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Montenegro -- 2007 Article IV Consultation Concluding Statement of the IMF Mission
October 26, 2007
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
In its first year of independence, all eyes were on Montenegro. Tourism potential was enormous. Growth surged, driven by massive FDI inflows.
In its second year of independence, all eyes are on the government. The boom has brought its own challenges. Fiscal policy is strained by competing demands. The Central Bank lacks the powers it needs to curb surging credit. Initiatives to address energy bottlenecks, the still difficult business climate, and restrictive labor practices, have become more urgent.
And the risks have increased. The external environment rocked by recent financial turbulence is less favorable. On the domestic market, ballooning asset prices fueled by rapid credit growth bear the typical signs of overheating.
The passage of the constitution and signing of the SAA provide an opportunity: To boost the reform effort, refocus fiscal policy, and strengthen banking supervisory powers.
The economy has picked up strongly since independence.
Montenegro's boom continues at full strength. Real growth is projected at 7 percent in 2007, and should remain strong in 2008. Retail inflation has edged up on higher electricity and food prices but remains contained, and unemployment has fallen. Much can be attributed to the reforms of the past few years, and sound macroeconomic management after independence. The budget stance remains strong. Public debt remains relatively moderate (although recent restitution provisions will raise debt by some 10 percentage points), while foreign debt is expected to decrease due to early buy backs.
The boom has brought its own challenges.
Like its neighbors, Montenegro has discovered early that transition brings its own trials. The boom, and the exuberance that it has generated, has brought new challenges and risks. Montenegro is seeing many of the problems that others have faced, but has fewer policy instruments to tackle them:
• Real estate and equity prices have escalated. Private and household debt has increased.
• Bank credit has soared. Credit growth accelerated to 170 percent in the year to August 2007. The aggressive push for market share by individual banks has resulted in credit surpassing FDI as the main reason for the deteriorating current account deficit. While credit has expanded from a low base, the young banking system has yet to be tested by a downturn, and such rapid credit growth strains the ability of banks to adequately assess loan quality, especially in real estate.
• The current account deficit has reached levels that demand vigilance. The current account gap is expected to widen to 36 percent of GDP in 2007. A higher current account deficit is not a cause for alarm if it reflects investment-related imports financed by FDI. However, increasingly import growth is being boosted by pent up consumer demand, initially financed through the wealth effects of real estate sales, but now sustained through credit.
• Rapidly rising wage costs are eroding competitiveness. Strong growth has led to a tightening of labor markets, and raised expectations above labor productivity growth. High costs erode competitiveness, and hamper the ability of the local economy to capture tourism-related activities and develop other sectors. A tourism enclave would have little benefit for the rest of the economy.
• Energy shortages may quickly put a brake on growth. The financial condition of the electricity company remains weak despite the tariff increase, and lack of a clear strategic direction for future energy policy has held up the investments needed to boost domestic energy production.
• Reform of restrictive labor practices and other improvements to the business environment lag. Outdated labor legislation and the difficult business environment need to be addressed. Uncompetitive labor practices continue to add pressures in an already tight labor market.
Montenegro has limited policy options.
Strong tourism potential and market optimism following the signing of the Stabilization and Association Agreement with the EU, provide an opportunity to address these concerns. However, Montenegro has few policy options. Most transition countries have tackled these problems through monetary policy. The euro has served Montenegro well, but the downside is that the country does not have effective monetary instruments to tackle demand pressures. This places a premium on ensuring the fiscal stance is consistent with use of the euro, and ensuring that the market can work unencumbered by restrictive legislation and nontransparent practices.
Fiscal policy: leaning against the wind
Fiscal policy is the main macroeconomic policy instrument to manage the boom and ensure a soft landing. Recent large budget surpluses should not be mistaken for fiscal conservatism. Under the current private sector led boom, the government ought to be leaning against the wind to ensure the economy does not overheat. A strong government financial balance should not be seen as an enticement to spend, but as an important buffer in the face of future adverse shocks, and fiscal support when revenue growth cools.
The budget has strengthened in 2007, but the fiscal stabilizers have not been allowed to work fully. Strong import growth is expected to raise revenues by some 4 to 5 percent of GDP in 2007, but the rectified budget only raised the republican surplus by some ½ percent of GDP. While capital spending was raised, most of the additional money is to be spent on wages and goods and services. The rectified budget implies in a deficit in the last quarter of 2007, directly fueling demand and contributing to the widening current account deficit.
The 2008 budget should withdraw stimulus. However, announced policies would be expansionary unless offset. The 30 percent public sector wage increase and tax cuts would provide an unhelpful boost to an already overheated economy. With public spending at 45 percent of GDP, and capital investments only accounting for some 3 percentage points of this, it is not justifiable to argue that there is no money for development.
Tax cuts have also been procyclical, and could be potentially destabilizing when the economy slows. Sharp cuts in income taxes when the economy is already booming add to demand pressures. Corporate tax cuts combined with absence of capital gains taxation in a country with the enormous potential of Montenegro only provides investors with a windfall. Strong VAT growth driven by imports, should not be seen as providing scope for further tax cuts, as these revenues are temporary and will eventually disappear.
Montenegro will not reach potential without sound public finances. The government should seize the opportunity in good times for fiscal reform. Tax cuts and wage increases will be difficult to claw back when the economy slows, and when large infrastructure projects are eventually prepared, the money may not be there. The government would be well served by:
• Attracting skills to the public sector. Montenegro is not alone in the region in facing the challenge of keeping good staff in the public sector as private sector wages increase. The answer elsewhere has not been generalized wage increases, but reform of pay scales and streamlining of the public sector to allow pay to better match skills.
• Developing a credible medium-term budget framework. The risks to medium-term fiscal sustainability from large public sector wage increases, aggressive tax cuts, and high infrastructure and restitution demands need to be addressed. Development of a medium-term budget focus that clearly sets the government's priorities, would help reconcile competing spending needs. A small country cannot afford big government, and sustained fiscal consolidation will further ease pressures.
• Reassessing tax reforms. With tax rates already low by international standards., further reform should aim at strengthening the revenue base, improving efficiency and fairness, and preventing distortions by eliminating exemptions and preferences.
• Improving budgetary management by strengthened controls over extrabudgetary activities and municipal spending, distorted by large proceeds from privatization.
• Moving public sector deposits to the central bank. These deposits have contributed to excessive credit expansion.
Financial sector policies should focus on preserving bank soundness.
The Central Bank is the guardian of bank stability and needs the instruments to perform its task. The Central Bank has responded quickly to rapid credit growth. It has raised capital adequacy ratios, tightened reserve requirements and implemented a number of other measures to improve supervision. However, further prudential tightening is needed, and is hampered by delays in key banking legislation needed to ensure independence and fully implement best international practice. The delays have also held up the credit registry, precisely at a time when rapid credit growth demands that credit quality be rigorously assessed. Bank exposure to the real estate and stock markets require supervisory vigilance.
Structural reforms needed to boost Montenegro's potential.
Structural reforms need to be reinvigorated. We welcome the authorities' intention to continue unbundling the electricity company, and privatization options need to be urgently assessed. The financial position of the electricity company is weak, ruling out further internal investment, and increasing dependence on high cost imports.
Labor reform is an urgent priority. The Ministry of Labor has revised the labor law to reflect ILO and EU directives. The key task now is to ensure that the new law eliminates restrictive practices and provides the best framework possible to ensure a flexible and dynamic labor market. Other labor legislation also requires attention, including the law on collective contracts which does not match the needs of a modern market economy.
The business environment needs to be freed from unnecessary regulations and local practices that hamper private sector growth. Business licensing laws need strengthening. Urban zoning regulations need to be quickly put in place to impose order on an unregulated real estate market, and provide investors with the certainty they need to start operations.
Infrastructure needs are daunting, and budget resources limited. While PPPs could be an attractive way to finance large infrastructure projects, they could generate substantial fiscal risks. PPP legislation should be amended in line with the recent IMF technical assistance mission. In the end, different schemes cannot substitute for a strong and transparent medium-term budget framework.
Quality statistics are indispensable for sound economic policy and are missing in Montenegro.
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