OREANDA-NEWS. The economy has entered a broadly favorable trajectory of healthy and balanced growth, as a multi-year reform effort comes to fruition. But income convergence with Western Europe still has a long way to go. It will take continued policy discipline and steady progress on reforms in the following areas to extend the recovery: (i) securing euro adoption with underpinning frameworks to make it a lasting success; (ii) completing public finance repair; and (iii) implementing structural reforms to secure consistently high investment.

Economic outlook-a broadly favorable picture

1. Economic performance in 2013 was solid, with real GDP growth of 3.3 percent, one of the highest in the EU. Domestic demand drove the expansion, while exports held up well in a difficult external environment. Recovering investment and rising employment-together with a balanced external position-are welcome developments. Inflation declined to 1.2 percent, reflecting well-contained domestic price pressures and subdued international and global commodity prices.

2. Growth is projected to pick up to 3? percent in 2014. Domestic demand will likely remain the main driver-employment and wage growth supporting private consumption, and high capacity utilization and new territorial planning rules underpinning investment. Inflation is set to remain low (1 percent) and the current account broadly balanced. Real GDP would exceed 2008 levels for the first time, but now free of unsustainable excess. Beyond 2014, growth should rise to its estimated potential rate of 3? percent, but this will be contingent on sustained investment and staying the course of reforms and disciplined policy making.

3. The balance of risks around this generally favorable outlook is tilted to the downside, primarily due to global factors. Important external trade and financial linkages make Lithuania susceptible to spillovers from abroad, although the balanced external position and the absence of domestic overheating provide a degree of protection. Tapering of unconventional monetary policy in the U.S. has had few domestic repercussions so far. On the domestic front, the recent revival of investment could yet fizzle out for lack of credit.

Euro adoption plans-the next logical step on Lithuania's European integration path

4. Lithuania seems well placed for euro adoption, regarding entry criteria, sustainability of low inflation and public finances, and external stability. Two decades of currency board arrangement have attuned the economy to operating well without an independent monetary policy. Lithuania has demonstrated the economic flexibility and political grit to pull out of crises and deliver adjustment. Controlling business and financial cycles has been more of a challenge.

5. Euro adoption would be a welcome boon for the economy. While not a sea change from the euro-based currency board, it will shift several factors in Lithuania's favor: access to ECB liquidity would enhance financial stability, thereby tending to reduce risk premiums; and even closer integration with the euro area would tend to foster trade, involvement in global value chains, and foreign direct investment, if accompanied by the right policies.

6. But supporting policy frameworks will be essential for making EMU membership a lasting success. They would facilitate adjustment to shocks, temper the business cycle in the absence of an independent monetary policy, help build fiscal and financial buffers, and guard against the loss of competitiveness or undue debt accumulation:

The fiscal framework will be strengthened by the Fiscal Compact, but it should be supplemented by a countercyclical fiscal rule to ensure that fiscal buffers are bolstered in good times. Integration with the compact's correction mechanism is important to avoid potential inconsistencies and fragmentation in public financial management. The establishment of a fiscal council and building its capacity should be expedited.

Financial frameworks will strengthen with the impending establishment of macro-prudential powers for the Bank of Lithuania. Close cooperation of home and host country authorities of cross-border banks remains important-the Nordic-Baltic cooperation forums are valuable platforms that should be preserved, built upon, and adapted to the emerging European banking union.

There have been tangible reforms to the restructuring and insolvency frameworks and more are in the pipeline. Court rulings have established precedents that clarify procedures for non-performing-loan resolution, thereby reducing delays. Speedier and more widespread use of the new household insolvency law would be desirable to reduce the debt overhang, which still afflicts many households with underwater mortgages. Limited effectiveness of the framework for going-concern restructurings should be addressed.

Lithuania's relatively flexible labor markets need to be preserved and strengthened by further reforming the labor code.

Fiscal policy-finishing the consolidation, building fiscal buffers, and locking in gains

7. The repair of public finances is well advanced but not yet complete. Multi-year consolidation efforts brought exit from the Excessive Deficit Procedure in spring 2013. The deficit declined further during 2013, most likely below the 2?-percent-of-GDP target for the general government. Nonetheless, the ratio of public debt to GDP is only beginning to stabilize-after the relentless increase since the crisis-and the medium-term goal of a broadly balanced budget is not yet reached. Considering the already compressed overall spending envelope, remaining consolidation should come from high-quality revenue-enhancing measures, in particular recurrent wealth and capital taxation, such as motor vehicle and real estate taxes.

Further fiscal adjustment of ? percent of GDP (in structural terms) in 2014 is adequate if the over-performance in 2013 is confirmed.

It would be advisable to temporarily go beyond the ?-percent-of-GDP medium-term objective for the structural fiscal deficit, to achieve a meaningful debt reduction, rebuild fiscal buffers, and prepare for the looming fiscal costs of demographic aging, in conjunction with pension reform.

Court-mandated compensation for past pension and wage cuts should be designed with an eye on competing claims on budgetary resources. Payments should be phased over time, so as to preserve the impending reduction of the public debt ratio and avoid a spike in public borrowing.

8. General government spending would benefit from a public expenditure review. Crisis-induced spending cuts compressed Lithuania's expenditure to one of the lowest levels in the EU (relative to GDP). A review would help improve the quality of public spending and ensure that the overall expenditure reduction is sustainable.

9. Local government finances should be better controlled. Past spending overruns and arrear accumulation are a cause for concern, notwithstanding local governments being a relatively small part of the Lithuanian public sector. Independent scrutiny of their finances would enhance transparency. Hard constraints on debt and borrowing limits that remain stable over time would instill better spending discipline and incentives to raise revenues locally.

Financial sector-overall stable with pockets of softness

10. The largely Nordic-owned banking sector is liquid and well capitalized, but supervisors need to remain vigilant. Capital adequacy increased further in 2013 (CAR of 17? percent) and reliance on parent bank financing continued to edge down. Reduction of the non-performing loans ratio is particularly encouraging, although progress across banks remains uneven. Careful monitoring of provisioning levels and rigorous stress testing remain essential particularly for some smaller banks-the Bank of Lithuania should encourage these banks to increase capital buffers, especially as the regulatory bar rises with the implementation of global, European, and euro area reforms.

11. Credit unions are in need of reform; efforts by the Bank of Lithuania to strengthen supervision are welcome. While only a small part of the financial system, the recent failure of several institutions points to ongoing fragilities. It will be important to adopt the amendments to the Law on Credit Unions already submitted to parliament as soon as possible and continue to enforce other safeguards put in place by the Bank of Lithuania until a much-needed broader reform of the sector comes to fruition.

12. Low credit growth could hamper growth-enhancing investment. Some banks are nearing the completion of the work-through of legacy assets and the repair of borrowers' balance sheets is advancing, thus laying the foundation for reviving credit. But entrenched risk aversion on the part of both banks and potential borrowers limits scope for a significant pickup in the near-term. Workout regimes for non-performing loans should be further improved and alternative financing avenues explored, such as more recourse to capital market financing.

Structural reform-the linchpin for future income convergence

13. Structural reforms and consistently high investment will be necessary to secure income convergence in the medium term, as dividends from macroeconomic adjustment run their course and headwinds from demographic aging build. Important progress has already been made. Government efforts to avoid a dip in EU-funded investment in the transition to the new EU financial perspective are welcome. So are efforts to use EU funds strategically.

14. Upgrading the energy and transportation infrastructure remains a high priority. Important projects in the gas, electricity, and rail sectors are underway. They should be carried out in the context of a regional strategic plan and geared toward the ultimate objective of reducing user costs and increasing the efficiency of the economy.

15. Reform of public enterprises should be advanced, with the ultimate objective to create value added for the economy and improve service delivery in a cost effective manner. Already initiated governance reform of state-owned enterprises should be pushed forward-to achieve tangible results in terms of more independent directors on enterprise boards and faster progress toward return-on-equity targets-and broadened to also cover municipally-owned enterprises.

16. A multipronged approach is needed to tackle high structural unemployment. In addition to the labor code reform, better management of the benefit system would help avoid unemployment traps. Bringing down high labor taxation would also be desirable. But any meaningful reduction would need to be imbedded in comprehensive tax and pension reform to be fiscally neutral. This will require careful planning and take time to implement. The same is true of education reform, which is ultimately needed to reduce skill mismatches in the labor market.