Montenegro
Staff Report for the 2012 Article IV Consultation
Author:
International Monetary Fund
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Publication Date:
23 May 2012
eISBN:
9781475503876
Language:
English
Keywords:
ISCR; CR; commercial bank loan; staff appraisal; IMF staff representative; financing risk; deficit; fiscal policy; current account; exchange rate; banking system; liquidity injection
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This 2012 Article IV Consultation highlights that three years after the sudden end of Montenegro’s boom, there has been considerable progress toward recovery. Fiscal imbalances have proved difficult to rein in, reflecting a large fall in revenue after the collapse of the boom. Executive Directors have commended the authorities’ efforts to stabilize the economy, and welcomed the progress made since the financial crisis. Directors have also recognized the sizable public expenditure adjustment over the past few years, but underscored the need for further high-quality deficit reducing measures.

Abstract

This 2012 Article IV Consultation highlights that three years after the sudden end of Montenegro’s boom, there has been considerable progress toward recovery. Fiscal imbalances have proved difficult to rein in, reflecting a large fall in revenue after the collapse of the boom. Executive Directors have commended the authorities’ efforts to stabilize the economy, and welcomed the progress made since the financial crisis. Directors have also recognized the sizable public expenditure adjustment over the past few years, but underscored the need for further high-quality deficit reducing measures.

CONTEXT: THE BOOM-BUST CYCLE HAS NOT YET RUN ITS COURSE

1. Three years after the sudden end of Montenegro’s boom, some important adjustment has taken place, but the deleveraging challenge remains. Economic output has now almost regained its pre-crisis level and bank deposits are recovering (Tables 1-3). In other ways, though, the repercussions of the asset bubble and the rapid credit growth that fuelled the boom are still acute, most visibly in the sizeable and continuing buildup of public debt and a tightening liquidity squeeze in the economy. As recommended in the 2011 Article IV consultation, the authorities have progressed with repair of the banking system and initiated fiscal consolidation, but the weak economic outlook and political factors have presented obstacles.

Table 1.

Montenegro: Selected Economic Indicators, 2007–16

(Under current policies)

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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.

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

Includes extra-budgetary funds and 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.
Table 3.

Montenegro: Summary of Accounts of the Financial System, 2007–2012

(Millions of euros)

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

2. Montenegro’s experience reflects the challenges of its demanding policy framework and the economy’s high degree of openness. Without an exchange-rate and monetary-policy tool, fiscal policy was overburdened by the task of preventing overheating during the pre-2008 inflow-driven economic boom. Since then, government dis-saving partly offset the drag on domestic demand due to private sector deleveraging, but at the cost of rapidly accumulating public debt and still high external imbalances. With access to external funding markets more challenging, however, fiscal policy is now constrained.

3. With elections expected this year, the near-term economic policy reform agenda is light. Following progress with respect to EU accession—with the European Commission expected to initiate membership negotiations later in the summer—elections are expected to be called in late summer or early fall.

BACKGROUND AND RECENT DEVELOPMENTS: STRONGER HEADWINDS BUT EXHAUSTED POLICY BUFFERS

A. Further Adjustment Still Needed

4. The bust has so far been less severe than in comparable countries. (Figure 1) To some extent, this reflects data deficiencies and a later start of the boom compared especially to other fixed exchange rate systems. More importantly, however, the significant use of the public sector balance sheet has offset the impact of private deleveraging since 2008. Conversely, rebalancing has not significantly progressed, evidenced by lagging export growth, despite an increasingly buoyant tourism sector (Table 4).

Figure 1.
Figure 1.

Montenegro: Comparative Economic Trends Since Independence (2006-11)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Table 4.

Montenegro: Balance of payments, 2007-16

(Under current policies)

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

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

5. The recovery is at risk of stalling. High-frequency economic indicators depict a sharp weakening of activity in the fourth quarter of 2011 (Figure 2). Going forward, the policy buffers that have supported growth over the last two years are no longer available, while the international environment continues to be clouded. Staff project growth of only 0.2 percent in 2012 after some 2½ percent in 2011.

Figure 2.
Figure 2.

Montenegro: Real Sector Developments in 2011

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

  • The 2011 external demand boost is wearing off. Tourism was the main driver of growth—benefitting from new lodging capacity coming on stream, reductions in cost, and the re-orientation of package tourism away from traditional North-African destinations in the summer of 2011. However, a severe cold spell has cut electricity production in the early part of 2012 and necessitated imports, while additional short-term drag is expected from waning terms of trade and ongoing weakness in the eurozone.

  • Domestic demand is not picking up. Household demand and investment remain weak and bank credit continues to decline (Figure 3). Three larger foreign-owned banks, in particular, have curtailed new lending given the need to repair their balance sheets, in the context of dwindling support from their parent banks experiencing financial stress elsewhere. The largest domestic bank has only recently resumed lending.

  • Policy buffers are depleting. The repair of private sector balance sheets was more than offset by the public sector, in the process increasing debt some 15 percent of GDP, selling assets of 11 percent, and issuing guarantees of 8 percent (some 1 percent of which have already been called; Table 5). Faced with external financing challenges, the government is increasingly drawing down its deposits in banks, further aggravating the liquidity squeeze.

Figure 3.
Figure 3.

Montenegro: Financial Sector Developments in 2011

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Table 5a.

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

(Millions of Euro)

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

Includes republican budget and local governments.

According to GFSM 1986, payments of loan guarantees or related to court rulings are recorded as government expenses.

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

Table 5b.

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.

According to GFSM 1986, payments of loan guarantees or related to court rulings are recorded as government expenses.

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

Table 5c.

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

(Millions of Euro, GFSM2001)

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

Includes republican budget and local governments.

Table 5d.

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

(In percent of GDP, GFSM2001)

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

Includes republican budget and local governments.

uA01fig02

Public sector deposits

(millions of euro)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

B. A Fast Rise in Public Debt as Fiscal Imbalances Have Proved Difficult to Tackle

6. The end of the boom quickly turned budget surpluses into large deficits, resulting in a rapid rise in public debt. Deficits averaged 4.8 percent of GDP during 2008-11 and consistently overshot initial targets. Market access and World Bank lending facilitated financing these imbalances and public debt more than doubled in nominal terms.

Montenegro General Government Operations 2008-12

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Source: Country authorities and IMF staff estimates.

On accrual basis

  • Revenue collections dropped some 10 percent of GDP in two broad episodes. Since the crisis, the disappearance of some of the boom-level revenue base (characterized by massive absorption and booming real estate) was compounded by untimely cuts in the personal income tax and social contributions. Subsequent increases of excises and social contributions helped stabilize the revenue share, but 2011 again witnessed a sharp drop in social contributions and nontax revenues.

  • Most of the spending cuts came from capital expenditures. Tight control efforts on personnel expenditures ran into political difficulties.1 Expenditures on social security programs actually increased by more than 2½ percent of GDP, driving the social security deficit to 4½ percent of GDP in 2011, a level that now exceeds total capital spending.

  • Expenditure arrears became significant. Between 2008 and 11, arrears averaged 1¾ percent of GDP. Most reflected unbudgeted current expenses by line ministries, other agencies, and local governments. Measures taken in 2010 aimed at containing arrears, including publication of high frequency fiscal statistics, adoption of a single treasury account, and introduction of a mandatory reporting requirement for line ministries. These steps slowed down arrears accumulation in 2011, though still an estimated 1¼ percent of GDP were accrued.

  • Contingent claims materialized. In 2011, a loan guarantee extended to the steel plant in 2010 was called, adding 1 percent of GDP to the deficit. An additional €132 million (4 percent of GDP) in loan guarantees that were extended to the aluminum plant (KAP) are also at risk of being called.

  • Moreover, sizeable below-the-line repayments to non-banks occurred. They largely reflected ex-Yugoslav legacy restitution and compensation issues and implied additional market debt accumulation of 1¾ percent of GDP per year on average.

C. Rapid Deleveraging and Gradual Repair in the Banking System

7. Banks have significantly downsized their balance sheets since 2008 in response to the sharp decline in domestic deposits (Figure 3). While a return of confidence has resulted in a modest recovery of deposits, they remain more than one-fifth off their August 2008 peak.

8. Moreover, foreign parent-bank support has recently been reduced. By the later stages of the lending boom, banks had increasingly relied on foreign borrowing to finance credit expansion. This reliance rose further as foreign parents stepped up their support to offset the large deposit outflows in order to avoid an immediate disorderly adjustment to banks’ balance sheets. As deposits began to stabilize, however, flows from parents began to reverse and funding from parents declined steadily during 2010 and 2011 as credit lines were repaid. Banks’ foreign liabilities fell to 27 percent of total funding at end-February 2012, their lowest level since the end of 2007.

9. On the asset side, the deleveraging reflects a combination of bad-loan disposal and slow new lending. Bank lending more than doubled from the end of 2006 through September 2008, with rapid growth to both households and corporates fuelled by real estate speculation. Banks’ assets have since declined by 20 percent, with credit to the non-financial private sector contracting by one-third. By early 2012, banks had made considerable progress in re-aligning their lending with their domestic deposit base and the average loan-to-deposits ratio returned to end-2007 levels at 112 percent in February, bringing Montenegro much closer in line with regional peers.

  • A reduction of nonperforming loans (NPLs) was one factor. Reflecting a sharp reassessment of collection prospects and stepped-up Central Bank monitoring and provisioning requirements, banks aggressively sold bad loans to parents or factoring companies. This contributed to a sharp decline of NPLs from a high of 26 percent of gross loans in June 2011 to 16 percent at end-2011 (Table 6). Provisioning is, however, still lagging. While overall banking system profitability improved in 2011 with most banks recording positive results, the system as a whole continued to be loss making.

  • But bank lending was also curtailed. The existing debt overhang in the economy continues to limit prospective borrowers, while concerns about asset quality and the significant uncertainty over the economic outlook are constraining banks’ appetite for risk.

Table 6.

Montenegro: Financial Soundness Indicators of the Banking Sector, 2007–11

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Source: Central Bank of Montenegro.

Net interest income in percent of interest bearing assets.

D. Structural Reform Pushback from Insiders

10. Structural reform progress has somewhat slowed from the immediate post- independence period, when Montenegro championed rapid and comprehensive market liberalization. Recent international business environment and structural reform indicators suggest a slower pace in the past several years.

Global Rankings in Business Environment and Regulatory Framework

(total number of countries surveyed in parentheses)

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Sources: World Bank’s Doing Business database, World Economic Forum Global Competitiveness Report, World Bank’s Worldwide Governance Indicators, Institutional Investor.

  • Deep-seated problems in the enterprise sector are again coming to the fore. While the steel and aluminum enterprises were privatized before 2008, they remained a significant drain on public finances in the form of non-paid taxes, direct cash transfers, and loan guarantees. Public support to private enterprises mainly reflects the political clout of their unions, which in the Yugoslav system had broad powers to manage these plants. In 2011, the steel company was declared insolvent and in early 2012, the aluminum company was re-nationalized, in both cases triggering recourse by the previous private owners.

  • Labor markets don’t perform well: The unemployment rate remains at 18 percent, with a low level of participation in the labor force and a growing share of long-term unemployed (Figure 5). Meanwhile, the market for non-resident employment adjusts freely and efficiently. The 2010 reform, which liberalized the use of “fixed-term” contracts that were lower-cost and less regulated than “permanent contracts”, triggered significant duality in the labor market, with nearly all hiring since having taken place under fixed terms (see Annex I). Labor law amendments in 2011 have attempted to simplify labor market processes and provide scope for more flexible hiring and firing. At the same time, these amendments have substantially reduced the availability of fixed-term contracts, but by leaving in place many of the protections of permanent contracts, run the risk of depressing new hiring going forward. The government, employers and labor union representatives, however, agreed that these were welcome steps towards better functioning of the labor market while still maintaining appropriate protection for employees.

  • There are also weaknesses in product market regulation: There is survey evidence that high administrative barriers to business entry impede entrepreneurship and job creation. In the energy sector, price regulation contributed to the poor financial performance of the electricity producer, which has delayed further investments in this area. In the transportation sector, high airport fees may deter low-cost carriers from entering into Montenegro, adversely affecting the tourism industry.

Figure 4.
Figure 4.

Montenegro: Fiscal Developments in 2011

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Figure 5
Figure 5

Montenegro: Labor Market Indicators

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

REPORT ON THE DISCUSSIONS

A. Outlook and Risks

11. Staff and authorities agreed that sustainable medium-term growth required attracting large-scale FDI to unleash Montenegro’ significant potential. Given the limited amount of financing available domestically, foreign investment offers the benefit of a more rapid transition to higher income levels. The authorities observed that despite the ongoing sharp post-boom slowdown, FDI inflows still amount to more than 10 percent of GDP. They saw this as evidence of continued investor confidence that augured well for a quick pick up in FDI once global and European economic conditions improved. The staff concurred in principle, but noted that some of the recent FDI was in fact backward looking—for example bank recapitalization.

12. Differing views were held regarding competitiveness. Staff and authorities concurred that the application of traditional competitiveness analysis in Montenegro is subject to considerable uncertainty. In addition to the weak statistical base, the very small size of the economy implies that a few lumpy foreign investment projects—that need not be large in absolute terms—could drastically change the outlook, a fact not captured in standard real exchange rate assessments or the computation of current account norms. Even so, staff considered that competitiveness appears somewhat compromised, in particular in view of the poor labor market and export performance, indicators that are subject to less statistical uncertainty (Box 1).

13. All agreed that there was an abundance of risks at the current juncture, with staff viewing them as skewed to the downside. Staff’s baseline scenario is based on the current WEO forecast for a modest downturn in the euro area, but projections are very sensitive to prospects for tourism and foreign investment. A more pronounced deterioration in eurozone conditions with attendant spillovers would significantly worsen the growth outlook and prospects for achieving the planned fiscal adjustment. In addition to external risks, which also include parent-bank restructuring and commodity developments, there were large home-grown risks (see Risk Assessment Matrix, Annex II). In particular, if depositor confidence again retreated or if government were faced with another shock that would exhaust stretched deposits, some foreign parents may end support, thus triggering potential outward reputational spillovers despite Montenegro’s small size. The authorities considered that their macroframework with 0.5 percent GDP growth in 2012 already included a large part of the risks, and that there was significant upside, especially if conditions in the eurozone improved more than currently projected.

14. The outlook remains challenging. Looking ahead toward the medium term, the authorities expected a return to sustainability, while staff projected sub-par performance even after a resumption of inflows, given the erosion of past policy buffers and the difficult external and domestic environment. Moreover, and despite evidence of wage declines, inflation has remained above trading partner levels—recently reflecting food price increases—thus impeding the needed external adjustment.

15. Accordingly, staff argued for a significant recalibration of policies. Staff considered that the recent experience with public borrowing, which did not result in a lasting improvement in growth prospects or vulnerabilities, underscored the need to change the policy framework. Tighter fiscal policy, accelerated structural reform, and policies facilitating orderly banking sector deleveraging would attract and catalyze stronger inflows. The immediate priority was a substantial reduction in the fiscal financing requirement, while invigorating labor markets. The details are discussed in the following sections.

External Competitiveness

The application of traditional competitiveness analysis in Montenegro is subject to considerable uncertainty, given the very small size of the economy and the weak statistical base. Even so, competitiveness appears compromised.

A standard assessment of the real exchange rate using the CGER methodology indicates that Montenegro’s exchange rate is overvalued. However, there are large data uncertainties that make the exercise imprecise (errors and omissions amount to some 10 percent of GDP), and only a relatively short time series is available. In addition, there is considerable uncertainty regarding the country’s medium-term current account balance; for a small economy such as Montenegro, a surge in service exports or a contraction in imports can substantially narrow the current account gap without any underlying gain in competitiveness.

A look at the CPI-based REER estimates shows Montenegro’s REER began to depreciate again in 2011. Montenegro’s wage data show continued erosion in competitiveness stemming from its high labor costs. Over the past few years, gross wages have risen steadily while producer prices have been flat.

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

(in percent of GDP, unless otherwise specified)

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Source: IMF staff estimates

Rahman, Jesmin (2008). “Current Account Developments in New Member State of the European Union: Equilibrium Excess, and EU-Phoir,” IMF Working Paper 08/92.

Montenegro’s exports as a share of total world trade which began to decrease in 2008 have started to pick up again in 2011. On the other hand, its share of imports peaked in 2008 and has been declining ever since.

uA01fig04

Montenegro’s Export in World Trade

(percent of total world trade)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

The sector that has contributed to increased external competiveness is tourism. The tourism competitiveness ranking has improved substantially owing to a better regulatory framework and infrastructure. Moreover the growth of international tourist arrivals into Montenegro has on average outpaced the growth rates seen at the regional and world levels in the past four years. Given its importance in the Montenegrin economy, it is essential that the tourism sector continues to make gains.

uA01fig05

Growth in International Tourist Arrivals

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Competitiveness Ranting in the Tourism Sector

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Source: World Economic Forum. Note: Lower ranking indicates improvement.

B. Fiscal Policy

16. Despite a deterioration of the headline deficit in 2011, some tightening of the fiscal stance occurred. The authorities considered that the evolution of fiscal balances based on the GFSM accounting framework—which puts the overall deficit at a post-independence high of 6.3 percent of GDP because of the inclusion of guarantees at the time they are called—did not correctly reflect their fiscal efforts. Instead, they felt that it was preferable to include called loan guarantees in the fiscal accounts retroactively in the year in which they were extended. However, staff did not see a basis to depart from GFSM accounting.

  • Staff agreed that the payment of called-up loan guarantees in 2011 did not constitute a demand boost that year, but rather in 2010 when the guarantees were extended and largely used to finance the metal firms’ redundancy payments and arrears clearance.

  • No consensus was reached as to what extent the recently accelerating revenue shortfall reflected automatic stabilizers. On the one hand, imbalances in the economy—especially still large absorption—inflated the tax base for indirect taxes beyond its structural and sustainable level, such that lower VAT collections may still be a structural rather than cyclical phenomenon. In addition, tax administration problems became apparent in the recently consolidated collection of income taxes and contributions, as the latter dropped far more than the former, despite being levied on largely the same tax base. On the other hand, the liquidity squeeze was arguably affecting taxpayers’ ability to pay, though there were no firm data on the evolution of tax arrears.

Estmation of Fiscal Stance in 2010 and 11

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17. However, the underlying deficit is still large and risks of further slippage are substantial. Staff noted that the underlying deficit remained too high. Moreover, revenue and expenditure trends in the first part of 2012 had resulted in a considerable slippage from the budget plan, while the uncertain situation surrounding KAP posed substantial risks that new contingent claims would materialize.

Kombinat Aluminijuma Podgorica (KAP)

Kombinat Aluminijuma Podgorica (KAP) is the aluminum smelter in Montenegro. Up until recently, it has been operated by the Russian company Central European Aluminum Company (CEAC). The company acquired a majority share in KAP in 2005 when the plant was privatized. In 2010, the government retook half of CEAC’s stake in exchange for loan guarantees. KAP accounted for 41 percent of the value of goods exported by Montenegro in 2011.

The plant currently suffers from significant operational inefficiencies and is neither competitive nor profitable without large investments in technology upgrades. In recent years, the company has been able to sustain operations only with the support of government-issued loan guarantees and energy subsidies that constitute an increasing drain on public finances. In addition, despite favorable aluminum prices in 2011, KAP has been running large payment arrears on its electricity bills. As the largest energy consumer in the country, the mounting receivables are in turn threatening the viability of the electricity producer. Without these subsidies, staff estimates show that KAP would have made a €21.9 million loss in 2011, or 0.7 percent of GDP. With €132 million of its €350 million debt covered by state guarantees, KAP is currently the biggest and most imminent fiscal risk.

While KAP remains an important contributor to Montenegro’s exports, its overall macroeconomic impact has declined considerably over the past decade. The net impact on the balance of payments is mitigated by the imported inputs required (both electricity and alumina). Moreover, KAP has substantially reduced the number of workers in recent years and now accounts for only 0.8 percent of total employment. The direct impact on GDP from closing KAP due to decreased export is estimated at 1.3 percent (a similar estimate of 1.9 percent is obtained using the production approach). The short-term impact of closing down its operations would likely be substantially offset over the medium-term by efficiency gains realized from increased fiscal space, energy surplus, and reduced alumina import.

Estimated Impact of Closing down KAP

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18. The authorities aim at significant fiscal consolidation, targeting a deficit of 1.2 percent of GDP in 2012 and achieving balance in 2013 and were preparing a budget revision in light of the worsened outlook compared to the one assumed in the original 2012 budget. Staff considered these targets to be quite ambitious and cautioned that they will likely be missed again. Instead, the focus should be on urgent identification and implementation of high-quality structural deficit reducing measures that should reverse the debt dynamics quickly (See Debt Sustainability Analysis, Annex III).

19. Taxation and spending need to be brought closer in line, with the more sizeable adjustment from expenditure cuts. There was consensus that the revenue share remained at a comparatively high level, while expenditure stood at the top end of emerging Europe. Although some laudable progress was made on expenditure commitment controls, some deep-seated problems remain:

  • There was agreement that at some 12 percent of GDP, personnel spending is very large. The authorities pointed to last year’s adoption of their Personnel Policy paper, the resulting 2 percent staff cut, and the recent agreement with public sector unions to contain wage increases in 2012 and beyond. The staff welcomed these steps but cautioned that the complex triggers in the new agreement—tying the initiation of wage negotiations to growth and deficit performance—carried risks and that further staff cuts may be a more lasting solution.

Estimated Impact of Closing down KAP

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Note: Based on various sources of information. The Prescott tax wage seeks to account for the impact of consumption taxes on the labor-leisure choice. For details see Bell and Tawara (2009), IMF WP/09/92. i) 2011 Staff Report; ii) Tax comparison table prepared by Ruud De Mooij.

C. Financial Sector

20. The discussions were framed by the uncertainty about a viable post-boom banking business model. There was agreement that the uncertainty called for ongoing focus on protecting macrofinancial stability and liquidity as deleveraging evolves. The need for additional buffers arose from the unilateral use of the euro in Montenegro which essentially rules out significant central bank liquidity injections. Weaker foreign owners and liquidity stretched domestic ones further add to the challenges. There was broad agreement on the following elements:

  • Direct efforts to force more lending are unlikely to work and would probably require resources from the already stretched budget. While political concerns had arisen from the ongoing lending drought, and some big banks had stopped lending, other banks considered that there was a shortage of profitable lending opportunities. Central Bank and staff agreed that this called for further structural reforms.

  • Intense supervisory presence in banks and aggressive enforcement of regulations across the system: The risk profile and capital needs of individual banks should be carefully examined, including through the recently upgraded stress testing framework. Bank owners must meet capital shortfalls expeditiously or face sanctions. The Central Bank of Montenegro (CBCG) also plans to soon phase out temporary regulatory relaxations of prudential regulation and in their place adopt a permanent framework, which should be fully in line with international best practice.

  • Continued efforts to improve asset quality: The recent offloading of troubled assets to factoring companies, other investors, and parent banks needs tight monitoring, e.g., to guard against asset stripping. The CBCG pointed to its recent adoption of relevant regulations and broader work to formulate legislation. Staff stressed that further concerted efforts by the government, CBCG, and other relevant entities to improve the framework and processes related to the execution of collateral are also essential.

  • Raising and monitoring liquidity: The CBCG has stepped up efforts to monitor liquidity. While the government saw a case for raising the share of reserve requirements that may be held in treasury bills, staff and Central Bank remained unconvinced, stressing that doing so would impart additional risks and distort incentives for credit extension. Instead, staff recommended general reductions in reserve requirements once further gains in confidence and stability are made.

  • Further improving the framework for crisis preparedness and banking resolution: Considerable progress has been made in recent years, including the passing of a set of financial sector legislation and the creation of the Financial Stability Council (FSC) for cross agency cooperation. Further improvements should include concrete contingency plans. The ongoing work on a national contingency plan, in keeping with a decision by the FSC in its first meeting, and following Fund staff technical assistance, is therefore welcome.

D. Structural Reform

21. There was broad agreement that further ambitious structural reform can achieve the essential rebalancing without sacrificing growth by unleashing Montenegro’s large potential, especially in the energy and tourism sectors.

22. Labor market reform deserves priority status. A common factor in recent reform backsliding has been labor related, as difficulties in redressing overstaffing have loomed large in the problems in the metals sector. Staff called for further reform of labor legislation, importantly by making regular contracts more attractive for employers, including by giving greater scope to opt out from collective bargaining arrangements. Staff and authorities also saw scope to use public expenditure reforms—for example of social transfers—as a way to reduce unemployment traps.

23. The business environment needs nurturing and improvement. The authorities are focused on redressing gaps indicated in various business environment surveys, notably deficiencies in the time required to obtain construction permits and complete registration procedures, particularly at the municipal level. Staff noted that the recent public complaints about regulatory shortfalls or legal proceedings by foreign investors in the metals and energy sectors could imply adverse repercussions for Montenegro’s reputation as an investment destination and encouraged the authorities to demonstrate their commitment to arm’s length and rules-based relation with business, while continuing to streamline investment procedures.

24. Staff also stressed that liquidations and work-outs in the metals sector could be used to improve efficiency and productivity. Liquidations could well arise when public support stops, but would permit whatever parts of the enterprises that remain viable to be sold. Moreover, by now these companies’ direct employment effect is small as is their contribution to value added and the balance of payments, if properly measured (Box 2).

25. Continued improvements in economic statistics are also essential. Although there has been significant improvement in the number and timely release of high frequency indicators, inconsistencies across some indicators remain a problem. National accounts data are currently published only annually and with significant lags. External data are subject to frequent revisions, and there is evidence of continued export underreporting. Achieving data accuracy and timeliness will further contribute towards sound policymaking.

STAFF APPRAISAL

26. The Montenegrin economy has recorded valuable progress since the financial crisis. With GDP growth estimated at some 2½ percent in 2011, real output has almost reached its pre-crisis level in 2008. In addition, confidence in the banking system is recovering with deposits continuing to grow, while foreign direct investment remained above one tenth of GDP.

27. However, the recovery is now at risk of stalling. Economic activity indicators have slowed sharply as the boost from tourism has worn off, problems in the metals sector re-emerged, and the international environment turned more challenging. Liquidity is tight and the debt overhang hampers credit growth. After a very rapid buildup of public debt that served to offset the drag from private deleveraging, fiscal policy is now constrained. Accordingly GDP is projected to only record modest growth in 2012.

28. Current policies risk sub-par economic performance. While the economy’s small size and high openness impart a large degree of uncertainty on forecasts and projections, medium-term prospects are imperiled by large fiscal and external imbalances, even if the international context turns more auspicious. Ambitious structural reform can unleash Montenegro’s large potential, e.g., in the energy and tourism sectors.

29. The steep upward trajectory of public debt needs to be urgently reversed. This requires bringing taxation and spending closer in line in order to redress the large persistent fiscal deficits, which have withstood strong efforts at expenditure control and ambitious consolidation targets.

30. Specific deficit-cutting measures should be identified. Budget targets should be ambitious, yet achievable. The focus should be on urgent identification and implementation high-quality structural deficit reducing measures in order to reverse the debt dynamics quickly.

31. The more sizeable fiscal adjustment needs to come from expenditure cuts. The revenue share remains at a comparatively elevated level, while expenditure stands at the high end of emerging Europe. The very large personnel bill must be brought down and the recent sharp growth in entitlement spending reversed—notably by advancing pension reform. The fiscal drain from the aluminum and steel plants must be arrested by ending all fiscal and quasi-fiscal support.

32. There is scope to raise tax rates and strengthen tax administration. VAT and income tax rates are below levels in the region. The same is true for the tax wedge on labor. Limited rate increases would thus not significantly impede new employment, though care needs to be taken in raising indirect taxes in order not to heighten cost in the tourism sector. Moreover, flanking any rate increases by reducing poverty traps—for example by introducing an Earned Income Tax Credit—would provide an important boost for formal employment and tax collection.

33. Despite welcome stabilization, the banking system still has some way to go. A recovery in deposits together with a sharp slowdown in lending lowered the loan to deposit ratio. Still, the system remains burdened by high non-performing loans—notwithstanding their recent sharp decline—and is lagging in provisioning. Moreover, unilateral use of the euro in Montenegro essentially rules out significant central bank liquidity injections, thus requiring higher prudential buffers than elsewhere.

34. Continued vigilance is necessary to foster stability and create a sustainable foundation for a more broad-based resumption of lending. Supervision and regulatory enforcement need further strengthening, and bank owners must meet capital shortfalls expeditiously or face sanctions. Further efforts to improve asset quality and the framework and processes related to the execution of collateral are also essential. Administrative efforts to boost credit growth or direct lending to certain sectors should be eschewed as should selective relaxations of the reserve requirement.

35. Labor market reform needs to target employment creation. The well-functioning market for non-resident employment should serve as the model to redress poor labor market performance, characterized by high unemployment, low labor force participation, and a growing share of the long-term unemployed. The labor law must reduce hiring and firing costs and provide greater scope to opt out from collective bargaining arrangements. Social protection schemes should be reformed to ensure that benefits target the neediest and no longer serve as impediments to labor market participation.

36. The business environment needs nurturing and improvement. Montenegro has recorded steady progress in various business environment surveys. Still, the time required to obtain construction permits and complete registration procedures, particularly at the municipal level, continues to hamper new investment. Arm’s length and rules-based relation with business will also anchor Montenegro’s reputation as a safe haven for foreign investment. Continued improvements in economic statistics are also essential.

37. It is recommended that the next Article IV consultation with Montenegro be held on the standard 12-month cycle.

Annex I. Employment Gap in Montenegro’s Labor Market

The Montenegrin labor market continues to struggle with high unemployment rates, long unemployment spells, and falling labor force participation. For an economy dependent on labor-intensive primary industries and service exports, these problems are an important structural challenge for the medium- to long-term growth prospects. Since 2008, the quarterly unemployment rate in Montenegro has ranged between 16 and 21 percent. Such rates are among the highest and most persistent relative to comparators in the region and central Europe.

The unemployment problem in Montenegro is most severe among the younger generations. Those between ages 25 and 49 comprise the largest segment of the unemployed while the jobless rate is highest among those in the 15-24 age group.

uA01ann01fig01

LFS Unemployment

(percent)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

1/Annual data2/ Latest data from November 2011.
uA01ann01fig02

Unemployment by age group

(percent of total unemployment)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Source: Monstat’s Labor Force Survey
uA01ann01fig03

Unemployment by age group

(percent of age group labor force)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Source: Monstat’s Labor Force Survey

The high unemployment rate among the economically active young points to a gap between the skills supplied and demanded in the labor market. To an extent, this gap is driven by the mismatch in skills produced in the education system and those needed in the growing sectors. At the same time, the lack of unemployment deterrents and the existing structure of social safety nets may provide the jobless with an incentive to choose unemployment over certain types of jobs. Therefore, more and more foreign workers are hired into the economy each year to fill the labor need despite the availability of workers in the domestic labor market. In 2011, recorded foreign workers accounted for as much as 10.5 percent of the labor force.

uA01ann01fig04

Foreign Work Permits by Quarter

(thousands)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Source: Employment Agency of Montenegro

The jobless typically face long unemployment spells, during which previously acquired skills depreciate and job search becomes increasingly more difficult. Labor force survey statistics show that on average over 60 percent of the unemployed in Montenegro are without a job for more than two years. Since over 80 percent of the unemployed are below 50 years in age, it is the younger generations that make up the bulk of the chronically unemployed in the country. Such a structure of unemployment means that enhancing re-employment should be the immediate priority in order to prevent those with the highest productive potential from becoming discouraged with job search and leaving the labor force altogether.

uA01ann01fig05

Unemployment Spells

(percent of total unemployment)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Source: Monstat’s Labor Force Survey

Already there is evidence that job seekers are becoming discouraged and withdrawing themselves from the search process. The recent decline in the unemployment rate in Montenegro has been driven by a shrinking labor force rather than a higher rate of job creation. Over the past two years, the average labor force and the number of employed persons have fallen by 8 percent, whereas the inactive population has gone up by 3 percent.

uA01ann01fig06

Labor Force and Employment

(thousands)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Source: Monstat’s Labor Force Survey
uA01ann01fig07

Labor Force and Inactive Population

(percent of working age population)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Source: Monstat’s Labor Force Survey

Job creation with a focus on the domestic labor market should be the near-term imperative going forward. Recent amendments to the labor law have made progress by simplifying the dismissal and redundancy processes. On the other hand, however, the amendments have restricted hiring flexibility by regulating the availability and the duration of fixed-term employment contracts. Such a restriction detracts from the increased flexibility of the dismissal process and could be detrimental to job creation as the majority of new jobs over the last 3 years were generated through fixed-term contracts.

uA01ann01fig08

Permanent vs Fixed Term Contracts by Quarter

(percent of new employment)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.A001

Source: Employment Agency of Montenegro

Along with job creation, congruent measures to reabsorb the long-term unemployed and eliminate disincentives to work should also be considered. Reducing unemployment benefits and adopting the Earned Income Tax Credit policy, for example, would encourage greater job search efforts while offering training in areas where there is a skill shortage would improve the employability of the long-term unemployed.

Annex II. Montenegro Risk Assessment Matrix

article image

Annex III. Debt Sustainability Analysis

Table 1.

Montenegro: External Debt Sustainability Framework, 2007-2017

(In 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 Euro terms, g = real GDP growth rate, ε = nominal appreciation (increase in euro 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) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GD

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/ 2/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.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/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.4/One-time real depreciation of 30 percent occurs in 2010.
Table 2.

Montenegro: Public Sector Debt Sustainability Framework, 2007-2017

(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 + αε(1 +r)]/(1 +g+πr+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 Euro).

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 2.
Figure 2.

Montenegro: Public Debt Sustainability: Bound Tests 1/ 2/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2012, 122; 10.5089/9781475503876.002.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/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.4/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2010, with real depreciation defined as nominal depreciation (measured by percentage fall in euro value of local currency) minus domestic inflation (based on GDP deflator).
1

However, year-by-year comparisons are made very difficult by frequent reclassifications.

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Cover IMF Staff Country Reports
Montenegro: Staff Report for the 2012 Article IV Consultation
Author:
International Monetary Fund
Volume/Issue:
Volume 2012: Issue 122
Publisher:
International Monetary Fund
ISBN:
9781475503876
ISSN:
1934-7685
Pages:
61
DOI:
https://doi.org/10.5089/9781475503876.002
Figure 1.

Montenegro: Comparative Economic Trends Since Independence (2006-11)
Figure 2.

Montenegro: Real Sector Developments in 2011
Figure 3.

Montenegro: Financial Sector Developments in 2011

Public sector deposits

(millions of euro)
Figure 4.

Montenegro: Fiscal Developments in 2011
Figure 5

Montenegro: Labor Market Indicators

Montenegro’s Export in World Trade

(percent of total world trade)

Growth in International Tourist Arrivals

LFS Unemployment

(percent)

Unemployment by age group

(percent of total unemployment)

Unemployment by age group

(percent of age group labor force)

Foreign Work Permits by Quarter

(thousands)

Unemployment Spells

(percent of total unemployment)

Labor Force and Employment

(thousands)

Labor Force and Inactive Population

(percent of working age population)

Permanent vs Fixed Term Contracts by Quarter

(percent of new employment)
Figure 1.

Montenegro: External Debt Sustainability: Bound Tests 1/ 2/

(External debt in percent of GDP)
Figure 2.

Montenegro: Public Debt Sustainability: Bound Tests 1/ 2/

(Public debt in percent of GDP)