Republic of Montenegro
2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Republic of Montenegro
Author:
International Monetary Fund
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Publication Date:
09 Mar 2009
eISBN:
9781451826739
Language:
English
Keywords:
ISCR; CR; FDI inflow; Montenegro; authority; deposit; current account; gross domestic product; capital expenditure; fiscal policy; net debt anchor; Fiscal stance; Commercial banks; Global; percent of GDP
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This 2008 Article IV Consultation highlights that Montenegro has made significant progress in overhauling its economy. The authorities have taken several welcomed steps to help strengthen financial sector stability. Executive Directors have welcomed the structural reforms implemented over the past few years and financial integration that have helped Montenegro attract substantial foreign direct investment and generate rapid growth with moderate inflation. Directors have also supported the authorities’ actions to bolster financial system stability and reduce vulnerabilities by intensifying supervisory oversight, tightening prudential regulations, and lifting bank capitalization requirements.

Abstract

This 2008 Article IV Consultation highlights that Montenegro has made significant progress in overhauling its economy. The authorities have taken several welcomed steps to help strengthen financial sector stability. Executive Directors have welcomed the structural reforms implemented over the past few years and financial integration that have helped Montenegro attract substantial foreign direct investment and generate rapid growth with moderate inflation. Directors have also supported the authorities’ actions to bolster financial system stability and reduce vulnerabilities by intensifying supervisory oversight, tightening prudential regulations, and lifting bank capitalization requirements.

I. Staff Appraisal and Summary

1. Montenegro is highly exposed to the rapidly dimming global outlook. Global financial turmoil and recession will likely have a substantial adverse impact on confidence, credit growth, tourism, and FDI inflows in the near term. Thus, a sharp deceleration in growth is expected in the near term. Moreover, over the medium term only a modest rebound in growth is expected, as FDI and credit growth are unlikely to return to the extremely high levels observed in recent years. Cooling demand will also have a substantial adverse impact on fiscal revenues, and the fiscal position is coming under pressure.

2. Financial sector vulnerabilities are substantial. Banks’ Non Performing Loan (NPL) ratios have been rising despite booming credit growth, and there is a substantial exposure to the rapidly cooling construction sector. Banking system exposure to a sudden stop or even reversal in foreign financing inflows from parent banks is also high. Public confidence remains fragile, and a blanket deposit guarantee introduced in October 2008—as nervousness about the impact of global financial turmoil on the largely foreign–owned banking system intensified—slowed but did not stop deposit withdrawals. However, all parent banks have supported their subsidiaries with additional funding thus far, thus partly offsetting the drain on deposits.

3. Moreover, fiscal plans are likely to undermine fiscal stability, and should be reconsidered. As a result of a pro-cyclical fiscal policy in recent boom years, a substantial structural deficit has already emerged in 2008. Plans for cuts in tax and contribution rates and increases in capital and social expenditure will substantially increase the structural deficit in 2009 and beyond, leading to rapidly rising public debt. Moreover, there are substantial contingent liabilities linked to the blanket guarantee of bank deposits, potential recapitalization of banks, the lossmaking aluminum company, and longer term aging pressures. And the fiscal stimulus is unlikely to be very effective, given the large share of imports, narrow production base, and tight credit conditions.

4. And rapid wage growth, in the context of the euro peg, is reducing the competitiveness of the economy. A continued erosion in competitiveness will ultimately undermine Montenegro’s attractiveness as a destination for FDI, making it more difficult to broaden the production base of the economy.

5. Policy should focus on maintaining financial sector and fiscal stability, while continuing to improve the regulatory and institutional framework. In addition to macroeconomic stability, sustained growth will require improvements to public infrastructure and administration, the business environment, and the flexibility of the labor market.

6. Fiscal policy should be guided by a net debt anchor, and supported by a medium term expenditure framework to help entrench countercyclical policy. The objective should be to reduce net debt to 20 percent of GDP by 2013, which would require a cancellation of the tax and contribution cuts and capital expenditure increase, plus modest restraint on current expenditure. A well designed medium term expenditure framework would create scope for the free operation of automatic stabilizers while supporting consolidation efforts. In order to be credible, the expenditure envelope should be underpinned by the development of a coherent planning framework backed by tangible measures and expenditure reforms.

7. Continued vigilance and strong implementation of prudential measures will be needed to enhance bank soundness. Welcome steps already taken include tighter reserve requirements, temporary credit ceilings, a centralized credit registry, and higher solvency ratios for banks with high credit growth. Moreover, tighter capital, liquidity, and provisioning rules are being phased in through March 2009, which should help strengthen banks’ resilience to shocks. Reducing the lag in repaying deposits from failed banks would also increase confidence in the deposit insurance system.

8. Future economic growth will depend critically on further improvement of the regulatory framework and institutions. Increased labor market flexibility and a substantial reduction in red tape at the municipality level are needed to support private sector development. And firm implementation of electricity sector reforms is needed to improve the efficiency and reliability of electricity production. Moreover, some additional resources in statistics will also go a long way in improving economic policymaking.

9. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

II. Context

10. Montenegro has made significant progress in overhauling its economy. The last five years have seen inflation performance improved through the adoption of the euro as sole legal tender; banking sector restructuring; significant privatization; strengthened market infrastructure; and progress in fiscal consolidation. The authorities’ objective is to create a business friendly, open economy with low taxes and minimal state interference, and to integrate the country in Atlantic-European structures. After joining NATO’s PfP program in 2006, accession to the EU is at the top of the political agenda: the Stabilization and Association Agreement (SAA) was signed in 2007, and an application for EU membership was submitted in December 2008.

11. Reform efforts have been rewarded, particularly following independence, by strong foreign investor interest. There have been large FDI inflows primarily into the tourism sector and associated real estate, and banking. Real estate sales to foreign investors have generated strong wealth effects, contributed to a sharp increase in bank deposits, and boosted domestic demand. Alongside, construction has boomed. Credit growth has soared, stimulated by surging deposits and keen competition in the largely foreign owned banking sector.

12. As a result, the economy has boomed (Tables 1–2). GDP growth accelerated from 4.2 percent in 2005 to 10.7 percent in 2007, led by construction and consumption. Employment and wages have grown strongly, while registered unemployment has halved from 20 percent in 2005 to 10.7 percent in 2008.

Main Economic Indicators, 2005–08

(Percent)

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Sources: Ministry of Finance; Statistical Office of Montenegro; Employment Agency of Montenegro; and IMF staff estimates.

As of August, 2008

As of October, 2008

13. However, financial sector stability and the fiscal position are coming under pressure as the global outlook dims, and a large external deficit has emerged. Banks’ credit risk management does not appear to have kept pace with booming credit, and asset quality is declining rapidly. Moreover, banks are vulnerable to shocks to foreign financing from their parents as global financial turmoil continues. Also, a substantial structural fiscal deficit raises the prospect of a rapid deterioration in the fiscal position as the demand boom unwinds. And the current account deficit increased to over 30 percent of GDP in 2008 as booming FDI and credit stimulated strong demand for imports.

14. Much of recent Fund advice has been implemented. The central bank has implemented most of the recent FSAP recommendations, and also reined in credit growth. Privatization efforts continue, and in the electricity sector tariffs have been raised while cross subsidization has been reduced. A new labor law goes some way towards meeting Fund-Bank recommendations. However, it has proven difficult to implement countercyclical fiscal policy during the boom.

15. But despite reform progress, red tape and political strains persist. Excessive regulation, particularly at municipality level, remains significant, constraining the business environment. The grey economy is reportedly very large. And while the services and construction sectors appear buoyant, the manufacturing base is narrow and has been declining in 2008. There have also been strong differences in opinion on the reform agenda within the ruling coalition, with the minority coalition partner exhibiting lower enthusiasm for reforms, and raising concerns about corruption in the privatization process. Early elections are expected by end-March.

16. Given the concerns about fiscal and financial sector soundness and the worsening outlook, the mission focused on policies to help achieve a soft landing. Thus, discussions focused on measures to strengthen banking system stability; crisis response preparedness; fiscal consolidation and measures to help entrench countercyclical policy; and competitiveness.

III. Olutlook: Weaker Growth With Substantial Downside Risks

17. Recent data point to elevated wage and price pressures, but a deceleration in activity in 2008.

uA01fig01

Retail price and wage inflation

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Source: Statistical Office of Montenegro.

  • Wages grew 25 percent in August 2008 (y/y) well in excess of productivity growth and partly reflecting a 30 percent hike in public sector wages in early 2008. Inflation also rose sharply in the first half of 2008, reflecting domestic demand pressures, administrative price increases, and the general global increase in food and energy prices in early 2008, but has since eased.

  • Private sector credit growth dropped to 23 percent in 2008, well below the record high 176 percent for 2007, reflecting prudential tightening measures in early 2008, lower risk appetite by foreign and domestic banks, and a significant decline in deposits as global financial turmoil tested public confidence (Figure 1).

  • And FDI inflows are weakening as investment opportunities narrow. For Q1–Q3 2008, FDI inflows were €668 million, 10½ percent below the inflows for the same period of 2007. Construction activity has also weakened considerably in the latter part of 2008. And while comprehensive data on real estate prices are not available, anecdotal evidence suggests that prices in tourist areas have fallen sharply in the past few months.

  • As in other countries in the region, equity prices have dropped sharply in thin trading as worries about the impact of global financial turmoil mount.

  • However, the trade deficit continued to widen, as import growth remained strong while exports were dampened, in part, by the impact of low aluminum prices on the aluminum company responsible for about 15 percent of exports.

Thus, GDP growth is projected to have declined to 7½ percent in 2008, while annual average inflation is projected to have risen to around 8¾ percent. Also, the current account deficit is expected to have increased to over 31 percent of GDP.

Figure 1.
Figure 1.

Montenegro: Financial Sector Developments, 2005-08

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Sources: Central Bank of Montenegro; Global Stability Report (Oct 2008); Bloomberg; and IMF staff calculations.

18. Staff project a sharp deceleration in growth in the near term. GDP growth is likely to decline to about 2 percent in 2009–2010 as the demand boom fades. Credit growth is likely to slow to low single digits at best in 2009, given banks’ reduced appetite for risk, further prudential tightening, and the difficulty of accessing foreign financing in the current global environment. And global recession is also likely to adversely affect tourism and FDI. In addition, the aluminum company has already announced a halving of its output in 2009, and it could shut down completely without public assistance.

19. And only a modest rebound is likely as global recession ends. While FDI is likely to remain strong over the medium term, the recent exceptionally high levels—which saw FDI rise to as much as 21¾ percent of GDP in 2006—are unlikely to be repeated. Similarly, credit growth is also unlikely to return to the unsustainably high levels observed in recent years. Thus GDP growth is expected to increase to around 4½ percent over the medium term. With demand pressures abating the current account deficit is projected to decline to 10 percent of GDP, while inflation is projected to fall to around 3¼ percent, over the medium term.

Medium-Term Macroeconomic Framework, 2006–13 1/

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Sources: Ministry of Finance; and IMF staff estimates and projections.

Fiscal projection reflects the authorities’ plan.

20. The authorities were more optimistic about the outlook, however. They pointed to the country’s tourism potential and possible large FDI projects as drivers of growth. However, over the course of the mission a steady flow of negative news on the global economy and outlook caused some movement—particularly in the central bank—towards staff’s position.

21. Domestic and external risks to the outlook are substantial and tilted to the downside. Financial sector, fiscal, and external vulnerabilities are substantial, and rapidly declining growth in Europe could have a more adverse impact on growth than currently envisaged.

  • Despite high credit growth, the NPL ratio has been rising, signaling a very rapid buildup of bad loans (Tables 3–4). Problem assets (classified B-E) doubled in one year to 236 percent of banking system capital and reserves as of September 2008. Private sector credit is now well above the typical level for countries at Montenegro’s stage of development, and banks are heavily exposed to the rapidly cooling construction sector.

  • While the credit boom was initially funded by deposits, foreign financing from parent banks has increased rapidly recently. As a result, the vulnerability of the banking system to a sudden stop or even reversal in financing from parent banks is substantial (Figure 2).

  • Reflecting these financial sector risks, the authorities have recently had to extend support to Prva Banka, the second largest bank, and its loan portfolio is likely to contract significantly in 2009. Also, in October the Hungarian bank OTP—parent of the largest bank—came under pressure amid a sharp selloff in its equities, increasing public nervousness about the banking system and contributing to significant deposit outflows.

  • While a substantial portion of the current account deficit is covered by FDI inflows, this coverage is declining, and private external borrowing, particularly by banks, is rising rapidly (Table 5). Although euroization shields Montenegro from currency crises, the scale and pace of the deterioration in the current account could indicate eroding competitiveness. From a savings-investment perspective, the main counterpart of the current account deficit is high private sector dissaving (-10 percent of GDP in 2008).

  • And headline fiscal surpluses primarily reflect surging VAT revenues as demand boomed (Table 6). Fiscal policy has been procyclical, and the structural deficit increased to an estimated 3¼ percent of GDP in 2008. This raises the risk that a fiscal tightening may be needed during a downturn, amplifying the cycle.

Counterparts of credit growth

(Change in percent of GDP)

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Sources: Authorities; and IMF staff estimates.

Preliminary figures.

uA01fig02
Source: WEO databank.
Figure 2.
Figure 2.

Parent Banks’ Equity Performance, 2007-09

(February 1, 2007=100)

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Source: Bloomberg.

On the other hand, there is a possibility that large FDI projects could be implemented, which would have a significant upward impact on economic activity. Also, the economic stimulus packages worldwide could have a strong effect on foreign demand.

22. While competitiveness appears broadly adequate currently, it is likely to decline further over the near term (Figure 3, Box 1, Table 7). Given the strong impact of credit growth on private sector saving, the expected sharp deceleration in credit growth should have a substantial corrective impact on the current account deficit. However, strong wage pressures points to a further deterioration of competitiveness, which will likely limit Montenegro’s attractiveness as a destination for FDI.

uA01fig03

Private savings rate vs credit stimulus

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Source: Central Bank of Montenegro; WEO; and IMFstaff calculations.
Figure 3.
Figure 3.

Montenegro: Developments in the External Sector, 2008

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Sources: Montenegrin authorities; WEO; and IMF staff estimates.

Montenegro: Assessing Competitiveness

The CGER methodology yields divergent assessments, but, on balance, finds no substantive evidence of weak competitiveness. Montenegro’s high current account deficit primarily reflects transitory demand pressures (stimulated by extremely high credit growth and FDI inflows, and sharp increases in real estate and stock market prices) and should decline as these pressures unwind. Under the macro balance approach, the underlying balance, which adjusts for transitory factors, is currently close to its equilibrium level (which includes FDI among its fundamental determinants), implying a moderate real exchange rate overvaluation of 6 percent. On the other hand, the external sustainability approach implies a 10 percent undervaluation, while the ERER approach—with the largest uncertainty margin due to data problems—suggests undervaluation of 16 percent.

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Rahman (2008).

Consistent with FDI of 7 percent of GDP at the end of the projection period.

Adjusted for transitory elements in savings and investment.

Calculation based on elasticities reported in Isard and Faruqee (1998).

However, competitiveness appears to be declining. CPI-based competitiveness measures show little movement but ULC-based measures suggest erosion of competitiveness (not atypical in the first phase of convergence). There has been a large decline in the ratio of producer prices to unit labor costs, suggesting deteriorating business profitability.

uA01fig04
Sources: Monstat, statistical offices of trading partners, and Fund staff calculations.
uA01fig05
Sources: Monstat, statistical offices of trading partners, and Fund staff calculations.

The wage level is currently mid-range, compared to neighboring countries, but wages have been rising rapidly. And Montenegro’s tourism sector has a low ranking for price competitiveness.

uA01fig06

Gross wages and productivity

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Sources: National Authorities; and IMF staff estimates.

Travel and Tourism Competitiveness Rankings

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IV. Financial Sector Risks Require Careful Management

23. Financial sector vulnerabilities are substantial, but the central bank has been pro-active in introducing prudential measures. In addition to rising NPL ratios, key financial stability indicators have been deteriorating, including bank profitability and provisioning. The average banking system solvency ratio is 16 percent, but staff estimate that a 10 percent loan loss will reduce it to 10½ percent, barely above the prudential minimum of 10 percent. Thus, strong prudential measures are needed to strengthen bank soundness. Cognizant of these vulnerabilities, the central bank has taken several welcome steps to strengthen financial sector soundness (Box 2). It has also been pro-active in seeking understandings with parent banks and home supervisors regarding the handling of potential liquidity and solvency problems. Market participants were very supportive of the temporary ceilings on credit growth, which they considered instrumental for taming the race for market share at the expense of loan quality.

24. And in October 2008, as global financial turmoil intensified, the authorities took strong steps to reduce banking system risks. As public nervousness about the impact of global financial turmoil on the domestic banking system increased in late September, widespread and significant deposit withdrawals occurred throughout the banking system, prompting the announcement of a package of measures (see Box 2). These measures, particularly the blanket deposit guarantee, helped slow deposit withdrawals. In addition, all parent banks have supported their subsidiaries with additional funding, thus helping to partially offset the decline in deposits, and banking system net foreign liabilities increased significantly in Q4 2008 (see Table 3). However, confidence in the banking system remains fragile, as deposit withdrawals have slowed but not stopped, particularly in the larger banks—in December private deposits declined by a further 5 percent, bringing the cumulative decline over Q4 2008 to 18 percent.

25. Staff welcomed these measures and urged firm implementation of the planned prudential tightening. Stronger provisioning and larger capital and liquidity buffers would improve the resilience of banks in weathering any shocks that could occur, and would also help increase public confidence in the banking system. The mission also suggested that excessively high debt to income ratios for borrowers should be discouraged. Staff also recommended that the lag between a bank failure and repayment of deposits be significantly reduced from the current 60 days, in order to increase public confidence in the deposit guarantee system.

26. The enforcement powers of the central bank could be further strengthened, as recommended in the recent FSAP. The current banking law does not give supervisors sufficient latitude to impose remedial measures on banks under administration without prior approval by shareholders, or to impose penalties without first obtaining court approval. And legal protections for supervisors could be improved. The authorities considered that the current level of legal protections had been adequate thus far but remained to be tested in courts, and noted that increasing legal protections further would require changes to the constitution.

Recent Measures to Strengthen Bank Soundness

The rapid credit expansion during the boom has overstretched banks’ credit risk management capacity, leading to excesses and the weakening of prudential ratios (Table 4). With a view to safeguarding bank soundness, the CBCG has taken several important measures to improve credit and liquidity risk management at banks and beef up their capitalization:

To reduce credit expansion to more sustainable levels and improve credit risk management:

  • Temporary bank-by-bank credit ceilings were introduced in January 2008. Ranging from 30% to 60%, the ceilings were inversely related to each bank’s receivables.

  • The base for required reserves was broadened in January 2008 to include public sector deposits irrespective of maturity, and the required reserves rate on time deposits with maturity of up to 180 days was increased.

  • The credit registry became fully operational and banks were required to use it in assessing and classifying loans.

To beef up capital, reserves, and liquidity buffers and improve the operating environment:

  • Tighter rules for asset classification and provisioning were introduced in September 2007. The threshold for “loss loans” was shortened from 270 to 180 days, and reserves for general banking risks linked (positively) to credit growth; and banks were required to review monthly the classification of assets and off-balance sheet items.

  • The minimum solvency ratio was raised from 8% to 10% and the new Banking Law allows CBCG to ask for en even higher ratio if warranted by the risk profile of the bank. Banks should comply with the new provisions by March 2009.

  • Stricter capital, liquidity and provisioning rules are to be phased in by March 2009.

  • The AML/CTF framework is also being upgraded. A new Law has been passed and implementing legislation is being prepared; meanwhile, the FATF-style regional body, MONEYVAL conducted a mutual evaluation, the report of which is expected during 2009.

In addition, the following measures were taken in response to the international financial crisis.

The government:

  • Guaranteed all bank private deposits, and on a case-by-case basis, interbank lending until end-2009 (a public contingent liability of about 48 percent of GDP).

  • Stood ready to use the substantial government deposits to repay early bank loans to government, and to provide banks with loans for up to one year against collateral of shares of at least equal nominal value, to help boost liquidity. In this context, a collateralized loan of €44 million was provided to Prva Banka in December.

  • Pledged up to €100 million for bank recapitalization on a case by case basis at the request of banks or, in the case of systemically important banks, the central bank.

The central bank

  • Created a short-term liquidity support facility enabling solvent banks to borrow against prime collateral for up to 30 days, renewable up to three times. It also allowed banks to borrow up to 50 percent of their required reserves for periods not exceeding seven days in each month.

27. The authorities’ crisis response preparedness appears to be good. The authorities have demonstrated strong vigilance and appreciation of the financial sector risks, and have implemented MCM recommendations on contingency planning for emergency liquidity support situations. These recommendations included dialogue with parent banks regarding liquidity support, detailed bank by bank contingency plans, increase in banknote inventory of the central bank, and arranging contingent credit lines. A follow-up MCM mission on crisis preparedness and management is planned for January 2009.

Implementation of FSAP Recommendations 1/

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Status as of December 2008.

V. Fiscal Stability is Coming Under Pressure

28. Booming domestic demand helped generate a substantial improvement in the headline fiscal balance in 2007. The fiscal balance improved by 4¼ percentage points to a surplus of 6½ percent of GDP, led by strong VAT revenue from booming consumption and imports. Corporate tax and social security contributions also performed strongly.

29. But the fiscal surplus likely declined significantly in 2008. While strong demand kept taxes buoyant, overall revenues declined (in percent of GDP) as a result of cuts to social contribution rates and a decline in non tax revenues. Moreover, expenditures increased significantly, as a result of the 30 percent hike in public sector wages and increased transfers, capital expenditure and net lending. Thus the headline fiscal surplus is expected to have declined to 1½ percent of GDP. Booming demand masked a worsening of underlying fiscal balances, and staff estimate that the structural fiscal balance declined to a deficit of around 3¼ percent of GDP in 2008 (Figure 4).

Figure 4.
Figure 4.

Montenegro: Fiscal developments, 2005-08

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Sources: Montenegrin authorities; Eurostat (for public administration employment); (and IMF staff estimates and projections.1/ Data for Montenegro refer to 2008.

30. And large deficits are projected for 2009 and beyond, undermining fiscal stability. Announced plans to cut tax and contribution rates by 2010 will substantially weaken revenues.1 Moreover, sharp increases in capital expenditure and social transfers are envisaged in the proposed 2009 budget. In addition to the tax and contribution cuts, the strong deceleration in demand expected as credit and FDI slowdown will weaken revenues significantly, with much of the revenue loss being permanent. Thus, staff project a deficit of 6¼ percent of GDP in 2009, with the position worsening further over the medium term as additional tax cuts and cooling demand reduce revenues. This would cause net public debt to increase by over 22 percentage points to 45¾ percent of GDP by 2013, raising sustainability concerns.

Montenegro: Fiscal developments, 2006-13

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

31. Moreover, the planned fiscal stimulus is not likely to have a significant impact on activity. The fiscal multiplier is likely to be low, given a narrow production base, a large share of imports in GDP, the sharp ongoing deceleration of credit, and the fact that a rapid rise in public debt could cause some households to increase saving.

32. Staff pressed for adherence to a medium term net debt target of 20 percent of GDP. During the 2007 Article IV consultations there was agreement that a medium term gross debt target of 30 percent of GDP would be appropriate. However, given large government deposits, staff argued that a net debt anchor—with a corresponding target of 20 percent of GDP—would be a better guide for preserving the net worth of government, and would help reduce pressures to draw down deposits. Achieving this target would require a cancellation of the tax and contribution cuts and capital expenditure increase, plus restraint on current expenditure, sufficient to reduce the structural deficit by a modest 0.2 percent of GDP in 2009 and a further 0.1 percent of GDP in 2010. Alongside, automatic stabilizers would widen the headline deficit by about 2 percent of GDP in 2009 and 1½ percent of GDP in 2010. Given large contingent liabilities linked to the blanket guarantee of bank deposits, potential recapitalization of banks, the lossmaking aluminum company, and longer term aging pressures this consolidation should be considered the minimum needed.

Montenegro: Structural Balance and Net Debt 2007–13

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Sources: Ministry of Finance, Central Bank of Montenegro; and IMF staff estimates and projections.

33. Public administration reform has significant potential to reduce expenditure. Public administration employment is well above European norms, and there is scope for efficiency gains from reforms (see Figure 4).

34. However, the authorities insisted that with the economy cooling rapidly they could not remain passive. They noted that limited possibilities for financing large deficits would act as a natural check, and that as financing options tightened they would reduce capital expenditure alongside. They also observed that plans for large public infrastructure projects to be financed using Public-Private Partnership agreements would have to be curtailed given the dimming outlook.

35. There was broad agreement on the need for a medium term expenditure framework to help entrench countercyclical policy. Given the absence of monetary policy, countercyclical fiscal policy is the main instrument available to help alleviate the buildup of macro imbalances. Implementing this would require a sound medium term expenditure framework to provide a more structural approach to fiscal planning, allowing automatic stabilizers to work freely while strengthening consolidation efforts. Staff noted that the credibility of the framework would need to be backed by tangible measures and expenditure reform.

VI. Further Structural Reforms are Critical for Sustained Growth

36. Given euroization, a flexible labor market is critical for maintaining competitiveness and stimulating sustained growth. Significant employment protections and a centralized collective bargaining system with little firm level flexibility have helped keep wage growth and the unemployment rate high, and limited the buoyancy of the corporate sector. Reflecting these rigidities, despite high unemployment seasonal surges in labor demand by the tourism industry are typically met by large inflows of foreign workers rather than from domestic sources. A new labor law, passed in mid–2008, reduces some of the rigidities but still contains substantial employment protections, discouraging job creation and longer–term employment contracts. The authorities however noted that the new law represented a social compromise, and it would be difficult to revise it so soon after its adoption.

37. Electricity sector reform is also needed to alleviate shortages that constrain growth. After a promising start, the unbundling of the lossmaking state owned electricity company (EPCG) appeared to stall in late 2008, following the authorities’ announcement that they were seeking a strategic investor to take up a minority stake in EPCG (with the government retaining a 55 percent share). The announcement created uncertainty about whether the authorities remained committed to unbundling, or were contemplating keeping EPCG as a single entity. The situation was further complicated by the failure of EPCG to pay its licensing fee to the electricity regulator, which undermined the regulator’s financial viability and ultimately resulted in a lawsuit against EPCG. The authorities however assured staff that the unbundling process would be re–energized in early 2009, and that at least part of the licensing fee arrears would be paid to keep the regulator going.

38. Staff also stressed the need to reduce the significant bureaucratic impediments to starting and operating businesses at the municipality level. The authorities acknowledged that red tape at the municipal level remained significant, but noted that a planned elimination of some municipal real estate related taxes would help improve the situation.

39. Macroeconomic data need further improvement. While there have been some improvements in economic statistics, there remain significant weaknesses, which hamper policymaking.2 National accounts and balance of payments data (particularly trade data and credit flows from abroad) are weak, and there are no data on the expenditure side of real GDP.

Table 1.

Montenegro: Selected Economic Indicators, 2006–10

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Sources: Ministry of Finance, Central Bank of Montenegro, Statistical Office of Montenegro, Employment Agency of Montenegro; and IMF staff estimates and projections.

Includes extra-budgetary funds and, from 2006, local governments, but not public enterprises.

Gross debt minus deposits; projected path dependent on privatization receipts and restitution compensations.

Table 2.

Montenegro: Macroeconomic Frameworks, 2005–13 1/

(Percent of GDP, unless otherwise noted)

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Sources: Statistical Office of Montenegro, Ministry of Finance; and IMF staff estimates and projections.

Fiscal projection reflects the authorities’ plan.

Table 3.

Montenegro: Summary of Accounts of the Financial System, 2005–2008

(Millions of euros)

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Sources: Central Bank of Montenegro; and IMF staff estimates.
Table 4.

Montenegro: Financial Soundness Indicators of the Banking Sector, 2004–Sept. 2008

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Source: Central Bank of Montenegro

Net interest income in percent of interest bearing assets

Table 5.

Montenegro: Balance of Payments, 2006–13

(Millions of euros)

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Sources: Statistical Office of Montenegro, Central Bank of Montenegro; and Fund staff estimates and projections.
Table 6.

Montenegro: Consolidated General Government Fiscal Operations, 2006-13 1/

(In percent of GDP)

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Source: Ministry of Finance; and Fund staff estimates and projections.

Includes republican budget and extra-budgetary funds; and local governments.

Reclassification of current to capital expenditure in 2009

Table 7.

Montenegro: Indicators of External and Financial Vulnerability

(In percent of GDP; unless otherwise indicated)

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Sources: Central Bank of Montenegro, Ministry of Finance; and Fund staff estimates and projections.

Appendix I: Montenegro—Debt Sustainability Analysis

I. Fiscal Sustainability

1. The monitoring of general government debt continues to improve with regular and transparent reporting of public debt by debt management unit in the Ministry of Finance. IMF has provided technical assistance over the last two years through a peripatetic advisor. In addition, the authorities now also include reporting of government deposits, making monitoring of net debt possible.

2. This debt sustainability analysis includes gross public debt that is recognized by the authorities and covers the general government.1 Estimates of the liabilities from the restitution process are also included. Parliament has limited the overall liabilities stemming from restitution to a maximum of 10 percent of GDP through amendments to the restitution law, and the plan is that the government repay 0.5 percent of GDP per year over 20 years. As of 2008, €325 million had been assumed. In 2008, approximately €105 million is added on account of pension arrears, stemming from 2002-03. The government has also decided to compensate confiscated foreign savings of Montenegrin citizens in banks outside Montenegro2 and for losses incurred during the pyramid-schemes (additional €17.6 and €9.5 million euro). Debt of municipal governments is now estimated at €42.4 million, including domestic payment arrears of €20.5 million). On the external side, The discussions between Serbia and Montenegro on the division of external debt are not yet final, and under the current scenario, debt equivalent to €29.8 million is added in 2009 on account of assumed debt from the former State Union.3 As regards Paris club debt, bilateral agreements have been signed with United States and Switzerland, while negotiations are ongoing with France, Spain, and Holland, and premature debt repayments are planned with Great Britain and Japan. Of the larger Paris club creditors, only an agreement with Russia remains to be concluded. There is still uncertainty regarding debt of public enterprises from before the reconstitution of the Union between Serbia and Montenegro that ultimately could become a liability of the government. Net debt is estimated at 23.1 percent of GDP at end-2008, with general government gross deposits reported at €304.3 million (9.2 percent of GDP).

3. Under the baseline scenario, reflecting the authorities’ fiscal plans, Montenegro’s gross debt-to-GDP ratio would increase to 52.3 percent of GDP by 2013 (Table A1). The primary balance is projected to worsen substantially as the current boom dissipates, and planned tax and contribution rate cuts and capital expenditure increases are implemented. Nominal interest rates, while low due to the high share of relatively cheap domestic and foreign debt, are projected to reach 2 percent on account of the government taking on a higher proportion of debt on non-IDA terms, and declining real economic growth will moderate the automatic debt dynamics. Privatization revenues are expected to decrease following the windfall in 2005–08.

4. The standard stress tests were performed using the methodology adopted in July 2005 (Information Note on Modifications to the Fund’s Debt sustainability Assessment Framework for market access Countries-http://www-imf.org/external/np/pp/eng/205/070105.htm), but with modifications due to data constraints. Relevant economic information for Montenegro prior to 2002 does not exist, and estimates for 2002–07 are used for historical averages and standard deviations.

5. The standard stress tests exacerbate the baseline trend of increasing gross debt (Figure A1), and the debt path is particular sensitive to growth shocks and contingent liabilities shocks. Montenegro is, furthermore, facing large risks due to external concentration in trade and uncertainties in real debt levels; and euroization limits the economy’s flexibility to respond to a shock. The relatively high sensitivity to changes in growth and fiscal policy reinforces the importance of continued structural reforms and a prudent fiscal stance.

II. External Sustainability

6. It has benefited from a debt restructuring by Paris Club and bilateral donors in 2003 (which almost halved external public debt to around 33 percent of GDP) and another debt write-off by Paris Club creditors in 2006 (which contributed to total external public debt falling to about 24 percent of GDP). The evolution of external debt has also benefited from favorable debt dynamics over the entire period.

7. The statistical information on private external debt is weak; however, staff and the authorities’ estimates indicate that external private debt has been increasing rapidly since 2006 which warrants cautious monitoring. Based on available data so far, private external debt is expected to jump from 20 percent of GDP in 2006 to 63 percent in 2008. Commercial bank debt accounted for the bulk of the increase, with banks resorting increasingly to foreign financing and subsidiaries of foreign banks borrowing increasingly from parent institutions. The remainder of the increase may partly reflect hidden FDI (driven by tax considerations), with this debt converted later into equity.

8. The macroeconomic framework projects real growth to slow down, while the current account situation improves with the weakening of FDI related imports and the rebound of private savings. Under the baseline scenario, the external debt-to-GDP ratio increases from 77 percent in 2008 to 87 percent in 2011 and declines gradually thereafter as the external current account deficit drops below its debt-stabilizing level. During this period, the external public debt declines gradually from 14 percent in 2008 to 11 percent in 2013. Meanwhile, the private sector external debt is projected to rise to 63 percent by 2008, peak at 78 percent in 2011 and decline gradually thereafter.

Table A1.

Montenegro: General Government Debt Sustainability Framework, 2003–13

(Percent of GDP, unless otherwise indicated)

article image

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π (1+g) - g + αε (1+r)]/(1+g+π +gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Figure A1
Figure A1

Montenegro: General Government Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Sources: International Monetary Fund, country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Table A2.

Montenegro: External Debt Sustainability Framework, 2003–13

(Percent of GDP, unless otherwise indicated)

article image

Derived as [r - g - ρ (1+g) + εα (1+r)]/(1+g+ρ +gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ= change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ (1+g) + (1+r εα)]/(1+g+ρ +gρ) times previous period debt stock. ρincreases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Figure A2.
Figure A2.

Montenegro: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2009, 088; 10.5089/9781451826739.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2009.
1

Personal income tax, pension contribution, and health contribution rates are to be cut from the current 15 percent, 21 percent, and 12 percent, respectively, to 9 percent, 20 percent, and 9 percent, respectively, by 2010.

2

For example, official GDP data for 2007, released in December, indicate that nominal GDP grew 30.7 percent. While real GDP growth of 10.7 percent was in line with other indicators, the deflator grew by an implausible 18 percent.

1

The central government, social funds (pension, health and employment) and local governments. Debt of state-owned enterprises is included only as so far it is explicitly recognized as a liability of the government.

2

This goes beyond the previous compensation that applied only to foreign savings confiscated by banks in Montenegro, and, in principle, the Montenegro government will have a claim on the countries in which these banks reside.

3

Debt expected to be assumed by Montenegro is toward Kuwait, Libya, Czech Republic, Slovakia and UBS bank (API bonds).

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Cover IMF Staff Country Reports
Republic of Montenegro: 2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Republic of Montenegro
Author:
International Monetary Fund
Volume/Issue:
Volume 2009: Issue 088
Publisher:
International Monetary Fund
ISBN:
9781451826739
ISSN:
1934-7685
Pages:
56
DOI:
https://doi.org/10.5089/9781451826739.002

Retail price and wage inflation
Figure 1.

Montenegro: Financial Sector Developments, 2005-08
Figure 2.

Parent Banks’ Equity Performance, 2007-09

(February 1, 2007=100)

Private savings rate vs credit stimulus
Figure 3.

Montenegro: Developments in the External Sector, 2008

Gross wages and productivity
Figure 4.

Montenegro: Fiscal developments, 2005-08

(Percent of GDP)
Figure A1

Montenegro: General Government Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)
Figure A2.

Montenegro: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)