Abstract
KEY ISSUESContext: Moderate growth is continuing; however credit and wage growth are weak.The level of nonperforming loans (NPLs) remains high and public debt has risen sharplyin recent years.Fiscal policy: Medium-term funding needs to roll over existing debt and to fund budgetdeficits are large. A new highway, budgeted to cost about one quarter of GDP, will cause deficits to widen and add to public debt. The draft 2015 budget shows appropriate restraint on other spending, but a long period of strong fiscal discipline will be needed to manage fiscal risks. Laying out clear long-term plans for managing the public finances would boost credibility and reduce risks to market access. Fundamental expenditure reform, especially of the pension system and the public sector wage bill, would be an essential part of such plans.Financial sector: The banking system’s liquidity appears comfortable; however, profitability is low and lending spreads are high. Regulatory provisioning is set higher than that reported under international accounting standards, but a wide range of provisioning levels across banks and weak incentives to take losses remain concerns. A more transparent and comprehensive reporting environment would be beneficial.Reforms to ensure better enforcement of contracts and collateral would help bring down structural lending risk premia.Structural reform: Higher levels of labor participation and employment are needed to boost potential growth and safeguard the public finances. Ensuring that wages adjust in line with productivity alongside reforms to achieve better employment outcomes and boost productivity would enhance the economy’s ability to respond to macroeconomic shocks, and are even more important in a country that lacks its own currency and with decreasing fiscal buffers.
The Montenegrin authorities thank staff for the very constructive dialogue during their mission in Montenegro. They appreciate staff’s comprehensive analysis and broadly agree with their assessments and policy recommendations. Discussions have helped the authorities to frame the policy measures needed to boost growth and resilience of the economy, and safeguard the fiscal sustainability going forward.
Economic developments and outlook
The Montenegrin economy continues to grow against a challenging background. Real GDP rebounded by 3¼ percent in 2013, but has weakened in 2014 and looks likely to be close to 2½ percent for the year. The slowdown is attributable to the weakened external demand and the floods in the region. However, positive developments have been registered in tourism, construction, forestry and the retail trade. Although employment is on the rise, the unemployment rate is persistently high. Inflation has fallen sharply but remains in positive territory. Credit growth has still not recovered. The external position remains vulnerable, although the ongoing political uncertainties in the region so far have had only limited effects on the foreign direct investments and tourism performance.
The medium-term growth is expected to converge to about 3 percent backed by a number of ambitious, large-scale investment projects, including the start of the first stage of the Bar-Boljare highway (costing a quarter of the national product), as well as projects in the energy sector and tourism. The authorities expect positive spillover effects from these projects to the rest of the economy. The highway is especially critical in this regard, not only in economic terms, but also for safety reasons, regional development and broader integration. However, there are clear risks to the outlook, given the country’s high dependence on foreign capital inflows and substantial refinancing needs, and it’s vulnerability to downturns in external demand.
Fiscal policy
The fiscal consolidation continued with laudable adjustments in the last two years, narrowing the overall deficit from -5.9 in 2012 to -0.9 percent of GDP in 2014. Important steps including higher taxes, a freeze on pensions, and measures to fight the grey economy contributed to such significant consolidation. Nonetheless, the public debt is on the rise reaching 58 percent of GDP in 2014.
The authorities agree with staff that, given the cost of the highway, strong fiscal discipline will be needed to preserve the sustainability of public finances. The recently adopted budget for 2015 envisages appropriate measures which are expected to result in further improvement in the budget balance (excluding the highway spending). Apart from better revenue collection, the focus is on rationalization of the current expenditures, while the capital expenditures will be limited to essential infrastructural projects. The wage and pension bill as well as social transfers will be contained. Although staff expressed concerns about non-renewing of the pension freeze in 2015, the expenditure adjustment to the pensions is likely to be on the downside since they will follow the cost of living and the average wages in the economy which are both on a declining path.
As for the fiscal rule, the authorities agree with staff that there is room for further strengthening of the framework. They have also made progress in divesting from state-owned companies. A positive example is the long-lasting issue of the aluminum plant (KAP) which was successfully sold to a new owner. However, full payment is still pending due to a prolonged court procedure. Privatization of the shipyards is also expected to start soon.
Public debt sustainability
Staff’s public debt sustainability analysis (DSA) indicates serious vulnerability of the Montenegrin public finances in different scenarios. In the authorities’ view, the underlying drivers of the debt trajectory presented in the Staff Report are not fully capturing the spillover effects from the infrastructural projects on growth and inflation, which will likely mitigate the debt dynamics. Also, caution is warranted when interpreting the results of the shock-to-growth scenario, given the high volatility of domestic growth in the past.
As staff points out, the medium-term financing needs are considerable. In the authorities’ view, the financial burden to the budget from the repayment of the highway loan may be somewhat overstated. The terms under which the loan for the first stage was signed with the Chinese partners are rather favorable. The annual installments of about EUR 50-60 million (taking into account the revenues from tolling, the net fiscal burden would amount to about EUR 25 million annually) are manageable. If the construction is finished as planned by 2019 the budget would have two years of receiving tolls before the first installment is due. Regarding the exchange rate risks, the authorities are prepared to consider a swap arrangement.
In the event of shocks to public finance and unanticipated highway cost over-runs, the authorities are prepared to lay out a contingent consolidation plan. Cutting or delaying spending on the highway in the middle of the construction process would be counterproductive in their view. Instead, they would focus on tackling the current budget expenditures and boosting revenues, possibly through stronger taxation of goods like alcohol, tobacco and oil derivatives.
Monetary policy and financial system
The Montenegrin banking sector is sound and liquid, as indicated by the liquidity and solvency ratios. However, the banks are operating in a challenging environment which is reflected in their tight lending policy, weak credit activity and low profitability. Despite recent improvements, the level of non-performing loans is still high at around 17 percent. The authorities are taking comprehensive measures to address these challenges. The new regulatory framework on voluntary financial restructuring (Podgorica Approach) will be an important step to elevate the debt burden for solvent but illiquid companies and gradually facilitate the reduction in NPLs. From a financial sector perspective, closer monitoring of factoring companies would also have positive effects, given their important role in this process.
The high level of lending interest rates is another major concern, as it hampers the resolution of NPLs and holds back new lending. Given the complexity of the underlying factors that contribute to such financing conditions, efforts are being made to reduce market inefficiencies stemming from the lack of competition and limited business opportunities. Despite the limitations of a small market, addressing structural credit risks will be the key to revive lending activity. Strengthening the institutions and legal framework as well as the rule of law, especially contract enforcement, is the priority in this regard.
Competitiveness and structural reforms
The authorities recognize that structural reforms remain essential to raise potential growth and improve the flexibility and competitiveness of the economy. Their priority areas are the labor market, the pension system and the business environment. Labor market reforms are crucial given the high unemployment and low participation rate. Several reform initiatives have been implemented to increase the labor market flexibility by reducing dismissal costs and simplifying hiring. A temporary government-funded program for graduates is also in place with the aim to help integrating the young into the labor market. Efforts are made to better match the educational system and the labor market needs. Streamlining of the social benefits through the introduction of “social cards” will increase the transparency of the system and reduce the disincentives to work. With regard to the pension system, the ongoing reforms aim to reduce the deficit of the Pension Fund to a sustainable level, through better collection of contributions and stricter retirement rules.
The Montenegrin business environment stands relatively well in a regional context. The latest improvement, from the 42nd to the 36th position on the World Bank’s Doing business 2015 list, is mostly due to the improvements in obtaining construction permits, which is critical for the upcoming tourism projects. However, the procedures for starting a business, enforcing contracts, registering property, and tax collection remain very challenging. In addition to focusing on these priorities, the authorities also focus on attracting FDI, which is essential to promote economic diversification. Along with efforts to simplify the investment procedures, they are considering new incentives for foreign investors.