90 Table 4.5 Unemployment by Educational Attainment and Occupation, 2000 Unemployment Share in Share in Rate (%o) Unemployment (%) Employment (%lo) Total 15.4 100.0 100.0 By Education: University 5.9 7.2 20.9 College 13.6 21.7 25.0 Upper secondary general 17.3 23.1 20.0 Upper secondary vocational 18.6 22.2 17.7 Lower secondary general 26.2 14.9 7.6 Lower secondary vocational 24.0 8.7 5.0 Primary or less 9.3 2.1 3.8 Source: Labor Force, Employment and Unemployment (survey data) 1997-2000, Statistics Lithuania, Vilnius 2001. Bank staff calculations. Job Security 4.26 Flexible labor markets are typically associated with short job tenure: in flexible markets jobs may be less secure but at the same time there is more hiring and it is easier to find a job. Accordingly, a dynamic labor market is characterized by a relatively short job tenure and a high proportion of new hires (short tenure workers). Lithuania falls somewhere in the middle in terms of its tenure characteristics: much shorter average job tenure (5 years) than in more rigid" market economies such as Germany or France (11 and 7.7 years respectively); slightly below that of other transition economies such as Poland (at 6.2. years); but above that of "flexible" market economies such as the U.S. (4.2 years). All in all, its tenure rates would, however, point to a flexible market. Yet at the same time, there are relatively few new hires in Lithuania than in most OECD economies. For example, the proportion of new hires in total employment in Lithuania is only 15.5 percent, some 20 points lower than in Spain and 10 points lower than in Denmark. Compared with other transition economies, Lithuania has fewer new hires than the Czech Republic but more than Poland. 4.27 There are significant differences across sectors and jobs in the degree of security. Public sector jobs, for example, exhibit much longer tenure than private sector ones but also a much lower proportion of new hires. Despite facing the same regulatory environment than larger or public firms, small private firms constitute the most flexible and dynamic part of the Lithuanian labor market. Median tenure in firms of up to 10 workers is 3 years, and the proportion of workers with less than a year tenure is 30 percent. In comparison, in firms with more than 50 workers median job tenure is 7 years and the proportion of new hires is only 10 percent. A worker looking for a job thus has a much larger chance of finding a job in a small firm, than in a larger firm. Overall, about one-half of the Lithuanian labor market appears to be "flexible" as regard labor turnover, while in the other half regulations seem to be more binding and may be restricting labor turnover. While in practice this translates into a fairly flexible labor market, such dualism does bring about significant inequities in treatment across workers depending on firm size. In this context, labor market deregulation can both enhance labor market flexibility and yield more equitable outcomes. 4.28 Another component of the flexible segment of the labor market are so called "flexible jobs". These include fixed-term and temporary jobs, part-time jobs, and self-employment. These types of jobs have accounted for a large part of the recent employment growth that has occurred in the EU. How does the Lithuanian labor market score in this respect? The data indicate that flexible forms of employment are fairly limited in Lithuania. Fixed term and temporary contracts 91 are not popular and account for only 6.5 percent of all employment contracts. Similarly, part- time jobs are held by less than 9 percent of workers, and thus are relatively rare. Finally, self- employment is not a common form of employment, either. Only one in ten Lithuanian workers chooses self-employment as a way of earning a living, which is less than in most transition economies of Central Europe, and also less than in some EU countries, such as Spain or the U.K. Accordingly, the vast majority of jobs are traditional permanent, full-time jobs. Flexibility is achieved through employment adjustment (firing and hiring), rather than by using flexible forms of employment. 4.29 The limited incidence of flexible forms of employment reflects the existence of regulatory restrictions on the use of part-time and fixed-term contracts, possibly unfavorable treatment of part-time employment with respect to the entitlement to various work-related benefits, and probably the lack of tradition and incentives to use flexible contracts. Clearly, there is scope in Lithuania to increase employment through a more widespread utilization of flexible employment contracts and self-employment options. In this context, the new Labor Law recently approved by the Seimas (see para. 4.32 below) should help. The Law introduces some new modalities of part-time and temporary employment which should contribute to raising employment rates among some segments of workers (most notably women and youth). The new Law, however, maintains restrictions on the use of fixed-term contracts by limiting the number of permissible renewals. While the idea behind these restrictions-to increase job security and protect workers from possible abuse of FTCs by employers-is understandable, its implementation is likely to be achieved at the cost of limiting hiring and job creation. 4.30 What kind of labor market deregulation should Lithuania pursue in regards to hiring and firing? In many respects, the current legal regulations of employment are already quite liberal. And the entry into force of a new comprehensive Labor Law -as of January 2003- should reinforce the existing degree of labor market flexibility. The authorities are thus moving very much in the right direction. 4.31 The new Lithuanian Labor Law has been largely inspired by the need to conform to EU standards. The Law introduces new forms of flexible employment contracts, liberalizes firing conditions, and foresees the possibility of reducing minimum wages for specific sectors or groups. Most notably, the Law also seeks to promote social partnership in enterprises, and to build a shared commitment to labor standards and labor mobility among employers, workers organizations and government. The assumption is that only a collective approach can simultaneously achieve the labor market flexibility that Lithuania needs to continue its rapid structural transformation, while ensuring fairness and equity of treatment for workers across all enterprise segments. Indeed, the European experience during the 1980s suggests that such a "negotiated" approach to flexibility has a high chance of success. Social partnership and negotiation has been a key ingredient of labor market reform in Austria, Denmark, Ireland, the Netherlands and Spain, among others. 4.32 The counterpart of more flexible negotiation between social partners (especially employers and worker organizations) on conditions of employment and work, has to be better and more effective enforcement of the rules that have been adopted. This will require appropriate institutions for resolving disputes, a continued development of Labor Inspectorates and an effort to set gradually higher standards for health and safety at work. Co-operation with the EU and individual countries appears particularly important in these areas. 92 Earnings Inequality 4.33 Labor market liberalization and institutional changes associated with the economic transition have brought about a marked increase in eamings inequality. A similar trend has been documented in nearly all transition economies (Rutkowski, 2001). A rising trend in earnings inequality need not be negative if it reflects that retums to skills and other worker characteristics are increasing in proportion to their relative value and scarcity. In fact, flexible labor markets tend to be characterized by a higher level of earnings dispersion than more rigid ones. Moreover, a certain degree of eamings dispersion has been found to be conducive to job creation (OECD 1994, Bertola et al., 2001). Excessive eamings inequality, however, can lead to the emergence of "working" poor, and can over the long-term be detrimental to social cohesion. 4.34 Eamings inequality in Lithuania is rather low in comparison with other transition economies of Central and Eastem Europe and modest by the EU standards. The Gini coefficient in Lithuania is 27.3, which is below that observed for pre-tax earnings in most OECD countries. A more intuitive measure of inequality is the decile ratio, which can be thought of as the ratio of high wages (upper decile) to low wages (bottom decile). This ratio is 2.8, which again indicates a modest level of inequality. The bottom decile worker eams about 60 percent of the median wage, which means that his/her relative earnings position is relatively good. On the other hand, the top decile worker eams only 67 percent more than the median worker, implying somewhat limited premium for high skills (productivity). In most transition economies the relative earnings position of low paid workers is worse than in Lithuania, while the relative position of highly paid workers is better. 4.35 Limited eamings dispersion is good news to the extent that higher incomes are associated with higher worker welfare, and with a lower incidence of working poverty. On the other hand, it is bad news to the extent it entails lower returns to high skills and, even more importantly, to the extent it translates in more harmful inequality, namely that in access to jobs. The latter effect may occur if relative wages do not adjust sufficiently to changes in demand for and supply of different categories of workers and thus price some workers out of the labor market. In other words, insufficient wage dispersion may entail the reduction in the number of low skilled jobs and thus contribute to unemployment. 4.36 Surprisingly, there does not seem to be much difference in wage setting practices between small and large, private and public firms. The lack of visible differences in wage dispersion across sectors distinguishes Lithuania from other transition economies, where as a rule wage variation in the private sector is considerably higher than in the public sector (Rutkowski, 2001). One possible reason, relating to the bottom tail of the wage distribution, is the minimum wage-which has more "bite" in Lithuania than inmost other transition economies. A high minimum wage may effectively prevent firms from adjusting wages downwards, and could produce an uniform wage floor. It is more difficult to find a plausible explanation for the compression at the top tail of the wage distribution. C. EMPLOYER PERSPECTIVE: CONSTRAINTS TO EMPLOYMENT AND WAGE ADJUSTMENT 4.37 This section looks at constraints faced by employers in adjusting employment and wages to changing demand conditions. Constraints to employment adjustment come primarily from the employment protection legislation, which imposes some firing and hiring costs. Constraints to wage adjustment come mainly from the existence of the statutory minimum wage. Broadly, our analysis indicates that regulatory barriers to labor market flexibility are modest in Lithuania. However, a relatively high minimum wage may be constraining necessary wage adjustments. 93 Although labor market rigidities are not overwhelming in Lithuania, in many dimension labor market flexibility can be improved. Constraints to Employment Adjustment 4.38 On paper, dismissals are easy in Lithuania. In practice, they have sometimes turned out to be more difficult and costly. The Law on Employment Contracts (which is a part of the Labor Code) lists a number of valid reasons for dismissal, which include business needs and poor- performance on the part of a worker. However, employers tend to complain that in practice dismissals are difficult since the burden of proof in justifying a dismissal is on the employer. Workers (especially those laid off for disciplinary reasons) often resort to court appeal, claiming unfair dismissal. Courts tend to exhibit a pro-labor bias and as a rule order job reinstatement and payment of compensation amounting to forgone earnings (up to 12 months salary). To the extent this indeed is the case, there is a risk involved in firing a worker, and monetary costs of dismissal-if found invalid-can turn out to be substantial. This can effectively prevent some employers from firing redundant workers. It seems, however, that the dismissal costs result mainly form the judicial interpretation of the law in favor of workers, rather than from the law itself.46 Difficulties associated with dismissals are likely to decline significantly with the entry in force of the new Labor Code in January, 2003. The new Labor Code eliminates the need for a "valid" reason for dismissal, and introduces an automatic severance payment in the case of a redundancy initiated by the employer. 4.39 In the case of normal dismissals, the employer has to give advanced notice 2 months prior to termination of employment and offer severance pay, which is related to job tenure and ranges from I month to 3 months salary.47 These costs are the same for both individual and collective dismissals.48 However, in the case of collective dismissal local authorities can suspend the dismissal for up to 6 weeks, which can lead to additional costs. All in all, these dismissal costs are within the range characteristic of other transition and OECD economies, although the advanced notice in Lithuania is rather long for workers with short job tenure-2 months compared with 2 weeks in Poland. 4.40 An alternative to employment adjustment is working time adjustment. In Lithuania employers have an option to redistribute working hours within a period of one quarter and to use overtime, which implies some degree of working time flexibility. However this degree is limited and can be enhanced. First, the period within which employers are allowed to redistribute working hours is relatively short. The longer the period during which employers can reschedule working hours the larger the room to adjust working time to seasonal fluctuations in demand. The world trend is toward annualization of working hours, i.e., calculating the weekly working time on a yearly basis. Second, the use of overtime is restricted by a relatively strict yearly limit of 120 hours, and by a high mandatory overtime premium (50 percent of base salary). The limit on the use of overtime is in Lithuania much stricter than in most other countries. For example, in Estonia and Hungary it is 200 hours. As regards mandatory overtime premia, they are high in most transition economies of Central and Eastern Europe, and Lithuania is not an exception. In contrast, in many OECD countries the overtime premium is only 25 percent. Moreover, in many 46 The law offers a way to reduce the risk associated with dismissals, but this comes at price. There is a provision whereby an unconditional dismissal is feasible (i.e., the emnployer is not required to prove a valid reason) provided that the employer pays a statutory compensation. The amount of the compensation is proportional to job tenure and ranges from 4 months to 12 months salary. 47 Some worker groups, such as workers with children, workers with disabilities and workers near retirement, are entitled for 4 months advanced notice of dismissal. 48 In many countries collective dismissals are associated with higher costs than individual dismissals. For example, in Poland severance pay is mandatory only in the case of a collective dismissal. 94 countries efforts have been made to minimize the cost of overtime work. An increasingly widespread measure is to grant compensatory rest time instead of extra overtime payments (Ozaki, 1999). Constraints to Wage Adjustment 4.41 Constraints to wage adjustment come from the existence of the statutory minimum wage, as well as from other so-called wage floors, such as unemployment benefits, which provide a floor for the wage distribution. Since the mid 1990s the minimum wage in Lithuania has been relatively high (Table 4.6). Currently it accounts for about 40 percent of the average (mean) wage. This is high by standards of most CEE economies, where the minimum wage tends to account for around 30-35 percent of the average wage; for example, in Estonia the minimum wage accounts for less than 30 percent of the average wage (IMF, 2001). 4.42 Although the "bite" of the minimum wage is commonly measured by the ratio of the minimum wage to the mean wage, this can be misleading. The problem with using the average (mean) wage is that it is not representative of the market wages of a "typical" worker, especially of the low-skilled. The average wage is to a large extent influenced by earnings at the top of the distribution, and owing to the asymmetric nature of earnings distribution, a vast majority of workers earn less than the mean wage. Therefore a more accurate measure of the bite of the minimum wage is the ratio of the minimum wage to the median wage, or alternatively to that of the bottom decile. On these measures the bite of the minimum wage in Lithuania proves substantial. The minimum wage accounts for 50 percent of the median wage, and is close to 100 percent of that of the bottom decile. The latter indicates that there is a relatively large number of workers working at or even below the minimum wage. Table 4.6 Evolution of the Minimum Wage, 1994-2000 Minimum wage as % of 1994 1995 1996 1997 1998 1999 2000 Gross average wage 15.5 26.1 35.7 45.8 41.4 40.0 39.5 Median wage .. .. .. .. 50.1 Bottom decile wage .. .. .. .. 97.1 Source: Earnings indices 1991-2000, Statistics Lithuania, Vilnius 2001. Earnings distribution in October 1999, Statistics Lithuania, Vilnius 2000. 4.43 The high minimum wage prevailing in Lithuania in recent years might have had a negative employment impact. This is because a minimum wage that is high relative to productivity inhibits the creation and encourages the destruction of low-productivity jobs. The gain is faster restructuring and higher average productivity; however, it comes at the high social costs of higher unemployment, as low-skilled workers are priced out of the market. Put differently, a high minimum wage leads to employment rather than wage adjustment, which carries both benefits and costs (Boeri and Terrell, 2001). Are the Constraints Binding? 4.44 Regulatory constraints restrict employers' choices to the extent that they are enforced. As evidence by high job turnover, and especially by the high job destruction rates, employment protection legislation and associated dismissal costs do not seem to significantly restrict employers' ability to adjust the size and composition of their workforce. However, firing seems '9 The relatively high incidence of minimum or sub-minimum wage employment in Lithuania can be in part accounted for by underreporting of wages by employers in order to lower the burden of taxation and social security contributions. 95 to be easier in small firms and more difficult in large firms. This leads to significant inequities in treatment across workers. Such inequities are also a product of very different enforcement of existing regulations in small and large firms. Employment protection regulations, as well as other regulations affecting conditions of work, are well-enforced in large, unionized firms,. However, in small private, non-unionized firms enforcement is weaker. Weak enforcement in smaller firms increases labor market flexibility overall, but in some cases may come at the price of violation of basic worker rights and standards. According to anecdotal evidence, in many small firms basic standards of occupational health and safety are often not observed. There is a trade-off here, and not always the optimal balance is struck. In some firns there is too little worker protection while in others there is too much protection and too little flexibility. Relaxing some of the regulatory restrictions while improving enforcement would probably improve the social outcome. 4.45 The minimum wage is likely to be a binding constraint to wage adjustment, although is some segments of the economy enforcement seems lax. The major piece of indirect evidence on the detrimental effects of the high minimum wage in Lithuania is high unemployment concentrated among less productive workers: the youth and the low-skilled. Consistent with this is wage distribution that is compressed at the lower end. There is a visible spike at the minimum wage, suggesting that it truncates the wage distribution. The bite of the minimum wage is particularly pronounced in industries employing large numbers of low skilled workers, such as agriculture, hotels and restaurants, and trade. In these industries the incidence of minimum and sub-minimum wage employment ranges from 20 to 30 percent. However, these figures also indicate that some workers are paid less than the minimum wage. 4.46 Indeed, the average wage in the lowest wage bracket is significantly less than the minimum wage, implying that enforcement is weak.50 To the extent employers are able to circumvent the minimum wage regulation, it obviously does not harm employment. However (similarly as in the case of the employment protection regulations) it would be preferable to adopt a lower minimum wage with stricter enforcement, rather than the other way round. 4.47 The evidence suggests that there are two groups of workers in Lithuania that may be especially negatively affected by the minimum age, namely first-time entrants and low-skill workers. These are often workers in need of significant on-the job training, whose cost to the firm at the minimum wage exceeds their immediate productivity. This problem is not limited to Lithuania, but is widespread in many other OECD countries as well. In response, many countries, such as Belgium, France, and the Netherlands, have introduced sub-minimum wages for particular groups, most notably younger workers. Other countries have a single minimum wage, but allow a lower wage for apprentices. This is the case, for example, in Hungary and Spain, and also in Canada. And yet others, such as New Zealand, have both a sub-minimum wage for young workers and an apprenticeship wage. For the most part, country experiences with such sub-minimum wages has been very successful. For example, in Spain, where the introduction of an "apprenticeship" minimum wage in the mid-1990s was greeted with much distrust from unions and worker representatives, the evidence has proven their fears unfounded. Employment by first-time entrants increased significantly following the introduction of the apprenticeship wage, and did not come at the cost of firings or higher unemployment of older workers (Jimeno, 2002). For other at risk groups, such as the long-term unemployed, the more common approach has been to use wage subsidies to reduce the de facto minimum wage, rather than altering the minimum per se. 50 According to the employer based survey, the average wage in the lowest wage bracket in 1999 was 330 Lits while the minimum wage was 430 Litas. Although the former figure is biased downwards due to the inclusion of part-time workers, still the discrepancy is substantial. 96 4.48 While limiting employment chances of less-skilled workers, the high minimum wage in Lithuania has contributed to the fast pace of enterprise restructuring and productivity improvements. By restricting adjustment of wages to the fall in the demand for low-skilled labor, the high minimum wage in Lithuania forced employers to close low-productivity jobs implying a rise in the average productivity level The high rate of job reallocation provides support to this view. If this argument is correct, then the high minimum wage would explain the apparent paradox that high job turnover coexists in Lithuania with a stagnant unemployment pool. Job turnover.is high, because employers have to close low-productivity jobs and replace them with higher productivity jobs. The unemployment pool is stagnant since low-productivity workers due to the high minimum wage are locked out of employment (Boeri and Terrell, 2001). 4.49 To conclude, Lithuania has modestly restrictive employment protection regulations but a relatively high minimum wage. However, the effects of legal norms seem to be unevenly distributed across different segments of the economy. There is a flexible segment, consisting of small private non-unionized firms, where enforcement of regulations is weak. At the same time, there is a less flexible segment, consisting of large public or privatized firms with strong unions, where actual firing and hiring costs are higher, and thus the adjustment capacity is lower. And on top of this there is a substantial informal sector where employers by definition face virtually no regulatory constraints and flexibility is unfettered.5' In general, the labor market would benefit from allowing more flexible negotiation between social partners, while coupling this with more effective enforcement of the adopted norms. D. SUMMARY AND POLICY RECOMMENDATIONS 4.50 Overall, the labor market in Lithuania is relatively flexible. There are few effective constraints to employment adjustment, as witnessed by high rates of job creation and job destruction. However, the scope for wage adjustment is limited due to the relatively high statutory minimum wage, which might have led to elimination of low-productivity jobs. As a result, there has been far-reaching reallocation of labor associated with substantial productivity improvements and thus relatively high economic growth. At the same time, labor resources have been underutilized, which manifests itself in the relatively low labor force participation rate and high unemployment, concentrated among low-productivity workers. In short, the structure of the labor market in Lithuania favors productivity and wage growth over employment growth. Labor market institutions in Lithuania do not seem to inhibit economic growth, however they contribute to "jobless" growth and persistent unemployment. 4.51 Although the labor market in Lithuania is relatively flexible, there is a number of measures that if undertaken would improve labor market performance. These include: * Improve business environment, especially for SMEs. Small firms are particularly vulnerable to bureaucratic harassment. At the same time, SMEs play a critical part in both job creation and job destruction. Improving the business environment thus carries the potential to foster job creation with resulting growth in employment; * Lower barriers to entry. Business start-ups account for a large fraction of all newly created jobs. Accordingly, fostering entry of new firms is likely to result in faster job creation; * Foster the creation of new jobs (by improving investment climate) but do not try to prevent the destruction of unviable, low-productivity jobs. Job destruction and 5' According to data compiled by SSIF (Social Security Institution), the share of informal sector in employment is from 8 to 13 percent (depending on the definition adopted). 97 restructuring are conducive, not detrimental, to employment growth. Accordingly, attempts to forestall restructuring in order to protect jobs are in the longer-run counter- productive; * Improve access to credit by small firms with growth potential, and tighten banking practices to prevent the absorption of credit by unviable firms; * Improve the skills of poorly educated workers as a means of addressing the skills gap. This can be achieved by improving access to and better quality of primary and secondary education, including vocational education. Emphasis should be placed on making workers with lower educational attainment trainable and employable, rather than on mechanically increasing the number of workers with higher education; * Enhance wage flexibility in order to accommodate the excess supply of low skilled workers. This can be achieved either by reducing the minimum wage as a percentage of the average wage, or by differentiating the minimum wage (e.g., by introducing the youth sub-minimum); * Promote flexible forms of employment, including fixed-term contracts, in order stimulate labor supply (e.g., part-time work by women) and labor demand; * Liberalize the use of fixed-term contracts by removing a limit on the number of successive renewals while keeping the existing limit on total duration; * Adopt the practice of annualization of working hours, i.e. calculating the weekly working time on a yearly basis; * Lower the cost of overtime work by allowing social partners to negotiate freely the number of hours as well as the amount and forms of compensation (monetary vs. time off), while setting the ceiling on the total number of hours (at least 200 hours) and the minimum overtime premium at 25 percent of the base salary; and * More generally, labor market performance could be improved by letting social partners "negotiate flexibility", which would be consistent with a world-wide trend (Ozaki, 1999). This would imply deregulating labor relations and devolving the responsibility for determining them to social partners themselves, while the state would be responsible for setting and enforcing only basic norms and standards. In other words, the state should reduce the scope of its regulatory activity in the area of labor relations, and at the same should improve its capacity to enforce basic worker rights and standards. 4.52 Some of these measures are implicit in the new Labor Law recently adopted by the Seimas. In this regard, the authorities are clearly moving in the right direction. 98 5. REGULATORY REFORM: IMPROVING THE BUSINESS ENVIRONMENT52 5.1 A recent World Bank study, Transition: The First Ten Years (World Bank, 2002), showed that new enterprises, especially Small and Medium Enterprises (SMEs), have been critical to growth in transition economies. In the most successful transition countries, growth has been driven by the transfer of resources from old, unviable enterprises to the new, more productive ones. The process has involved a combination of discipline-inducing policies (e.g. hard-budget constraints) on the old enterprise sector on the one hand, and adequate encouragement and support of new enterprises, on the other. In general, growth has taken off when the new enterprise sector reached a minimum size threshold (or the order of 40 percent of employment), and when this new sector evolved from being a passive receptacle for absorbing resources into an active competitor attracting the more qualified resources. Consistent with this role as the "engines of growth", enterprise surveys have found that new enterprises (mainly SMEs) outperform old enterprises on all dimensions (sales, value added, exports, investment, employment and productivity). 5.2 In Lithuania, the shift of labor and capital resources in from public to private sectors has roughly followed this pattem. By 1998, SMEs accounted for about 55 percent of both employment and value added. However, the growth payoff of this process has been somewhat lower than in neighboring Poland or Estonia. Two factors help explain this lower growth performance. First, the discipline imposed on the old enterprises sector has been less than in some of its faster-growing neighbors. Substantial resources in Lithuania are, in fact, still directed to the "old" enterprise sector in the form of subsidies, soft credit, and tolerance of payment arrears. This is particularly true in agriculture, but also in some critical infrastructure sectors. By delaying restructuring in these sectors, and by favoring their absorption of resources which could be more productively employed in new enterprises, these types of policies have contributed to slowing down growth. Creating a policy environment that imposes greater discipline in these lagging sectors and encourages restructuring, thus has the potential for putting Lithuania on an accelerated growth path. 5.3 Second, the growth of the new enterprise sector in Lithuania has also been slowed down by weaknesses in the business environment. A 1999 Foreign Investment Advisory Service (FIAS) study, Lithuanian Administrative Barriers, identified over-regulation, restrictions in land and labor markets, unpredictability of new regulations and legislation, and lack of transparency in the workings of the public administration as important barriers to business development. A recent update of the FIAS study suggests that the regulatory and business environment has not improved much since then (Rodogno, 2002). These barriers represent much more of a burden on SMEs and on new entrants, than they do on larger enterprises. Improving the investment and business climate will allow the size of the new, SME sector to increase. This in turn will help 52 This chapter draws on the work presented in Chapter 6 (Smarzynska) and Chapter 7 (Vilpisauskas) of The Background Papers Volume of this study, as well as on the background paper by Rodogno (2002) and on the recent World Bank study, Transition: The First Ten Years (World Bank, 2002). 99 increase the growth rate of the economy. A more dynamic SMEs sector will also play an important social role, by facilitating the re-employment of labor resources to be released from agriculture and other restructuring sectors. A. ELEMENTS OF A FAVORABLE BUSINESS ENVIRONMENT 5.4 There is a very large number of factors that affect the overall business and investment climate. Roughly, these factors can be divided into two categories. One is the overall enabling environment, or the nature and quality of public goods needed to complement private activity. These would include a stable macroeconomic framework; an open trade regime that allows firms to enter foreign markets with minimal risk; a banking system that provides effective and balanced financial intermediation; a legal and judicial system capable of enforcing contracts and protecting property rights; a social system that promotes the development and maintenance of human capital; and a network of basic infrastructure. 5.5 The other critical category is the set of rules and regulations that shape the business environment per se. This comprises administrative procedures and processes, conditions of open and fair competition, and the numerous interfaces between private and public sectors that influence business activities. 5.6 Improving the business climate in Lithuania requires action on both fronts. First, it is necessary to improve the quality of the overall enabling environment- that is of the public policies, institutions and services that support the development of the private sector. In this regard, Lithuania's record is already quite strong. Nevertheless, as discussed in Chapter 1, there are a number of remaining items from the structural reform agenda which still need to be addressed. Progress on these remaining structural issues would do much to improve the country's overall business and investment climate, increase savings and attract foreign investment. 5.7 Structural reform priorities which would contribute to improving the overall business environment include: * Prioritizing public expenditures to allow room to finance necessarv investments in education, social expenditures and public infrastructure. Skill shortages are emerging as one constraint to business growth in Lithuania. Putting in place an education and training system that can equip the labor force with the skills in demand is critical to long-term competitiveness and productivity growth. Provision of good quality infrastructure to support business development is equally critical; * Streamlining Lithuania's complex tax structure according to EU requirements. Burdensome tax requirements and tax administration are consistently highlighted as a major constraint on business operations. There is an ongoing reform of the tax system aiming at the harmonization of tax laws with the EU requirements, which should go some way towards streamlining tax procedures and increasing transparency. Tax reforms, however, must also encompass the tax administration, and must be consistent with the pace of the targeted deficit reduction; * Continuing financial sector reform. While the foundations of a sound financial system have been put in place, further reforms are needed to enhance the resilience of the financial system and to foster a broadening and deepening of the range of financial products and services available. Improving the abilities of small and medium enterprises to meet the requirements of the creditors is necessary to underpin sustained growth of that sector; 100 * Completing the privatization process; Completion of privatization in airlines, shipping and railways will lay the basis for a more competitive and efficient transport sector, with important positive spillover effects on the competitiveness of other sectors. Similarly, the development of an efficient and competitive energy sector should remain a key policy objective. In agriculture, completion of land privatization remains an urgent priority; and * Enhancing labor market flexibility. Greater labor market flexibility will improve labor market outcomes and reduce Lithuania's underemployment of labor resources. Greater wage flexibility is needed to ensure that the labor market absorbs the excess supply of low skilled workers. This can be achieved either by reducing the minimum wage as a percentage of the average wage, or by differentiating the minimum wage. More flexible forms of employment can also add to overall labor market flexibility, as can more generally the practice of letting social partners "negotiate freely" over overtime and working conditions (see Chapter 4). Targeted training programs and other measures aimed at improve the skills of poorly educated workers can reduce skill mismatches and the existing skills gap 5.8 Beyond this, the Government also needs to focus directly on eliminating the obstacles that discourage investment and competition, and impinge on the operation and growth of business, and especially SMES. As highlighted by the 1999 FIAS study, and by multiple firm and enterprise surveys, businesses in Lithuania face a myriad of administrative restrictions and other non-market barriers to their operation. These barriers de facto limit the expansion and growth of the new enterprise sector. Eliminating remaining distortions and restrictions in land, construction, labor and transit; rationalizing registration and licensing procedures; streamnlining liquidation and bankruptcy procedures; and increasing the effectiveness of public administration officials dealing with businesses, will all contribute greatly to improving the business climate and to hence to the growth of new enterprises. 5.9 The rest of the chapter is organized as follows. Building on the evidence provided by enterprise surveys, Section B identifies some of the main administrative and regulatory constraints impinging upon the operation of Lithuanian private enterprises, and especially SMEs. Section C then examines how the regulatory framework, and the business environment more generally, will be affected by EU accession and the consequent adoption of EU regulations and norms. Finally, Section D concludes with a broad policy agenda to improve Lithuania's business and investmnent climate. B. OBSTACLES TO PRIVATE SECTOR DEVELOPMENT: A FIRM-LEVEL VIEW 5.10 This analysis of the business environment is based on several different sources of information. The main one is an enterprise level survey first undertaken in 1994, then in 1997, and now repeated in 2001 in preparation of this report.53 In all runs, the survey was based on the same questionnaire and was conducted by the same polling agency using the same sample selection methodology to ensure comparability of results (see Chapter 6, The Background Paper Volume for details). The second source of information is the 1999 Business Environment and Enterprise Performance Survey (BEEPS) commissioned jointly by the World Bank and the European Bank for Reconstruction and Development. The survey covered more than 3,000 enterprise owners and senior managers in twenty-two transition economies.54 Employing its results allows us to make comparisons between Lithuania and other EU accession countries. A third source of data is a worldwide study of entry regulation for start-up firms conducted by 53 See World Bank (1999) for a discussion of the 1994 and 1997 results. 54 For more details, see World Bank (2000). 101 Djankov et al. (2000). In addition, Rodogno (2002) provides a detailed and updated discussion of recent changes in the regulatory and business environment. Market Expansion, Benefits from Exporting and FDI 5.11 Chapter 2 discussed the positive impact of foreign sales on the exporting firm's productivity. This benefit may stem from the opportunity to expand production and thus reap gain from scale economies, which may be difficult to achieve by relying solely on the small domestic market. Indeed the survey results indicate that many Lithuanian companies produce below their capacity. Thirty-six percent of firms surveyed believe that they could produce more without adding to or upgrading their existing equipment. Among this group, the average spare capacity was equal to 69 percent. This figure is lower than those found in 1994 and 1997, suggesting that many firms have made progress in restructuring and/or finding new markets. Micro and small enterprises (i.e.j those with employment up to 10 and 50 workers, respectively) tend to have higher spare capacity than firm with over 100 workers. The lowest spare capacity can be found among medium sized firms, i.e., those employing 51-100 people. 5.12 When asked about reasons preventing the expansion of sales, companies indicated insufficient and unstable demand as the primary constraint (see Table 5.1 ). The perceived severity of this constraint has not changed between 1997 and 2001, and has slightly increased from the 1994 level. Producers also indicated that they face increasing competition from foreign goods. On the other hand, export barriers are perceived as lower than in 1994, but higher than four years ago. The same is true of the lack of foreign contacts needed for exports. These perceptions may partially reflect the impact of the Russian crisis of 1998, which resulted in dramatic decline of Lithuanian exports to the region. Table 5.1 Constraints Preventing Firm Growth (mean score) Scale from I to 5. I=no obstacle, 3-moderate, 5= severe obstacle 1994 1997. .2001 1. Insufficient or unstable demand 3.54 3.58 3.58 2. Too much cormpetition from foreign goods 2.44 2.74 2.96 3. Barriers to my exports imposed by other countries 2.45 2.13 2.33 4. Lack of foreign contacts required for exports 2.44 2.22 2.32 Source: Lithuanian Firn Surveys, 1994; 1997 and 2001. 5.13 While in 1994 and 1997 about three-quarters of companies made attempts to reach new markets, this percentage declined to 53 percent in 2001 (see Table 5.2). So did the percentage of companies introducing new products. The breakdown by firm size paints a picture consistent with the findings from the firm level analysis showing that micro companies and small and medium-sized enterprises (SMEs) are less likely to engage in exporting. SMEs were also less likely to search for new markets than large firms, and less likely to introduce new products. 5.14 When asked about factors Table 5.2 Companies Trying to Reach New Markets preventing them from increasing their (%) sales in the European Union, 1994 1997 2001 respondents cited high costs of doing New countries 77% 74% 53% business abroad as the main constraint New products 74% 65% 60% (Table 5.3). As expected, this cost Source: Lithuanian Fir nSurveys, 1994; 1997 and 2001 was reported to be more of a problem to SMEs and micro firms than to large enterprises. The lack of information about markets and the lack of new technologies also ranked high among the constraints. They were followed by high price of own products, barriers to trade, lack of experience and marketing skills. The factors hindering exports to Eastern markets (mainly Russia, other FSU and Latvia) are somewhat 102 different. While the high cost of doing business abroad still tops the ranking, it is closely followed by the price of own product. The perceived hindrance of trade barriers is also higher in Eastern than in Western markets. On the other hand, technical and sanitary standards and lack of marketing skills seem to be less of a constraint in the East. 5.15 Access to technology and know-how are often cited as the benefits stemming from FDI and from trading arrangements with foreign companies. Indeed, eleven percent of firms surveyed reported receiving technologies from their trading partners abroad (see Table 5.4). Over one- fifths of firms with foreign capital received technologies from foreign investors. One-tenth of enterprises benefited from instruction provided by a foreign partner. Nine percent of firms obtained equipment and machines through a trading relationship with a firm abroad. This was also the case for 14 percent of FDI recipients. Additionally, foreign partners provided assistance with quality control and obtaining quality certifications. Thus, the faster productivity growth experienced by FDI recipients and exporters may be explained by technology and know-how transfers received through direct instruction and equipment sales from foreign trading and investment partners. Table 5.3 Main Factors Preventing Firms from Increasing Sales in the EU (mean score) Size of company Sector Factor: ALL 10 1- SJ 100+ Industry Retail Service <10 so o Itcoststoomuchtodobusiness 3.12 3.5 3.3 3.4 2.6 3.1 3.1 3.2 abroad Lackofinformationaboutthe 2.71 2.8 2.4 2.9 2.8 2.8 2.8 2.6 markets Lack of access to new 2.67 2.5 2.7 2.9 2.6 2.8 2.5 2.8 technologies The price of my product is too 2.64 2.7 2.3 2.7 2.9 2.8 2.6 2.3 high Trade barriers imposed by other 2.63 2.1 2.6 2.8 2.7 2.6 2.6 2.4 countries Lack of experience and 2.62 3.1 2.5 2.8 2.3 2.6 2.6 2.9 marketing skills Technical / Sanitary standards 2.61 2.7 2.6 2.7 2.5 2.7 2.5 2.5 Lack of export credit 2.58 2.5 2.7 2.9 2.3 2.6 2.6 2.6 Other 4.55 5.0 4.5 4.4 4.5 4.6 4.5 4.3 Note: I=no obstacle, 3=moderate obstacle, 5= severe obstacle. Source: Lithuanian Firm Survey 2001. Table 5.4 Assistance Received from Foreign Partner (% of firms reporting each form of assistance) Foreign trading partners Investors (Firms with Foreign Capital) Technology 11 22 Instruction 10 11 Equipment and rnachines 9 14 Help for quality control 5 11 Computers 3 0 Help for obtaining ISO 9001 or ISO 3 5 14000 certificates No answer 78 72 Source: Lithuanian Firm Survey, 2001. 103 5.16 Five percent of firms reported receiving free inputs from foreign trading partners or investors. Most frequently, these were design materials, fabric, yarn, thread, details for footwear, etc. When asked about benefits from receiving foreign capital, 31 percent of FDI recipients indicated easier access to purchases, 27 percent guaranteed markets and new technologies, 16 percent mentioned new investment and 6 percent tax benefits. These findings confirm the our earlier conclusion that foreign direct investment brings new technologies and access to new markets and can, therefore, facilitate future expansion of exports. Business Environment-Public Private Interactions 5.17 As part of our survey, firms were asked questions about various aspects of Lithuania's business climate. The results indicate that the tax system is perceived as the leading constraint facing Lithuanian companies. Survey respondents were concerned about: (a) the level of tax rates; (b) frequently changing regulations; and (c) operations of the tax authorities. Respondents also had reservations about the functioning of the Customs Office, but in general tariff rates were not viewed as a significant hindrance. On the positive side, the survey results indicate a declining level of corruption. 5.18 Taxation was the top concern in all three runs of the survey (Table 5.5). In 2001, 40 percent of respondents viewed it as a leading constraint to the operation and expansion of their business. The 2001 figure is lower than in 1994 but higher than the result from 1997. The legal framework in general was viewed as the second most serious constraint, with a quarter of respondents considering it to be a problem. The lack of operating capital, which occupied the second position in both 1994 and 1997, slipped to the fourth place in 2001. Lack of skilled workforce, on the other hand, increased in importance with 13 percent of firms viewing it as a constraint. All the above mentioned factors were ranked higher than weak demand, lack of new markets and lack of new technologies. Table 5.5 Leading Constraints to Operation and Expansion (% of respondents indicating each constraint) 1994*(%) 1997(%) 2001 (%) Taxation (policy, system) 48 35 40 Legal framework 18 25 Problems with payments (late payments) 8.4 21 Lack of operating capital 29 39 17 General economic crisis 3.8 15 Lack of skilled workforce 7.6 13 Bureaucracy of civil servants, corruption 9.2 13 Weak demand 18 11 Problems with supply, raw materials 8 Lack of new markets 4.6 5 Customs duties (policy, system) 5.3 5 Old technology, equipment 5 Lack of credits (high interests) 7.6 4 Instability of banking system 4.6 2 Fixed rate of litas and USD 1 Unfair competition 9.9 Cost of credit 26 Note: * 200 responses. 40 different constraints specified. The most fiequent ones are listed in the table. Source: Lithuanian Firn Survey, 20001. 5.19 When asked to indicate the single most severe obstacle to business expansion, respondents overwhelmingly (54 percent) pointed to high level of taxation. Eighteen percent of respondents had major reservations about tax-related regulations. Tax inspection was viewed by 104 39 percent of firms as the government agency causing the greatest difficulties for business operation (up from 21 percent in 1997). In terms of obstacles stemming from government activities, more than half of respondents view frequently changing rules as a problem (Box 5.1). Some 46 percent of firms pointed to bureaucracy as being an obstacle. Corruption was ranked 4th, with only 11 percent of firms considering it a problem. 5.20 The quality of business environment affects not only domestic firms and entrepreneurs but also the magnitude of FDI inflows. FDI inflows are to a large extent determined by how business climate in Lithuania compares to the conditions in other CEEC. According to the 1999 BEEPS survey, which presents views of domestic and foreign firms operating in each transition economy, this comparison is not very favorable for Lithuania. As Figure 5.1 illustrates, Lithuania ranks second, after the Czech Republic, in terms of the negative perceptions of tax regulations and tax administration.55 Lithuania leads the ranking as far as the perceived difficulties with business licensing are concerned. It is also in the second place in terms of labor regulations being an obstacle to business operations and development. Box 5.1 Over Regulation and Unpredictability of Legislation The mnajor obstacle to the development of the private sector in Lithuania, including the SME sector, is the complex and unstable business environment. Business in Lithuania is still quite heavily regulated. Areas particularly over-regulated include access to land and labor, and the sale and movement of goods. Most investors complain about the plethora of laws and regulations in the country, which are said to be vague, confusing and often contradictory. New legislation or amendments are still very frequent, and there is little advance notice to the business community of new legislationL Laws and rules change too frequently entailing a highly unpredictable and uncertain business environment, favoring corruption and damaging especially the SMEs. Interpretation of the rules is ambiguous and information for business agents is insufficient. According to many business associations the unpredictability of the legislation is a direct consequence of the political instability. However, the changing of Govermnent is not the sole cause for the unpredictability o legislation. Lack of horizontal coordination between the Ministries, lack of information, lack o administrative capacities, the overlapping of competencies between multiple institutions, are additional contributing factors. According to some foreign investors in Lithuania, a major impediment to the modermization and the development of the country is its weak administrative capacity. This point of view is shared by many domestic entrepreneurs. Source: Rodogno (2001). 55 This may be influenced by the perception of tax admninistration rather than the tax rates themnselves, as tax rates are average for the region. 105 Figure 5.1 How Problematic Are These Areas for Your Business? 4.00- 3 50 - 2.50 200 3, 7X~~~~~~~~~~~~~~~~ 01.00 4 0.00 Czch.H IU Czech Lithuania Latvia Romania Poland Hungary Slovakia Bulgaria Slovenia Estonia Rep I Tax regulation/administration O High Taxes El Business Licensing l Labor regulations Source: BEEPS Survey. Chapter 6, Volume 2 5.21 One of the costs of bureaucracy and regulatory complexity is the increased amount of time firm management has to devote to dealing with government officials and regulations. According to our survey, on average more than 15 percent of senior management time was spent in this way in 1994. This figure increased to 28 percent in 1997 and then declined to 24 percent in 2001. The increase in the amount of time spent dealing with govermment officials has been accompanied by a decline in irregular payments that are being made to officials. While in 1994, 54 percent of companies made such payments, this figure dropped to 41 percent in 1997, and to 26 percent in 2001. The average annual cost of the payments declined between 1994 and 1997 from 13,043 Litas to 3,796 Litas but increased to 19,797 Litas in 2001.56 Business Registration Procedures 5.22 As we saw in Chapter 4, start-up companies have been a major source of job creation. Thus, removing barriers to entry is a crucial component of an effective campaign to lower unemployment. A recent study (Djankov et al. 2000) compared the procedures required to start a new business in 75 countries. It found that this process was the least complex in Canada where it required only two steps and on average took about two days. The cost of registration was equal to 1.4 percent of the 1997 GDP per capita. The process is much more complicated in Lithuania where in order to set up a business an entrepreneur needs to go through 13 steps, which take about 66 days. The cost of the process is equal to 6 percent of the 1997 GDP per capita. When compared to other accession countries, Lithuanian entrepreneurs face the highest number of steps that need to be completed but, on the other hand, the procedure is the least expensive relative to GDP per capita. In terms of time required to complete the registration, Lithuania ranks sixth among nine transition economies considered. It does not compare favorably with Latvia where 56 One of the factors hindering pnvate sector development in Lithuania is its relatively weak institutional capacities. The public administration still has limited capacity to formulate and implement policies, in particular in the field of economic policy. It suffers from underdeveloped horizontal and inter-ministerial coordination, lack of strategic vision and heavy reliance on legislation. See Rodogno (2002). 106 the number of steps is equal to half of those required in Lithuania and can be completed in one- third of the time needed in Lithuania. 5.23 The survey asked entrepreneurs what requirements were the most difficult to meet when starting their business or registering a previously informal activity. About one-third of respondents reported difficulties with obtaining the necessary information (Table 5.6). While this is a decrease from fifty percent in 1997, one-third is still large. A quarter of firms found it challenging to fulfill requirements with respect to their premises, with no change reported in this area since 1997. Twenty-six percent of firms had trouble complying with quality requirements, an increase from 18 percent in 1997. The burden of complying with the requirements is much higher for small and micro enterprises than for medium-sized and large finns. For instance, while 40 percent of small companied had a hard time obtaining the necessary information, it was true of only 22 percent of large firmns. Similarly, one-third of small firms found it challenging to fulfill requirements concerning premises, as compared to 19 percent of large enterprises. On the other hand, it was the easiest for micro enterprises to comply with quality requirements. Access to financing Table 5.6 Main Difriculties Associated with Starting a New Business 1997 2001 5.24 Lack of access to Availability of necessary information 53% 31% credit is still a problem for To fulfill requirements concerning premises 25% 26% Lithuanian companies, even To comply with quality requirements 18% 26% thoug there haOther requirements 31% 12% though there has been Don't Know/Not Applicable 24% significant improvement since Source; Lithuanian Firm Survey 1997 and 2001. 1994. Strengthened banking regulation, privatization and a independent central bank have greatly improved the situation of the banking sector. As a result, liquidity in the system has improved considerably, as have borrowing terms both in terms of interest rates and repayment periods. However, obtaining a credit from a commercial bank remains difficult for smaller companies. Only one-fifth of firms employing up to 10 people has ever received such a credit. About a quarter of small finns were recipients of a commercial credit, as compared to almost a half of medium-sized enterprises and 57 percent of large firms. 5.25 High level of interest rates were perceived to be less of a problem in 2001 than in 1994 and 1997. An improvement was also registered with respect to collateral requirements. Yet, despite these positive changes collateral requirements remain the second most serious problem for firrns seeking financing. Respondents also reported difficulties with producing required financial documents with no improvement registered in this area over the past few years. As a result of these difficulties, intemal funds rerain the main source of working capital for Lithuanian firms, with their importance increasing over time. Over 89 percent of firms reported using intemal funds to finance working capital, with an average of 83 percent of working capital coming from this source. A quarter of finns use commercial loans, which on average provide 37 percent of working capital. The next most important sources of financing are suppliers and advances from clients. Overall, however, the situation has improved. In 1994 and 1997, finns ranked the lack of short term finance to be a major obstacle; in 2001 this perception had been reduced to that of a moderate obstacle. Labor Market 5.26 Signs abound that the lack of skilled labor may emerge in the future as a constraint on Lithuania's growth. According to the respondents, finding skilled workers and technicians has become more difficult over the past several years. Lack of skilled labor has been reported as a constraint to expansion by 13 percent of firms (nearly double those reporting the same problem in 107 1997). On the other hand, it has become easier to employ managers. The cost of labor is perceived as more of an obstacle now than either in 1994 or 1997. On the positive note, firms tend to be more satisfied with the attitude and motivation of their workers than before. 5.27 Labor regulations are perceived to be a more serious obstacle to business operations in Lithuania than in other CEEC. According to the BEEPS survey, Lithuania ranked as the second worst among ten accession countries in this respect. In the area of labor regulations, Lithuanian firms perceive payroll taxes and related rules as the main impediment to their operations. However, Lithuanian payroll taxes are actually modest when compared to tax rates in other CEEC. Regulations on working conditions (hours, benefits, etc.) rank second among the labor- related constraints. Together with restrictions on hiring and firing workers they represent two areas, where the situation is perceived as having deteriorated (see Chapter 4). C. REGULATION AND ACCESSION INTO THE EUS7 5.28 The requirement to adopt the EU's body of primary and secondary legislation-the acquis communautaire-is a precondition for joining the EU, as formulated in the list of Copenhagen criteria. Progress in adopting the acquis is one of the determinants of Lithuania's prospects of joining the Union.58 However, the adoption of EU regulatory norms and standards will have an important impact on Lithuanian companies and consumers, and can affect the country's competitiveness and economic growth. For this reason, it is worth examining the expected impact on the business environment of aligning domestic regulations with EU norms and standards. 5.29 There have been a number of studies on assessing the regulatory impact of adopting EU norms on Lithuanian economy and consumers. Some of these studies have been undertaken for concrete EU directives and regulations, while others have been conducted for specific companies and/or for the specific sectors of the economy. The insights from these studies and concrete cases are presented below grouped around selected issues. The issues selected do not represent a full picture of the impact of regulatory alignment on Lithuanian economy. However, they provide a basis for building an initial assessment of this impact. The Free Movement of Goods 5.30 Participation in the free movement of goods implies a number of regulatory changes which include: (i) the removal of the remaining tariff and quantitative barriers to trade between Lithuania and the EU, (ii) the removal of physical barriers, in particular, customs formalities; and (iii) the alignment of quality standards and their conformity assessment procedures. In general, changes (i) and (ii) will contribute to strengthening the competitiveness of Lithuanian exports, but (iii) is likely to involve significant adjustment costs. 5.31 The liberalization of trade in industrial products between the EU and Lithuania was completed by year 2001. However, the association agreement provides for the possibility of using WTO-compatible commercial protection instruments. In practice, the EU has exercised this right a number of times by initiating antidumping cases against several Lithuanian manufacturers. The removal of the anti-dumping instrument upon accession will improve the competitiveness of some Lithuanian producers (see Box 5.2). 57 See Chapter 7 (Vilpisauskas) in The Background Paper Volume for a much more detailed and thorough discussion of the impact of adopting the EU regulatory framework on the Lithuanian economy. 58 The legal basis for the adoption of the Eu's acquis was first established by the Association. Agreement, signed in June 1995, and which incorporated the Free Trade Agreement liberalizing trade in industrial products between EU and Lithuania. 108 5.32 Another important change in the regulatory environment for the exporting company is related to the removal of barriers on the border, i.e., customs procedures inside the internal market. As discussed previously, these procedures are perceived as a moderate constraint by exporting enterprises. The removal of physical barriers to trade will thus bring some savings for Lithuanian companies trading both with the EU and with other candidate countries. In recent years, more than 85 percent of all.import documents and over 50 percent of all export documents presented to Lithuanian customs were related to trade with the EU and candidate countries.5 Some 17,000-20,000 companies are likely to experience directly the impact of removing barriers to trade created by the customs procedures, which might bring savings equal to about 2 to 3 percent of declared annual value of exports. The industries which might experience the largest benefits from these savings are the ones exporting most to the EU and include textiles, food, chemicals, wood articles and furniture. Similar gains could be expected by importers of products from the EU. The competitiveness of these companies will be strengthened by the complete abolishing of barriers inside the intemal market. Box 5.2 The Effects of Participating in the Internal Market on the Achema Company Achema is the biggest producer of fertilizers in the Baltic states with a turnover of around US$116 million in 2000. It is a relatively large and internationalized company, employing above 1,000 enployees. It imported most of its raw materials and exported about 85 percent of its production in 2000 (about 80 percent of its sales went to the EU). Three brands of nitrogenous fertilizers account for about 90 percent o its sales. Although no customs duties on industrial products are applied, trade in industrial goods between the EU and Lithuania is still distorted by antiduniping duties applied by the EU to the fertilizers (urea and urea anamoniurn nitrate) produced by Achema. These antidumping duties increase significantly the costs o company's products, and the removal of them upon the date of accession will improve the competitiveness of the company. The comnpany will benefit significantly from the removal of physical barriers to trade. According to comnpany's calculations, its staff is spending about 500 working hours per year for complying with the customs procedures when exporting its products. Removal of customs procedures together with the prohibition of antiduniping duties and other commercial protection instruments inside the internal market is likely to bring the biggest savings for this producer. In the field of product standards, most EU norms in the field of chemicals have been adopted in Lithuania by 2001. Moreover, the company already meets EU norms and has been exporting to the EU successfully for a number of years. However, the reform of the market supervision system is not complete yet, because the producers still do not have a possibility to certify their products in Lithuania by the accredited institutions. In order to export to the EU, the company has to certify its products in each EU member state. The actual costs of adjustment to the new quality (packaging, labeling, etc.) standards will be more significant for the domestic producers (and importers from the third countries). Companies like Achema which are already exporting to the EU are likely in the long term to save some of the certification costs once the EU wide list of accredited institutions, including the Lithuanian one, is agreed. In the short term, investments into setting testing and certification infrastructure are required, although part of them will be budgetary contributions (a likely cost of a certification laboratory in the case of fertilizers is about US$300,000 dollars). Source: Impact Assessment Study, Lithuanian Free Market Institute, December 2001. See Chapter 7, The Background Paper Volume (Vilpi0auskas). 59 The study on assessing the impact of adopting Community customs code in Lithuania (regulation 2913/92/EEC and regulation 2454/93/EEC) commissioned by the European Committee and conducted by the Economic consulting and research co., December 19, 2001. As the concept paper on transit law prepared by the Lithuanian stevedoring companies in May 22, 2001, indicates, the costs of delays on the Lithuanian borders experienced by the carriers amount to about 125-145 US dollars for one vehicle per day. 109 5.33 The regulatory alignment in the field of product standards and conformity assessment procedures is likely to cause the most significant changes to Lithuanian companies. The extent of adjustment will depend on the level of internationalization of the specific business. As the cases of Achema and other exporters illustrate, companies currently exporting to the EU already comply with product quality standards and further regulatory alignment will bring them significant savings. On the other hand, as the case of pharmaceutical industry illustrates, companies that had been producing mainly for the domestic market are likely to experience significant adjustment costs (Box 5.3). 5.34 Although areas such as chemical and pharmaceutical industry are particularly regulated in the EU and therefore the adjustment costs for domestic producers are likely to be high, similar challenges are faced by companies in other sectors where relatively detailed health and safety requirements are set. Some examples are production of electronics and equipment, food products, construction materials, etc. The adjustment costs will to some extent depend on the size of enterprise. Small companies producing for the domestic market will face the greatest adjustment costs and competitive pressures. At the same time, these small companies typically to face the greatest constraints in accessing the financing needed to implement the necessary changes to meet new requirements. For this reason, attracting foreign investors and/or merging with other domestic producers are two strategies, which could be increasingly exploited by domestic companies to reduce adjustment costs. Box 5.3 The Impact of Adjusting to the EU Quality Standards in the Pharmaceutical Industry In Lithuania, by the end of 2001 there were 27 companies operating in the pharmaceutical sector employing about 1,800 people. While some large companies such as Ilsanta have already invested into adjusting to EU norms, a number of small companies are still not ready for participation in the internal market. According to the estimates of Lithuanian pharmaceutical association, the costs of renovating one lm2 of a pharmaceutical company are around US$1,000. However, the process of adjustment to the EU norms includes a number of measures to be taken by a company: renovating or constructing premises o production, purchase of new production equipment, adoption of quality management system, changes in assortment of production, training of personnel, preparation of technical documentation and the certification of the production. On average, the costs of meeting EU quality norms for one Lithuanian pharmaceutical company during the period of 1998-2004 are estimated to range between US$20-25 million. A Lithuanian company "Biotechnologija" instead of renovating old premises chose to build a new factory with the involvement o a foreign investor. The investments into the factory meeting international quality standards amounted to about US$20 million. Additional US$2 million were invested to implement the GMP system o certification. The investments into the GMP are likely to increase the quality of the products, however, at the same time the costs of local products are estimated to increase by 30-40 percent. Source: Feiden, K Implementation of Good Manufacturing Practice (GMP) requirements for medicines and the consequences for Lithuanian pharmaceutical industry. Report of the Phare Seil project, Vilnius, 2000. Cited in Chpater 7, The Background Paper Volume. Transport Policy 5.35 In Lithuania, transport accounts for about 8 percent of GDP. It plays an important role in exploiting Lithuania's strategic geographical location as a transit corridor. In addition to transit services, transport also provides important support services to Lithuanian producers, and critically influences their competitiveness. 5.36 The impact of regulatory alignment in transport is expected to be similar to that of other sectors. In this regard, EU accession will bring significant benefits for road haulage companies which are already operating in the Union, while domestic carriers will experience significant adjustment costs (Box 5.4). 110 5.37 Domestic carriers will be faced with new mandatory licensing requirements, including relatively high requirements for financial standing of carriers, and technical and safety norms. Adjustment to these requirements, even when transition periods are applied, is likely to increase market entry barriers for smaller companies and reduce their competitiveness. For example, according to some estimates there are about 30,000 domestic carriers that would have to install recording equipment.60 The costs include installation of the equipment, which sometimes exceeds the value of the vehicle in use, and its maintenance. To ease the adjustment costs, Lithuania has negotiated transition periods for a gradual increase in the norm of financial standing of carriers, and for the mandatory installment of recording equipment. Nevertheless the short- term impact is expected to be substantial. Box 5.4 The Impact of EU Membership on International Road Haulage Carriers The Lithuanian national association of road carriers Linava currently has a membership of 1,700 entities. The participation in the TIR system amounts to 1521 member. Members of association are providing carrier services to about 40 countries. Lithuania is a member of the Conference of the European Ministers of Transport and takes part in the system of multilateral quotas for international transport activities. Bilateral agreements are signed with 34 countries. The bilateral quotas (for transit, single entry or a number of entries for a limited period of time) with European countries are negotiated annually. The number of pernits used by Lithuanian international road carriers in 2001 exceeded 387,000. Lithuanian road haulage carriers actively operating in the Single market already comply with all EU norms, including the directives on working time, recording equipment and speed limniting devices as well as licensing requirements. Currently 3,475 comnpanies are licensed to provide international carrier services. More than 12,000 vehicles are used for these services. The nurnber of environmental friendly "green," "greener and safe" and "Euro 3 safe" lorries exceeds 5,000. The accession into the EU will not require additional investments and will remove the main remaining barrier to their activities-the permits (which are limnited and often do not satisfy the demand) to transit through EU members states, provide services between EU countries and the right to operate inside EU member state, although in the latter case only after a transition period of up to 5 years. The benefits will include the removal of administrative costs and contribute to the increase in flexibility of services and competitiveness of Lithuanian carriers. Source: Chapter 7, The Background Paper Volume. 5.38 The domestic road haulage companies will also be more affected by an increase in fuel prices resulting from the alignment of excise taxes. In Lithuania, the gap between the tax rate currently applied and the one set by the EU is the largest among all the candidate countries. This gap at end-2001 ranged from 14 percent for petroleum and 16 percent for gas, to 48 for diesel fuel.6' The alignment of excise taxes and the implementation of requirements concerning the security of supplies (maintenance of minimum stocks of crude oil and petroleum) are expected to increase the price of fuel, with significant effects on the transport sector. 5.39 The impact of adopting other EU norms regulating the transport sector will depend largely on the use of exceptions provided by the directives (for example, of technical compatibility of railway infrastructure and transportation of dangerous goods), as well as on the choice of structural reform measures implemented by the Lithuanian government. For example, government policy and choice of market regulation model will determine the efficiency and the price competitiveness of railway sector in the future. Particular importance should be given to the creation of real conditions for competition among the providers of railway services, not restricted by too high regulatory barriers of market entry. In this regard, EU legislation provides policy 'o The study on assessing the impact of adopting EU directive 3821185/EEC on recording equipment, commissioned by the European Committee under the Government of Lithuania, prepared by the Economic consulting and research, July 15,2001. 61 The alignment of excise duties will increase the incentives for smuggling of fuel from neighboring countries which will remain outside the EU, i.e,. Belorussia and Kaliningrad region of Russian Federation. III objectives to be achieved, but Government choices with respect to reforms will determine the outcome of the restructuring in currently state dominated sectors of railway and air transport. Agriculture 5.40 The challenges of adjusting to changing regulatory environment are particularly important in the agricultural and food sector, characterized by a large number of small and relatively inefficient companies. The adjustment costs to the new regulatory requirements in the agricultural sector will be relatively high not only due to the size and structure of agriculture in Lithuania, but also due to the number of EU regulations to be enforced, which require investments into productions process to meet product quality standards, animal welfare standards, environmental standards, payments for veterinary inspections, and more detailed requirements to submit information on farm activities (Boxes 5.5 and 5.6). Box 5.5 The Impact of Adjustment to the Quality Norms in the Milk Production Sector In 2000, milk production constituted above 17 percent of total agricultural production in Lithuania (the third item after grain and meat). In October 2000, there were about 241,800 milk producers.62 Majority of them were small size farms. Farms with 1-2 cows accounted for about 84 percent of total number of farms, while farms with up to 10 cows accounted for 99 percent of all farms (although there is a clear tendency of the increase in an average size of the farm). It is estimated that only about 50 percent of milk produced in Lithuania meets EU quality requirements. Investments into a new farmstead could reach 3,000-6,000 US dollars per cow while renovating existing ones could cost about 1,500-2,000 US dollars. Overall investments into meeting EU norms are estimated to amount to US$300 million. It is forecasted that the number of milk producers will decrease by 35 percent while the number of farms having more than 10 cows will increase 2.3 times up to the year 2004. At the same time, milk prices could increase by up to 40 percent. Source: Vilpilauskas (2002). 5.41 The introduction of EU standards is likely to have mixed effects on Lithuanian agricultural production and prices. On the one hand, it will stimulate widespread restructuring and increase revenues for more productive farmers remaining in the sector. On the other hand, many producers will be forced to exit or will go bankrupt. Dairy and beef appear to be two the sub-sectors with largest potential to benefit. To date, only milk and dairy sector exporters, which are most advanced in adjusting to Community norms, have taken advantage of quotas of reduced duties provided by the EU for exports of Lithuanian products into the Single market. The quotas for cheese, milk powder and butter have been used by almost 100 percent in recent years.63 Quotas for exports live cattle and meat products, for example, poultry, beef, sheep meat, were not used due to the lack of certified enterprises. 62 Data provided by the Lithuanian Institute Agrarian Economics, January 20, 2002. 63 Data provided by the Lithuanian Ministry of Agriculture. 112 Box 5.6 The Impact of Adjusting to Veterinary Standards According to the State food and veterinary service, currently there are 38 companies operating in the agro-business which meet the EU quality standards." Out of them, 19 are dairy product producers, 10 from the fish product sector, 5 processors of meat and 4 slaughter houses. The number of companies from these sectors which will meet EU norms by 2004 is estimated to be around 314 out of total 675. It is expected that 152 meat processing companies and 136 slaughter houses will meet EU standards by that date. These estimates are based on the evaluation of the action plans provided by the agro-business firms. It should be noted, that 323 companies asked for the transition until 2007 or did not provide any action plan. According to the estimates of the Ministry of Agriculture, it costs about 150,000-375,000 US dollars to renovate one meat processing company to meet EU veterinary standards. Source: Vilpisauskas (2002). Environment 5.42 The number of EU legal acts to be implemented on environment amounts to about 300. It is an area where significant investments will be needed in order for the accession countries to implement EU norms.65 The chapter on environmrent includes norms regulating general requirements; waste management; air, water and nature protection; industrial waste mranagement; chernical substances; genetically modified organisms; radiation; and nuclear safety. Box 5.7 The Adjustment to the EU Enission Norms The EU directive 2001/81/EC prescribes national emission ceilings for its member states as regards SO2 and NO2. The implementation of these norms will require significant restructuring for some industrial and power plants in Lithuanian, resulting in a more extensive use of natural gas or biomass. The EU requirements on sulphur content will be applied for petrol and diesel used in Lithuania from the year 2005. In 2004 heavy oil with up to 2.5 percent sulphur content will be allowed to be used in large combustion plants (e g., boiler-house, electric power station) under condition that these plants keep SO2 emission limits. If these plants are not able to keep emission limits, only heavy fuel oil with up to 1 percent sulphur content will be allowed for use, or the enterprises would be fined. The most significant adjustment is likely for the Mazeikiai oil refinery which uses crude oil with sulphur content of 1-1.8 percent imported from Russia.66 It will have to replace currently used heavy fuel oil of 2.5 percent sulpher content with a low sulphur heavy fuel oil (or convert to natural gas or biomass). Desulphurisation at Mazeikiai refinery would raise the prices of heavy fuel oil by 30 USD/t. Investrnents to meet emission norms will also be required for the power plans and some industrial producers using large combustion plants having thermal input equal or larger than 50 MW. In Lithuanian, 43 such plants have been identified. The investments needed for the conversion of Lithuanian power plants which are likely to exceed US$200 million will be transmitted to consumers through increase in electricity prices. Source: Vilpisauskas (2002). 5.43 During 1992-2000, about US$235 million were invested into environment protection. Investments from the Lithuanian budget accounted for US$80 million (or 35 percent of total), while the rest came from allocations from bilateral and multilateral funds and from loans by intemational financial institutions.67 It has been estimated that Lithuania will commit investments into this sector up to EUR 50 million annually during 2002-2004. About 50 percent 64 Data provided by the State food and veterinary inspection, January 20, 2002. 65 Although it is one of the areas where the benefits of regulatory alignment have been calculated by the European Comrission. In the case of Lithuania, they are expected to reach about 79 euro per capita, or about 2.9 percent of annual GDP. See The Benefits of compliance with the environmental acquits for the candidate countries, ECOTEC et al., 2001. 66 See Danish Energy Agency, Environmental requirements to the energy sector, Interim report No. 1, 2001. 67 Data provided by the Lithuanian Ministry of Environment. 113 is expected to be financed from ISPA program of the EU. ISPA funds could be used until 2006, however, if Lithuania joins EU in 2004 as currently expected, financing from EU for the environment sector would be coming from Cohesion Fund. The priority areas for public investment are projects on water treatment and waste management. 5.44 The direct impact of regulatory alignment in the field of environment on Lithuanian companies will be the most significant as pertains to the requirements on reduction of waste, use of heavy fuel oil, industrial pollution and control (Boxes 5.7 and 5.8). By the year 2004, integrated permits are planned to be issued for enterprises, that impose the requirements concerning pollution limits, waste management, and energy saving (taking into consideration the best available technologies). Enterprises will have to implement the requirements no later than 30 October 2007. The requirements will be applied for new equipment from the year 2001. 5.45 The costs of complying with these requirements will depend on the level of modernization of enterprises, as well as on technical characteristics and actual levels of emissions. Compliance with process-related standards can be facilitated by the introduction of quality management systems such as ISO 9001 and ISO 14001, already implemented by some Lithuanian exporters but not otherwise generalized. Investments into such quality management systems reduce the future adjustment costs for complying with the EU norms, in particular, environmental standards. For example, under the EU norms, a company that has ISO 14001 quality management system could be eligible to a reduced charge for an ecological labeling. Box 5.8 The Adjustment to the Volatile Organic Components Emission Norms The EU directive 94/63/EC sets emission norms for air pollution with volatile organic components emissions from petrol during the process of its loading and transportation. Currently, there are about 260 tanks trucks used for the transport of petrol in Lithuania.68 Half of them are manufactured during the period of 1985-1995. About 50 percent of them do not meet the emission norms set by the directive. They account for about 20 percent of petrol transported in Lithuania. The majority of tank trucks (80-90 percent) which do not meet the emission norms are old small capacity vehicles produced in the CIS. The costs of modernizing such tank trucks exceed the price of the new trucks by 5-8 times. The partial renovation of an old-type tank truck by changing hatch structure, installing vapor collection system and petrol level measuring system would cost US$12,000-25,000 and would still exceed the value of the tank several times. Partial renovation of a tank truck produced in the Western countries is estimated to make up US$4,000-7,500. The implementation of the emission norms would be most challenging for a small carrier companies. Most rail tanks used by Lithuanian railways do not meet EU norms. Rail tank partial renovation costs could amount to US$1,250 per tank. The total renovation costs could amount to US$115,000- 150,000. The transition period for implementation of these norms would allow for some natural replacement of tank trucks and would reduce the adjustments pressure for enterprises. It would also reduce the potential increase of petrol prices. The modernization of tank trucks would bring savings due to the smaller losses of petrol during its loading and transportation. The emission of liquid organic components would be reduced by approximately 20 times. Source: Vilpi.fauskas (2002). 5.46 Some environmental standards in Lithuania are more restrictive than in the EU. They include provisions on evaluating the impact of planned industrial activities on environment, recycling of waste, defining dangerous manufacturing objects, regulating charges for the ecological labeling. Further adjustments in Lithuania might become necessary if the EU sets 68 Data from the impact assessment study commissioned by the European Committee under the Govemment of Lithuania, conducted by the Kaunas Technological University, November 2001. 114 higher requirements aimed at the protection of environment and consumers which are currently debated in the Union. Energy 5.47 The regulatory adjustment in the energy sector implies adoption of EU norms regulating internal market in electricity and gas production, security of supplies, and efficient use of energy and nuclear power. The Lithuanian energy sector is characterized by a dominant producer, the Ignalina nuclear power plant, which produces 70-80 percent of energy consumed in Lithuania. The national energy strategy foresees the closure of the first reactor by 2005. It is very likely that the decision concerning the closure of the second reactor will be taken in the nearest future. The EU has expressed its position that the date of its closure should be 2009. According to some estimates the costs of closing down the Ignalina nuclear power plant, including its social effects and costs of managing radioactive waste, could be significant; but these costs could be kept down through good economic and financial management. The EU and other international institutions have so far given 200 million euro to fund the closure of the nuclear plant and additional 50 million euro have been agreed by the European Commission and the Government of Lithuania. 5.48 The closure of the Ignalina plant will increase the production of electricity in thermal plants. All of the thermal plants are capable of using natural gas as fuel, which would allow emissions to comply with EU targets. Thus, this should not pose particular difficulties. A different area where some investment will be needed concems the security of supplies (Box 5.9). Box 5.9 The Impact of Implementing EU Norms on Security of Supplies According to the EU directive 98/93/EC, Lithuania has to ensure the minimurn stocks of oil and oil products for 90 days. It has been estimated that by the end of transition period (initially 2008, but later Lithuania asked for its extension by 2 years) about 165,000 t of oil products will have to be accumulated, with diesel accounting for more than two thirds of total.69 The costs of accumulating stocks needed to ensure supplies for 90 days include purchase of oil and oil products, storage and modernization of reservoirs. It has been estimated that the annual costs of accumulation and storage of oil products would amount to US$12-20 million. The total costs needed to accumulate stocks of supplies for 90 days would exceed US90 million (these calculations are based on the assumption that no excise tax is levied on these supplies). Additional US$12 million would be needed for maintenance and replenishment of the stocks every year. The modernization of the current reservoirs to install vapor recuperation system would amount to around US$7.5 million. The accumulation of stock needed would account for about half of total costs needed to imnplement EU norms. The costs of implementing the norms on minimum stocks of supply would be reflected in increase of prices of oil products. Diesel prices are estimated to record relatively most significant increase of about 2.8-3.7 percent. The impact of adopting these norms will be experienced by users of transport run by diesel. Source: Vilpisauskas (2002). 5.49 The regulatory alignment of environmental and energy norms as well as excise taxes is likely to result in the increase of oil product prices. The possible effects of regulatory alignment discussed above increase the importance of liberalizing the energy sector. The adoption of EU norms on internal market in electricity and natural gas provides a good basis for reforms in this sector. The opening of the market to suppliers of energy resources, and the creation of conditions for competition and consumer choice, are crucial in order to prevent long term increase of prices 69 The study on assessing the impact of adopting directive 98/93/EC amending the directive 68/414/EEC on minimum stocks of oil and oil products commissioned by the European Committee and conducted by the Economic consulting and research co., December 19, 2001. 115 of these products. Although privatization and restructuring of energy sectors is already under way, the main challenge is to ensure creation of real (not formal) conditions for competition in this field, currently characterized by dominant producers and suppliers and very limited infrastructure possibilities to link with foreign markets. D. SUMMARY AND POLICY RECOMMENDATIONS 5.50 Improving the business climate in Lithuania requires action on two fronts. First, it is necessary to continue to improve the quality of the overall enabling environment- that is of the public policies, institutions and services that support private activity. This requires maintaining the existing stable macroeconomic framework and open trade regime, but also making real progress on the remaining structural reform agenda including continuing with financial sector reforn; tax reform and harmonization; completion of privatization, especially in the infrastructure sectors; and enhancement of labor market flexibility. 5.51 Second, it is necessary to streamline business regulation and reduce existing administrative barriers. According to analysts and business leaders alike, the Lithuanian business environment remains highly regulated. Investors complain of the unpredictability of regulations and of frequent changes. Overall, different aspects of the tax system and in particular tax administration, are perceived by enterprises as the main obstacle to their business. Enterprises (and especially SMEs) also identify business registration processes, cumbersome customs procedures, corruption, lack of access to financing, and difficulties in finding skilled labor and technicians, as additional business constraints. 5.52 Eliminating remaining distortions and restrictions in land, construction, labor and transit markets; rationalizing registration and licensing procedures; streamlining liquidation and bankruptcy processes; and increasing the effectiveness of public administration officials dealing with businesses, will all contribute greatly to improving the business climate. The greatest beneficiaries should be SMEs, who are more affected by administrative barriers and regulatory constraints than larger firms. An increase in the size of the SME sector should, in turn, bolster job creation and increase the growth rate of the economy. 5.53 The reform of the business environment, however, cannot be envisioned in isolation of requirements associated with meeting the EU acquis. While in many areas complying with the acquis will bring about an improvement in the regulatory framework; there are others, where in effect the EU could bring about an additional regulatory burden. There is a danger, for example, that adoption of some EU wide quality and process standards -especially in a setting with weak administrative capacities-may create additional barriers to market entry for small companies and erode their competitive advantages. Attracting foreign investments could be one of the main ways to reduce the pressure of adjustment on domestic companies. Mergers of small and medium size companies could be another way of coping with increased regulatory requirements. 5.54 In general, the process of aligning domestic regulations with EU norms is likely to be more favorable to exporting companies, who already meet many of the EU standards, while it may create adjustment costs for those working only for the domestic market. Government regulatory policy, and its strategy for gradual adoption of the acquis, can dampen or exacerbate the adjustment costs. 5.55 The following few principles could assist the government in maximizing the benefits of economic integration into the EU, while reducing the adjustment pressure on businesses whose competitiveness will be negatively affected: 116 * Setting clear principles for the separation offunctions to be financed and implemented by the state institutions and those left to the markets. The separation of public investments and private investments is important for several reasons. First, this is a precondition for the efficient allocation of resources in the economy. Second, it would allow the state to focus its resources and capacities on essential functions that are to remain in the state's domain. Lastly, it can help prioritize needs for public investment and support the efficient use of EU funds and EU regional support. * Focusing on the removal of the remaining barriers to trade with the EU. The participation in the EU market without internal frontiers will provide the main long term benefit for the economies of the accession countries. The conditions for trade could still be improved by removing existing barriers. This includes: o Barriers applied by the EU in the form of tariff and other instruments of commercial protection. They include antidumping duties for several industrial products and customs duties for agricultural products which could be removed prior to the date of accession; o Barriers applied by Lithuania. They include customs duties for agricultural products, and de facto remaining compulsory certification practices (for example, cosmetics); and o Physical barriers, e.g., customs procedures, which cause significant costs for Lithuanian companies. The simplification of the existing procedures and the work towards removing barriers on the borders from the date of accession (or with as short transition period as possible) should be the main priorities backed with necessary investments. * Accelerating the adoption and enforcement of the EU acquis where it directly provides a stimulus for further reforms. In the fields of railway transport and energy, the integration into the internal market and the adoption of EU norms is likely to create conditions for economic growth and provide important political stimulus and legal guidelines for further reforms. Reforming these infrastructure sectors is important in terms of costs for the customers of these products, in particular companies for which these costs are relatively significant * Removal of existing barriers to business and economic growth in Lithuania. As the analysis of regulatory environment indicates, there are a number of barriers which increase the costs for business in Lithuania and reduce its competitiveness. Reducing of such barriers is particularly important in the background of regulatory alignment and EU accession: o First, norms which complement rather than implement EU regulations or are not linked with membership obligations should be critically reviewed questioning their necessity and their value for achieving public policy goals. This in particular concerns barriers to enter the market, for example, process of granting licenses and authorizations to set up a business. Other fields where regulatory barriers could be further removed include purchase of land, construction, transit issues and labor market;70 o Second, some of the norms currently in force are likely to be abolished because they will distort competition in the internal market. For example, the application of a tax on turnover of companies to finance infrastructure, which violates the "user pays" principle and would discriminate against companies registered in Lithuania. If such distortions are not removed by the date of accession, the 70 See Rodogno (2002), and the FIAS study on Administrative Barriers in Lithuania (1999). 117 process of discovery and removal of such discriminatory barriers is likely to be a long process depending on the activism of regulated businesses; and o Third, removing barriers to setting and conducting business and consolidating the conditions for the economic growth will be important for the growth of budgetary income to meet the increasing demands for public investments in the context of the Maastricht criteria. 118 6. SOCIAL POLICY REFORM: INCREASING EFFICIENCY AND EFFECTIVENESS71 6.1 Lithuania has seen a marked increase of unemployment and poverty during the economic transition to a market economy in the 1990s. The Russian crisis further exacerbated the situation, pushing unemployment to over 15 percent in 2000. Much of this unemployment is of long- duration. With the country facing further economic restructuring in the face of the EU integration process, continued outflows from employment-especially in agriculture-are to be expected. Given the existence of geographical and skill mismatches, many displaced workers could face a difficult time finding jobs, and add to the pool of long-term unemployed. In this context, social policy has a very important role to play in protecting vulnerable parts of the population from suffering large income losses and from falling into poverty. A. OVERVIEW OF THE SOCIAL PROTECTION SYSTEM 6.2 Like many transition countries, Lithuania inherited and developed a comprehensive set of social protection programs (Table 6.1). It consists of (i) state social insurance programs financed through social insurance contributions, (ii) social assistance programs financed through state and local govemment budget; and (iii) merit based state pensions paid out of state budget. 6.3 State social insurance programs are designed to assist individuals to manage various income risks using insurance mechanisms. They comprise long-term benefits such as old age, disability and survivor pensions, and short-term benefits paid in the case of sickness, maternity, unemployment, and work injury. Social assistance programs aim at assisting families and the needy by providing cash benefits and social services. More than half of the cash benefits are categorical, with a heavy focus on family and children. In addition, there are merit-based state pensions. These privileges are designated for officers, military servicemen, political victims, world war veterans, president, scientist, victims suffered from the Chernobyl accident, and parents of those died during independence. 6.4 Social protection programs consume more than one half of the total public expenditures and a significant portion of GDP. In 2000, social insurance schemes as a whole cost 14.5 percent of GDP, with pensions alone accounting for 7.2 percent. 72 These are equivalent to 48 and 35 percent of total public spending, respectively. Social assistance, cash and service combined, cost around 2.5 percent of GDP in 1999. In real terms, total expenditures on social protection programs have increased steadily since 1995. 6.5 Major policy changes are being contemplated for all major social protection programs. They will change the policy objectives of the programs and have significant financial and social implications. The Government has adopted a pension reform concept and is working towards the 71 This section summarizes the work presented in Chapters 9 (Steele) and 10 (Yu) of The Background Papers Volume of this study. 72 Including health insurance that has been administered by the Health Insurance Fund since 1997, separately from SSIF. 119 development of necessary legislation and regulation to implement a multi-pillar pension system. A concept paper on the restructuring of unemployment benefit program was prepared and presented to the government in the spring of 2001. A new Law on Cash Social Assistance is in draft form and will be reviewed by the government and parliament in the near future. Amendments to the law on sickness and maternity benefit came into effect in January 2001. Table 6.1 Structure of the Social Protection System in Lithuania STATE SOCIAL SOCIAL ASSISTANCE MERIT-BASED INSURANCE Cash Benefit Social Services STATE PENSIONS (main categories) Institutional care Other Pensions Social pensions Long term social care Home President's pension institutions (elderly, care disabled, orphans, etc.) Sickness and Family benefits Short term care shelters Home Officers & military maternity nursing servicemen pensions Unemployment Social benefit Day care Victim pensions Work injury and Compensations Mixed social services State pensions of I occupational (utility, public institutions and H degree disease transportation) Health Free school meals Scientists' pensions (administered separately from SSIF) Source: Yu (2002). B. STATE SOCIAL INSURANCE PROGRAMS 6.6 Since independence, Lithuania has maintained and developed a comprehensive set of state social insurance schemes. The policy of the programs evolved over time, but the basic framework has remained relatively stable. The state social insurance program covers all the employees in the formal sector. Individuals with employment contracts pay contribution to the mandatory system in the form of payroll tax, and subject to certain work record and age requirement, are entitled to all the insurance benefits. The self-employed contribute to the system in the form of a flat contribution, which would entitle them to basic pensions only. Similarly, registeredfarmers with land are required to contribute to the system at a low and flat level. For "economically weak farmers", the state budget makes partial contribution to the state social insurance system on their behalf. Contributing farmers are entitled to basic pensions. In 2000, contributors to the mandatory state social insurance programs accounted for 82 percent of the formally employed, 72 percent of total labor force, and 60 percent of working age population. 6.7 Expenditure. Social insurance programs are a major expenditure item in Lithuania's budget, and have been increasing over time in real value (Figure 6.1). In terms of absolute level, pension expenditure accounted for over 80 percent of total social insurance program expenditure. It has been the main source of the overall expenditure growth in the recent years. In terms of percentage growth, however, all programs have experienced major increase since 1995. The marked increase of expenditure was largely driven by the increase of number of beneficiaries and the increase of average benefit. For pensions, the total number of pensions granted increased by 23.5 percent from 1995 to 2000. The most significant increase in terms of number of pensions was in disability pensions, and survivor pensions. The number of old age pensions granted in 2000 was in fact smaller than that granted in 1995, but the average level of pensions increased substantially. In nominal value, old age pensions increased by 212 percent, and the disability pensions increased by 201 percent. 120 Figure 6.1 Expenditure of Social Insurance Programs Social insurance expenditure increased Pensions account for the most significant part significantly in real value from 1995 (mln of the program expenditure (January-June, LTLs, in 1995 price) 2001) 6,000 5,000 4.4 4% 0.3% 11% "F 0% 4,000 2,000 - 81% 1,000 * Pensions * Sickness & Nbternit t995 1996 1997 1998 1999 2000 Pesons *Sdress & Materrity 1 Unerployment C Adrunistrattvecost OunUpIoyrawt DAdnhrstratlvecost lOther EWorkinjury Source: Datafrom MSSL, SSIF 6.8 Revenue. State social insurance programs are financed largely by mandatory contributions (Table 6.2). They are collected and administered by SSIF, separate from the general tax revenue and state budget. For employees, 34 percent of their gross wage is allocated to the five insurance programs. This accounts for about 98.3 percent of the revenue of the social insurance system. The contribution rate has been relatively stable. It was kept at 31 percent between 1991 and 1999. In 2000, the contribution rate was increased to 34 percent in an attempt to balance the budget of the state social insurance fund. Starting from 1995, the self-employed pay a flat level of contribution to the system. Farmers are also required to pay a flat contribution, which entitles them to basic pensions. However, a great percentage of farmers were exempted on the basis that they are receiving some form of pensions. Together with those who claim to have no income, only about 14 percent of all registered farmers contributed to the system in 2000. 6.9 Defcit. Since 1996, there has been persistent deficit in the system, amounting to about 0.4 percent of GDP. In large part, the difficult financial situation of SSS1F is largely due to the heavy burden of debt accumulated since 1996 through short-term borrowing, and the cost of servicing this debt. This can be seen clearly in the high level and dramatic increase of administrative cost of SSIF (Figure 6.1). Table 6.2 Financing of the Social Insurance Programs, 2002 Social Insurance Schemes Contribution Rate Contribution made by (% of gross wage) Emnployer Employee Pensions 25 22.5 2.5 Sickness and maternity 3.5 3 0.5 Unemployment 1.5 1.5 - Health 3 3 Work injury 1 1 Total 34 31 3 Source: Chapter 10 (Yu), The Background Papers Volume. 121 Old-Age Pensions 6.10 The old age pension benefit consists of two main components-a flat basic pension and earnings related supplementary pension. * Eligibilitv-To be eligible for the state social insurance pensions, individuals need to (i) have at least 15 years of contribution record, and (ii) have reached legal retirement age. Retirement ages are being raised from 60 to 62.5 for men, and from 55 to 60 for women. The increase started in 1995 and the pace was 2 months per year for men and 4 months per year for women. In 2001, the retirement ages were 61.5 and 57.5 for men and women respectively. The pace of increase was adjusted to half a year per year for both men and women starting from 2001; * Level-(i) Basic pension is flat and cannot exceed 110 percent of the Minimum Subsistence Level (MSL). In 2000 it was 138 Litas per month, about 19 percent of average net wage of the economy. A 30-year contribution record will qualify an individual for full basic pensions, whereas between 15 and 30 years, one gets partially basic pensions. (ii) Supplementary pension is based on individual's earnings and length of contribution. It is the ratio of individual's annual wage to average wage of the economy of that particular year, summed over 25 highest ratio throughout individual's working life; and * Indexation-(i) The basic pension changes as a result of the changes of the MSL. MSL is adjusted to reflect inflation level on an ad hoc basis. (ii) The supplementary pensions are fully indexed to wage growth through the recalculation of average wage. Program Performance 6.11 Coverage. With only about 60 percent of the working age population making contribution to the system, Lithuania's state mandatory social insurance pensions have a low degree of coverage. A considerable number of workers are not contributing or only partially contributing to the system. As a result, many will not be able to meet the minimum contribution record requirement when reaching the retirement age and will not receive pensions. Some will receive only very small pensions. Except for those satisfying the conditions specified in the law, those who do not qualify for regular social insurance pensions will not be eligible for social assistance pensions either.73 6.12 Adeguacv . The average level of Lithuania's old age pension is low compared with most transition economies. In 2000, the average pension as a percent of average gross and net wage was 31 and 44 percent, respectively. About 5 percent of the pensioners receive basic pensions only. The real value of pensions increased by about 46 percent from 1995 to 2000, but the growth has been very uneven. Reflecting the wage and length of contribution differentials, there are significant disparities between urban and rural areas as well as between genders. Household survey data of 2000 indicates that average old age pension in urban areas is 16 percent higher than that,in rural areas. Average pensions for men are 22 percent higher than those for women. 6.13 As in other accession countries, public pensions have been crucial to reducing old age poverty. Household survey data shows that poverty rate is significantly higher among non- pensioners than among pensioners. In the absence of public pensions, the total poverty rate would increase substantially (Table 6.3). However, and despite this poverty alleviation impact, poverty among the elderly is extensive. Within the pensioners' population, the poverty rate is 73 See discussion of "social pensions" in the section on social assistance. 122 higher among rural and female pensioners In the coming decade, the situation will most likely become worse with more pension-age population not eligible for pensions, and more pensioners receiving lower pension benefits. Table 6.3 Poverty Impact of the Old Age Pension Program Poverty and inequality With all social protection Excluding old age pension measures programs program Total poverty rate 6.55 24.37 Gini 0.39 0.50 Urban poverty rate 3.40 19.54 Gini 0.37 0.46 Rural poverty rate 13.32 34.75 Gini 0.41 0.56 Source: Lithuania Household Budget Survey, 2000. 6.14 Efficienay. The payroll tax designated for pensions (25 percent) is commensurate with that of other transition economies, but it is still high. It is one of the contributing factors to the growth of the informal sector. The weak linkage between individual's contribution wage and benefit creates incentives to work in the informal economy, to underreport income within the formal economy, and to retire as soon as reaching the minimum retirement age. 6.15 Equitv. Lithuania's pension system is highly redistributive. This is largely due to two policy design features-(i) the existence of flat pension component, and (ii) the absence of a contribution ceiling combined with a pension benefit ceiling. Pensions are relatively flat in general, but particularly so for the higher income quintiles. Like most transition countries, Lithuania also inherited a pension structure that awarded many privileges. Some of these privileges were removed during the earlier reform, the remaining are categorized as "state pensions" and are financed by the state budget. 6.16 Sustainabilitv. The financial outlook for the state pension system in the medium and long term depends on the demographic structure and labor market performance. There will be a period in the early 2000s when the system will produce positive net cash flow in the range of 0.1-0.9 percent of payroll. In the absence of structural reform measures, however, demographic patterns will imply an unfavorable trend in the long term where the system dependency ratio will grow from 25 percent in 2009 to about 47 percent in 2050. This will generate negative net cash flow from about 2015 to 2030, when it reaches 5.5 percent of payroll or over I percent of GDP. The persistent deficit will necessitate a higher contribution rate or more reliance on general budget support.'4 Issues and policy recommendations 6.17 As recognized by the Government,75 the current pension system faces a number of problems including a weak linkage between contribution and benefit resulting in poor incentive for individuals to participate and contribute; difficult and unsustainable financial situation of the system; and low and decreasing coverage. To address these problems, a set of structural reform measures have been recently introduced. Most importantly, a framework proposal to develop a multi-pillar pension system was adopted by the Government and presented to the Parliament for review in December 2001. This proposal envisaged that the funded pension pillar would be 74 "Pension Reforn", background paper for SAL. 75 "Pensions Reforrn White Paper", Vilnius 2000. 123 introduced starting from January 2004. However, Parliament responded to the government's draft pension reform proposal by agreeing that funded schemes are appropriate, but suggesting that what is required is a voluntary third pillar scheme rather than a mandatory second pillar, and that the government should consider incentives to encourage participation in such schemes. In response the Government , on October 2, 2002, endorsed an alternative draft proposal which it has now put to Parliament. Box 6.1 Revised Pension Reform Proposal: Voluntary Funded Pillar The key design features of the voluntary funded pillar outlined in the revised draft legislation include the following: * Size-Commencing in 2004 at 2.5 percent and rising to five percent by 2007 of individual's gross wage will be diverted to the individual accounts in the funded pillar. The total level of payroll tax designated for pensions will remain the same at 25 percent; * Participation-Completely voluntary, government estimates that six percent of the working population will contribute in the early years; * Fund management-The fund in the second pillar will be managed by private pension comnpanies, or insurance companies. Participants can choose a pension fund; * Benefit payment-Benefit will be awarded only after reaching retirement age, and will be paid out in either periodic payments, annuities or as a lump sum, as determiined by the size of the pension buildup and the law determining payments; * Administration and supervision-The collection of contribution will be the responsibility of the Tax Inspectorate, while SSIF will be in charge of maintaining participant records and transferring contributions to the pension funds. The Securities Commission and the State Insurance Supervision Agency will supervise operations of the pension funds; and * Financing-The transition cost, , will be financed from funds obtained from the sale of state assets and the state budget. 6.18 The following measures, some of which are contemplated in the reform proposal, would contribute to the improvement of the financial position of the PAYG pensions and create room for the second pillar: * Improve incentive to participate by adjusting pension benefit parameters. A number of measures will help to strengthen the linkage of contribution and benefit and encourage compliance, including (i) eliminating the cap for basic pensions at 30 years of service to reward longer service and contribution; (ii) increasing the adjustment factor in calculating pensions for those who choose to retire after retirement age to encourage later retirement, (iii) shifting higher percentage points of the payroll contribution from employers to employees to improve transparency and incentives; and (iv) introducing contribution ceiling to reduce the level of redistribution; * Continue to increase the retirement ages. While the pace of pension age increase has been recently raised, it would be important for the Government to consider further increasing the retirement age to 65 for both men and women. This will have a long-term impact on the financial viability of the program; * Strengthen contribution collection. As recognized by the Government, one area of improvement in contribution collection is to establish a direct link between the collection of social insurance contribution and other forms of taxes. Better coordination between SSIF and State Tax Inspectorate would also allow for more efficient processing of contributions from budget institutions. The decision of consolidating collection functions and having the tax authority to perform the task will help to improve compliance in the 124 long term and allow for efficient processing of contributions in the multi-pillar pension framework and; * Improve the financial position and transparency of SSIF administration. A series of measures can be considered to contain expenditure and increase accountability: (i) develop a government strategy to service and repay the high debt accumulated; improve the budget preparation process to ensure adequate review of SSIF's financing plan; stop the practice of such high cost short-term borrowing by SSIF; and (ii) improve the administration of SSIF. 6.19 In its response to Parliament, the Government has decided to withdraw its proposals for a mandatory funded pillar (Box 6.1). The revised reform proposal relies entirely on a voluntary contribution, diverted from the current contribution to the PAYG scheme into funded schemes administered by pension or insurance providers. This measure still aims at improving old age income security through risk diversification and by increasing individual's responsibility in managing their retirement income. Projection analysis indicates that developing a mult-pillar pension scheme as proposed will indeed help achieve three main objectives: (i) the long-term financial viability of the SS1F will be improved, with the system showing a surplus starting from 2007; (ii) under reasonable macroeconomic assumptions, individuals will enjoy a higher pension under the reformed scheme; and (iii) the investment of pension funds will contribute to deepening financial markets in Lithuania. 6.20 However, while all the elements of the original pension reform are still present, making the revised proposal completely voluntary runs the risk of a very low take up, particularly amongst the younger work force. There are no incentives to join a funded scheme (other than tax exempt savings and the long term promise of a better pension build up) and encouragement to switch from the state scheme will depend entirely on the public understanding of funded schemes and public trust in private financial institutions, neither of these are particularly high. Unemployment Benefits 6.21 Lithuania's mandatory unemployment benefit program aims at providing individuals with short-term income support in the case of unemployment. The current program differs from traditional insurance schemes in that the benefit level is linked only to an individual's length of service, not past earnings. The unemployment support program expenditure is of relatively modest size. The total unemployment program expenditure (including unemployment benefits, active labor market programs, and administrative expenses) accounted for about 0.4 percent of GDP in 2000. About 46 percent of total program expenditure was used to pay benefits. However, the program has expanded at a fast speed in the 1990s (Table 6.4). Measured in constant prices, total program expenditure increased by about 1.5 fold, while the average level of benefit increased by 31 percent from 1996 to 2000. The number of beneficiaries has fluctuated markedly since 1995, with an increase of nearly 65 percent from 1999 to 2001. 125 Table 6.4 Unemployment Support Program Indicators 1995 1996 1997 1998 1999 2000 Expenditure (LTL, 000s) 53,400 100,716 155,467 208,018 180,370 175,472 as % of GDP 0.14 0.16 0.41 0.48 0.42 0.39 on Active Labor Market Program 19,953 27,869 40,408 56,456 54,904 39,113 on Unemployment Benefit 32,752 51,803 49,029 50,750 60,592 80,438 Unemployment rate (labor exchange) 7.3 6.2 6.7 6.9 10.0 12.6 Unemployment rate (labor force 17.1 16.4 14.1 13.5 14.1 15.4 survey) Registered unemployed (ooos)* 78.0 127.7 109.4 120.2 122.8 177.4 Number of beneficiaries (000s)* 23.2 38.4 26.0 22.7 23.1 31.1 as % of registered unemployed(%) 29.7 30.0 23.8 18.9 18.8 17.5 Average length of unemployment 5.5 5.7 5.5 5.5 5.8 6.7 (month) Average duration of benefit period 3.6 3.9 3.4 3.4 3.8 4.0 (month) Average monthly benefit (LTL) 80.9 122.3 169.8 187.6 181.4 186.9 Average monthly benefit (1995 price) 80.9 98.1 125.2 131.6 133.2 128.8 Average benefit/average gross wage 16.8 19.8 21.8 20.2 19.4 18.5 Average benefit/average net wage 22.3 26.2 29.4 27.4 26.5 26.1 Source: Lithuania Labor Exchange. * value at the beginning of the year 6.22 The statutory basis for the current unemployment benefit program is the Law on Support of the Unemployed. The main features of the program can be summarized as follows: * The unemployment benefit program has standard coverage. Employed individuals with certain minimum work record are eligible for this benefit. Self-employed and farmers with land are not eligible for benefit, although they can participate in the active labor market programs. A sizeable fraction of the unemployed are not registered, while some who are registered appear to be working in the informal sector; * Only a small fraction of registered unemployed receives benefits. About 17.5 percent of the registered unemployed received unemployment benefits at the beginning of 2000. The low fraction is mainly due to the fact that many unemployed do not have the 24 months of contribution record required. Other unemployed have simply used up their 6 months maximum duration. The average duration of unemployment benefit claims was about 4 months in 2000; * Modest disincentive to work. The current benefit structure implies that the unemployment benefit itself does not provide strong work disincentives. The level of unemployment benefit is modest. The average replacement rate calculated as the ratio of average benefit to average national net wage was about 26-29 percent between 1996 and 2000, and the ratio of average benefit to average gross wage has declined from 21.8 percent in 1996 to 18.5 percent in 2000. The six-month duration of benefits is relatively short (Figure 6.2); and * The unemployment benefit is redistributive. The absence of linkage between individual's past earning and benefit level implies that Lithuania's unemployment benefit is very flat. The benefit ceiling and floor further compress the range of benefits. The flat distribution of unemployment benefit can also be observed in terms of urban-rural and gender disparities. In comparison with the average income differential of about 33 percent between rural and urban areas, the household survey results suggest that in 2000 the 126 average unemployment benefit for rural recipients was about 89 percent of that received by urban beneficiaries. Similarly the average benefit level for females in 2000 was about 97 percent of that for males. Figure 6.2 Unem lo ment Benefit: Lithuania vs. Other Transition Economies Replacement Rate* Potential Duration (months, in late 1990s) (Initial benefit as % of individual's gross wage) l 18- Sloverds 16- ftiary 14 - BLigana 12- Sovak Rep. 10- Roiraia ______________ _8-_ 8 6- 4. cze Rch 2 Uthtena 0 20 40 60 80 so 4 *Average national gross wage was used for Lithuania. Source: Vodopivec, Vorgotter, Raju (2001)for other countries. The Government's Reform ProDosal 6.23 A concept document and draft legislation were presented to the Government Strategic Committee in the spring of 2001 to substantially change the structure of the unemployment benefit program. It is expected that it will be resubmitted to the current government for consideration in early 2002. The draft legislation reflects a shift of policy objectives away from protecting the unemployed by providing relatively flat short-term income support, and towards the development of a more traditional unemployment insurance scheme that partially replaces individuals' lost earnings. In particular, the main changes proposed include the following: * Benefit formula-Unemployment benefit formula would consists of a flat component equal to that of the newly proposed level of social benefit, and an earnings-related component with declining target replacement rate. The latter would equal to 60 percent during the first 3 months, 30 percent during the second 3 months, and would decline to zero after 6 months. Upon reaching the 6-month maximum, the flat benefit will be paid by the social assistance program; * Eligibility condition-The eligibility condition would be relaxed to having work record for 18 months during the past 36 months. A more generous provision will be introduced for those individuals close to retirement; * Administration-SSIF will not be able to reallocate contributions designated for various social insurance programs. Instead, separate accounts for unemployment benefit would be established within SSEF with a common reserve fund across programs allowing SSIF to tap into the reserve under unusual circumstances with the approval of the Council; and 127 * Linkage with Active Labor Market Programs (ALMP)-It was proposed that ALMPs should be made available to all people in the labor force, not only to those who contributed to the program. Therefore, they should not be part of the insurance scheme, but be financed directly from the budget and administered by the Labor Exchange. The designated payroll tax for unemployment program should be reduced accordingly. Reactions to Government's Prooosal and Recommendations 6.24 While motivated by legitimate concerns, the Government's reform proposal has some potentially harmful features. Some of the proposed changes of unemployment benefit program, in particular the rationalization of the financial management of SSIF, would improve the transparency of various social insurance programs. However, the policy shift from a flat and modest unemployment benefit structure to a more traditional insurance scheme would not protect Lithuanian workers in a more efficient and cost effective manner. 6.25 (i) Retain the flat and modest unemployment benefit structure. The current program is reasonably well targeted in reaching the poor households. A combination of flat benefit and an earnings related benefit as proposed would restrict the possibility of redistribution, and at the same time significantly increase the benefit level and generate perverse short term and long term effects (Figure 6.3). For someone with contribution wage at the national average, the replacement rate with respect to net wage would be 75 percent for the first three months and 45 percent for the second three months. For someone earning minimum wage during the 36- month period prior to unemployment, the initial replacement rate could reach 85 percent. This could severely reduce job search incentives, as has shown to be the case, for example, in Slovakia (World Bank, 2001). Moreover, the proposed policy will imply higher expenditure overall. Estimate of the Ministry suggested that the total expenditure on the unemployment benefit program will increase by about one-third. If it is the desire of the Government to introduce an insurance-based mechanism to replace the current system, we would advise that the scheme not contain a flat component, but only an earnings related component that has initial replacement rate at about 40-50 percent. Figure 6.3 Perverse Work Incentive in the Proposed New Benefit Structure (unemployment benefit as percent of individual's net wage) 120 100 80 c60 40 5 40-- e 20 0 "l " lb" kl 4) Ot Ib I 60 64 1 %4 I Average contribution wage l Initial UB as%oflndividual'save. contribution wage initial UB as%of average wage of the economy 128 6.26 (iU) Assist the long-term unemployed by adjusting social assistance policies, and ensuring ALMP are not targeted mainly to the most "re-employable ". As rightly recognized by the Ministry, the long term unemployed are not adequately protected by the current policy. The current social assistance policy leaves certain discretionary power to local authorities when it comes to decide whether individuals registered as unemployed for more than 12 months can be eligible for income tested social benefits. As a result, many long-term unemployed are not deemed eligible. Given that Lithuania already has a means-tested social benefit program, the Government could consider extending social benefit to these long-term unemployed for an indefinite period, subject to the standard income and asset testing criteria. However, this could introduce additional perverse work incentives. A potentially more useful approach is to rely on ALMP especially targeted towards the long-term unemployed. 6.27 (iii) Improve program efficiency by screening out ineligible recipients. It is widely believed that the size of the informal sector in Lithuania is extensive, and that there is strong incentive for individuals working in the informal sector to register as unemployed to qualify for various social benefits. One way to address this problem is to strengthen inspection and random checking. It was also suggested that requiring certain minimum participation in public works in exchange for benefit would effectively disqualify a high percentage of ineligible beneficiaries. There exist some legal barriers if the municipal authority requires the participation of public work without fully compensating the participants with minimum wage. The Government needs to consider modifying the labor legislation to allow for certain flexibility in wage requirement or to allow for other forms of labor relations for benefit recipients engaged in public work. C. SOCIAL ASSISTANCE PROGRAMS 6.28 The Government provides social assistance support in the forms of cash transfers and social services. Cash transfers include (i) categorical benefits rendered to certain groups of the population regardless of their income status, and (ii) income-tested benefits for those who fall below a specified income level. Social services include institutional, home and community care provided to children, elderly, and other vulnerable groups. 6.29 Social assistance programs were decentralized to the municipal government in the 1990s. Most of these programs are financed out of the municipal budget and administered by local authorities. The state budget finances a few social assistance items, including social pensions, children's school meal program, benefit for pregnant students, and orphan stipends. 6.30 Cash transfer social assistance programs consumed about 1.55 percent of GDP in 2000. Cash transfer expenditures experienced consistent, and in some years very substantial increase in real terms. Social services also accounted for a major component of the overall expenditure, with institutional care the biggest expenditure category (Table 6.5). 129 Table 6.5 Social Assistance Program Expenditure (as % of GDP) 1995 1996 1997 1998 1999 2000 Cash benefits 1.15 1.04 1.25 1.28 1.53 1.55 Categorical benefits 0.66 0.65 0.62 0.66 0.93 0.92 social pensions 0.26 0.24 0.20 0.19 0.21 0.21 family benefits76 0.33 0.35 0.36 0.41 0.47 0.46 Income tested benefits 0.49 0.38 0.63 0.62 0.59 0.62 social benefit 0.26 0.24 0.20 0.16 0.17 0.20 utility compensation 0.23 0.14 0.30 0.19 0.14 0.17 Social Services 0.83 1.08 0.94 Source: MSSL. SSIF 6.31 There have been continuous modifications to the program in the 1990s and some new changes are being proposed. In 1995, the Government adjusted the categorical benefit programs by reducing the number of categories and increasing certain level of benefits. In 1997, income- tested benefits targeted at large families were introduced. In 1998 and 2000, the levels of benefits related to orphans were increased substantially. In early 2001, a new draft law on Cash Social Assistance was prepared to further modify the cash transfer policies. It is expected that it will be presented to the Government in the spring of 2002. A new concept for social service provision has been prepared. Another major change that recently took place is the financing arrangement of these programs. Starting from January 2002, the financing of all statutory cash transfer programs was centralized back to the central government. Earmarked funds designated for these benefit programs will be transferred from state budget to special accounts maintained by the municipal authority. Cash Transfer Programs 6.32 Lithuania's cash transfer program is characterized by its significant portion of categorical benefits and its heavy focus on families with children and children without parental care. In 1998, about 55 percent of the total expenditure was spent on categorical benefits. Benefits for family with children accounted for about 42 percent of the total cash benefits excluding social pensions. 6.33 Categorical Cash Benefit Programs. Categorical cash benefits consist mainly of social pensions, various benefits to families with children, funeral grants, and public transportation rebates. The stated objective of family programs is very broadly expressed as to support Lithuanian families to raise children. 6.34 Social Pensions are granted to two major groups of population: (i) individuals who have reached pension age but do not have right to regular state social insurance pensions or state pensions because they have taken care of disabled children for an extensive period (at least 15 years), or raised many children (five and more) up to eight years of age; (ii) disabled children and those disabled before certain age. The size of the social pen3ion for group (i) is equal to basic pensions, with survivorship of the surviving children. The size of social pension for group (ii) ranges from 0.5 to 1.5 MSL. Social pensions are financed by the state budget. 6.35 Family Benefit is granted to all families with children. In terms of total expenditure level, it is the largest among all family related benefits. For those entitled to state maternity insurance, the benefit is paid for the period when the child is between one and three years old. For those not entitled to maternity insurance, it covers the period from child's birth to 3-years old. The level of benefit is 75 percent of minimum standard of living (MSL) per month per child, 76 Excluding benefits for families with three children which are income-tested. 130 equivalent to 94 LTL in 2000. About 88 thousand children received family benefit in 2000. The family benefit is completely financed by municipal governments. 6.36 Benefits related to orhans and adoptive children. There have been extensive coverage and growing expenditure on orphans. The main benefits include (i) foster care allowance granted to foster parents; (ii) one time settlement grant offered to orphans reaching 18 years of age to support their purchase of dwelling; and (iii) stipend paid to orphans attending high school and higher education. From 1995 to 2000, the total expenditure in these three categories increased ten-fold in nominal terms. In 2000, the level of foster care benefit was raised from 1.5 MSL to 4 MSL per child per month. Similarly, orphans' stipend was raised to 4 MSL, and settlement grant was increased from 18 to 50 MSL. 6.37 Income-Tested Benefits. Social benefits, utility compensation, benefit to families with three children, one time lump sum allowance, and payment for school meals are the five main categories of assistance that are targeted at the poor and are granted subject to income testing. Policies with respect to these benefits are currently specified in several legal acts77. The benefits are granted to households whose income is below the "State Supported Income", and the benefit levels are expressed in terms of Minimum Subsistence Level (MSL), approved by the government on a quarterly basis (see Box 6.2). 6.38 Social Benefit is the main maintenance benefit in Lithuania. It accounts for 18 percent of total cash transfer program in 2000. There were about 115 thousand beneficiaries. The main features of this program are the following: * Eligibility-A family is eligible for social benefit if the total household income (net of tax and social insurance contribution) is less than the SSI; * Size-The amount of the benefit is 90 percent of the difference between household income and the SSI; * Calculation-The benefit is calculated based on the income of the household in the proceeding three months. Municipal government is responsible for carrying out the income/asset testing. The benefit is paid once every 3 months; and * Financing-The system is financed out of the municipal budget and is administered by the municipalities. T Social benefit was govemed by the Law on Individual Income Security (September, 1990). Utility compensation was regulated by the Law on Compensation for Household Heating, Cold and Hot Water to the Low-Income Households (April 1999). Lump Sum Benefit was paid according to the Government decree issued in October 1992. 131 Box 6.2 Minimum Subsistence Level (MSL) and State Supported Income (SSI) The pulpose of the Minimum Subsistence Level (MSL) is to establish a socially acceptable subsistence level according to certain physiological and nutritional criteria. It is defined in the Lithuania Law on Individual Income Security. MSL The is calculated quarterly by the Ministry of Social Security and Labor based on the average cost of a basket of food and other essential expenditure items. The composition of the food basket is based on data from household budget survey (HBS) for lowest income groups, minimum food consumption norms for adults, and nutritional norms for children. The prices of the food items are determined based on average urban and rural food prices weighted by population. MSL is specified in terms of per person per month. The MSL that is applied in benefit calculation is officially approved by the Govemment every quarter. The applied MSL is substantially lower than the calculated MSL and is adopted taken into consideration the capacity of state budgetary resources. Almost all social assistance benefits, as well as basic pensions, are specified as multiples of MSL. The MSL for a family of n persons is n times the MSL for a single person. According to the Law on Individual Income Security, the State Supported Income (SSI) is defined as a level of income guarantee not lower than the money spent on food as determined in the MSL. It is also approved quarterly, and the level has been between the calculated MSL and the applied MSL. The SSI is the benchmark used to determine whether a household or an individual is eligible for any income-tested benefits. The value of MSL and SSI measured in constant price has been more or less stagnant, with slight decline in recent years. As a percentage of average net wage, MSL and SSI have both gradually declined over time. Source: Chapter 10, Vol. 11. 6.39 Utility Compensation is aimed at compensating households' expenditure on heating, hot and cold water. All compensation is capped by a ceiling defined in terms of a normative or assumed cost. For households whose income is below the SSI, the compensation they receive is the maximum compensation. For families whose household incomes exceed the SSI, the household is to pay certain percentage of the difference between their income and the SSI,"8 while the remaining expenditure will be compensated by the state. The municipal govenmments calculate the payment to be made by eligible families and send the information to the utility company. The utility company then bills the users and the municipal government accordingly. Like in the case of the social benefit program, compensation is granted every three months. 6.40 Benefit for Families with Three Children. In addition to various categorical family benefits, a semi-categorical benefit was introduced in 1997 for families with three children under 16 years of age and older until they complete full time education. Families with per capita income less than three times the SSI are eligible for this benefit. The size of the benefit is one MSL for an individual.79 Policy Changes Proposed by the Government 6.41 A new draft Law on Cash Social Assistance outlines the changes that the ministry wants to introduce. These include: 7 The proportions that households are required to pay was 25 percent for space heating costs, 2 percent for cold water and 5 percent for the cost of water heating in 2000. 79 For families with more than three children, they receive an increased benefit for the fourth child on, and these additional benefits are not subject to income testing. 132 * Income testing threshold: increase the level of income testing (SSI) from 135 to 180; * Benefit level: decrease the benefit level from 90 percent of the difference between SSI and income to 60 percent; * Coverage: extend the coverage of utility compensation from heating, hot and cold water to all utility expenditure, including electricity, gas, etc.; and * Administering income testing: introduce annual income and property declaration by requiring households to present income and property declaration to the state tax inspection. 6.42 The Ministry estimated that these changes will imply that the number of social benefit and utility compensation recipients will increase from the current 115 and 259 thousand respectively to 370 thousand in both cases. The total fiscal resources required to pay for these two programs will increase by about 97 percent from the current 160 million litas to 314 million litas. Issues and Policy Recommendations 6.43 The current social assistance programs have significant inclusion and exclusion errors and do not effectively assist the poor. It is clear that some of these problems are recognized by the ministry and municipal officials administering the program. 6.44 The allocation of overall resources is not sufficiently targeted at the poor. As indicated above, more than half of the expenditure is allocated to categorical benefits. Household budget survey indicates that the average level of social pensions and family related benefits as a whole is positively correlated with household income level, while the average level of family benefit is not correlated with household income in general (Figure 6.4). The comparative static analysis also shows that the poverty impact of categorical benefits as a whole is very limited. The poverty rate increases only marginally when the program is excluded. In other words, despite the large size of the program, its poverty impact is negligible (Table 6.6). Table 6.6 Impact of Means-Tested Social Assistance Programs on Poverty With all social Excluding all Excluding income-tested protection programs categorical benefits social assistance programs80 Overal Poverty Rate 6.55 7.11 7.63 Gini 0.39 0.39 0.40 Urban Poverty Rate 3.40 3.68 4.15 Gini 0.37 0.37 0.37 Rural Poverty Rate 13.32 14.48 15.10 Gini 0.41 0.42 0.42 State Support Income (SSl) is used as the poverty line for this exercise. Source: Lithuania HBS, 2000. 6.45 To improve targeting efficiency and assist the poor more effectively, the Government needs to gradually eliminate categorical benefits and concentrate the resources on providing more substantive income-tested benefits to the poor. As a first step, the Government may want consider reducing the size of categorical benefits either by reducing the duration of family benefit or restricting to even fewer categories. 8 The programs examined are social benefit, benefits for famiiies with 3 and more children, and utility compensations. 133 Figure 6.4 Categorical Benefits Are not Pro-Poor (average benefit level by income quintile) 350 - 300 _,.- - _ 250 ' s- -Tx - 4isrr 200 - !-< t 150 [ 100 : 50 0 Poorest 02 Q3 Q4 Richest Quintile Quintile osocial pension *familyrelated categorical benefits Ofamilybenefit Source: Household Budget Survey 2000 data, measured by household 6.46 The income-testing threshold is low but at the same time does not take into consideration economy of scale. At about 60 percent of the value of the relative poverty line,8' the SSI which is used to determine the eligibility of benefit is indeed low. This leaves out a significant portion of the population who are relatively poor. In the meantime, not applying any equivalence scale in determining household eligibility and benefit level means that the cost of living for larger families are over-estimated and the benefits they receive in relation to their needs are higher than for smaller families. The Government could consider increasing the income-testing threshold so that it reflects more closely the true minimal subsistence level, and indexing it fully to inflation. Meanwhile, the Government can explore the possibility of introducing equivalence scale to achieve a better estimate of cost of living. These changes will demand additional fiscal resources, but these could be released by reducing and eventually eliminating the categorical benefits. 6.47 Significant exclusion error exists for social benefit. Analysis using the household budget survey data shows that the exclusion error of the social benefit program is alarmingly high, indicating that majority of the poor (measured in terms of the low income threshold) are not receiving the benefit. About 87 percent of the poor households are not receiving social benefit. Interestingly, the result also shows that the level of exclusion error is not markedly different between the rural (87.3 percent) and urban households (85.9 percent). 6.48 One group of the vulnerable that is not adequately protected by the program is the long term unemployed. Social benefit is not extended to the unemployed beyond 6 months after the unemployment benefit is expired. Local social assistance officials also pointed out that some vulnerable groups (notably those with alcohol abuse and people in the rural areas) fail to register as unemployed and are left unprotected. Social benefit programs should not exclude individuals simply based on the duration of being unemployed. More broadly the reforms of social assistance policy and unemployment benefit program need to go hand in hand to ensure that the most 8 Most part of this report uses 50 percent of median per equivalent monthly expenditures as poverty line. In 2000, the value was 222.9 litas. 134 vulnerable groups are covered by the safety net while at the same time encourage individuals to seek for formal employment. 6.49 Inclusion error can be reduced to improving targeting. While the household survey data analysis suggests that the inclusion error of the social benefit program is rather modest, it is believed by the ministry and municipal government officials that many benefit recipients are not the most needy and are working in the informal sector. Three kinds of changes could be considered in this regard: * Develop income and asset declaration and establish close collaboration between the tax authority and the social protection programs. Having access to income information would allow social welfare program to verify income situation of benefit applicants and reduce inclusion errors; * Consider introducing asset testing criteria as part of the eligibility condition to complement income testing. Similar schemes are in place in some transition economies where ownership of second dwelling, relatively new automobiles, etc. have been used as additional criteria to disqualify potential beneficiaries. This, however, would require a significant increase of staff to carry out home visits and random checks; and * Introduce certain requirement for participation in pubic work program as a self-selection mechanism. This would help to screen out those working in the informal sector. As discussed in the section on unemployment benefit, some modification of labor legislation may be needed to allow for such work arrangement. 6.50 The current benefit structure implies poor work incentive. The rate at which benefit is reduced when income increases is rather high in the current program. For every extra Lita a social benefit recipient earns from work, his or her additional income is only 0.1 Lita.82 Meeting social benefit criteria also qualifies the household various benefits including utility compensation, and free school meals, etc. This makes low income work particularly unattractive and creates a poverty trap.83 The Government proposal will reduce the withdrawal rate from the current 90 percent to 60 percent and will help to moderate the poverty trap problem. This is a positive step. However, such a change combined with the increase of SSI will leave some families-those with little or no income (i.e., per capita household income less than 45 Litas)-actually worse off. Some modifications are needed to protect this most vulnerable group. 6.51 The high level of some categorical benefits distorts behavior. While the increase of benefit level for foster care allowance was partly driven by the desire to de-institutionalize the social service programs, the high level of benefit (4 MSL) lead some people to take advantage of the policy. The numbers of foster care parents (benefit recipients) jumped by 93 percent from 1996 to 2000. According to the Ministry, there are many cases where relatives adopted-children only to receive the benefit. In some cases, the recipients do not necessarily provide expected care to the adopted child. The Government needs to reconsider the level of such benefits. In addition, additional criteria may need to be included to limit those who only want to take advantage of the benefit and do not have the well being of the children as the primary concern. Better monitoring after the adoption would also help to ensure that the policy objective is met. 82 Assuming that the individual is not subject to income tax. 83 One should note that the fact that social assistance benefits are calculated and granted once every three months reduces the "withdrawal rate" as mentioned above and mitigate somewhat the disincentive to work. 135 6.52 The financing arrangement cannot ensure proper implementation of the social assistance policy. Up to the end of 2001, municipal governments have been responsible for financing most of the social assistance benefits. On the one hand, fiscal resources are limited, especially for poor municipalities where the social assistance need is the highest. There are always competing expenditure priorities and the municipal authority stated that they did not have adequate funds to fulfill the responsibilities of delivering these statutory programs, especially when the revenue situation is difficult. Meanwhile, it was very difficult for the central government (in particular Ministry of Social Security and Labor, and Ministry of Finance) to monitor the implementation of policies and program expenditure at the local level. The policy change introduced since the beginning of 2002 is a move in the right direction. D. MERIT-BASED BENEFITS-STATE PENSIONS 6.53 As a result of the social insurance reform in the mid 1990s, a series of pension privileges were removed from the state social insurance program. The remaining benefits are financed by the general budget and administered by SSIF. While they are broadly categorized as "state pensions", in nature they are merit based categorical benefits paid over an extended period of time. In 2000, the state pensions cost 232 million Litas, accounting for about 3.7 percent of public expenditure. About 104,000 people received such pensions. The Government recognized the equity and fiscal concerns associated with such publicly financed pensions, and in the context of pension reform proposed a series of measures to gradually reduce and eliminate all such pensions. Policy recommendations 6.54 State pensions raised fiscal and equity issues. There has been public discontent with the state pensions, regarding such publicly financed privileges as unjustifiable. In addition, with the state budgetary resource being very limited, one would question the use of fund on these categories of individuals that are not regarded as the most needy or vulnerable. The objectives of the reform therefore should aim at containing the cost of the program and eliminating those benefits that are considered unjustifiable. The Ministry of Social Security and Labor made some detailed proposals as to how to adjust certain programs. The overall principles and approaches that the Government can consider would include the following: * Consider replacing certain pensions with lump sum payment (e.g., at the point of completing military service). This would free the states from long-term obligations, while encouraging the recipients to be active in the competitive labor market; * Eliminate certain pension categories (e.g., scientist pensions, survivors' and orphans' pensions). In a more developed labor market, the income level of scientists would be competitively determined. If the government and the society want to encourage certain scientific activities whose benefit cannot be fully captured in the market, other more direct forms of support (e.g., more research funding) is more efficient and justifiable. Funded occupational pension scheme can also be developed, but it would not be financed publicly with taxpayers' contribution. * Reduce the number of recipients by (a) disqualifying working pensioners; (b) tightening the eligibility criteria (e.g., length of service); and (c) discontinue the payment of state pensions when individuals reach to retirement age and start receiving social insurance pensions; * Keep the benefit level modest so that it will not discourage individuals from seeking for work, and 136 * Continue paying the pensions that have been granted but keep the nominal level of the state pensions constant. This will contain overall cost and let the benefit level erode over time; some "opt out" options can be offered to certain eligible groups of current benefit recipients so that they can receive lump sum payment instead. E. SUMMARY AND POLICY RECOMMENDATIONS 6.55 EU accession is likely to accentuate competitive pressures on the Lithuanian economy, and will demand continued economic restructuring, especially in sectors such as agriculture which are lagging behind. In this context, it is critical to ensure that the social protection policy and programs are supportive of the development and integration process, and can address social concerns in an efficient and sustainable manner. 6.56 Lithuania's social protection system is fairly extensive. It provides support to the elderly, the disabled, the unemployed, the sick, the poor, and Lithuanian families at large through a range of social insurance and social assistance programs. Comparing with many similar programs in the region, the social insurance programs (pensions and unemployment benefit) offer relatively modest benefit and are fairly redistributive. The unemployment benefit does not create significant disincentive to work. The social assistance program is characterized by a heavy reliance on categorical benefits and heavy focus on families with children and children without parental care. Income tested social benefit accounts for a small portion of the overall cash transfer programs. There are still some merit-based benefits, but they are separate from the state social insurance and social assistance programs. Over the past ten years, many modifications were introduced to make the social protection programs more efficient and affordable. 6.57 Major problems also emerged in the past decade, indicating the weakness of current policy and program administration. The state social insurance pensions have accumulated high deficit in recent years, despite the relative modest size of pension benefit and the increase of pension age. This trend will become even more pronounced combined with the competitive pressure from the EU accession process and the aging of Lithuanian population. It will not only imply that the system will become financially unsustainable, it will also result in a significant decline in pension coverage. Many of the elderly will be left with no or very small pensions in future. Old age income security will become a major risk, particularly in the rural areas. 6.58 In spite of many positive features of the unemployment benefit program, it has the problem of not being able to adequately coordinate with other social protection programs. Consequently, certain vulnerable groups, notably the long term unemployed, are left unprotected in the current system. 6.59 Review of the social assistance program also indicates major efficiency and effectiveness problems. First, the allocation of the overall resources is not sufficiently targeted at the poor. Categorical benefits, which consumed most of the expenditure, are not designed to reach the poorest. Second, the income-testing threshold for targeted social benefit is very low, leaving significant portion of the poor ineligible. Third, even with this low poverty line, the income-tested benefits only reaches a small fraction of the intended population, suffering from very high exclusion error. Fourth, the current benefit structure of income-tested social benefit has high withdrawal rate, making low income job particularly unattractive and creating a poverty trap. 6.60 To address these problems, the Government of Lithuania actively engaged in policy discussion and developed reform proposals in almost all aspects of social protection programs. The current proposal calls for a reform of the pension Droaram bv introducing a multi-pillar 137 pension system and creating voluntary funded individual pension accounts. There was a proposal to restructure the unemployment benefit program. A draft law on cash transfers suggested increasing the income-testing threshold and reducing the benefit rate. Along with reforms in benefit structure, there are proposals to modify the administration to improve efficiency. Proposed changes include the modification of financial management of the social insurance program, changing the financing arrangement of active labor market programs, and improving income and asset declaration to enhance tax and contribution collection. Some of the proposed changes have already taken place. 6.61 The active pursue of reform options indicates a good understanding of the Government regarding the problems that social protection programs face. Most of the proposed approaches represent a move in the right direction. The reform of the social protection programs should aim at (i) improving program targeting so that the limited resources can reach the intended recipients and assist the most vulnerable in the Lithuania society; (ii) increasing policy efficiency so that it reinforce positive behaviors and support economic restructuring and productivity enhancement; and (iii) ensuring that the program is financially viable in the long term. 6.62 In the area of pensions, the re-enforcement and extension of a multi-pillar pension system and continued reform of the pay-as-you-go pensions will improve pension coverage and adequacy, but more is required to encourage younger workers to take a direct interest in their own pension provision. To strengthen the incentive to participate, the reform needs to adjust pension benefit parameters in the pay-as-you-go pension pillar. The introduction of the option to divert up to five percent of social contributions into the funded pension pillar will establish an even stronger linkage between individuals' contributions and pensions, and encourage individuals to play an active role in managing their retirement income. 6.63 In the area of unemployment benefit, the proposal of the Government to establish a traditional unemployment insurance program may not suit the need of Lithuania at this stage of development. The proposed benefit structure will imply weak incentives to work, and reduced ability of the system to redistribute to the poor. It would be more appropriate to retain the current unemployment benefit structure, but strengthen the linkage with social assistance programs when tackling the issues of long-term unemployment and the unemployment problem of those close to retirement age. 6.64 To improve the targeting efficiency of social assistance program, the Government needs to consider reducing the categorical benefits, and reallocating the resources to a better administered income-testing program. Within income-testing programs, there needs to be a gradual shift from utility compensation to social benefit. When fiscal capacity allows, the income-testing threshold needs to be modified to include more poor households. Efforts are also needed to screen out the ineligible recipients by developing a better income/asset testing mechanism and stronger income/asset verification capacity. 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