UPDATE 3-Greece must slash budget gap in 2 yrs-cbank

* Central bank says Greek budget gap, debt are swelling

* Deficit cuts, reforms needed to avoid sluggish recovery

* Greek debt reached 111.5 pct of GDP, deficit at 12.5 pct

* Greek GDP seen contracting by more than 1 pct in 2009

(Adds Greek finmin budget deficit projection, fourth paragraph)

By Harry Papachristou

ATHENS, Oct 20 (Reuters) - Greece's central bank on Tuesday urged the indebted country's new socialist government to cut its budget deficit by around 5 percent of its GDP by the end of 2011 to avoid a sluggish recovery from the economic crisis.

"Countries like Greece, which suffer from twin (current account and fiscal) deficits and debt, are faced with a serious risk of a much more difficult and slow exit from crisis, with a protracted period of slow growth," the Bank of Greece said in an interim monetary policy report.

The central bank said Greece's public debt swelled to 111.5 percent of gross domestic product (GDP) at the end of June from 99.2 percent last year.

In Luxembourg for the EU finance ministers' meeting, Greece's new Finance Minister George Papaconstantinou said this year's budget deficit will hit 12.5 percent of GDP, more than twice its 2008 level of 5.6 percent.

"(We must put) the brakes on deficits, and accelerate structural reforms," the central bank said, urging the government to cut its structural budget deficit relative to GDP by a total of 5 percentage points in 2010-2011.

Seen by investors as the euro zone's weakest link, Greece is teetering on the brink of recession after years of booming growth.

The Bank of Greece expects the country's economy to contract by close to or more than 1 percent in 2009, with unemployment expected to rise above 9 percent from 7.7 percent in 2008.

TOUGH TARGETS

Economists said cutting the budget deficit by the magnitude suggested by the central bank will be hard and may hurt growth even further next year.

"If past experience is any guide, this will be a tough target to implement," said Paolo Pizzoli, a senior economist with ING. "If you start cutting the deficit next year, private demand will be suffering."

Greece's new socialist government, which won an Oct. 4 snap election, wants to narrow the deficit to single-digit levels next year.

A chronic budget deficit offender under the euro zone's rules, Greece will submit to Brussels a 3-year fiscal discipline plan to bring the shortfall below the EU's 3 percent limit.

HANDS-ON APPROACH

The Bank of Greece said it would adopt a more interventionist policy on bank supervision, as declining GDP weakens banks' loan portfolios. It sees the ratio of non-performing loans (NPLs) rising to 6.8 percent at the end of June from 5 percent in December last year.

"Loan impairments continue to rise and constant vigilance is required," the report said.

The Bank of Greece expects the country's EU-harmonised inflation rate to fall to 1.1 to 1.3 percent this year from 4.2 percent in 2008.

The current account gap, another serious macroeconomic imbalance, is seen narrowing to about 11 percent of GDP in 2009 from 14.5 percent last year, based on central bank data. (With additional reporting by Marcin Grajewski and Jan Strupczewski; Editing by Patrick Graham)