Montenegro
2011 Article IV Consultation-Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Montenegro
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International Monetary Fund
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Publication Date:
06 May 2011
eISBN:
9781455272488
Language:
English
Keywords:
ISCR; CR; staff recommendation; authority; staff; authorities of Montenegro; central bank; country authorities; government employment; private sector; banking system; Commercial banks; Employment; Global; Europe
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Since its independence in 2006, Montenegro has experienced an economic and financial roller coaster ride. The baseline is predicated on continued improvements in cost competitiveness and productivity-raising foreign direct investment (FDI). Avoiding a relapse into recession will thus require strengthening the health of the banking system and removing impediments to restructuring the economy. Montenegro’s attractiveness to investors will depend on reducing macroeconomic and structural vulnerabilities. The business environment needs to be further improved. Redressing solvency issues and improving liquidity were jointly seen as priority tasks.

Abstract

Since its independence in 2006, Montenegro has experienced an economic and financial roller coaster ride. The baseline is predicated on continued improvements in cost competitiveness and productivity-raising foreign direct investment (FDI). Avoiding a relapse into recession will thus require strengthening the health of the banking system and removing impediments to restructuring the economy. Montenegro’s attractiveness to investors will depend on reducing macroeconomic and structural vulnerabilities. The business environment needs to be further improved. Redressing solvency issues and improving liquidity were jointly seen as priority tasks.

I. Background

1. Since its independence in 2006, Montenegro has experienced an economic and financial roller coaster ride. The country’s abundant potential attracted large capital inflows, an increasing share of which were debt creating. With expectations of rising living standards, the inflows helped fuel a domestic demand boom. Wealth effects made real estate lending and absorption booms mutually reinforcing, and overstretched the nascent financial sector’s ability to guard against risks. The economy began to overheat and then, as elsewhere, the inflows juddered to a halt. The result was a sharp decline in output (Tables 1 and 2).

Table 1.

Montenegro: Selected Economic Indicators, 2007–16

(Under current policies)

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

In 2007, there is a break in the national accounts and balance of payments data, stemming mainly from the revision of exports and imports.

Cost of living index for 2006-2008.

2007-2009 wage data have been adjusted to reflect a change in the methodology by Monstat starting January 1, 2010.

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

Estimates, as private debt statistics are not officially published.

Table 2.

Montenegro: Macroeconomic Framework, 2007–16

(Under current policies, percent of GDP, unless otherwise noted)

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Sources: Statistical Office of Montenegro, Ministry of Finance; and IMF staff estimates and projections.
A01ufig01
Sources: Central Bank of Montenegro; and IMF staff estimates.

2. The boom/bust cycle overwhelmed the policy framework. Huge vulnerabilities were accumulated during the boom when the authorities did not take the opportunity to sufficiently strengthen policy buffers. With policy space exhausted at the beginning of the crisis, the authorities were forced to adopt unconventional policies to mitigate its effects.

  • Unilateral euroization generally imported inappropriate monetary conditions. During the boom the Central Bank of Montenegro (CBM) raised the cost of credit through higher reserve requirements and tightened supervisory and prudential standards, but credit growth was hardly dented. In the Fall of 2008, banks suffered from a simultaneous run on deposits, loss of access to financing, and deterioration in asset quality (Figure 1 and Table 3). Foreign parent banks met liquidity and solvency needs, but the government stepped in to boost liquidity in a large domestic bank, initially by temporary liquidity injections, and subsequently by the direct placement of public sector deposits.

  • Fiscal reserves were not sufficient. The early surpluses largely reflected temporarily buoyant tax collections from high imports. Initially, they were placed in the domestic banking system, thereby enabling further credit extension. Then at the peak of the boom period, the fiscal stance relaxed (through tax cuts and public sector wage increases), leading to a structural fiscal deficit of some 6 percent of GDP in 2008. The remaining fiscal buffers were quickly exhausted in the crisis, while large loan guarantees to the aluminum and steel companies created substantial new contingent liabilities. By 2009 public and publicly guaranteed debt had risen to nearly 55 percent of GDP.

  • Some key structural reform priorities were not addressed. Despite progress in some areas, excessively restrictive employment protections and an unduly rigid centralized collective bargaining system remained in place. This contributed to fast wage growth, limited the flexibility of the corporate sector, and stifled new hiring, thereby raising unemployment. Privatization occurred later than elsewhere in Eastern Europe, and in consequence the interest of bidders was more limited. The large industrial sector legacy enterprises were sold to smaller investors who lost access to new financing during the global crisis, forcing the government to retake a significant equity stake in the aluminum plant in exchange for extending loan guarantees. The electricity company was sold into a thin market in 2009.

Table 3.

Montenegro: Summary of Accounts of the Financial System, 2007–2011

(Millions of euros)

article image
Sources: Central Bank of Montenegro; and IMF staff estimates.
Figure 1.
Figure 1.

Montenegro: Financial Sector Developments, 2006–10

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: Central Bank of Montenegro; Global Stability Report (Oct 2008); Bloomberg; and IMF staff calculations.1/ NPL to total loans for June 20102/ NPL to total loans for September 2010.3/ NPL to total loans for November 2010.
A01ufig02
Source: Central Bank of Montenegro; Fund staff estimates.
A01ufig03

Montenegro has been hit hard by deposit withdrawals and a credit crunch

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Source: International Financial Statistics.
A01ufig04

Montenegro: Tax and Contribution Rates 1/

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: Country authorities, and IMF staff estimates.1/ Contributions includepension, health and unemployment insurance. CIT and VAT have remained constant since 2007.
A01ufig05
Sources: Country authorities, and IMF staff estimates.1/ The budget figures switched from cash-basis to accrual-basis starting in 2009.2/ Only include new agreementssigned in 2010 and early agreementswith remaining balance in 2010.
A01ufig06
Source: World Bank.
A01ufig07
Source: Transition Indicators, EBRD 2010.

3. The global crisis thus exerted heavy blows upon the economy. In addition to the deposit run, the sudden stop in capital inflows also dried up financing for corporates just as the prices of their key export products began to fall sharply. With the very large contractions in industry and construction (Figure 2), the decline in GDP (6 percent) would have been even worse but for the ability of the tourism sector to mostly withstand the downturn.

Figure 2.
Figure 2.

Montenegro: High frequency indicators suggest a recovery in 2010

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: MONSTAT; Central Bank of Montenegro; Ministry of Finance; and IMF staff calculations.

4. A tentative recovery is now taking hold. A good tourism season was followed by resumed metal production, while heavy rains in the region boosted electricity production and exports. After contracting for almost two years, industry began to grow again in the second half of 2010. Nevertheless, industrial production at end-2010 was still considerably below of its pre-crisis peak. Expected large-scale infrastructure FDI has so far not materialized and construction activity remains depressed. Overall 2010 GDP growth is estimated at 1.1 percent, keeping output below its 2008 level (Figure 3).

Figure 3.
Figure 3.

Macroeconomic Developments in International Perspective

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: WEO; and IMF staff calculations.

5. The needed rebalancing of the economy has now begun. Inflation and wage growth decelerated sharply and the current account deficit halved to around 26 percent of GDP (Figure 4). While most of the adjustment in 2010 was due to a weather related boost in electricity exports and rebounding metals production, the nascent adjustment in costs has also improved competitiveness. The improved fundamentals have also contributed to the September 2010 debut Eurobond issuance of €200 million, subsequent spread tightening, and a further €180 million issuance in April 2011.

Figure 4.
Figure 4.

Montenegro: Inflation pressures have been declining

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: MONSTAT; and IMF staff calculations.
A01ufig08

Spreads and Sovereign Ratings for First-Tine Bond Issuers

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: MCM’s Debt Management and Debt Markets Monitor.
A01ufig09

Five-Year Eurobond Yield Spreads in bps

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Source: Bloomberg.

6. The new government is intent on fast reform progress towards EU integration. In granting of candidate status to Montenegro in fall 2010, the EU called for greater political reform efforts. An end-2010 government reshuffle promoted the Minister of Finance to Prime Minister and strengthened pro-reform forces. The government aims to commence membership negotiations still in 2011.

II. Report on the Discussions

A. Economic Outlook and Risks

A01ufig10

Real GDP growth

(In percent)

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: MONSTAT and IMF staff estimates.

7. The baseline is predicated on continued improvements in cost competitiveness and productivity-raising FDI. This is expected to drive an external-demand-led recovery—notably a reorientation toward tradable services and restructuring of industry. Projected GDP growth would rise from 2 percent in 2011 to close to 4 percent by 2016. Against the background of tight external and domestic financing conditions, as well as envisaged structural reforms in the context of EU accession, the current account deficit is projected to shrink to around 9 percent of GDP by 2016, financed by FDI inflows (Table 4). Inflation is expected to remain below that of trading partners, with fiscal tightening putting downward pressure on costs, and structural reforms lowering relatively high retail margins. The authorities broadly agreed with these projections, while noting the wide confidence bands around them.

Table 4.

Montenegro: Balance of payments, 2007–16

(Under current policies)

article image
Sources: Central Bank of Montenegro; and IMF staff estimates.

Currency and deposits held by Other sectors were reclassified from Other investment to Errors and omissions.

This includes only estimates of private external debt as private debt statistics are not officially published.

A01ufig11

Annual change in real terms

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: Central Bank of Montenegro; IMF staff estimates.

8. For the near term, key risks are tilted to the downside, inter alia:

  • External environment, the key source of shocks for an open and small economy. Should there be another sudden stop, the still very large external imbalances are at risk of disruptive adjustment. Renewed sovereign and banking stress in the euro-area periphery could undermine confidence and financing, while more competitive Mediterranean neighbors could increase competition for tourists. Privatizations could prove more difficult.

  • Reform fatigue and legacy structural problems. Bank restructuring has been uneven, leaving some banks in difficult positions, with potentially adverse implications for intermediation and confidence. The needed household deleveraging could also turn disruptive. The restructuring of heavy industry could run into further problems; already intermittent production stoppages are standing in the way of supplying buoyant global commodity demand, and even current production levels may not be sustained. The political context for continued reform and adjustment could also become more difficult, given the recent decline in incomes.

9. Avoiding a relapse into recession will thus require strengthening the health of the banking system and removing impediments to restructuring the economy.

B. Medium-term External Rebalancing

10. It was agreed that FDI holds the key to re-launching growth. In order to benefit from the recovery in global capital flows, Montenegro must swiftly redress any impediments to investment (Annex I). FDI should also be complemented by heightened domestic flexibility and cost competitiveness in order to avoid renewed overheating pressures and to help provide the spark for domestic investment, notably in labor-intensive SMEs.

11. FDI will also be essential for external rebalancing. While there is a need to boost cost competitiveness, it was agreed that leaving rebalancing to macroeconomic policies alone—which in Montenegro’s case would largely amount to engineering an internal devaluation via fiscal and incomes policies—would require an excessive degree of domestic adjustment, if such policies were not accompanied by productivity- and capacity enhancing investment. This is also a reflection of the small size of the economy, as only a handful of projects—which do not have to be large in absolute terms—can drastically alter economic prospects. Thus, the current account in any given period may not be a reliable indicator for such economies, which is also reflected in the inconclusive CGER assessment (Box 1)1. Still, staff suggested it would be prudent to consider the real exchange rate to be somewhat overvalued. While not taking a view on the level of the real exchange rate, the authorities stressed that their policy focus on structural reform and fiscal consolidation would improve competitiveness in any event.

12. Montenegro’s attractiveness to investors will depend on reducing macroeconomic and structural vulnerabilities. The authorities and staff agreed that these tasks are mutually reinforcing; lessened vulnerabilities will help dispel reservations among potential investors, while higher levels of investment could create positive agglomeration effects thereby strengthening fundamentals. Conversely, without buoyant investment, the consolidation task would be harder. Montenegro’s EU candidacy should provide a key comparative advantage in attracting investment, and the authorities are eager to quickly commence negotiations.

13. Provided the required policies are in place, the medium term outlook is favorable. The authorities and staff agreed that a strategy centered on enabling private sector-led growth, healthy banks, smaller government, and deregulation should form the basis for sustainable growth ahead. The country’s unique geography and favorable climate still offer large untapped potential, e.g., in tourism and hydro-electricity. This could well trigger larger-than-currently-projected FDI. Even in this case, though, the above policy recommendations would still be beneficial to lessen the danger of Dutch disease. Discussions on the specific policy requirements are described in the following sections.

External Competitiveness

The application of CGER-type methodology in the case of Montenegro does not reveal conclusive evidence of competitiveness problems. However, it should be noted that limitations in terms of data availability and length of sample do not allow the application of the equilibrium real exchange rate approach and introduce a large margin of error in the external sustainability approach. In addition, the estimated equilibrium balance in the external sustainability approach should be taken only as a rough guide because it assumes debt stabilization at an arguably too high level. It should also be noted that the improvement of the external current account in 2009–10 does not so much stem from competitiveness gains, but rather from recovering export production and some import contraction.

Current Account Balance Gap and Real Exchange Rate Overvaluation in Macrobalances and External Sustainability Approaches

(in percent of GDP, unless otherwise specified)

article image
Source: IMF staff estimates.

Rahman (2008).

Adjusted for transitory elements in savings and investment.

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

CPI-based REER estimates show that after a period of substantial appreciation during 2007–09, the REER has remained broadly unchanged during 2010. Economy-wide wage and producer price data analysis indicate a further erosion of competitiveness, and, as Figure 5 shows, the level seems to be one of the highest in the region.

A01ufig12
Sources: Monstat; IMF staff estimates.

Finally, it seems that the tourism sector has managed to achieve continuous gains in its competitiveness ranking which is essential given its growing share in the Montenegrin economy.

The overall competitiveness ranking in tourism has improved substantially

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Source: World Economic Forum. Note: A rise in the ranking indicates improvement.

C. Boosting Employment

14. There is consensus on the need to improve the performance of the labor market. Unemployment is high and participation low (Figure 5). Moreover, a distinct segmentation of the labor market has occurred, with employment of foreign workers serving as the buffer. Thus the headline change of domestic employment understates the decline of actual employment (including that of foreigners). Even so, domestic unemployment has crept up, with anecdotal evidence of a large share being long-term unemployed.

Figure 5.
Figure 5.

Montenegro: Labor Market indicators, 2007–10 1/

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: MONSTAT; and IMF staff calculations and estimates.1/ Employment and wage data have been adjusted based on staff estimates.

15. “Insiders” are dominating the policy debate. Strong employment protection has contributed to low wage flexibility and—in the industrial sector—has effectively stalled restructuring.2 High costs of layoffs are also a disincentive to new hiring, especially of older workers losing their jobs in restructurings. There are also sizeable impediments to labor supply implied by an unemployment trap as the unemployed stand to lose several social benefits if they accept employment. The recent more-than-doubling of the minimum wage (compared to the previous “minimum price of labor”) aggravated this problem by depressing demand for low-skilled workers, further marginalizing this vulnerable group. There are strong political pressures to further tighten employment protection and to limit the application of fixed term contracts, e.g., in a draft revision of the labor law.

16. The staff argued for employment friendly reform. The contrasting experiences of the tourism and heavy industry sectors offered salient lessons: the former, in which liberalized foreign employment is essential, was nimble in adjusting to the global recession and registered growth throughout the crisis, whereas the latter is struggling despite global buoyant commodity demand. Staff saw significant scope for raising both labor supply and demand.

  • Labor demand could be boosted by raising flexibility with a view toward creating and sustaining jobs; for example, the authorities could engage the social partners in order to provide scope for the introduction of temporary opt-out clauses from collective bargaining agreements to allow for emergency restructuring, or to boost the nascent tradable-oriented private sector. Similarly, the recent doubling of the minimum wage should be revisited and excessive employment protection be reduced. Moreover, public sector wage restraint and pension reforms, in addition to their importance for fiscal consolidation, should be used to lead tight economy-wide incomes policies.

  • Labor supply could commensurately rise if the very high marginal effective taxation of the unemployed was cut. One option is the incorporation of negative income-taxation elements, e.g., an Earned Income Tax Credit (EITC) (Annex II). This scheme would also provide an incentive for formal employment (as only incomes earned in the formal sector would be benefitting from a cash payment), thereby reducing its costs. The authorities expressed an interest to study the issue and were also looking at targeted active labor market measures to lower skill mismatches.

17. The business environment needs to be further improved. The authorities are focusing on upgrading technical and administrative skills of government agencies that provide business services, and streamlining construction licensing by municipalities. Staff welcomed these efforts that targeted key weaknesses documented in surveys, and also noted that improved economic statistics are essential to bolster investment and policy making.

D. Banking and Financial Sector

18. Redressing solvency issues and improving liquidity were jointly seen as priority tasks. Confidence is returning, as evidenced by increasing deposits, though they are still below their levels in the third quarter of 2007. However, NPLs have not leveled off and Financial Soundness Indicators have continued to deteriorate (Table 5 and Box 2). There was agreement that the next steps must focus on fully restoring soundness across the system in order to allow for renewed lending growth when credit demand for quality projects returns. Stagnant lending at the current juncture, however, primarily reflected the dearth of such projects and the staff recommended that the authorities continue to resist calls to force credit growth.

Table 5.

Montenegro: Financial Soundness Indicators of the Banking Sector, 2007–10

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Source: Central Bank of Montenegro.

Net interest income in percent of interest bearing assets

19. With the recently strengthened legal framework, the central bank is in a position to play the central role in safeguarding financial stability. Key improvements to financial sector legislation were enacted in 2010, including a new Central Bank Law and laws on banks, bank bankruptcy, and deposit insurance. The authorities considered them in line with international best practice, having benefited from Fund, World Bank and EBRD advice. Staff stressed that, endowed with new powers, the CBM must be uncompromising in redressing any weakness in the system. This called for continued high-frequency and risk-based audits, and fast follow up. Adequate solvency and liquidity buffers should be required. Recent temporary regulatory relaxations should be phased out quickly and be replaced with permanent regulations that are fully in line with best international practice. The authorities agreed and pointed to preparations already underway, including their joint discussions with the World Bank on bank restructuring. Staff welcomed efforts to strengthen regulations related to collateral execution (from corporate and households) as well as the envisaged move to IFRS and urged to properly prepare for it.

Parent Bank Support

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Source: Central Bank of Montenegro

20. Bank owners must promptly address any slippages from regulations, especially capital or liquidity shortfalls. Throughout the last years, foreign parent banks have remained supportive. Meanwhile the ability of domestic owners was impaired owing to the sudden stop. The staff underscored that with resuming international capital flows, all bank owners should be expected to quickly meet any capital or liquidity calls from now on, or risk immediate and forceful sanctions. The authorities indicated that they were intensively working on a solution for the largest domestic bank that would incorporate these recommendations.

Financial Soundness Compared to Other Emerging Europe Countries

The global financial crisis has left the banking system in Montenegro in a worse shape than in emerging Europe in general. At end-2007, before the crises, key Financial Soundness Indicators (FSIs) for Montenegrin banks did not stand out in comparison to the average for other emerging Europe countries, for which FSIs were reported in the Spring 2011 GFSR. However, three years later, in late 2010, the picture is bleaker in Montenegro. While capital to asset ratios have held up, including on account of owners’ capital injections, profitability and asset quality indicators have deteriorated much more. Although one must be careful in comparing FSI levels across countries, it is worth noting that the indicators for return on equity and assets, non-performing loans to total loans, and provisions to total loans are the weakest in Montenegro among all of the emerging Europe countries in the GFSR.

A01ufig13

2007

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

A01ufig14

2010

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

All indicators in percent. A larger value for any indicator is better. CAR: Regulatory Capital to Risk-Weighted Assets; C/A: Capitalto assets: -NPL/L: the negative of Non-Performing Loans to TotalLoans; P/NPL: Provisions to Non-Performing Loans; ROE: Return on Equity; ROA: Return on Assets.

Emerging Europe: Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Latvia, Lithuania, Macedonia, FYR, Montenegro, Poland, Romania Serbia Turkey

Source: GFSR.

21. In any event, reserves need to be rebuilt from low levels. The empirical results for reserves in a dollarized economy are ambiguous (Box 3). Some dollarized economies have done quite well with relatively few reserves. At the current juncture, the authorities and staff, however, saw this model as not well suited for Montenegro; a weakened banking sector and a potentially difficult fiscal financing environment make a higher level of reserves essential. Staff also cautioned that use of the euro placed very tight limits on central bank liquidity support operations, such that redressing banking liquidity and solvency problems could impose large fiscal demands. Aggressive safeguarding of the banking system in line with the authorities’ plans is one important requirement to avoid this from happening—including by mandating banks to hold considerably higher capital and liquidity buffers than international norms. But staff argued that the accumulation of fiscal reserves via fiscal consolidation will also be essential to provide an additional backstop for confidence in the system.

Liquidity Support in Other Dollarized or Currency Board Countries

In countries where the central bank cannot increase base money supply, the central bank’s capacity as a lender of last resort is limited. This is the case in both dollarized economies like Montenegro and Kosovo, but also in countries with a currency board such as Bosnia and Herzegovina, and Bulgaria. Therefore the fiscal authorities have a particularly important financial role in supporting the banking system in times of stress in these countries. The legal and institutional arrangements for this vary. Some countries have more explicit financial arrangements in place, like Bulgaria, while others have tended to rely on temporary measures and legislation.

A key implication is then that the capacity of country to provide liquidity support to solvent or insolvent banks is to a large extent determined by the financial capacity of the government. This is also true for countries with other exchange rate arrangements, but when the central bank is not free to issue new currency, the fiscal position is even more important.

Having said that, even in dollarized settings some liquidity support can still be provided and it is worth looking at some measure of the liquidity support capacity of the CBM compared to central banks in other countries. The most straightforward measure is perhaps to calculate the amount of reserves in relation to deposits in the banking system.

Such a comparison gives a mixed picture, but the CBM’s level of reserves are not high (table below). It must be noted that the issuance of a Eurobond in the fall of 2010 significantly boosted reserves in Montenegro. Before the issuance, the level of reserves in relation to deposits had declined significantly in 2010 and was only above the level in Panama. This picture is not altered by looking at net foreign assets instead.

Reserves to Depoists

(in percent)

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Source: IFS and staff estimates.

Government foreign assets over deposits.

E. Fiscal Policy

22. The budget is the key near-and medium-term policy tool. In the fully euroized economy, fiscal policy is the only stabilization tool, is critical to backstop banking problems, and has a role to play in boosting the economy’s attractiveness to investment. At the current juncture all these objectives call for consolidation. Given the highly open economy, the fiscal multiplier is unlikely to be large in any event; moreover, credible deficit cuts could well improve investor confidence and result in renewed access to cheaper capital.

23. Fiscal consolidation has commenced, and the authorities’ budget targets for 2011 and the medium term are appropriate. Reflecting mainly significant capital expenditure cuts, the 2010 fiscal deficit is estimated to have declined by 1½ percent of GDP to 3.9 percent (Table 6), though loan guarantees of 3.6 percent were extended to industrial companies. Going forward, the authorities aim at balancing the budget in 2012 and achieving a sizeable surplus thereafter in order to bolster sustainability, lower financing risk, and boost the economy’s resilience to shocks. They also envisage a tight-fisted approach to loan guarantees. Staff endorsed these targets, noting that if they were carried over the medium term, public debt could fall below 20 percent of GDP by 2016, boosting growth prospects and building buffers.

Table 6.

Montenegro: Consolidated General Government Fiscal Operations, 2009–2016 1/

(in percent of GDP)

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

Includes republican budget and local governments.

Part of the discrepancy is due to new issuance of restitution bonds and court rulings, both leading to increase of government liabilities.

Normative Fiscal Adjustment Path

(in percent of GDP)

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

Based on authorities’ medium-term targets.

24. Staff recommended adding robustness to the strategy, observing that the targets are predicated on keeping the nominal wage bill constant and effecting further cuts in goods and services spending. Against the background of recently rising arrears, staff cautioned that these goals may be overly ambitious on the basis of existing policies. In all, some 1 and 2½ percent of GDP in 2011 and 2012, respectively, in additional measures would likely be required to safeguard adherence to the fiscal targets. The authorities indicated that they would not hesitate to undertake further measures should achievement of their targets be at risk. The subsequent discussions focused on high-quality measures, also with a view to securing significant surpluses after 2012.

Additional Fiscal Measures Needed

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Source: Country authorities, and IMF staff estimates and projections.

  • Staff saw scope to boost revenue collections in a growth-friendly way. Property is rather lightly taxed by international comparison, and collections could be boosted by a combination of higher rates, better valuation, and an improved cadastre. Small increases in income- and VAT tax rates could result in significant additional revenue, while still leaving intact Montenegro’s regionally favorable taxation regime. Moreover, flanking such increases by reducing poverty traps—for example by introducing an EITC—would provide an important boost for formal employment and tax collection. The authorities stressed that they considered a tax system with a broad base and low flat rates to be an essential comparative advantage. Within this broad principle, they were looking for further base-broadening and tax efficiency improvements and strengthened revenue administration.

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Source: Country authorities.

As of 2010.

In parenthses are reduced rates.

A01ufig15

General Government Expenses, 2010

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

A01ufig16

General Government Wage Expenses, 2010

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: Country statistical yearbooks; World Economic Outlook (WEO); and IMF staff estimates.

  • Expenditure was jointly seen as an area where efficiency savings were possible. Elevated public expenditure ratios (especially for current spending) are typical for ex-Yugoslav countries; Montenegro’s ratios are comparatively high even for this group.

    • There was agreement that the most durable and effective way to bring down the share of public expenditure in GDP is to cut government employment. The large wage bill constitutes a priority in the authorities’ consolidation strategy. In order to avoid excessive reliance on wage cuts, which have adverse effects on morale, the government has initiated the process with the requirement that for every new hiring, at least two positions need to be cut. Staff recommended a less decentralized approach to cuts, built around an overall vision of the civil service.

    • The recent pension reform marked important progress in improving the long-term sustainability of public finances but staff noted the long implementation period (Box 4). Accelerating the introduction of increased retirement ages and/or reducing the indexation to wages, as well as tightening eligibility criteria, could be considered to make further savings without adverse social implications. In the longer term, a comprehensive reform that establishes a strong link between contributions and benefits could further reduce the tax wedge, as contributions become more like savings rather than taxes.

    • The need for direct budget support to private companies has waned. While inconsistent with their past reforms that were predicated on the primacy of the private sector in allocating resources, the authorities noted that such support was inevitable in a severe crisis. Staff suggested that a new reform push, including more flexible labor regulations and boosting banks’ resilience are a better way to enable entrepreneurs to restructure.

    • Proper control of potential expenditure arrears is essential. The staff stressed that such arrears need to be closely monitored, especially at the municipal level. The authorities’ recent transparent high-frequency publication of fiscal statistics, adoption of a single treasury account, and mandatory commitment reporting were welcome.

    • Capital spending is unlikely to be a further source of savings in the near term. After having borne the brunt of the recent consolidation, staff and authorities agreed that spending should be sufficient to cover key infrastructure needs that are critical to Montenegro’s attractiveness to tourists and business. To the extent possible, the authorities emphasized their desire to involve private sector financing via PPPs or concessions, but considered the current environment to be challenging.

25. Budget financing going forward entails risks. Eurobond proceeds have met a large part of the 2011 budget financing requirement. Notwithstanding the repeated successful market access in a difficult regional environment, staff cautioned that the uptake of market debt was fast (13 percent of GDP over two years) further underscoring the need for fiscal adjustment in order to secure future market access and repayment capacity. Given the high opportunity cost of budget financing, every effort should be made to place public funds safely, while achieving reasonable returns. With the crisis having passed, staff stressed that the placement of public sector funds should now be exclusively governed by prudent financial management principles, rather than with an eye to support banks. The Fund also stood ready to help if needed.

Pension Reform

The social security financing gap is one of the biggest fiscal challenges. The financing gap widened sharply from 1.3 percent of GDP in 2007 to 5.1 percent in 2009, to a large extent due to rapid pension benefit increases resulting from court-mandated increases. While adjustments to the compulsory contribution requirement in 2010 reduced the gap to an estimated 2.6 percent of GDP, it still accounted for nearly 70 percent of the overall fiscal deficit in the year. In addition, the need to finance high transfers through contributions largely explains the high tax wedge.

The recent pension reform marked important progress in improving the sustainability of public finances. It included three measures: (i) increase in the retirement age for both men, from 65, and women, from 60, to 67 (the new retirement age for men will be fully implemented in 2025, and for women in 2041); (ii) re-indexation of pension benefits to 75 percent of living cost index and 25 percent of general wage level, compared with 50-50 percent previously; and (iii) reduction in the frequency of pension benefit index calculation, from biannually to once a year.

A01ufig17

Social Security Financing Gap and Pension Reform

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources Country authorities, and IMF staff estirrates and projections.

III. Staff Appraisal

26. Growth is resuming and the recovery is projected to gain momentum. The recovery is being supported by high world prices and demand for Montenegro’s industrial exports, new tourism projects, and increased confidence in the financial system. Accordingly, real GDP is projected to grow some 2 percent in 2011 after an estimated 1.1 percent in 2010, while inflation is expected to remain below the level of that in trading partners.

27. Substantial risks still linger. Near-term risks reflect an unfinished reform agenda: poor labor relations and persistent financial problems could yet prevent industry from profiting from the global demand boom; the repair of the banking system is not yet completed; and, notwithstanding recent welcome budget consolidation, fiscal buffers remain depleted. In addition the external environment harbors large risks.

28. Policies must aim to advance external adjustment in order to make future growth sustainable. Montenegro’s experience demonstrates the crucial importance of persevering with reform, strengthening resilience and building policy buffers. The still very large current account deficit requires improved cost competitiveness and a significant increase in domestic savings. Luckily, Montenegro’s large potential can be tapped, such that external rebalancing need not sacrifice growth.

29. Investment holds the key to economic growth and job creation. Foreign investment is particularly important. It must be leveraged by improved domestic flexibility and cost competitiveness in order to avoid renewed overheating pressures and to spark off domestic investment, notably in labor-intensive SMEs. The business environment needs to be further improved.

30. The labor market should be invigorated. Demands to restrict the flexibility and availability of fixed term contracts must be resisted. The authorities should engage social partners to facilitate the use of opt-out clauses from collective bargaining arrangements. Poverty and unemployment traps need to be addressed and employment protection and severance packages have to become affordable.

31. Completing the repair of the banking system is the key near-term priority. Thanks to the authorities’ timely actions and the extension of support by parent banks, confidence has begun to return. The next steps should focus on fully restoring soundness across the system in order to allow for renewed lending growth once credit demand for quality projects returns. Adequate solvency and liquidity buffers should be required and recent temporary regulatory relaxations be phased out quickly. The envisaged move to IFRS—properly prepared—is welcome. Owners must promptly address any slippages from regulations, especially capital or liquidity shortfalls or face immediate and forceful central bank intervention in line with the recently strengthened legislation.

32. Use of the euro requires greater buffers. Central bank liquidity support operations are severely constrained in the euroized monetary framework, and banking liquidity and solvency problems could thereby easily impose large fiscal demands. Aggressive safeguarding of the banking system, including by mandating higher-than-Basel capital and liquidity buffers is one requirement to avoid this happening, while the accumulation of fiscal reserves is an essential backstop for confidence.

33. The required fiscal consolidation has commenced, and the authorities’ budget targets for 2011 and the medium term are appropriate. The authorities appropriately aim to balance the budget by 2012 and to achieve a sizeable surplus thereafter. This target will bolster sustainability, lower financing risk, and boost the economy’s resilience to unforeseen shocks. In the near term, some 1 and 2½ percent of GDP in 2011 and 2012 in additional high quality measures should be implemented to secure these targets.

34. There is scope to boost revenue in a growth-friendly way. Property is rather lightly taxed, and collections could be raised by a combination of higher rates, better valuation, and an improved cadastre. Small increases in income tax and VAT rates would result in significant additional revenue, while still leaving intact Montenegro’s regionally favorable taxation regime. Moreover, flanking rate increases by reducing poverty traps—e.g., by introducing an Earned Income Tax Credit—would provide an important boost for formal employment and tax collection.

35. Expenditure should be contained in a durable fashion. Cuts in government employment and tight wage policy are essential to lower the large wage bill. The recent pension reform marked important progress in improving the long-term sustainability of public finances. Accelerating the introduction of increased retirement ages and/or reducing the indexation to wages, as well as tightening eligibility criteria, should be considered to bring its beneficial effects forward. Tight public sector wages and pensions will also help anchor incomes policies to boost external cost competitiveness. Direct budget support to private companies should be eschewed. Close monitoring of potential expenditure arrears is imperative, especially at the municipal level.

36. Given the high opportunity cost of budget financing, every effort should be made to place public funds safely, while achieving reasonable returns. With the crisis having passed, the placement of public sector funds should now be exclusively governed by prudent financial management principles, rather than with an eye to support banks. Freeing currently parked deposits can also help reduce the costs and risks involved in tapping capital market.

37. Further progress on improving the statistical base is essential. The transparent high-frequency publication of fiscal statistics, adoption of a single treasury account and mandatory commitment reporting are welcome. However, weaknesses in economic statistics continue to hamper economic analysis and policy making. Priority areas for improvement include national accounts, external sector and labor market statistics.

38. It is expected that the next Article IV Consultation will take place based on the standard twelve-month cycle.

Annex I. Foreign Direct Investment in Montenegro1

A. Background

Being a small economy with significant potential, Montenegro attracted very high levels of FDI in relative terms. As Figure 1 shows, for the last five years it had the highest FDI per capita as well as FDI as percent of GDP among the emerging market economies of Central and South Eastern Europe.

Figure 1.
Figure 1.

FDI in Montenegro and other countries of the region

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Source: IFS

The FDI boom mostly targeted the tourism, real estate, financial and energy sectors. FDI took the form of both greenfield investments and privatization of state-owned enterprises. Regarding the latter, prominent examples are two, relatively major, investments in the aluminum smelter and the steel works. The banking sector continued to attract FDI even after the initial equity acquisitions, mostly because of recapitalization needs in the aftermath of the financial crisis.

As a result, all energy sector companies now have substantial foreign ownership, so do most of major hotels and industrial enterprises, and the banking sector is around 90 percent foreign-owned. Regarding the origins of FDI, these were quite diversified, with Italy and Russia topping the list of the investor countries. Figure 2 below presents the FDI allocation by broad sectors of the Montenegrin economy as well as by countries of origin.

Figure 2.
Figure 2.

Distribution and origin of FDI in Montenegro

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Source: CBM

B. Literature on FDI and Its Relevance to Montenegro

What explains FDI in general and FDI in Montenegro in particular? Empirical research suggests FDI is sensitive to host-country political and economic conditions such as the political situation in the country and the region, the education level of the labor force, overall market size, factor costs, quality of infrastructure, and the general business climate.2 In particular, a number of such studies find that FDI is lower in countries with higher corporate tax rates and suggest that host-country taxation regime is likely to influence FDI decisions.3

Regarding the impact of FDI on economic growth, while many studies failed to provide conclusive evidence on possible links between FDI and economic growth, studies that tried to account for initial conditions in the recipient countries were more successful in showing such a linkage. Dabla-Norris et al (2010) mention, amongst others, the level of financial sector development, quality of institutions and macroeconomic policies, and capital endowments as factors that can help explain a country’s ability to benefit from FDI externalities.

Looking at the period since 2006, when Montenegro gained its independence, one can see that most of the factors mentioned in the literature are relevant to Montenegro. During this period the country was politically stable, maintained good relations with its neighboring countries, and has recorded substantial progress on the road to European Union integration. The unilateral adoption of the euro as the legal tender has anchored investors’ expectations (more than half of countries of FDI origin use euro) and, together with the liberal trade and exchange systems, most likely played an important role in FDI decisions.

Although a small economy with a small internal market, Montenegro has benefited from its geographical location and natural endowments to become a popular tourist destination and is continuing to improve its tourism competitiveness. According to the World Economic Forum’s 2011 assessment, Montenegro has managed to substantially improve its travel and tourism competitiveness index and ranks 36th amongst 139 countries included in the assessment (Figure 3).4 Montenegro has also tried to stay competitive in terms of taxation regime and currently has one of the lowest income taxation rates in the region (Figure 4).

Figure 3.
Figure 3.

2011 competitiveness ranking in tourism

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Source: World Economic Forum.
Figure 4.
Figure 4.

Corporate income tax rates as of 2010

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Source: Country authorities.

C. FDI Prospects in Montenegro

The prospects of the Montenegrin economy largely depend on FDI prospects. In particular, the tourism and energy sectors present clear potential for large projects such as the development of the coastal line and the transformation of Montenegro into a hub for the regional electricity exchange. However, in order to achieve a broad-based growth which will be accompanied with substantial employment generation, the economy needs also investment flowing into medium and small businesses. Hence, it is important to further improve the business environment for such enterprises and to provide possibilities for improving competitiveness.

Particular near-term priorities for Montenegro comprise reforms in labor and product markets and in market regulation. Other important areas of action include improvement of the quality of education to better align it with the labor skills required in the market and the development of transport infrastructure. Finally, well-developed and stable domestic financial markets and sound macroeconomic policies can create a general stimulus for FDI.

Annex II. Scope for Improving the Tax System of Montenegro1

During the last decade, Montenegro has moved towards a relatively simple and transparent tax system that combines broad bases with low rates. While this generally complies with principles of ‘good taxation’, there is room for improvement and some aspects of the tax system warrant reconsideration. Some improvements could also contribute to fiscal consolidation in the short-term. Four key priorities are identified.

Reduce the tax wedge on labor

Despite a low proportional personal income tax rate of 9 percent, the total tax wedge on labor is high due to additional local surcharges and a high rate of social security premiums. The total tax wedge as a percentage of labor costs exceeds 40 percent. This exerts significant adverse labor-market incentives and may partly explain the very weak labor-market performance in Montenegro. For instance, the participation rate among the low-skilled is only 13 percent and the overall unemployment rate is almost 17 percent. Reducing the tax wedge, especially for low incomes, should be a key ingredient of a comprehensive reform strategy to mitigate labor market distortions. A potentially promising instrument that could be considered—and that has been successfully introduced in various other countries—is the earned income tax credit. By gradually phasing out this credit with higher incomes, the credit can be targeted to low labor incomes, while limiting the budgetary cost.

Mitigate tax arbitrage in the income tax

Two forms of arbitrage threaten income tax revenue from entrepreneurs.

  • The self-employed with low turnover are taxed according to a lump-sum regime. The way this is structured creates ample incentives for underreporting and for operating in the informal sector, especially due to spikes in the tax schedule and a regressive social security burden. A straightforward improvement would be to transform the lump-sum regime into a turnover tax for those self-employed.

  • Entrepreneurial income from limited liability companies is taxed at much lower rates than the income of nonincorporated businesses. This creates strong incentives for entrepreneurs to incorporate and for director-owners to label their business income as capital returns. Arbitrages can be reduced by increasing the mandatory remuneration for owner-directors of companies, which is taxed as labor income. Moreover, the tax difference should be reduced by increasing either the corporate income tax rate or the personal tax rates on capital income.

Strengthen the property tax

Current property tax revenue in Montenegro is low in an international perspective. This can be partly explained by deficiencies in the system of registration and valuation of properties, and partly by policy parameters, such as low tax rates and ample exemptions. Strengthening property tax revenue by improving registration and valuation, increasing rates and abolishing tax concessions could reduce reliance on other revenue sources of local government finance, such as central government transfers, revenue sharing with central government taxes and the plethora of local fees and taxes, which are perceived as a significant burden by the business community.

Remove remaining tax incentives

Although the tax base is generally broad, Montenegro still applies some tax incentives in the personal income tax, the corporate income tax and the value-added tax, the benefits of which are unlikely to outweigh their costs. For instance, in the personal income tax on business income, there is a tax concession for the labor costs of newly hired workers that could better be abolished. In the corporate income tax, there is a three-year tax holiday for newly established firms in underdeveloped municipalities, which could better be phased out. In the VAT, more goods and services should be taxed under the normal VAT rate of 17 percent, including tourism and computer equipment.

Annex III. Debt Sustainability Analysis

Table 1.

Montenegro: External Debt Sustainability Framework, 2007–2016

(In percent of GDP, unless otherwise indicated)

article image

All calculations are very preliminary estimates based on staff assumptions and subject to change as private sector external debt statistics are not officially published.

Derived as [r - g - ρ(1+g) + ɛα(1+r)]/(1+g+ρp+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, ɛ = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + ɛα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ɛ > 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 1.
Figure 1.

Montenegro: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ All calculations are very preliminary estimates based on staff assumptions and subject to change as private sector external debt statistics are not officially published.2/ 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.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
Table 2.

Country: Public Sector Debt Sustainability Framework, 2007–2016

(In 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 + αɛ(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 ɛ = 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 αɛ(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 2.
Figure 2.

Montenegro: General Government Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2011, 100; 10.5089/9781455272488.002.A001

Sources: International Monetary Fund, country deskdata, 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 occurin 2011, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency)minus domestic inflation (based on GDP deflator).

RReferences

  • Dabla-Norris, E., Honda, J., Lahreche, A., and Verdier, G., 2010, “FDI Flows to Low-Income Countries: Global Drivers and Growth Implications,” IMF Working Paper 10/132.

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    • Export Citation

  • Hanson, G., 2001, “Should Countries Promote Foreign Direct Investment?” No. 9, G-24 Discussion Paper Series, UN Publication.

  • Hines, J., 1996, “Tax policy and the activities of multinational corporations,” NBER Working Paper No. W5589.

1

The very few historical comparators with deficits in excess of 30 percent of GDP were all very small economies.

2

The recent severance package at the aluminium plant amounted up to €20,000, about 2.3 annual wages and more than 400 percent of per capita GDP.

1

Prepared by Vahram Stepanyan.

2

See, for example, Hanson (2001).

3

See, for example, Hines (1996).

4

The overall index consists of three sub indices: regulatory framework; business environment and infrastructure; and human, cultural, and natural resources.

1

Prepared by Ruud De Mooij.

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Cover IMF Staff Country Reports
Montenegro: 2011 Article IV Consultation-Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Montenegro
Author:
International Monetary Fund
Volume/Issue:
Volume 2011: Issue 100
Publisher:
International Monetary Fund
ISBN:
9781455272488
ISSN:
1934-7685
Pages:
57
DOI:
https://doi.org/10.5089/9781455272488.002
Figure 1.

Montenegro: Financial Sector Developments, 2006–10

Montenegro has been hit hard by deposit withdrawals and a credit crunch

Montenegro: Tax and Contribution Rates 1/
Figure 2.

Montenegro: High frequency indicators suggest a recovery in 2010
Figure 3.

Macroeconomic Developments in International Perspective
Figure 4.

Montenegro: Inflation pressures have been declining

Spreads and Sovereign Ratings for First-Tine Bond Issuers

Five-Year Eurobond Yield Spreads in bps

Real GDP growth

(In percent)

Annual change in real terms
Figure 5.

Montenegro: Labor Market indicators, 2007–10 1/

2007

2010

General Government Expenses, 2010

(percent of GDP)

General Government Wage Expenses, 2010

(percent of GDP)

Social Security Financing Gap and Pension Reform

(percent of GDP)
Figure 1.

FDI in Montenegro and other countries of the region
Figure 2.

Distribution and origin of FDI in Montenegro
Figure 3.

2011 competitiveness ranking in tourism
Figure 4.

Corporate income tax rates as of 2010
Figure 1.

Montenegro: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)
Figure 2.

Montenegro: General Government Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)