Colloquium 1996 Panel I : Balance Sheet of Economic Performance and Reforms in Cooperation Partner Countries

The Parallel Side of the Economies in Transition: Case of Lithuania Eugenijus Maldeikis Director, Economic Research Center, Vilnius, Lithuania Summary In analyzing the development of economic reforms in countries of transition, the main attention is given to successful macroeconomic stabilization, industrial restructuring, privatization, and other spheres. The achievements are significant, of course: growth of GDP, expansion of export volume, etc. The other, parallel, side of the economic and social reforms is discussed and analyzed, however, rarely. Nevertheless, the existence of this economy usually influences and modifies the models of economic and social reforms, creating the different trends of reforms in various countries. This report is based on the case of Lithuania, whose economic development and process of reforms has been continually analyzed by us for several years already. The process of economic reforms activates economic and social phenomena that affect and alter the trends and speed of the reforms, as well as economic decisions of the government. The phenomena of legal inflation can be observed in the course of economic transformation. Due to the radical changes of the legal system and rapid introduction of new acts, and in the absence of systematic legal reform, the following issues arise: contradictions in the legal framework, gaps in the legal framework, neglecting of the legal norms by citizens as well as civil servants. The gap between issues of economic reforms and its legal regulation is wide spread. In practice, market relations as well as private initiative are developing faster than the legal framework. Together with other issues, this gap is a prerequisite for the growth and functioning of the parallel, unrecorded, economy. Great difficulties in controlling such phenomena are faced by state institutions, especially as short-term goals are the priority. The main sources of the unrecorded economy are listed in Figure I. The internal sources can be distinguished, such as households, enterprises as well as the financial sector. The external sources comprise mainly export-import transactions and foreign capital inflows. Figure I (15Kb)

Household Sector The following underground practices in the household sector are observed: In addition to official salaries and wages, cash supplement is received from the employer. Working unofficially, especially by the retired or youths, in order to receive higher pay by saving benefits and taxes for the employer. The Department of Statistics has estimated that in this way some 200 thousand active persons (5.3 percent of the whole population) are denied employment or an official source of living. This figure is an average of three different approaches. Commercial shuttling to neighboring countries (Russia, Latvia, other C.I.S. countries) and countries of cheaper goods (China, Turkey, etc.) According to the Department of Statistics, the household survey represents inadequately the population by income. The bias of the survey towards the poorer segments of households is caused by low rate of responses from the rich and to a high extent underestimates household income and expenditure, given the great inequality of the population. The underground activities also escape the survey's questionnaires because high income persons are responsible for the biggest share of the hidden production, not to mention the natural inclination of any respondent to conceal unofficial income. Assuming that the survey in general does represent the money income and expenditure structure of the household sector except for the wealthiest few, it becomes evident that saving has not been characteristic during the base period. In 1994-1995, household savings made up 3 percent of total disposable income, which in nominal terms does not exceed 100 million litas for the whole household sector in 1995. Compared to the average standard of living this figure seems to be close to actual. Figure II (6Kb) As shown in Table I, commodities and other standing expenses add up to over 75 percent of total consumption expenditure, and income received at least once a month constitutes some 87 percent of total money income. As nearly the entire income is used for everyday consumption we can use the upper limit of the two figures when thinking of monthly income and expenditure, which gives us in round numbers 90 percent. The balance supposedly corresponds to consumer durables that are bought after some period of saving and seasonal items, such as those related to agricultural production. Table I Household Money and Income Expenditure Pattern (1) Litas per Month Percent Strictly Monthly Pattern Consumption expenditure Food 100.21 45.8% X Non-food commodities 40.04 18.3% Services 32.16 14.7% X Alcoholic beverages 2.87 1.3% X Agricultural production costs 9.13 4.2% Taxees, fees, duties 30.69 14.0% X Other Expenditure 3.83 1.7% 218.93 100.0% 75.8% Money income Wages and salaries 139.19 62.9% X Income from business 17.43 7.9% X Income from household farming 13.55 6.1% Dividends, interest 1.62 0.7% X Cash allowances 4.87 2.2% X Pensions 28.75 13.0% X Scholarships 0.60 0.3% X Other income 15.28 6.9% 221.28 100.0% 87.0% Years' 1994-1995 average By the end of 1995 the average disposable income per household increased to 260 litas ($60) per month, which is considered to be slightly over the real living minimum. At this level of income and high inflation (36 percent in 1995), significant hoarding of currency by households is unlikely, which leads us to the overall conclusion that monthly income is consumed within a month. The growth rate of households' disposable income was much lower than that of foreign currency deposits as well. As was mentioned earlier, in 1994-1995 households' savings made up 3 percent of total disposable income which does not exceed 100 million litas for the whole household sector in 1995. Figure III (6Kb) After the introduction of a national currency the structure of deposits has changed in favor of national currency deposits. However, in nominal terms growth of foreign currency deposits remained stable until the banking crisis at the end of 1995. The growth of foreign currency households' deposits in nominal terms comprised 35.5 million litas ($8.8 million) per month in 1994, and 34.8 million litas ($8.7 million) per month in 1995 until the banking crisis in December, 1995. The crisis resulted in a significant outflow of foreign currency deposits-138.3 million litas ($34.5 million) per month. The more important trend in the sales and purchases of foreign currency by commercial banks is increasing sales of foreign currency cash in 1995. The conclusion can be drawn that more foreign currency income is used for current consumption. It is interesting to compare the composition of households' deposits structure in Lithuania and Estonia (Figure IV). Figure IV (10Kb) According to the Estonian economist Kalev Kukk "the biggest difference between the Baltic States is the role which cash and foreign exchange deposits play in money supply. Both Latvia and Lithuania have large foreign exchange deposits compared to Estonia, which is somewhat paradoxical when one considers the revalued exchange rates of the lats and litas and the higher interest on deposits held in the original currency."(Kalev Kukk, 1995) The situation can be explained by a higher confidence in the national currency in Estonia than that in Lithuania, as well as a higher level of dollarization in Lithuania. Enterprise Sector These are the activities in the enterprise sector related to the underground economy: Industrial enterprises with standard cost accounting alter production factor rates to increase manufacturing cost; Contractual prices are set at a break-even level with the balance being paid in cash or more product is supplied compared to the market value; Part of employee remuneration is paid out of unrecorded cash inflows in addition to the official pay. Occasionally companies use loans, insurance and other fringe benefits to increase salaries without a tax burden; Fictitious contracts are drawn and money paid to off-shore companies; Reporting is evaded by improper registration with authorities. All companies in Lithuania are entered into the comprehensive register of business enterprises maintained by the Ministry of Economics. Upon registration of a company, information on the company is provided to the Department of Statistics, the Tax Inspection and a social insurance institution. A bank is allowed to open an account to the applying company on condition that a proof of registration with all the institutions is in place. However, there are companies that have been able somehow to obtain an account from a bank with the act of incorporation only, i.e. without notification of all the involved institutions apart from the Register. Such a company can freely use the bank account and need not pay any taxes or report statistics. Malpractice in the Register or/and the bank is responsible for the existence of such companies. However, a high share of currency in circulation used in the non-household sector implies that non-households use a lot of cash in business transactions. Also, this indirectly suggests that the share of cash used for underground transactions is substantial because of natural incentives of companies to keep transactions off-the-books whenever possible. According to our research, about 60 percent of currency in circulation was used by non-household sector in 1995. This is more than two-thirds of total transactions money of the non-household sector. Such a structure would seem surprising if companies followed restrictions on the maximum amount of cash payment for sale and purchase of goods and services. Actually there are no real obstacles for the company to cash in account money, and companies do it because currency earns unreported income. Financial Sector Voucher privatization did not bolster rapid restructuring in that much national assets had been distributed to companies and individuals not interested in the businesses that the assets represented. Often such property went for a pledge to the banks in return for loans that ultimately were used for different purposes. On the surface, the pledge of property is good for the bank and in addition is required by the supervising authorities and preferred by auditors in the highly risky lending environment. Also, one of the ways of selling the property profitably now that supply is excessive and purchasing power low is by taking a loan from a bank and pledging the property as security. Whether it is done deliberately or not, the bank pays the money and retains illiquid property. Experience shows that similar selling of real estate was massive and often deliberate on the borrower's side, with the same property being pledged to several banks. Occasionally commercial banks were players in the game, too. The bank's involvement in this kind of arrangements can be explained by private interest of the managers, pressure from the interested shareholders or both. The recent banking crisis in Lithuania revealed the fact that such behavior was typical for the local banks. In the process of voucher privatization a number of investment companies buy up vouchers from populations and take over entire sectors of industries, growing to large holding companies. Aiming at corporate goals, rather than at those of individual companies, the owners of the holding instruct the subsidiary companies to buy into a newly established bank, controlled by the same holding company, in this way reallocating funds from a problem manufacturing business into the profitable financial sector. False accounting is also used in order to avoid actually paying in funds. As the bank is leveraged by incoming deposits of bank clients, the holding company instructs the bank to extend credits to specified companies, nominal as a rule. The credits are occasionally guaranteed by the stakeholder companies going bankrupt, and the funds received are paid to off-shore companies or 'lost' in some other ways. Finally, at the end of the year huge dividends are declared on the false profits that will never be realized. Other sources of underground activities include: Bank employees are granted preferential rates of interest for the salaries' accounts with the same bank, which nearly doubles salaries if the rate of interest, as it were, reaches 80 percent; All forms of money laundering that are feasible under weak control by the authorities. The existence of unrecorded foreign trade transactions and cash payments can be demonstrated using the data of the Bank of Lithuania and the Customs Department. According to the Bank of Lithuania, a great number of economic transactions with non-residents is not reflected in the official accounting. It is evidenced by errors and omissions in the Balance of Payments that amounted to 1 154.88 million litas in 9 months 1995 (growing by more than 300 million litas per quarter). The experts of the Bank of Lithuania explain the omission mentioned above by the fact that a part of imported goods (especially oil products and alcoholic beverages) were not included into accounting, while part of capital was exported in cash or by payments through the accounts of Lithuania's entities with foreign banks. As an example mirror statistics on import and export of selected goods can be used, and Russia and Germany can be taken as the main trading partners of Lithuania (Table II). Significant discrepancies (disregarding the differences in the methodology of accounting, measurement units and other factors) can be observed, especially concerning such groups of goods as spirits, tobacco, metals and oil products. Table II Lithuania and Germany Mirror Statistics - 9 Months '94 Thousand dollars Import Lithuania Export Germany Tobacco 838.4 22,386.0 Vodka 558.1 23,762.0 Export Lithuania Import Germany Copper 6,694.7 14,476.0 Ferrous metals 14,796.0 4,545.0 Lithuania and Russia Mirror Statistics - 9 Months '94 Thousand dollars Import Lithuania Export Russia Oil Products 514,345.5 186,491.0 Scrap Metal 63.5 1,029.0 Export Lithuania Import Russia Motor Vehicles and Spare Parts 14,395.5 2,031.0 Chocolate 16,793.0 7,981.0 Under the discussed assumptions, our estimate of the underground economy is 36 percent of GDP in 1994 and 41 percent in 1995. About 30 percent of currency in circulation is servicing the underground economy. The processes mentioned above result in the following issues: distortion of the competitive environment, creating more favorable conditions for the economic agents compared to entities that are observing the rules; slow down of the restructuring processes, growth of enterprise arrears, debts to the national budget, social security and banking sectors; constraints on the national budget and inability to carry out an effective social policy; establishment of strong lobby groups thus creating the background for corruption. The empirical evidence is that the existence of the parallel economy decreases social tension, redistributing the income among various social groups. References Bulletin of the Bank of Lithuania. Vilnius, 1995, 1994. Concentration of Capital as the Result of Investment Stock Companies' Activities in the Privatization Process in Lithuania / Authors: Eugenijus Maldeikis, Rasa Morkûnaitë, Diana Sutkaitytë. Vilnius, March 1994. Eesti Pank Bulletin. Tallinn, 1995/5. 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