OREANDA-NEWS. Lithuania’s economy is expanding at a healthy pace. Macroeconomic adjustment undertaken after the crisis is paying off with increased resilience, balanced growth, and job creation. Despite these positive developments, Lithuania remains susceptible to risks associated with shocks emanating from trading partners and volatile global financial markets. Key policy priorities are to cautiously manage the 2013 budget, implement a credible 2014 budget that targets further fiscal consolidation and is underpinned by high quality measures, build on the recent improvements to strengthen financial sector stability, and ensure that overall policies support euro adoption.

Growth has held up well, and confidence is returning. With the recovery well underway, GDP is approaching its pre-crisis level and growth is expected to reach about 3? percent in 2013. Exports and private consumption have been the key drivers, reflecting earlier gains in competitiveness, falling unemployment, and rising real wages. Investment and credit growth have also started to recover from their historic lows, as both bank and corporate balance sheets have improved and confidence has increased. Inflation (average) should decline to about 1? percent this year, largely because of falling energy prices. Despite improvements in the labor market, structural unemployment remains high, with about half of the unemployed out of work for over a year.

The current pace of economic expansion is expected to be sustained, but with some downside risks. In 2014, GDP growth is projected at 3? percent, with the composition shifting to domestic demand (as investment picks up) and away from net exports (as imports rise). As a result, the output gap is expected to close. Inflation is projected to normalize (rising to 2? percent) as the effect of falling energy prices vanishes. However, despite much improved fundamentals, Lithuania remains susceptible to shocks emanating from trading partners or global capital markets given its high degree of trade and financial openness.

The fiscal deficit in 2013 is expected to exceed its target by about ? percentage point of GDP, leaving no room for further deviations. Despite the relatively strong economic recovery, revenue performance has been weak, especially from consumption taxes. This, combined with additional outlays (including civil service wage restoration), is expected to increase the fiscal deficit to 2.9 percent of GDP. In light of the government’s euro adoption goals, this leaves virtually no room for further slippages, and calls for cautious budget execution across all levels of government.

Fiscal consolidation efforts should be strengthened in 2014, especially with specific measures to increase revenue. Without further fiscal consolidation, Lithuania’s public debt would remain around its current level of over 40 percent of GDP-too high to provide sufficient fiscal buffers. Hence, further fiscal adjustment is needed and, in light of the favorable economic outlook, consolidation of ? percent of GDP in structural terms (broadly in line with the deficit reduction announced in the authorities’ 2013 EU Convergence Program) would be appropriate. The government is still in the process of formulating the details of the 2014 budget, but it is essential that it be underpinned by concrete high-quality measures. Given that Lithuania’s tax-to-GDP ratio is one of the lowest in the EU (and about three percentage points of GDP below that of other Central and Eastern European EU countries), there is ample scope to increase revenue. In particular, expanding wealth taxation-notably on property and motor vehicles-would provide a stable source of revenue that tends to be progressive and less distortionary than other forms of taxation. Improvements in tax administration are also necessary, but expected revenue yields from this source should not be budgeted before they materialize.

The largely foreign-owned financial system is liquid and well capitalized. The recent intervention of Ukio Bankas has strengthened financial stability. The Bank of Lithuania’s stepped-up supervision of the credit union sector is welcome and should be bolstered by implementation of additional regulatory reforms to strengthen functioning of this sector. The banking system’s high liquidity and capitalization, alongside declining non-performing loans and the improved economic outlook, should pave the way for healthy credit expansion. In this regard, steps to broaden the mandate of the Bank of Lithuania to include macro-prudential policy are timely and should help ensure that credit growth remains sustainable and does not jeopardize financial stability.

Euro adoption appears within reach, but supporting policies will be needed for Lithuania to thrive in the currency union. Exiting the currency board and joining the euro area is the next logical step for Lithuania on its path towards integration with Europe and will substantially reduce residual exchange rate and liquidity risk. Yet, being a member of a currency union also requires appropriate supporting policies. In this regard, continued fiscal discipline is essential to reduce the public debt ratio and provide space for countercyclical policy. Maintaining competitiveness through structural reforms and increased investment will help ensure that Lithuania is in a position to enjoy the full benefits of euro area membership.