Montenegro: 2019 Article IV Consultation—Press Release, Staff Report, and Statement by the Executive Director for Montenegro
Author: International Monetary Fund. European Dept.
Publication Date:
10 Sep 2019
eISBN:
9781513513720
Language:
English
Keywords:
ISCR; CR; authority; debt; CBM balance sheet; development goal; MONSTAT; Montenegro; minimum wage; IMF staff calculation; feasibility study; wage freeze; labor force; Fiscal stance; Fiscal consolidation; Global; rate of return
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2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Montenegro

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Montenegro

Context

1. Montenegro is a small, open tourism-dependent economy. Rigid labor markets and weak demographics constrain economic growth. The Bar-Boljare highway project has significantly increased public debt (Box 1), necessitating a fiscal adjustment which began in 2017. With unilateral euroization, there is no independent monetary policy. Foreign-owned banks make up nearly ¾ of the banking sector by assets.

2. Since independence in 2006, Montenegro has made progress in legislative reform and institution building. Yet, weaknesses in financial sector oversight the application of the AML/CFT framework, tax administration, procurement, and the regulatory framework could create vulnerabilities to corruption. Technical capacity in public investment also needs to strengthen. Montenegro is an EU candidate country, with accession envisaged in 2025 at the earliest. Parliamentary elections are due by late 2020.

uA01fig01

Selected Sub-Components of Pillar 1. Institutions, 2018

(Index: 1–7, 7=best performer; 9 lowest indicators out of 12 total)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: World Economic Forum, Global Competitiveness Index; and IMF Staff calculations.

Recent Developments

3. Growth was strong in 2018. The economy expanded 4.9 percent, the fastest since 2008, following growth of 4.7 percent in 2017. Growth continues to be bolstered by public (highway) and private (energy and tourism) investment. Tourism experienced another record year. Private consumption remained strong, despite fiscal adjustment measures. Average inflation increased from 2.4 percent in 2017 to 2.6 percent in 2018, due to a VAT increase and oil prices. The unemployment rate declined from 17 percent in 2017 to 15 percent in 2018. Partially driven by a public sector wage freeze, average wage growth declined to 0.1 percent, down from 2.3 percent in 2017.

uA01fig02

Real GDP Growth Decomposition

(Percentage point contribution to growth)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Monstat; and IMF staff calculations.

Bar-Boljare Highway Project

The Bar-Boljare highway aims to connect Montenegro’s coast with Serbia. Only the first 41-kilometer phase—also the costliest due to difficult terrain—connecting Podgorica with the less-developed northern municipality Kolašin, at a cost of around €1 billion, is currently under construction. The remaining phases (totaling 136 kilometers) may cost somewhat more than the first phase. Phases 2 (21 kilometers from Mateševo to Andrijevica, with a possible cost around €300 million) and 3 (about 50 additional kilometers) would link the highway to the Serbian border. Phase 4 (about 65 kilometers) would extend the highway from Podgorica to the coast. An eventual corridor to Belgrade requires Serbia to extend a road currently under construction an additional 100 kilometers to the border.

China Road and Bridge Corporation started construction in 2015. Completion was initially expected in 2019 but has been delayed to 2020. Domestic contractors are allocated 30 percent of the work. China Ex-Im Bank is providing a USD-denominated loan for 85 percent of the total cost. The cost of phase 1 was initially set at €809 million (23 percent of 2014 GDP), but overruns may raise the cost by about 7 percent. Because of subsequent USD appreciation, and unhedged currency risk, the cost has increased a further 18 percent. The loan carries a 2 percent interest rate and a 20-year repayment period. Principal payments begin in 2021.

uA01fig03

General Government Debt with Guarantees

Percent of GDP

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

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

Highway construction has weighed heavily on public finances. Had the first phase not been built, the tough fiscal adjustment strategy adopted in 2017 would not have been necessary to return debt to sustainable levels. Assuming no highway spending and a primary surplus of 1 percent of GDP (consistent with the non-highway primary balance before the 2017 fiscal strategy), government debt including guarantees would likely have declined to 59 percent of GDP by 2020 instead of rising to a projected 82 percent of GDP.

4. Fiscal adjustment continued in 2018, with some setbacks. The authorities continued the 2017 adjustment by increasing the VAT 2 p.p. and continuing a partial public sector wage freeze. However, the July 2018 supplemental budget slowed the pace of tobacco excise increases due to increased smuggling. The supplemental budget also had to accommodate new public sector hiring. The primary fiscal deficit declined from 4.5 percent of GDP in 2017 to 4.1 percent of GDP in 2018. Excluding highway spending, the primary balance improved by 3 p.p. of GDP since 2016, indicating continued progress in the underlying fiscal adjustment. General government debt (including guarantees) reached 79 percent of GDP, up from 74 percent of GDP in 2017.

uA01fig04

General Government Primary Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Ministry of Finance; and IMF staff calculations.

5. The authorities intervened in two banks in 2018. Longstanding weaknesses in two related non-systemic domestic banks (Atlas and IBM) worsened in late 2018, forcing the Central Bank of Montenegro (CBM) to intervene by installing interim administrations and freezing deposit withdrawals.1 The CBM placed the smaller of the two banks (IBM, 1 percent of system assets) into bankruptcy within one month and placed Atlas (5 percent of system assets) into bankruptcy in April 2019 following unsuccessful offerings for new private capital. By early June, the Deposit Protection Fund (DPF) had paid out 84 and 73 percent, respectively, of eligible insured deposits.

uA01fig05

Bank Lending by Sector 1/

(Percent, year-on-year)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

1/ 2019 data distorted by recent Atlas/IBM bankruptcies.Sources: CBM; and IMF staff calculations.

6. These interventions have not triggered spillovers into the broader banking sector. Despite the freeze on deposit withdrawals from the two intervened banks, system-wide deposits have been stable. Non-performing loans (NPLs) declined from 8 percent at end-2017 to 7.5 percent at end-2018. Private sector credit growth strengthened to 9.1 percent, led by household lending. Following the closure of the intervened banks, NPLs declined further to 5.3 percent in April 2019. The aggregate capital adequacy ratio of 15.3 percent remains above the minimum of 10 percent, while provisioning has improved. Liquid assets remain high at 22 percent of total assets.

7. External imbalances remain elevated. The current account deficit increased 1 p.p. in 2018 to 17 percent of GDP. While goods and services (especially travel services) exports expanded, imports also increased strongly, driven by oil and investment-related goods (including machinery). Net FDI declined to 7 percent of GDP from 11 percent of GDP in 2017. Driven mainly by the government’s issue of a Eurobond, external debt increased 8 p.p. to 167 percent of GDP in 2018.

Outlook and Risks

8. Growth is expected to moderate as highway investment peaks. The authorities have not yet defined the model or timing for construction of further phases of the highway. Therefore, baseline projections assume no further construction past phase 1. Growth is projected at 3.0 percent in 2019, driven again by domestic demand. With highway spending likely already having peaked in 2018, public investment will begin to act as an increasing drag on growth over 2019–21 as highway construction ends. Growth is projected to decline towards 2.5 percent in 2020 before increasing to around 3 percent over the medium term. Private investment, driven by tourism and energy sectors, is likely to remain strong over the medium term at around 21 percent of GDP. However, with public investment at a lower level, the contribution of investment to growth will moderate. Household consumption growth—alongside household credit and employment growth—is projected to moderate over the medium term to around 2 percent, compared to an average of 4.5 percent over 2016–18.

uA01fig06

Real GDP Growth Decomposition: 2018–2024

(Percentage point contribution to growth)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Source: Monstat; and IMF staff projections.

9. The medium-term supply-side effects of highway completion are uncertain. With highway spending peaking and the underlying fiscal adjustment nearly complete, the medium-term growth outlook depends partially on how supply-side effects of the completed first highway section balance the contractionary effect of lower public investment Albeit uncertain, these effects are estimated to be moderate compared to a typical investment project due to the low economic rate of return.2

uA01fig07

Highway/Fiscal Adjustment: Contribution to GDP Growth

(Percentage point contribution to real GDP growth)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: IMF staff estimates and projections.

10. External and domestic risks persist.

  • The external environment is the main risk: The need to refinance Eurobonds maturing in 2020/21 leaves Montenegro (B+/B1 rating) vulnerable to a tightening in global financial conditions. These risks could be largely mitigated with a successful Eurobond issue later this year. The current account deficit is projected to stay elevated, highlighting Montenegro’s dependence on FDI and external debt financing. A significant slowdown in growth in Europe could also pose risks for tourism. On the other hand, new investments in tourism facilities, could provide new tourism receipts.

  • Domestic risks relate mainly to sustaining fiscal consolidation. Parliamentary elections due in 2020 could pose a risk for fiscal discipline. Pressures to move ahead with further phases of the highway, or other large projects, without the necessary fiscal space may prove difficult to resist. Any further banking sector weakness could erode confidence and adversely affect financial stability and fiscal sustainability.

Figure 1.
Figure 1.

Montenegro: Real Sector Developments

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: CBM; Monstat; and IMF staff calculations.
Figure 2.
Figure 2.

Montenegro: Fiscal Developments

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: CBM; Ministry of Finance; and IMF staff calculations.
Figure 3.
Figure 3.

Montenegro: Tourism Developments

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Monstat; Eurostat; CBM; Haver Analytics; and IMF staff calculations.

Policy Discussions

11. Policy discussions focused on three key issues: (i) consolidating the gains from fiscal adjustment, while weighing carefully the costs and benefits of further near-term construction of the Bar-Boljare highway; (ii) strengthening banking and AML/CFT supervision to safeguard financial stability; and (iii) improving labor market outcomes. Governance-related discussions focused on the structure of financial sector oversight, developing stronger AML/CFT supervision tools, and increasing the capabilities of tax administration.

A. Fiscal Policies

Rebuilding Fiscal Space: Preserving Fiscal Adjustment, and the Medium-term Reform Agenda

12. The bulk of the fiscal adjustment strategy has been implemented. The authorities have implemented 4½ percent of GDP in adjustment measures over 2017–19 (Table 1). The 2019 budget contained no further setbacks as did the 2018 supplemental budget. The primary balance is now projected to peak at 2.7 percent of GDP in 2021 (after the conclusion of highway spending), compared to a previous projection of 4½ percent of GDP based on the original 2018 budget.

Table 1.

Montenegro: Staff Assessment of Fiscal Adjustment Factors 1/

Permanent fiscal impact (percent of GDP)

article image
Sources: Montenegrin authorities; and Fund staff estimates and projections.

In this table, a positive (+) sign indicates an improvement in the fiscal balance, while a negative (-) sign represents the opposite. A positive entry followed by “…” indicates a permanent impact in year 1, with no further impact in year 2 relative to a scenario without fiscal adjustment.

Fuels excise was increased as part of the 2017 budget.

The tax debt rescheduling raised a large amount of revenues in 2017, but these revenues are not permanent. Negative signs in later years indicate that the amount raised will be smaller than the previous year.

Social contributions made by government for mothers who received the social benefit and were previously employed. This is offset by equivalent spending by the government to make the contributions.

Dividend payments from state-owned electricity generator.

Includes the savings from partial wage freeze relative to alternative scenario with wage increases.

The authorities intend to reduce staffing levels at central and local government levels. Because the results are still uncertain, staff has not yet included savings in projections.

Includes support for Montenegro Airlines, the health sector, and other spending not envisioned in June 2017 spending projections.

Beginning in 2019, highway expenditures will begin to decline, and spending should stop in 2021, producing an automatic improvement in the fiscal balance.

uA01fig08

General Government Primary Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Ministry of Finance; and IMF staff projections.

13. Successful debt management operations have reduced, but not eliminated, refinancing risks. In 2018, the authorities pre financed their 2019 financing needs by issuing a new €500 million Eurobond, which included the exchange of 1/3 of €1 billion in Eurobonds that were maturing in 2019–21. The authorities are exploring €500 million Eurobond issuance in 2019, which if successful would pre-finance the amortizations of the 2020 and 2021 Eurobonds. This would increase general government debt with guarantees to 89 percent of GDP.3

14. Staff underscored the need to maintain a primary fiscal surplus of at least 2 percent of GDP over the medium term. Under current policies (without further highway construction past phase 1), the primary surplus is projected around 2 percent of GDP over the medium term. Should planned bond issuance be completed successfully, there would be a significant decline in near-term refinancing risks, and currently projected primary surpluses are adequate to lower the trajectory of public debt and rebuild fiscal space to cope with future shocks. Under current policies, government debt including guarantees is projected to decline strongly beginning in 2020, reaching 61 percent of GDP in 2024. However, in the unlikely event of prolonged external market closure, the achievement of a peak primary surplus of 4½ percent of GDP by 2021, along with additional domestic funds, would be necessary to fully meet financing needs.

uA01fig09

General Government Debt with Guarantees

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Ministry of Finance; and IMF staff projections.

15. Additional desirable reforms would create space for a more growth-friendly budget. The authorities plan to reduce government employment where inefficient and eliminate tax expenditures, especially related to the VAT, as part of EU directive harmonization. Pension reform is also important These initiatives are not included in the baseline.

  • Government employment (Annex VIII): The authorities aim to reduce employment at the central and local government levels, respectively, by 5 percent and 10 percent by 2020. The limited progress in 2018 underscores the difficulty of these reforms. The authorities should review active labor market policies to transition redundant employees to the private sector. Current plans to offer zero-interest loans to start businesses are not well targeted.

  • Tax expenditures: As recommended by FAD TA, the authorities should work to establish a transparent benchmark tax system based on economic grounds to estimate and phase out tax expenditures related to the VAT and other taxes. The authorities intend to move forward in 2019 to eliminate VAT tax exemptions, which they estimate totaled some 0.8 percent of GDP in 2018.

  • Pensions: Eligibility for early retirements should be tightened and early retirement actuarial penalties increased. Pensions should be valorized by wages and benefits indexed to inflation. Valorization by wages is necessary to maintain socially sustainable replacement rates. Eligible pension ages should be linked to life expectancies.4

16. Stronger fiscal institutions are needed to promote better medium-term adherence to fiscal targets.5 A comprehensive medium-term budget framework is needed, with more binding medium-term expenditure limits and the need to reconcile and justify deviations from these limits. The authorities could consider an overall expenditure limit based on the envelope of the medium-term budget. Any legislation with budgetary consequences should require an assessment by the Ministry of Finance.

17. The continuation of recent tax administration improvements would help generate additional revenues while combating the grey economy. Fiscal Affairs Department (FAD) TA has enabled the development of a multi-year agenda with the tax administration (MTA) to build on prior gains in tax administration. Tax arrears have been reduced, and a strategy with a clear reform direction to overhaul auditing and compliance has been adopted to focus on major tax risks. The government has also granted operational autonomy to the MTA. Yet, the operationalization of these significant reforms will encounter challenges. Legislative changes to the interest and penalty regime are also necessary to induce greater tax compliance.

18. The materialization of additional upside risks would increase scope to rebuild fiscal space. The authorities also hope to raise additional revenues through airport concessions, economic citizenship, and electronic fiscalization. Given the large uncertainties associated with these plans— both in terms of timing and magnitude—they have not been included in the baseline. Progress in these areas could significantly improve the outlook. Given the uncertainties, however, it is important to refrain from spending resources that have not yet materialized.

Authorities’ Views

19. The authorities broadly agreed with staff’s policy recommendations. The authorities agreed on the importance of maintaining primary surpluses to reduce debt. Compared with staff’s primary surplus projection of 2.7 percent of GDP in 2021, the authorities forecast a primary surplus of 4.6 percent of GDP, based on lower projections of spending on the government wage bill, transfers to public institutions, and capital expenditures, and gains to revenues from fiscalization. The authorities plan to complete medium-term refinancing needs with an additional Eurobond this year. They expected that a forthcoming offer of severance packages would help facilitate the planned reduction of public sector employees. They also agreed on the importance of further pension reform but did not plan to re-open the issue in 2019. The authorities plan to implement a medium-term budget beginning in 2021.

A More Careful and Considered Approach to the Bar-Boljare Highway Project

20. Staff advised the authorities to weigh the benefits of the Bar-Boljare highway project carefully against alternative uses for scarce public resources. With phase 1 of 4 to be completed in 2020, the authorities are weighing options for phase 2. Past feasibility studies completed several years ago estimated a low economic return on the overall highway, based on limited potential for toll revenues relative to the cost. Risks of delayed implementation of the Serbian section raise further questions. In this context, staff pointed to the need for better infrastructure and more public goods (such as waste water treatment) in areas which already experience significant bottlenecks, as well as for more and better targeted education and health spending (Figure 4). Staff urged the authorities to closely consider such opportunity costs before prioritizing one highway project with an uncertain rate of return.

Figure 4.
Figure 4.

Montenegro: Expenditure Efficiency

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: IMF FAD Expenditure Assessment Tool; World Bank Database; Making Public Investment More Efficient. IMF, 2015; and IMF staff calculations.

21. A rush to complete the highway is likely to jeopardize fiscal sustainability. Completion of the phases 2–4 of the highway could cost an additional 25 percent of GDP. Should the authorities move ahead to complete the highway over 2021–26 with new debt financing, general government debt (including guarantees) could remain over 80 percent of GDP for most of the 2020s, versus reaching 50 percent of GDP by 2030 in the baseline. Returning debt to the baseline level in 2030 would require a new round of fiscal adjustment around 3 p.p. of GDP over 2021 -23 and the maintenance of primary surpluses averaging nearly 4 percent of GDP over 2026–2030 (Figure 5). Completing and sustaining a new fiscal adjustment of this size would be difficult.

Figure 5.
Figure 5.

Montenegro: Fiscal Scenarios for Highway Completion

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Ministry of Finance; and IMF staff projections.

22. Further highway planning should be paused until a new and credible feasibility study is completed. The authorities have commissioned a feasibility study to be completed in 2020. With results of the study, the authorities should weigh its rate of return against other priority infrastructure projects. Should they decide to proceed, the authorities are advised not to embark on further construction or its financing until at least 2023, when general government debt (by the authorities’ definition) is projected to decline below 60 percent of GDP. Phase 2 alone is likely to be less expensive (roughly EUR 300 million, or 5 percent of 2023 GDP) and to deliver a significant share of the envisaged benefits by further connecting the north and tourism areas. Assuming the feasibility of securing grant financing for 20 percent of phase 2 costs, a modest, temporary fiscal adjustment of 1 percent of GDP (returning the primary balance to the current baseline during construction) would be sufficient to nearly return debt to the baseline by 2030.

uA01fig10

General Government Debt with Guarantees

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Ministry of Finance; and IMF staff projections.

23. Continuation of the highway through a PPP structure could also entail significant fiscal costs. The authorities are keen to explore a PPP structure to complete the highway to avoid taking new debt onto the government’s balance sheet. Should the feasibility study suggest that the remainder of the project is unlikely to meet a private partner’s required rate of return, a private partner would likely require guarantees from the state. The assumption of certain risks by the state -including construction, availability, and demand risks – would according to Eurostat rules require the project to be recognized on the government balance sheet, thus having an equivalent effect to the project being financed by government debt. The need to make minimum revenue guarantee payments from the budget could also impose significant expenditures over a lengthy concession contract.

24. More robust investment management and PPP frameworks are needed. For the Bar Boljare highway and other projects, it will be critical to establish a strong legislative and institutional framework to analyze projects, identify fiscal risks, and give the Finance Ministry a strong role in safeguarding public finances. The authorities have drafted a new Law on PPPs, strengthened through FAD input.6 Staff also advised the authorities to consider a Public Investment Management Assessment (PIMA) TA from FAD.

Authorities’ Views

25. The authorities emphasized that they would proceed cautiously on further highway construction. Pending the results of the new feasibility study in 2020, the authorities plan to analyze possible financing models for phase 2, including through a PPP or on-budget public procurement They stated that they viewed the completion of the first phase as the top priority and that they would not proceed with phase 2 unless questions about feasibility and financing are resolved such that fiscal sustainability is not jeopardized.

B. Financial Sector Policies

26. Initial steps taken by the CBM regarding Atlas/IBM could not prevent their eventual failure. The 2015 FSAP identified three weak domestic banks. In 2017 the CBM placed Atlas and IBM, along with a larger domestic bank (11 percent share) under supervisory action plans. Subsequent examinations of Atlas and IBM in 2018 revealed a high level of NPLs, inadequate provisioning, and significant lending to related parties. These problems were more acute for IBM, and it was placed into bankruptcy within one month of interim administration. Montenegrin prosecutors froze a sizeable portion of Atlas clients’ deposits due to concerns about money laundering, previously undetected by nearly annual full scope AML/CFT on-site inspections. The deposit freeze also severely lowered Atlas’ liquidity.

27. However, no immediate fiscal and real economy spillovers from these closures have materialized. With large related-lending activity, the closed banks did not play a significant role in credit creation, minimizing real economy spillovers. The deposit insurance fund promptly began to pay insured depositors without recourse to its EBRD credit line. Some local governments, however, have lost uninsured deposits.7 The central government will not compensate their losses.

28. These events do highlight the need for stronger banking supervision. The CBM’s supervisory structure needs enhancement, the process needs to be more risk based, and tools for credit risk supervision require further improvement. The CBM needs to focus on increasing the effectiveness of measures, not only their administrative enactment. The CBM is receiving TA from the Monetary and Capital Markets Department (MCM) to support these efforts.

  • Supervisory Committee: The CBM’s supervisory structure will now be strengthened by the establishment of a supervisory committee to better support decisions made by senior management. This staff-level committee with auditable activities aims to bring together all relevant supervisory expertise within the CBM, including on AML issues, and will vet all supervisory decisions, while avoiding the dilution of responsibilities.

  • Off-site supervision: Capacities for off-site supervision need to be strengthened, including by ensuring the availability of well-qualified and appropriately-compensated staff. Continuous off-site supervision and analysis is necessary to better inform and prepare on-site supervision, as well as to help identify systemic risks at an early stage.

29. A thorough asset quality review (AQR) is essential to provide a full diagnostic of banking sector health. This is a key recommendation pending since the 2015 FSAP. The AQR needs to be completed no later than end-2020 to help understand the true value of assets on bank balance sheets, the valuation of collateral (including real estate), and the adequacy of provisioning against potential losses. To ensure the integrity of the process, the AQR needs to be carried out by reputable international assessors.

30. Decisive action is needed to address any residual banking sector vulnerabilities. Informed by the AQR and ongoing supervision, any other weak banks in the system need intense scrutiny with effective action plans and timely enforcement. The CBM is also closely monitoring the rapid growth of uncollateralized consumer lending – often having long maturities and higher interest rates than collateralized loans – and should implement as needed effective macroprudential measures to pre-empt the buildup of systemic risks.

uA01fig11

New Loan Origination

(Index, 2012 = 100; >1 year maturity)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: CBM; and IMF staff calculations.

31. The CBM is continuing its efforts to improve the regulatory framework for the financial system. The credit registry has been modernized and now covers a broader range of financial institutions with additional information. The rules for asset classification have also been gradually tightened, including with the implementation of IFRS-9 in January 2018. Effective July 2019, asset classification rules have been tightened by reducing the possibility that adequate collateral could prevent a reduction in asset classification. The CBM adopted in July a decision to remove the remaining reference to “prime” collateral for asset classification, effective in 2020.

32. The CBM has prepared a comprehensive package of legislation that would harmonize banking laws with EU directives. Legislative approval is expected later this year. The new legislation will increase the minimum capital requirement for new banks from EUR 5 to EUR 7.5 million. Banks will be required to develop clear recovery plans, and the CBM will establish a resolution fund to be financed by banks, with a special resolution unit within the CBM. The deposit protection fund will double the coverage of insured deposits to EUR 100,000, gradually shorten the mandate payout time, and be permitted to use its resources to finance the transfer of insured deposits from unresolvable banks to healthy ones (purchase and assumption).

Figure 6.
Figure 6.

Montenegro: Credit Developments

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: CBM; and IMF staff calculations.
Figure 7.
Figure 7.

Montenegro: Banking Sector Developments

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: CBM; IMF FSI database; and IMF staff calculations.

33. NPL ratios are expected to further improve, driven by continued credit growth and improved debt service. Loan restructuring and NPL sales should play a smaller role than in the years following the global financial crisis. The so-called “Podgorica Approach” to facilitate out-of-court restructuring has now expired. There is also room to improve debt recovery ratios, compared to peers.

uA01fig12

EU and West. Balkans: Resolving Insolvency, 2018

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Source: World Bank, Doing Business 2018.

34. Montenegro still has many banks relative to its size. With 13 banks in a small country, high fixed costs and increasing regulatory costs, following the implementation of the envisaged Basel III prudential framework, will trigger additional earnings challenges for small banks. After the completion of the purchase of Société Générale’s subsidiary by OTP, the number of banks will fall to 12. The CBM should forcefully apply prudential regulation and grant any new licenses carefully. Empirical evidence suggests that good governance practices – ranging from the rule of law, regulatory quality, government effectiveness, control of corruption, effectiveness of the insolvency framework, and contract enforcement -usually correlates with lower financial intermediation costs.8

uA01fig13

Net Interest Margins of Banks in Montenegro and EU

(Percent)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Source: Thorsten Beck, Aslı Demirgüç-Kunt and Ross Levine, 2000, “A New Database on Financial Development and Structure,” World Bank Economic Review 14, 597–605. Database updated July 2018. Note: Net interest margin defined as the accounting value of banks net interest revenue as a share of its interest-bearing (total earning) assets.1/ Simple average of current EU members; missing 2015–2016 Finland observations.

35. The AML/CFT regime needs to be further strengthened to mitigate financial stability risks. The new AML/CFT law has improved the legal framework, and the CBM has issued detailed guidelines to provide guidance to banks on ML/TF risk analysis, but actions are needed to strengthen AML/CFT supervision by developing risk-based tools and procedures for offsite monitoring and onsite inspections. The fit and proper tests for banks’ owners and managers need to be formalized and applied consistently.9

36. The investor citizenship program launched this year creates potential financial integrity and reputational risks that should be addressed. The authorities should ensure implementation of comprehensive due diligence measures on applicants, including on their source of wealth and funds, as well as good transparency practices, including publication of the names of the new citizens.

Authorities’ Views

37. The CBM stressed that the overall banking system has remained stable, highly liquid, and well capitalized. Apart from Atlas/IBM, the overall sector was profitable. They also stressed that they are moving to contain remaining pockets of vulnerability, including through continued efforts to strengthen a third weak bank. The improved credit registry and the tightened asset classification will improve credit risk assessment and reduce information asymmetries. The CBM is studying the increase in uncollateralized cash loans and plans to shortly introduce macroprudential measures.

38. The CBM acknowledged the need to further improve bank supervision. In line with staff advice, the CBM has established a supervisory committee to better the support senior management. The offsite unit will be strengthened with additional staff. A separate AML Directorate has already been formed, and additional staff are being hired. The CBM is working to make the supervisory approach more risk-based to better allocate scarce resources. The legislative package transposing pertinent EU banking directives, which is expected to be adopted in late 2019, will bring the CBM’s banking supervision and crisis management tools in line with EU practices. The CBM also reiterated its commitment to completing an AQR of the banking system by end-2020 and has begun creating an action plan, defining a timetable, and drafting terms of reference for independent international assessors.

C. External Competitiveness and Labor Markets

39. The external position is assessed to be weaker than fundamentals and desirable policy settings warrant (Annex IV). Since 2010, the REER has appreciated 4 percent, in line with regional peers. The EBA-lite current account model suggests that the REER is overvalued by 12 percent, while the REER regression model estimates the REER to be in line with fundamentals. On balance, staff believes that the REER is overvalued by 10 percent due to persistently large current account deficits, high unit labor costs, stagnant productivity, and weak goods export performance. Gross international reserves appear adequate.

uA01fig14

Real Effective Exchange Rate

(Index; 2010=100)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: IMF INS database; and IMF Staff calculations.
uA01fig15

Volumes of Goods and Services Exports

(Index, 2006=100)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Monstat; and IMF staff calculations.

40. Labor market outcomes remain weak. Despite an improvement in recent years, labor force participation remains low, and the unemployment rate is still high at 15 percent. The informal economy employs an estimated quarter of the labor force, and more than 30 percent of workers are employed on temporary contracts, the highest rate in Europe.

  • Reduction of labor tax wedge: The tax wedge, at nearly 40 percent, is the second highest in the Western Balkans.10 A large tax wedge reduces incentives for employment in the formal sector, particularly for low-wage earners. The authorities intend to implement in the second half of 2019 a 2 percentage point reduction in employers’ health insurance contributions, which would reduce the cost of employment. Such a reduction will reduce revenues by about 0.5 percent of GDP. The authorities expect that an increase in the minimum wage (see below) will partially offset the revenues losses. The authorities should ensure that lost revenues are fully offset through a reduction in tax expenditures. They could also consider extending the 11 percent upper tax rate on personal income past end-2019, when it is currently set to expire.

  • Labor Law: Employees on temporary contracts usually experience lower job security and development opportunities than those on open-ended positions. Montenegro’s draft new labor law (expected to be approved in 2019) appropriately aims to ease the most rigid employment protections, including large severance payments under regular contracts. By narrowing the gap between temporary and regular contracts, the draft law aims to make the use of open-ended contracts more attractive. The law will also extend the maximum length of fixed term contracts from 24 to 36 months, with some greater exemptions for seasonal activities. Before the law is finalized, the authorities should also ensure that requirements for organizational charts and classification of positions does not impose an unreasonable administration burden on micro enterprises.

uA01fig16

Productivity and Labor Costs

(Index, 2008 = 100)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Monstat; WEO; and IMF Staff calculations.

Remittances in Montenegro

Registered inflows of remittances appear low, given the very high expatriated share of the Montenegrin population. About 38 percent of the population living in Montenegro has resettled abroad, mainly in several neighboring countries, which suggests a high dependency on remittances. However, Montenegro’s recorded remittance inflows are smaller than regional peers and remain lower than FDI inflows.

uA01fig17

Montenegrin Expatriates: Country of Settlement

(Percent, 2017)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Source: World Bank.
uA01fig18

Remittances and FDI Inflows, 2017

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: National Authorities; WIIW FDI Database; and IMF staff calculations.

The actual magnitude of remittances may be much higher and could help explain the large share of the informal economy in Montenegro. Reported remittances are mainly based on bank reports and underestimate actual cash inflows. A steady flow of unreported cash transfers primarily supporting family incomes and new real estate construction could help entrench a high level of informality in the economy.

uA01fig19

High Protection of Regular Contracts Associated with Greater Temporary Employment

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Eurostat and OECD.
uA01fig20

OECD Index of Regular Employment Protection

(Scale 0–6, 6=most restrictive)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: OECD; and IMF Staff calculations.
uA01fig21

OECD Index of Temporary Employment Protection

(Scale 0–6, 6=most restrictive)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: OECD; and IMF Staff calculations.

41. The authorities need to balance competing considerations for future decisions on the minimum wage. The government plans to increase the minimum wage 15 percent in the second half of 2019, the first increase since 2013. The net minimum wage will increase from EUR 193 to 222 per month, thus increasing modestly the ratio to the average wage from 38 to 42 percent This ratio and the absolute level of the minimum wage had been below regional peers but will now shift towards the regional average. The stagnant minimum wage had also not kept pace with increases in the poverty line. Yet, the hike exceeded both accumulated inflation and average wage gains of 6 percent since the last increase in 2013. In discussions with social partners, the government emphasized the importance of containing the fiscal impact of the minimum wage. For future discussions, the authorities are advised to assess the impact of prior minimum wage increases and consider a broad set of labor market indicators, including the poverty line, trends in average growth, productivity, and migration.

uA01fig22

Wages and Productivity Growth

(LHS: Index, 2012=100; RHS: Percent)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: MONSTAT; Haver Analytics; ILO STAT Database; and IMF staff calculations.
uA01fig23

Net Minimum Wages, July 2019

(Euro / month)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Country authorities.1/ Republika Srpska.
uA01fig24

Net Minimum Wage and Absolute Poverty Line

(Euros per month)

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Monstat.

Authorities’ Views

42. The authorities expect labor market reforms to have a positive impact on overall employment and informality. The authorities viewed the minimum wage increase and labor tax wedge as a package of measures negotiated with the social partners. They believe that employers would benefit from the reduction in the overall cost of employment while a minimum wage increase would help workers after a long period of stagnation. The authorities also believe that the minimum wage increase would force greater payment of salaries through formal means, thus raising tax revenues and partially offsetting the revenue loss from the tax wedge reduction. The authorities are of the view that the new labor law would significantly increase the flexibility of labor markets.

Staff Appraisal

43. Over the last two years, the Montenegrin economy has performed well, and public finances have improved. Growth is expected to moderate in 2019 as highway investment peaks. So long as external conditions remain stable, private investment and tourism should underpin continued growth of around 3 percent over the medium-term. The authorities have implemented most of the measures from their fiscal adjustment strategy begun in 2017. The underlying fiscal position (excluding highway investment) has improved by 3 p.p. of GDP since 2016.

44. High public debt still limits the room for countercyclical fiscal maneuver as well as the ability to invest for future growth. Notwithstanding recent progress, Montenegro lacks a strong track record of sustained fiscal discipline. To set the economy on a more durable path to stability and prosperity, a balance between debt reduction and more efficient public spending is needed. The primary surplus needs to be at least 2 percent of GDP over the medium-term for debt to reach safer levels. At the same time, resources need to be prioritized to where they deliver the highest economic and social returns. Improving technical capacity in public investment assessment and management is thus very important.

45. A more cautious and prudent approach to the Bar-Boljare highway is central to safeguarding fiscal sustainability. The authorities need to carefully evaluate this project against other uses of scarce resources. Financing the rest of the highway with debt would prevent the projected decline in debt over the medium term and likely jeopardize fiscal sustainability. The authorities should move cautiously with future phases of highway construction only after a new and credible feasibility study is completed. Outstanding questions about feasibility and financing must be resolved in a manner that does not jeopardize fiscal sustainability. Extra caution is needed with regard to possible PPP arrangements which could introduce significant contingent fiscal liabilities.

46. Fiscal reforms are needed to create space for a more growth-friendly budget. The authorities should formulate a disciplined medium-term budget framework that brings together short-term debt reduction and medium-term strategic fiscal priorities with more binding expenditure limits. Further expenditure reforms – including to government employment levels, tax expenditures, and pension reforms – would also increase fiscal space over the medium term for high-productivity capital spending and well-targeted social spending.

47. Recent measures to strengthen banking supervision are welcome. Robust action is needed to further improve supervision and address any remaining vulnerabilities. The structure of supervisory oversight is being strengthened. Its efficacy, however, depends on the development and employment of risk-based approaches to financial sector and AML/CFT supervision. An asset quality review should be completed no later than end-2020, with any identified weaknesses promptly addressed. The decisions to further refine the definition of non-performing loans to fully eliminate any role of collateral in asset classification and establish a supervisory committee are welcome. The transposal of EU banking directives into domestic law will also provide the authorities with new supervisory tools. The authorities should forcefully apply prudential regulation – including fit-and-proper requirements – and be judicious in granting any new bank licenses.

48. The proposed initiatives to improve labor market outcomes are well-motivated. Montenegro faces competitiveness challenges, and its external position is weaker than that consistent with medium-term fundamentals and desirable policy settings. Structural labor market impediments discourage greater labor force participation and the generation of formal sector employment. The authorities appropriately aim to reduce the cost of formal sector employment by reducing the labor tax wedge. It will important to offset the foregone revenues of this reform. The draft labor law also appropriately aims to reduce the gap in employment protection under temporary versus open-ended contracts. In setting the level of the minimum wage, the authorities should assess the impact of prior increases and consider a broad set of labor market indicators.

49. It is expected that the next Article IV consultation with Montenegro will be held on the standard 12-month cycle.

Figure 8.
Figure 8.

Montenegro: Labor Markets

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: Monstat; ILOSTAT; and IMF staff calculations.
Figure 9.
Figure 9.

Montenegro: Business Environment

Citation: IMF Staff Country Reports 2019, 293; 10.5089/9781513513720.002.A001

Sources: World Bank, Doing Business.
Table 2.

Montenegro: Selected Economic Indicators, 2014–2024

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

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

The authorities do not include the arrears of local governments in their definition of general government gross debt.

General government debt, including guarantees, net of central and local government deposits

General government debt, excluding guarantees, net of central and local government deposits

A negative sign indicates depreciation a REER depreciation.

CBM’s international reserves have been revised to exclude CBM’s holdings of Montenegrin government securities and reclassify SDRs for 2015–17.

Table 3.

Montenegro: Savings and Investment Balances, 2014–2024

(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 4.

Montenegro: Contribution to Real Gross Domestic Product, 2014–2024

(Contribution to real GDP growth)

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Sources: Statistical Office of Montenegro; Ministry of Finance; and IMF staff estimates and projections.
Table 5.

Montenegro: Consolidated General Government Fiscal Operations, 2014–2024 1/

(Millions of euro, GFSM 2014)

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

Includes central government budget and local governments.

Historical discrepancy refers to differences between reported financing and that derived from monetary and debt data.

Table 6.

Montenegro: Consolidated General Government Fiscal Operations, 2014–2024 1/

(Percent of GDP, GFSM 2014)

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

Includes central government budget and local governments.

Historical discrepancy refers to differences between reported financing and that derived from monetary and debt data.