The start of European Monetary Union (EMU) and the successful launch of the euro are significant events for Central and Eastern European nations. The policies needed to achieve economic and monetary integration establish applicable precedents for countries in a pre-accession stage. Lithuania is one of these countries and is seeking membership to the European Union (EU) and, ultimately, EMU.

The process of EU monetary integration is being closely watched and analysed at the Bank of Lithuania, with the expectation that the role of the euro will increase in the years ahead. The new currency will be widely used in foreign trade and settlements, as Lithuania's trade with EU and EMU countries expands further. As discussed below, Lithuania's currency is likely to become more closely linked to the euro in the relatively near future. The year 1998 was one of special importance to Lithuania in its efforts to become a member of the EU. In February, the European Agreement came into effect and established the legal framework for the relationship between the Republic of Lithuania and the EU. In March, the Accession Partnership Programme and the Road Map for the Alignment of Lithuania with the single market were approved. These agreements will stimulate economic development, in addition to accelerating the process of accession.

The present monetary regime

Perhaps the most important requirement specified in the Maastricht Treaty and the protocols on the European System of Central Banks (ESCB) is that each bank be independent and have the ability to formulate and implement policy in an environment that is free of direct political pressure. Lithuania has adopted this standard, therefore, the Bank of Lithuania does not and cannot legally lend to the Government. A proposed new law concerning the central bank would make the pursuit of price stability the Bank of Lithuania's primary objective. Adoption of this law will be an important step in adding to the nation's ability to assume the full responsibilities of EU, as well as EMU membership.

At the present time, monetary policy in Lithuania is implemented under a modified currency board arrangement. The Seimas, the nation's Parliament, established this when it enacted the Law on the Credibility of the Currency (the Law). It outlines procedures for setting the exchange rate and specifies the backing of the currency. When the Law took effect on 1 April1994, the exchange rate for the national currency was set at 4 litas (LTL) to 1 US dollar. The rate has not changed since that time.

Lithuania differs from other nations using currency board arrangements in that it was not adopted in response to a failure to prevent hyperinflation. In fact, the central bank used a restrictive monetary policy to successfully reduce inflation from the very high levels that emerged when the nation's independence was re-established. The arrangement was adopted to insulate policy from pressures to adopt an easier monetary stance.

Under the arrangement, the quantity of reserve money is strictly limited by the gold and foreign exchange holdings of the Bank of Lithuania. At present, backing for the Lithuanian currency is close to 163 per cent.

The monetary policy programme: a pragmatic and careful strategy

In considering strategies for making accession to the EU and EMU, the Bank of Lithuania took into account the disadvantages associated with currency board arrangements. In particular, it discouraged the development of domestic money and capital markets, as well as severely limiting the ability of the central bank to perform lender of last resort functions. Thus, the Bank decided that the best approach would be to first develop the standard functions of a modern central bank. This would enable it to employ the methods used by the national central banks (NCBs) that are part of the ECSB; it would encourage the development of more active domestic capital markets during the process of accession. The ability to serve as a lender of last resort could be useful at times of severe pressure in international capital markets, even though this has not been necessary in the past year. Finally, since it is not known how long it will take for Lithuania to become a full member of the EU and the EMU, it may be desirable to allow for some flexibility in monetary policy. However, this does not mean that the Bank of Lithuania has any plans for abandoning a fixed exchange rate regime. It recognises that this is most appropriate for a small open economy such as Lithuania and that it has been highly successful in reducing inflation to a low level. Therefore, the Bank gives the very highest priority to the external stability of the litas.

These goals are incorporated into the Monetary Policy Programme for 1997-1999, which was adopted by the Board of the Bank at the start of 1997. This Programme contains a plan for exiting from the formal currency board arrangement to a more traditional fixed exchange rate regime. It has three phases:

• the development and introduction of open market operations and a Lombard facility with the currency board still in existence;
• the adoption of amendments to the Law on the Credibility of the litas;
• the reorientation of the exchange rate of the litas to establish a closer relationship with the EU and the EMU.

The Programme was designed to create opportunities for the Bank to encourage the development of more liquid financial markets in Lithuania and to be consistent with the maintenance of the free and open capital markets that characterise the nation. It also provides for the Bank of Lithuania to give priority to the external stability of the litas.

Implementation began in 1997 when the Bank of Lithuania introduced open market operations on a limited basis. These operations are designed to be fully consistent with the limits currently allowed by the Law on the Credibility of the litas.

Open market operations for macroeconomic purposes are not directly applicable under a fixed exchange rate. Instead, they can be used to dampen the excess volatility in short-term interest rates that arise from temporary or seasonal variations in bank reserves. At times, they can also be used to help transmit changes in external rates to domestic markets. This may be necessary when institutional factors or imperfections prevent this from taking place. The Bank of Lithuania uses policy instruments that are very similar to those used by the ESCB, these include:

• reserve requirement: the reserve ratio is set at ten per cent of domestic and foreign currency bank liabilities under one year (except liabilities to other domestic banks). The calculation period is one month before the maintenance period. The maintenance period is one month, which begins on the 13th and ends on the 12th of the following month. An averaging provision is used;
• market instruments:
  - repos to increase liquidity,
  - deposit auctions to decrease liquidity,
  - collateralised overnight loans - a Lombard facility for settlement purposes,
  - collateralised liquidity loans - lender of last resort loans in special cases.

During the second stage of the Programme, the fixed rate of the litas with regard to the anchor currency, the US dollar, will remain unchanged and the Law on the Credibility of the litas will be amended. These modifications will form the legal preconditions for the use of discretionary monetary policy.

During the third stage, policy will begin to be orientated towards the integration of Lithuania into the EU. However, the third stage is not likely to begin before the year 2000. Requirements at this time will be that the financial and money markets should achieve relative stability and calm in global financial markets. When the final stage begins, the litas exchange rate will be reoriented. In this final stage, the Bank of Lithuania may peg the litas to a currency basket [50 euro and 50 US$]. Ultimately, the nation plans to fully peg to the euro. Any re-pegging will be at the same external value of the litas, since the commitment to currency stability and the retention of public confidence precludes devaluation. The Bank of Lithuania will provide information to the public pertaining to the exchange rate reorientation well in advance, to enable economic agents to adapt. (At the same time, the Bank will be preparing to meet the requirements of ERM - II.)

In addition to meeting the technical requirements that are needed to implement its policy programme, the Bank of Lithuania has been active on other fronts. It co-operates closely with international financial organisations and other central banks. The Bank is highly respected for its strong and consistent banking supervisory standards. Policies in this area incorporate the provisions of EU directives, recommendations of the Basle Committee and BIS requirements. The research effort at the Bank has become considerably broader and deeper, so that it can provide the support needed for policy formulation and implementation. Most importantly, the Bank makes sure that all of its actions are transparent and that the public fully understands policy goals. All of this readily leads to the conclusion that monetary policy in Lithuania will continue to prove successful.