Recent developments

Modest economic growth in the beginning of the decade has accelerated since mid 2006 when Montenegro proclaimed its independence. Ambitious structural reforms, prudent fiscal policy and a substantial capital inflow helped the country to shift from the phase of establishing stability to the phase of accelerated growth. In the last two years real output increased by 16 percent, mainly driven by capital inflows and a construction boom. In fact, Montenegro is one of the fastest growing tourist destinations in the world. Inflation was subdued in 2006, but picked up in 2007, reflecting drought and an increase in food prices, further liberalization of electricity and telecommunication prices and an increase in global oil prices. Employment has been on an upward trend, with the unemployment rate approaching single digit. Fiscal deficits turned into surpluses, public debt declined, and structural and state-building reforms were launched. Furthermore, the financial sector displayed a remarkably dynamic development.

Montenegro's success has been recognized by international institutions. Becoming a member of the IMF and World Bank in early 2007 had a positive impact on the sovereign credit ratings. Committed to trade liberalization, Montenegro became a member of the Central European Free Trade Agreement (CEFTA), and is now in the process of acceding to the World Trade Organization (WTO). Following an intensive political process, the new Constitution was adopted in October 2007, the same month in which the Stabilization and Association Agreement with the EU was signed, a milestone in the EU integration process.

Nevertheless, the authorities acknowledge that much remains to be done and there are many risks up the road. The current account deficit is large, the private sector is still weak and the business climate needs to be enhanced. The challenge for fiscal policy is to strike the right balance between counter-cyclical measures to contain strong demand pressures, and the need to strengthen institutions and infrastructure in support of nation building.

Fiscal Policy

Growing economic activity accompanied by improved collection of fiscal revenue and rationalization of public expenditure, led to an overall budget surplus in 2006, for the first time in a long period. The favorable trends continued in 2007. The revenue windfall from the economy being confronted with unprecedented FDI inflows resulted in a significantly higher than budgeted surplus. As explained by staff in the Selected Issues papers, tightened fiscal policy in the last two years created fiscal space by withdrawing stimulus, and there was not much more that could have been done to sterilize the shocks. The authorities, as well as the private sector consider high indirect labor costs to be one of the obstacles for business development, employment growth and reducing the gray economy. Thus, the authorities have been gradually cutting tax and social contribution rates. The approach has been giving positive results over the last four years as the economy has been accelerating and overall collection of tax revenues has increased.

One of the issues highlighted in the staff report and extensively discussed during the mission is the approach of the fiscal authorities to public wage increases and investment expenditure. Public sector wages in Montenegro are based on a minimum wage. The public sector wage policy in the period 2002–2007 was very restrictive, and kept wages below subsistence level. At the same time, robust economic growth and an increase in productivity, led to a substantial increase in wages in the private sector, widening the gap between public and private sector wages. The comfortable fiscal position enabled a gradual increase of public wages in 2007 and in the beginning of 2008. The authorities see these measures as instrumental to at least partly restoring purchasing power of public sector employees and to achieve some catching up with the private sector. They argue that the need for a highly qualified public administration, as a pillar for the EU integration process, asks for a revised wage policy in order to strengthen administrative capacities. After the increase planned for 2008, the authorities intend to conduct a restrictive wage policy in 2009 and 2010.

During the 1990s the investment in infrastructure in Montenegro was neglected. The recent dynamism of the economy and future growth prospects reinforce the importance of an appropriate public investment policy. To this end, the authorities view increasing public investment as imperative for achieving sustained growth. Accordingly, capital expenditures more than doubled in 2007.

Marked improvements in revenue collection and a stronger than expected budgetary performance were used for the regular servicing of all liabilities towards domestic and international financial institutions. In addition, the authorities made a prepayment of the debt to the World Bank, which, with other prepayments, decreased the public debt to GDP ratio to 32.4 percent at the end of 2007.

The Government of Montenegro has recently approved an Economic and Fiscal Program (EFP) for 2007–2010. The EFP envisages the balancing of the consolidated public spending (overall surplus around 1 percent of GDP). The Program is frontloaded in 2008 on account of the catching-up process, nation building and the public wage structure pressures, but it is envisaged to be restrictive in 2009 and 2010. Capital expenditures will rise steadily to about 9 percent of GDP by 2010, while current spending will decline from 41 percent of GDP in 2007 to 37 percent by 2010. The authorities' mid-term fiscal revenue projection is conservative (as confirmed by the achievement of a higher than budgeted surplus in 2007), and they are committed to accumulating additional surpluses in case of revenue windfalls and to refraining from higher spending.

Financial Sector

The Montenegrin authorities broadly agree with the Financial System Stability Assessment, and they have already implemented several recommendations.

The financial sector has grown rapidly and its health has improved significantly in recent years. In only six years since the Central Bank of Montenegro (CBM) was established, the banking sector was completely transformed from being underdeveloped, ruined and state-owned, to a reputable system with high credibility. With dominant foreign players, the banking sector has seen a strong increase of the deposit base.

Like in many other countries in the region, a rapid credit expansion has been observed over the past years, which in recent months has been supported by foreign borrowing. Although the credit growth originates from a very low initial base, the authorities are fully aware of the macroeconomic and financial stability risks associated with such rapid growth. They have undertaken a set of measures in that respect recently. The CBM has passed a new Decision on the classification of bank assets and loan loss provisions that became effective as of October 2007. The implementation of this decision will allow a better quality of credit risk assessment based on international standards and improve the insurance of depositors in the banking system. In addition, the CBM imposed the following measures effective as of the beginning of 2008: an increase in the solvency ratio (to 10 percent and 12 percent for banks with credit growth faster than 60 percent and 100 percent respectively), ceilings on credit growth, and broadening of the reserve requirement base while decreasing the reserve requirement rate on long-term deposits. Besides, the Credit Registry that will enable banks and micro-credit financial institutions to gain insight into indebtedness of legal entities and private individuals, shall be operable as of January 15, 2008.

The authorities also agree with staff that passing key banking legislation through Parliament is crucial for further strengthening risk-based supervision. The Draft law on banks, prepared in accordance with international standards, was adopted by the Government in November 2007. The law is expected to be discussed in the Parliament early this year, under an accelerated procedure.

The Insurance Supervisory Agency, as an independent institution that will be in charge of supervision and control of insurance companies, was formally established in December 2007, and will start to perform its activities prescribed by law in January 2008. In line with the strategic interest of Montenegro of joining the EU, as well as becoming a member of the WTO, the Agency has successfully contacted various donors for the provision of assistance and technical support.

External Sector and Structural Reforms

Montenegro has been experiencing a significant inflow of various foreign direct investments in recent years, including privatization, green field investments, and in 2007 through real estate purchases. According to the preliminary data for 2007, FDI inflow amounted to a record-high level ranking Montenegro on the top among transition countries with regard to the share of net FDI in GDP (22%). However, similar to other small, open, service-oriented countries, Montenegro faces a large current account deficit. The existing level of the current account deficit does not represent a problem for the time being, since it is mostly covered by FDI inflows and other investments and it is self-correcting. Yet, the authorities concur with staff that the large current account deficit and increasing spending needs warrant attention and require sound policies to support its reduction.

Having said this, the authorities are aware that preserving competitiveness, while stimulating capital inflows and accelerating the privatization process, is necessary to contain external vulnerabilities. They remain committed to improving the business environment and supporting the development of small and medium enterprises. Envisaged measures, among others, include further facilitation of business start-ups, simplification of licensing procedures, introduction of on-line registration and regular updates of the Central Register. Furthermore, the Draft labor law, which incorporates EU directives and International Labor Organization (ILO) conventions, and provides more flexibility in the labor market, was adopted by the Government. The law will be discussed in Parliament in the first half of 2008.

Montenegro currently imports around a third of its electricity and the authorities attach great importance to comprehensive energy sector reforms. They adopted the Energy Development Strategy striving to considerably increase investments in the sector. The Action Plan for the implementation of the Strategy will be completed in the first quarter of 2008. Moreover, a tender for research and preparation of feasibility studies for the construction of small hydropower plants was launched in November 2007. In cooperation with the World Bank they will continue activities to improve efficiency in the energy sector.

Finally, on behalf of the authorities, we would like to thank staff and management for their highly-valued policy advice. The authorities look forward to continue their very fruitful relations with the Fund.