OREANDA-NEWS. June 20, 2012. Lithuania has come a long way in reducing the imbalances that were at the root of the 2008 crisis, thanks to determined policy implementation. As a result, the broad-based economic recovery that began last year is continuing, albeit at a much slower pace. But external risks pose challenges to the recovery, unemployment is high, and remaining vulnerabilities still need to be fully addressed. Key policy priorities are to complete the fiscal consolidation, continue to strengthen the resilience of the banking system, and further advance structural reforms to boost potential growth and promote sustainable job creation.

1. Growth rebounded strongly in 2011, helped by competitiveness gains. The recovery was broad based, reflecting a resurgence in exports and domestic demand. Gains in competitiveness, which were underpinned by the sizeable fiscal consolidation, and the maintenance of confidence in the banking system supported the recovery. Inflation edged up to just over 4 percent, mostly because of rising food and energy prices. Although there was an increase in job growth, the unemployment rate remains very high, particularly among the youth.

2. Looking ahead, the outlook is clouded by external risks and uncertainty. Real GDP growth is projected to slow from nearly 6 percent in 2011 to 2 ? percent in 2012, as lower external demand and heightened uncertainty about the external environment weigh on economic activity. Underlying inflation remains low, and headline inflation should fall to around 3 percent in 2012. The main risk arises from the possibility of an intensification of the crisis in the euro area. This would affect Lithuania through trade and financial channels, including increased sovereign borrowing costs.

3. Fiscal consolidation needs to be completed, and a fiscal deficit of 3 percent of GDP this year is appropriate. While revenue and expenditure performance so far in 2012 has been broadly in line with expectations, this needs to be sustained in the coming months. On this basis, we project that the deficit will reach 3 percent of GDP. Contingency measures should be prepared in case revenue shortfalls or expenditure overruns materialize. Should the authorities choose measures on the expenditure side, care should be taken to ensure that vulnerable groups are protected. Looking ahead, a further reduction in the fiscal deficit by 1 percentage point per year is appropriate and additional fiscal measures will be needed. Given that most of the consolidation has so far taken place through expenditure restraint, consideration should be given to implementing revenue measures. This could include expanding real estate and vehicle taxation, which are progressive and less distortive than other taxes. In light of the uncertain external environment, it will be important that budget preparation is based on sufficiently prudent assumptions about the macroeconomic outlook.

4. The banking system has strengthened. The intervention of Snoras bank removed a major source of financial sector vulnerability, and the authorities' careful management of the process was crucial to maintaining banking sector stability. The banking system as a whole has increased its resilience: non-performing loans are declining, capital adequacy is rising, liquidity ratios are well above the regulatory minimum, and most banks have continued to be profitable. Nevertheless, the BoL's stepped up onsite inspections, strict stress testing, and careful monitoring of banks’ loan loss provisions are essential for the continued health of the banking system and to ensure that any remaining pockets of weakness are addressed. To the extent that its monitoring identifies shortfalls, the BoL should require banks to raise capital. The new lending standards, the unification of supervision, and the recently passed personal insolvency framework are important steps toward further strengthening the system.

5. Despite these generally encouraging developments, credit growth has remained negative. Although this partly represents low credit demand given the uncertain outlook for growth, credit supply factors are also at play. Deleveraging by foreign owned banks has reduced the loan-to-deposit ratio to 124 percent at end-March, down from its peak of 187 percent at end-2008. While this partly represents a healthy rebalancing and a shift toward more stable funding sources, it is important that credit availability is not unduly constrained, as this could dampen the recovery going forward. The continued commitment of parent banks to their Baltic subsidiaries is welcome in this regard.

6. Structural reforms would help boost medium-term growth. To return to potential growth over the medium term, reduce unemployment, and lower public debt, further progress is needed on structural reforms. Key priorities include further pension reform to help address costs associated with demographic trends, fiscal reforms to help ensure that fiscal policy can play a stabilizing role in downturns (including through the introduction of a fiscal rule), and energy sector reforms to reduce costs. While it is essential that competitiveness gains are not eroded, it is also important to ensure that low-income workers earn a sustainable wage. For this reason, we support a moderate increase in the minimum wage in conjunction with measures to improve job matching and reduce obstacles to job creation.