OREANDA-NEWS. October 29, 2010. The emerging economic recovery reflects determined policy action and the strengthening external environment. Much has been achieved over the past two years: sizeable fiscal adjustment has been rewarded with renewed access to international capital markets on improving terms; confidence in the banking system has been maintained; and significant gains in competitiveness, including through wage adjustment, have helped support the viability of the currency board arrangement.

2. Looking forward, the economic recovery is expected to broaden from exports to domestic demand. Improving corporate profitability should support a turnaround in fixed investment, while growing labor income should underpin a recovery in consumption. However, with the severity of the recent downturn still fresh in their minds, firms and households are likely to be cautious in their spending decisions, which will dampen the magnitude of the upturn. Altogether, real GDP is projected to grow by about 3 percent per year in 2011-12, though external and domestic risks remain.

3. With the fiscal deficit expected to be about 8 percent of GDP in 2010, further fiscal consolidation is urgently needed to stabilize debt over time. The targeted reduction in the general government deficit as outlined in the Convergence Program (to 5.8 percent of GDP in 2011 and 3 percent of GDP in 2012) strikes a good balance between the necessary fiscal adjustment and preserving the emerging economic recovery. Measures approved over the past few months, such as changes to parental and sickness benefits, and those contained in the draft 2011 budget are therefore welcome.

4. The government’s intentions to improve tax compliance and the performance of state-owned enterprises (SOE) are commendable. On tax compliance, the government should implement a comprehensive strategy with tight deadlines, encompassing education, enforcement, and administration tailored to different taxpayer segments. As part of the strategy, unifying multiple tax rates and eliminating exclusions, exemptions, and deferrals would reduce opportunities for avoiding taxes. On SOE, the publication of the first annual review of state-owned commercial assets is an important step towards increased transparency. Looking forward, governance reforms under consideration are needed to secure efficiency gains.

5. As substantial revenue gains from improved tax compliance and SOE reform are likely to materialize only gradually, additional measures are needed to secure the 2011 fiscal target. Given that fiscal adjustment thus far has fallen primarily on spending and that wealth taxation in Lithuania is relatively low, serious consideration should be given to extending property taxes to residential real estate and motor vehicles, and to withdrawing exemptions for interest income, capital gains, and pension income. On the spending side, further reforms of the social insurance system are needed to ensure its long-term viability. Further deficit-reducing measures should be taken immediately, so as to have full effect already in 2011. The contingency plan in the draft 2011 budget—which calls for a supplementary budget if developments suggest that the fiscal target is at risk—helps to provide confidence that the deficit target will be achieved.

6. There are tentative signs of improvement in the banking system as a whole, but challenges remain. While total loans are still contracting, anecdotal evidence suggests that credit is available for sound, profitable borrowers. Capital adequacy and liquidity ratios remain well above regulatory minima; non-performing loans have leveled off; and net interest income has risen. However, bank supervisors should continue to closely monitor the sufficiency of all banks’ loan loss provisions and ask banks to increase capital where needed under a strict timeframe.