Recent Economic Development and Outlook

The first results published by Monstat showed that the positive economic developments from 2018 continued during the first quarter of 2019. The growth of economic activity in the first quarter was broad-based across sectors, particularly supported by a further increase in tourism activities and investments. Real GDP growth in the medium-term is projected to remain robust, although the average annual growth rates will decelerate to 3 percentage points due to the end of the first phase of the highway. However, this is still higher compared to the average growth rate recorded in 2014–2016 period as well as the expected rise in economic activity in most EU countries. At the same time, the authorities expect, similar to the European Commission’s Spring Forecast, that the further expansion of tourism and investments in the renewable energy sector and agriculture, supported by the ambitious set of structural reforms will sustain domestic demand and exports.

Fiscal Policy and Debt Management

The authorities remain strongly committed to the fiscal consolidation strategy (FCS) that started in 2017 and will put public finances on a stable footing over the medium term. The fiscal consolidation measures outlined in the 2017–2021 Budget Deficit and Public Debt Recovery Plan, supplemented by the 2017–2020 Fiscal Strategy, have been largely implemented. The main fiscal policy objective in the following medium-term period is to preserve public finance sustainability, defined by maintaining the primary surplus of 2 percent of GDP and reducing the level of public debt, excluding state guarantees close to 60% by 2022. In this context, they remain committed to the continuation of fiscal consolidation in the upcoming election year.

Cognizant of development needs, and the fact that Montenegro did not have even one kilometer of highway, the authorities have launched the long-term Bar-Boljare highway project in 2014, envisaged to be built in four phases. The financing of the first and most expensive phase of the project, was secured on an international tender and on the most favorable terms at the time. As envisaged, this large infrastructural project increased public debt, but also significantly boosted economic growth. The authorities are aware that launching the second phase of the project at the current level of public debt would not be in line with the FCS or the MTMDS. Therefore, they will refrain from any new major debt-financed investment project, and to continue with the second phase of the highway only after public debt is put on more sustainable level, and favorable financing conditions are secured, potentially with a grant element.

At the same time, they will continue to work on the preparation of the second phase project, mostly by securing the legal documentation, for which the EU grant funding was secured. Through the grant of the Western Balkan Investment Framework, the EU’s program for infrastructure investments in the region, the Ministry of Transport and Maritime Affairs of Montenegro and the Directorate for State Roads will prepare the Preliminary Design and Environmental and Social Impact Assessment for the second phase section of Bar-Boljare highway. In addition, a Cost Benefit Analysis and Feasibility Study for the entire Bar-Boljare project will be prepared with the aim to present the financial viability of the planned infrastructure works and justify the current planning of investments. Furthermore, the authorities would like to emphasize that the EU representatives have identified investments in the project of national, regional and international significance for the Western Balkans, and that once the Bar-Boljare highway is fully operational, it will significantly decrease travel time, reduce emissions and accidents and lower vehicle operating costs, improve trade flows with countries in the region and bring other tangible benefits, such as better living conditions and thus induce a positive impact on the broader economy of Montenegro, its citizens and its neighbors.

On the revenue side, activities will focus on the expansion of the tax base and improvement of tax discipline. In this regard, the Parliament granted the Montenegrin Tax Administration (MTA) as of January 1, 2019 full autonomy, which has already improved their efficiency and significantly reduced tax arrears. At the same time, the MTA has adopted a reform program with the aim of improving the core processes, supported by IMF technical assistance. Furthermore, a system of electronic issuing of fiscal invoices will be introduced as of January 1, 2020. Significant positive effects in generating revenues, primarily through attracting new investments, are also expected from the implementation of the Economic Citizenship Program which implies acquiring Montenegrin citizenship based on the implementation of an investment program that contributes to Montenegro’s economic and commercial development. For this purpose, the authorities have signed a contract with three international and reputable agencies that will be responsible for the due diligence to minimize risks. The expected budget impact could be around 30 million EUR in three years from fees, and 500 million EUR in investments with further multiplying effects on budget revenues and economic activity (0.6 and 10.6 percent of GDP respectively). Lastly, a further increase in excise taxes on carbonated water and ethyl alcohol, the introduction of coal excise, the reduction of tax arrears through the implementation of the Law on Rescheduling Tax Receivables, as well as the implementation of the Law on Local Self-Government Financing and legalization of informally constructed buildings is also scheduled for 2019 and 2020.

On the expenditures side, the strategic commitment is to further rationalize the current expenditures, which is in line with staff’s recommendations. The focus will be on the further implementation of the 2018–2020 Public Administration Optimization Plan and a freeze on employment in the public sector. This will facilitate a reduction in the number of employees in the public sector and a further reduction in the aggregate gross wage bill. The authorities agree with staff on the limited progress so far. However, they would like to emphasize that in a small state and a country in transition, it takes more time for such important reforms to make visible progress. In addition, implementation of the new concept of “consolidated public procurement” will create the conditions for rationalization of the “common” costs of the state authorities.

The authorities share staff’s concerns that robust investment management and Public-Private-Partnership (PPP) frameworks are important. As a small state with high development needs, Montenegro needs to strike a proper balance between the availability of fiscal space and the development needs. Cognizant of development needs, the authorities are currently preparing a strong legislative and institutional PPP framework that could help them achieve these goals. Bearing in mind the risks that PPP projects could bring, the draft version of the law on PPP was prepared and agreed upon with the European Commission to ensure integrated regulation of this area. The authorities are also working jointly with the IFC, the IMF and several bilateral partner countries in preparing an appropriate law. It is paramount for the authorities to include the strong role of the Ministry of Finance in the process of approving the PPP projects as well as their supervision, both at the national and local level. This also includes putting limits on the number of projects as well their value, at all levels of the government. In this regard, the Ministry of finance has requested PFRAM support by FAD to proactively engage in further staff capacity development on this matter.

Regarding the strengthening of oversight of the implementation of fiscal policy, options are being considered for the identification of the most adequate model for establishing a Fiscal Council, and expert assistance has been sought from the European Union for this purpose. In addition, three-year budgeting will be formally introduced in the budget system as of 2020, where the first year will be mandatory, and the following two will be indicative.

Financial System and Policies

The banking system is very liquid, well-capitalized, and adequately profitable, despite the recent challenges associated with the resolution of two small banks. Interventions in two non-systemic banks had no spillovers effects to the broader banking sector and financial stability. Key performance indicators (KPIs) of the banking system for 13 banks (without Atlas bank and Invest bank Montenegro), improved by end-2018 and their positive trend continued in 2019, with assets, loans, deposits and capital recording growth compared to December 2018 (4.2%, 7.6%, 1.3% and 14.3% respectively).

The level of non-performing loans (NPLs) also recorded further improvement. The authorities’ efforts aimed at addressing NPLs in the last two years have been effective, and the systemic level of NPLs decreased to 4.8 percent at end-June 2019, compared to 8.2 percent in July 2017. At the same time, NPLs are adequately provisioned, with the provision coverage ratio standing at 83.2 percent at end-June 2019 and the coverage with regulatory reserves at 94.7 percent. However, they recognize that although the level of NPLs is not a systemic risk, it is still a challenge for some small banks. In this context, they will remain vigilant about the developments in these banks and stand ready to act appropriately. Lastly, the authorities announced the amendments to the Decision on Minimum Standards for Credit Risk Management in Banks, introducing a strict non-performing loans definition that does not exclude impaired assets that are deemed to have adequate or prime collateral.

The authorities agree that strong banking supervision is of utmost importance. In this context, they have already established a Supervisory Committee to better support decisions made by senior management as well as to allow another layer of oversight. At the same time, staffing of off-site supervision is ongoing, which will enable the implementation of the risk-based approach to supervisory assignments. The Supervision Department also underwent organizational improvements, with the establishment of a separate unit for off-site banking supervision, and thus, contributing to further improvement and strengthening of the risk-based supervision approach. An additional separate organizational unit was established which will be responsible for issuing and monitoring measures, compliance issues, and penalties. Lastly, the authorities are actively preparing for AQR that should be executed by end-2020. In order to assure the quality and transparency of the process, the AQR will be carried out by reputable international assessors. In addition, the CBM will hire a reputable international provider to assist the institution in assuring robustness of the process.

The authorities share staff’s recommendation on the need for further improvements in the supervision of AML/CFT risks. In this context, significant changes were made in the organization and staffing of the CBM’s Unit for Supervision of prevention of money laundering and terrorist financing in the period from September 2018 to August 2019. In February 2019, a separate Directorate for supervision in the field of money laundering (ML) and terrorist financing (TF) and a sub-unit for protection of users of financial services were established. A highly qualified Director has already been appointed and with the almost finalized procedure of employing a higher examiner, the leadership and expertise of the Directorate will be significantly strengthened. In addition, the Service for the Protection of Financial Services Users, which is part of the Directorate, also hired a new employee. It is planned to fill all the vacancies of the Directorate with highly qualified personnel. Immediately after the establishment of the Directorate, an act of the “Guidelines for developing risk analysis and risk factors for the purposes of the prevention of ML and TF by reporting entities under the supervision of the Central Bank of Montenegro”, was drafted and adopted by the Council of the Central Bank. Guidelines were sent to the Fund Mission team for comments and suggestions. Lastly, the process of developing an AML/CFT manual is underway as part of a twining project, within which it is planned to develop a risk-based approach for control of reporting entities, that would guide the capacity of the Directorate in right direction with good allocation of resources.

Structural Reforms and Competitiveness

Montenegro’s strategic development objective, defined in the ERP, is sustainable and inclusive economic growth will contribute to reducing the country’s development gap relative to the EU average and increase the quality of life of all its citizens. The authorities are aware that high growth rates needed to achieve this can be sustained in the medium term only by pushing forward a wide set of structural reforms, of which some of them are also emphasized by staff. They agree that migration and labor shortages in the key industrial sectors, are the two single biggest challenges the Montenegrin economy faces today. To mitigate this, the authorities have already passed a decision on decreasing employers’ health insurance contributions by 2 percentage points. This will decrease the already high tax wedge and lower labor costs for employers. At the same time, they have submitted the draft version of the new labor law in coordination with the European Commission which will ease the currently rigid labor protection.

One of the goals set out by the Vocational Education Development Strategy to 2020 is to ensure that vocational education is relevant to the labor market. To achieve this goal and eliminate the structural mismatch between the supply and demand of the labor force, the authorities are already developing qualifications, based on learning outcomes, that match the labor market needs and, in line with them, design modular curricula. The authorities plan to fully implement new curricula in the next two years.

The authorities would like to emphasize that the implementation of the reform measures from the ERP is monitored through regular reports by the Competitiveness Council, established by the Government in 2017 and in accordance with the recommendations of the European Commission.