## 1. Montenegro’s Highway Project

## Source details

**Canonical URL:** [1. Montenegro’s Highway Project](https://www.imf.org/-/media/files/publications/cr/2017/cr17276.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/cr/2017/cr17276.pdf.md)
- [Structured JSON version](/-/media/files/publications/cr/2017/cr17276.pdf.json)

---

### Context and project overview
- Montenegro is a small, open, euroized economy highly dependent on tourism and external financing; key concentrations include tourism, energy, real estate, services, and agriculture.
- Bar‑Boljare highway:
  - Purpose: connect the main seaport of Bar with Serbia to support regional integration, trade, and road safety.
  - Construction status: first 41 km segment under construction; remaining 136 km.
  - Contractor and timeline: China Road and Bridge Corporation started construction in May 2015; expected completion in 2019.
  - Domestic participation: domestic companies subcontracted for 30 percent of the work.
  - Financing: China ExIm Bank loan dollar‑denominated; ExIm Bank financing 85 percent of the first segment with a 20‑year US dollar loan, fixed 2 percent interest rate, six‑year grace period; remaining 15 percent financed by the government.
  - Cost evolution: original cost €809 million (20 percent of GDP) increased to nearly €1 billion (¼ of GDP) because the dollar‑denominated loan was not hedged.
  - Economic return assessment: short-term demand and longer-term supply effects expected, but economic and financial returns are estimated to be small.
  - Debt counterfactual: without the highway, debt-to-GDP would have declined to 64 percent of GDP in 2019 instead of rising to 89 percent; without the highway the adopted fiscal adjustment strategy would not have been necessary to return debt to sustainable levels.
  - Authorities plan to help fund repayments with toll revenues once the segment is completed.

### Recent macroeconomic developments (2016–2017)
- Growth and activity:
  - Real GDP growth: 2.5 percent in 2016 (one percentage point below 2015).
  - Construction accelerated and tourism remained strong in 2016; delays in highway construction contributed to slower growth.
- Prices and wages:
  - Deflation averaged -0.3 percent in 2016; prices rising again at year-end.
  - Wages rose 4 percent in 2016; public‑sector wage increases were about twice the average.
- Labor market:
  - Labor-force growth slowed for the second straight year.
  - Unemployment: 18 percent.
  - Some women exited the labor force to claim a lifetime benefit for mothers.
- Financial sector:
  - Private sector credit increased 6 percent in 2016 after prolonged shrinkage.
  - NPLs: 11 percent of gross loans (9.5 percent at end-June 2017).
  - Banks: highly liquid; capital ratios exceed regulatory minima; profitability modest with low returns on assets; lending standards high and risk averse.
- External sector:
  - Current account deficit: 13 percent of GDP in 2015; 19 percent of GDP in 2016.
  - Drivers: 12 percent increase in the volume of goods imports reflecting machinery for the highway and tourism and energy investments.
  - FDI inflows moderated to 10 percent of GDP in 2016; FDI covered about half of the current account deficit.
  - External debt increased 4 percentage points to 167 percent of GDP.
- Fiscal developments:
  - Fiscal deficit: nearly 6 percent of GDP in 2016; underlying position deteriorated.
  - Capital spending substantially less than expected due to highway delays.
  - Current spending increased by 2¼ percentage points of GDP (drivers include Mothers’ Law cost nearly 2 percent of GDP, public-sector wage increases, and one-off transfers).
  - Tax revenues improved (personal income tax, VAT) and included a one-off communications fee.
  - General government debt including guarantees: 78 percent of GDP (67.5 percent in the authorities’ definition without guarantees).
  - Interest payments increased, creating debt-related risks.

### Projected macroeconomic effects of the highway
- Growth impact:
  - 2017 projection: growth expected to accelerate to 3 percent, largely driven by expected doubling of highway spending to 6 percent of GDP in 2017.
  - Over 2017–22, growth might average 2¾ percent.
  - Staff assumed a fiscal multiplier of -0.5 for the estimated negative impact of fiscal adjustment on growth (staff usually assumes -0.3 for Montenegro but used -0.5 here).
  - With the highway, GDP is projected to be only 4¼ percentage points of 2014 GDP higher in 2023 despite costing 28 percent of 2014 GDP; thereafter the output difference declines due to higher capital depreciation.
- Inflation and VAT:
  - Inflation projected to increase to 2¼ percent on average in 2017.
  - Proposed VAT increase in 2018 will add approximately 1 percentage point to inflation.
  - With euroization and high unemployment, inflation contained at 2 percent over 2019–22.
- External balances:
  - Current account deficit projected to increase to 21 percent of GDP by 2018 due to high import content of large capital investments.
  - Projected to moderate to 14 percent on average over 2020–22 as public investment shrinks with highway completion.
- Public debt trajectory:
  - Highway spending increase over 2017–19 expected to cause overall fiscal deficit to average 5¾ percent of GDP.
  - General government debt (including guarantees) projected to reach 81 percent of GDP by 2019.
  - Once highway spending is completed, the overall fiscal balance should improve significantly in 2020, placing debt on a downward trajectory thereafter.

### Fiscal policy challenges, strategy, and measures
- Recent fiscal trajectory:
  - Government debt (including guarantees) rose from 32 percent of GDP in 2008 to 72 percent in 2014 and reached 78 percent in 2016.
  - Without any adjustment, debt would likely have risen above 95 percent of GDP by 2020.
  - Large Eurobond refinancing needs in 2019–21: between 6 and 11 percent of GDP each year.
- 2017 budget adjustment:
  - 2017 budget measures estimated to deliver 2 percent of GDP in adjustment (split nearly evenly between revenues and expenditures; about one-third temporary).
  - Revenue measures included extension through 2019 of the 11 percent top rate for the personal income tax, increase in excise on fuels, and steps to improve tax administration.
  - Expenditure measures included reduction in wages of senior public officials and freeze of parts of other public employee wages, monthly Mothers’ benefit reduced by about 20 percent, and cuts to discretionary expenditures including non-highway capital spending.
  - Staff estimate: 2017 budget policies would result in a primary surplus of 2½ percent of GDP in 2020; government debt would peak at 89 percent of GDP in 2019 under that scenario.
  - If primary balance held at 2 percent of GDP over the longer term, debt would fall slowly, reaching 70 percent of GDP in 2030.
- Fiscal Strategy (authorities’ medium-term Fiscal Strategy adopted July 2017):
  - Staff recommended targeting a primary surplus of 4½ percent of GDP by 2020 to fully address fiscal challenges.
  - Staff assessment: the Fiscal Strategy would deliver an additional 2¼ percent of GDP in net non-highway fiscal adjustment by 2020, with 1½ percent of GDP in measures implemented in 2017 and 2018.
  - Strategy weighted more heavily towards revenue gains.
- Specific revenue measures and yields:
  - VAT increase: VAT will rise from 19 to 21 percent; lower-rate VAT of 7 percent unchanged. VAT increase will raise an additional 1 percent of GDP. Parliament approved VAT increase in July 2017; it will take effect on January 1, 2018.
  - Excises: increases on cigarettes, sweetened carbonated beverages, and alcohol progressively through 2020; specific cigarette excise from €24 per 1000 to €50 by 2019. Authorities plan to introduce a coal excise at the EU minimum level in 2019 with a further increase in 2020. Parliament approved these rates in July 2017.
  - Tax debt rescheduling: program permitting tax debts (14 percent of GDP) to be repaid over five years; taxpayers with debts representing 4 percent of GDP entered the program; staff projects two‑thirds will be collected. Interest on tax debts is around 12 percent per year (includes penalty element).
- Specific expenditure measures and yields:
  - Mothers’ Law reform: Constitutional Court ruled lifetime benefit unconstitutional; new time-limited monthly benefits approved June 2017 represent net savings of almost ¾ percent of GDP through 2022.
  - Increase in targeted social assistance by 0.2 percent of GDP.
  - Public-sector wage bill: wages of senior officials reduced by 6 percent on top of an 8 percent 2017 cut; workforce freeze and no discretionary wage increases.
  - Discretionary spending cuts: intent to cut current and capital spending by ¼ percent of GDP through 2020.
- Staff macro-fiscal assessment of Fiscal Strategy:
  - With full implementation, government debt would peak at 81 percent of GDP in 2019 and fall rapidly thereafter.
  - After achieving a primary surplus of 4½ percent of GDP in 2020, authorities could relax fiscal stance by increasing capital spending on high-return projects; unlikely fiscal space to complete further highway phases through debt.
  - Staff projects general government debt (including guarantees) would reach 66 percent of GDP in 2022.
  - After 2023, authorities should maintain a primary surplus of 3 percent of GDP to ensure continued rapid decline in debt.
- Financing and market-access implications:
  - Unidentified financing needs would average 9 percent of GDP over 2019–21 without the strategy and would likely need Eurobond markets.
  - Fiscal Strategy would reduce unidentified financing needs by 2–3 percentage points of GDP each year over 2019–21.
  - Implementation track record should improve market-refinancing position.

### Risks, stress tests, and alternative scenarios
- Baseline medium-term outlook:
  - Growth supported by highway, tourism, and energy investments; modest drag from fiscal consolidation.
  - Over 2017–22 growth averaging 2¾ percent.
  - Fiscal consolidation projected to produce a primary balance of 4½ percent of GDP by 2020.
  - Government debt projected to peak in 2019 at 81 percent of GDP and fall thereafter.
- Downside external risks:
  - Large external financing needs, especially 2019–21 as large Eurobonds must be rolled over.
  - Vulnerability of tourism to external demand downturns and competitors’ security situations.
  - Significant decline in FDI could cause balance‑of‑payments pressures if not matched by lower imports.
- Domestic downside risks:
  - Narrow parliamentary majority could jeopardize fiscal consolidation.
  - Government financing difficulties could harm bondholders.
  - Large, unexpected budget overruns (e.g., judicial claims) could jeopardize adjustment.
  - Fiscal consolidation could reduce banking-sector profitability via slower growth.
  - Delays in investment implementation or prolonged cuts to non-highway capital spending could undermine growth.
- Upside risks:
  - Improved global (particularly European) growth.
  - Authorities project larger gains from fiscal adjustment than staff.
  - Construction of the Serbian part of the Belgrade‑to‑Montenegro highway—expected to start in 2018—could improve growth.
- Standard stress-test scenarios and impacts (selected):
  - Growth shock: lowers growth by one standard deviation (4.5 percentage points) in 2018–19; public debt peaks at 99 percent of GDP in 2019 before falling to 84 percent in 2022; gross financing needs ratio in 2019 increases 9 percentage points relative to baseline.
  - Interest rate shock: increase in interest rates on new debt by 200 basis points in 2018–22 (in addition to baseline 100 bps); debt increases by 3 percentage points in 2022 relative to baseline.
  - Combined macro shock: recession in 2018–19, 200 bps interest rate increase, real exchange rate shock, sharp rise in expenditures; debt rises by 22 percentage points to 88 percent of GDP by 2022.
  - Financial contingent liability shock: expenditures increase in 2018 equivalent to 10 percent of the banking sector plus GDP and interest/GDP shocks; debt rises by 17 percentage points to 83 percent of GDP by 2022; gross financing needs peak at 27 percent of GDP in 2019.
  - Real exchange rate shock (alternative tests): assumed 13 percent depreciation in 2018 could reduce debt ratio by 2 percent of GDP from baseline by 2020 depending on pass-through.
- External debt vulnerability:
  - External debt increased 35 percentage points of GDP since 2008 to an estimated 167 percent of GDP in 2016; under baseline projected to peak at 175 percent of GDP before declining to 165 percent in 2022.
  - Scenario extremes: real depreciation shocks (30 percent) could increase external debt substantially (examples in scenario table: real depreciation shock increases external debt by 84 percentage points in 2018 relative to baseline in one specification).

### Financial sector, credit recovery, and NPL resolution
- Financial sector structure:
  - Fully euroized banking‑dominated system: banks account for about 90 percent of system assets (~100 percent of GDP); foreign subsidiaries hold over ¾ of sector assets.
  - Loan composition: households 42 percent; trade sector 14 percent; nonresident loans 13 percent.
  - Insurance sector small (2 percent of GDP).
- Credit recovery:
  - Private-sector credit declined to 50 percent of GDP in 2012 from nearly 90 percent pre-crisis and has remained around 50 percent since.
  - Credit growth: 6 percent in 2016; projected 8 percent in 2017.
  - Household credit recovered to near pre-crisis peak; corporate lending remains below pre-crisis levels (58 percent of pre-crisis level).
- NPLs and resolution:
  - NPLs peaked at >25 percent of gross loans in mid-2011; declined to 9.5 percent at end-June 2017; other figures: 10.3 percent at end-2016; 8.2 percent at end-July 2017 in related text.
  - Decline partly due to shifting NPLs to AMCs owned by foreign banks’ mother houses and Law on Voluntary Financial Restructuring of Debts to Financial Institutions (extended until May 2018).
  - CBM obliged banks to adopt three-year NPL management strategies in 2015.
  - Staff recommends an AQR as soon as practicable, starting with banks with qualified audits.
- Banking sector performance and supervision:
  - At end-June 2017, aggregate CAR exceeded 10 percent minimum by 7 percentage points; capital adequacy ratio noted as 17.6 percent in related tables.
  - System assets grew 11 percent year-on-year; share of liquid assets 21 percent at end-June 2017.
  - Low profitability: return on equity 2 percent at end-2016 (0.3 percent on assets); ROA 0.84 percent end-June 2017 in other tables.
  - 15 banks operate in Montenegro; system may be “overbanked” (one bank per 40,000 residents).
  - Recommendation: consider increasing minimum capital from €5 million to €10 million to facilitate consolidation.
  - Supervisory reforms: CBM implementing FSAP recommendations and legislative package (Central Bank Act; Banking Law; Law on Financial Institutions; Law on Recovery and Resolution of Banks; Law on Voluntary Loan Restructuring; Deposit Insurance Law) expected adopted by end-2017.
  - Planned AQR timing: authorities plan system‑wide AQRs in 2019 (authorities prefer after IFRS‑9 implementation planned for 2018).
- Emergency Liquidity Assistance and resolution:
  - CBM disallowed T-bills as required reserves in March 2017 and lowered reserve requirement to 7 percent.
  - System-wide exposure to government €510 million (13 percent of GDP) at end-March 2017.
  - Nine foreign‑owned banks (¾ of assets) would likely receive owner assistance; CBM should seek credit lines from foreign banks for residual needs.
  - Authorities considering a resolution fund with risk-based contributions to supplement ELA.

### Structural reforms, SOEs, pensions, and competitiveness
- SOEs and privatization:
  - Privatization slowed; tender for Port of Bar cancelled.
  - Loss-making SOEs with tax arrears include Montenegro Airlines and Plantaže winery.
  - Pending exit of minority foreign investor in EPCG requires finding a new strategic investor or purchasing shares valued at €250 million (6 percent of GDP).
  - Staff recommends reaccelerating privatization and merging some municipal SOEs.
- Infrastructure and energy strategy:
  - Authorities plan undersea cable with Italy, improved interconnections with Serbia, second thermal power-plant, and smaller hydro‑stations; other infrastructure projects amounting to €1.1 billion over three years aligned with EU connectivity agenda.
- Pension system:
  - Pension funding gap reached 3.1 percent of GDP in 2016; pension spending at 10.4 percent of GDP.
  - Number of old‑age pensioners increased 36 percent since 2008; early retirees ~70 percent of new pensioners since 2010; early‑retirees constitute about one third of pensioners.
  - Baseline projections: pension spending projected to decrease from 10.7 percent of GDP in 2015 to 7.4 percent by 2050; pension deficit projected to turn into surplus by 2040 under baseline but with falling replacement rates.
  - Recommended pension reforms:
    - Valorize new pensions with wage growth and index existing pensions with CPI.
    - Restrict/eliminate early retirement; introduce actuarial penalties.
    - Restrict hazardous‑occupation pensions; make contributions actuarially fair.
    - Accelerate retirement age increases for women to reach 67 by 2025 instead of 2042; link retirement age to life expectancy.
    - Complementary measures: shift contributions from employers to employees gradually; consider healthcare contribution and PIT for higher‑earning pensioners.
  - Quantified reform projections (selected):
    - Valorizing new pensions at 100% wage growth: costs 2% GDP per year by 2050 and 10.5% by 2100.
    - Indexing existing pensions at 100% CPI: save up to 0.35% of GDP per year by 2050.
    - Reducing/eliminating early retirement: save 1% GDP per year.
    - Accelerating retirement age phase‑in for women: save up to 1.1% GDP per year during phase‑in.
    - Linking retirement age to life expectancy: save up to 0.8% GDP per year by 2050.
    - Under a policy package, pension revenues would increase from around 7.3 percent of GDP today to 10.3 percent by 2100; pension deficit would turn into surplus by 2025 under the package (vs 2040 baseline); pension spending would decline to 6 percent by 2040 under the reform package.
- Competitiveness and labor market:
  - Doing Business ranking fell from 48th to 51st.
  - Labor rigidities: long-term unemployment three‑fourths of total unemployment; one of highest rates of temporary employment in Europe; high tax burdens on low-income workers and relatively high minimum wage drive informality; public-sector employment high and pays more than private sector.
  - Recommendations: increase labor-market flexibility (adjust workforce rules, reduce tax wedge on low-paid workers, review minimum wage), reallocate ALMP funding, enforce active job-search verification for unemployment benefits.
  - External competitiveness: current account deficit 19 percent of GDP in 2016; staff considers REER moderately overvalued; productivity stagnation and high unit‑labor costs constrain export performance.
- Structural fiscal reforms:
  - Reduce public-sector employment (especially local government), improve taxation and revenue sharing, increase reliance on real-estate value taxation.
  - Introduce full cost‑recovery tariffs for water and waste.
  - Pension and civil-service reforms to improve sustainability and competitiveness.
  - Consider accelerating coal excise introduction to finance reduction of social contributions and reduce labor-tax wedge; implicit coal subsidies estimated at 14 percent of GDP (mostly local pollution costs).

### Key statistics and projections (preserved exactly)
- Highway segments: first 41 km under construction; remaining 136 km.
- Domestic subcontracting: 30 percent of the work.
- Original highway cost: €809 million (20 percent of GDP).
- Revised highway cost: nearly €1 billion (¼ of GDP).
- Construction start: May 2015; expected completion: 2019.
- Growth: 2.5 percent in 2016; projected 3 percent in 2017; average 2¾ percent over 2017–22.
- Deflation in 2016: -0.3 percent on average.
- Wage growth in 2016: 4 percent.
- Unemployment: 18 percent.
- Private sector credit growth: 6 percent.
- NPLs: 11 percent of gross loans (9.5 percent at end-June 2017).
- Current account deficit: 13 percent of GDP in 2015; 19 percent of GDP in 2016; projected 21 percent by 2018; projected average 14 percent over 2020–22.
- FDI: 10 percent of GDP in 2016.
- External debt: 167 percent of GDP (increase of 4 percentage points).
- Fiscal deficit: nearly 6 percent of GDP in 2016.
- Current spending increase: 2¼ percentage points of GDP (drivers include Mothers’ Law cost nearly 2 percent of GDP).
- General government debt including guarantees: 78 percent of GDP (authorities’ definition without guarantees: 67.5 percent).
- Highway spending in 2017: expected doubling to 6 percent of GDP.
- Fiscal multiplier used for adjustment impact: -0.5 (staff estimate, staff usually assumes -0.3).
- Projected highway cost relative to 2014 GDP: 28 percent of 2014 GDP.
- Projected GDP differential in 2023 with highway: 4¼ percentage points of 2014 GDP higher.
- Projected overall fiscal deficit over 2017–19: average 5¾ percent of GDP.
- Projected general government debt peak: 81 percent of GDP by 2019.
- Projected primary balance by 2020: 4½ percent of GDP.
- VAT increase in 2018 projected to add approximately 1 percentage point to inflation.
- Inflation projections: 2¼ percent average in 2017; 2 percent over 2019–22.

*International Monetary Fund staff report excerpts (cr17276).*

### 1. Montenegro’s Highway Project _________________________________________________________________ 4

### 1. Montenegro’s Highway Project

### Context
- Montenegro is a small, open, euroized economy highly dependent on tourism and external financing.
- Key economic concentrations: tourism, energy, real estate, services, and agriculture.
- Binding constraints: rigid labor markets, weak demographics, low labor force participation, elevated public spending.
- Monetary policy: no independent monetary policy due to euroization.
- EU accession: negotiations opened in 2012; 28 of 35 chapters opened.
- Political: October 2016 elections left the ruling party with a slim parliamentary majority.

Box: Bar-Boljare highway
- Purpose: connect the main seaport of Bar with Serbia; authorities cite regional integration, strengthened trade, and road safety benefits.
- Construction status: only the first 41 km segment (outskirts of Podgorica to Kolašin) under construction; remaining 136 km likely to cost a little more than the first segment.
- Contractor and timeline: China Road and Bridge Corporation started construction in May 2015; completion expected in 2019.
- Domestic participation: domestic companies subcontracted for 30 percent of the work.
- Cost evolution: original cost €809 million (20 percent of GDP) increased to nearly €1 billion (¼ of GDP) because the dollar-denominated loan from China’s ExIm Bank was not hedged.
- Economic return assessment: short-term demand and longer-term supply effects expected, but economic and financial returns are estimated to be small.
- Debt counterfactual: Had the highway not been built, debt-to-GDP would have declined to 64 percent of GDP in 2019 instead of rising to 89 percent; without the highway the adopted fiscal adjustment strategy would not have been necessary to return debt to sustainable levels.

### Recent developments (2016–2017)
- Growth and activity:
  - Real GDP growth slowed to 2.5 percent in 2016, one percentage point below 2015.
  - Contributing factor: delays in highway construction.
  - Construction activity accelerated and tourism continued strong in 2016.
- Prices and wages:
  - Deflation averaged -0.3 percent in 2016, with prices rising again at year-end.
  - Wages rose 4 percent in 2016, driven by public-sector wage increases of twice the average rate.
- Labor market:
  - Labor-force growth slowed for the second straight year.
  - Unemployment remained high at 18 percent.
  - Some women exited the labor force to claim a lifetime benefit for mothers.
- Financial sector:
  - Private sector credit increased 6 percent after a prolonged period of shrinkage.
  - NPLs continued to decline to 11 percent of gross loans (9.5 percent at end-June 2017), less than half of their earlier peak.
  - Banks are highly liquid; capital ratios exceed regulatory minima; profitability increased but remains modest with low returns on assets.
  - Lending standards remain high; banks are risk averse, citing problems with collateral execution and few profitable projects.
- External sector:
  - Current account deficit expanded from 13 percent of GDP in 2015 to 19 percent in 2016.
  - Drivers: 12 percent increase in the volume of goods imports reflecting machinery for the highway and tourism and energy investments.
  - FDI inflows moderated to 10 percent of GDP after a large inflow in 2015; FDI covered about half of the current account deficit.
  - External debt increased 4 percentage points to 167 percent of GDP.
- Fiscal developments:
  - Fiscal deficit nearly stable at 6 percent of GDP in 2016, but underlying position deteriorated.
  - Capital spending was substantially less than expected due to highway construction delays.
  - Current spending increased by 2¼ percentage points of GDP, driven by:
    - the new lifetime benefit (“Mothers’ Law”) for mothers of three or more children at a cost of nearly 2 percent of GDP,
    - public-sector wage increases,
    - one-off transfers.
  - Tax revenues improved (personal income tax, VAT) and included a one-off communications fee.
  - General government debt including guarantees increased to 78 percent of GDP (67.5 percent in the authorities’ definition without guarantees).
  - Interest payments increased, creating debt-related risks.

### Highway project: projected macroeconomic effects
- Growth impact:
  - 2017 projection: growth expected to accelerate to 3 percent, largely driven by an expected doubling of highway spending to 6 percent of GDP.
  - Over 2017–22, growth might average 2¾ percent.
  - Staff assumed a fiscal multiplier of -0.5 for the estimated negative impact of fiscal adjustment on growth (staff usually assumes -0.3 for Montenegro but used a more conservative -0.5 here).
  - With the highway, GDP is projected to be only 4¼ percentage points of 2014 GDP higher in 2023 (the year with the highest difference), despite costing 28 percent of 2014 GDP. Thereafter the output difference declines due to higher capital depreciation in the highway scenario.
- Inflation and VAT:
  - Inflation projected to increase to 2¼ percent on average in 2017, aligning with the euro area and higher commodity prices.
  - Proposed VAT increase in 2018 will add approximately 1 percentage point to inflation.
  - With euroization and high unemployment, inflation contained at 2 percent over 2019–22.
- External balances:
  - Current account deficit projected to increase to 21 percent of GDP by 2018 due to high import content of large capital investments.
  - Projected to moderate to 14 percent on average over 2020–22 as public investment shrinks with highway completion.
- Public debt trajectory:
  - Highway spending increase over 2017–19 expected to cause overall fiscal deficit to average 5¾ percent of GDP.
  - General government debt (including guarantees) projected to reach 81 percent of GDP by 2019.
  - Once highway spending is completed, the overall fiscal balance should improve significantly in 2020, placing debt on a downward trajectory thereafter.

### Outlook and risks
- Baseline medium-term outlook:
  - Growth supported by highway, tourism, and energy investments; modest drag from fiscal consolidation.
  - Over 2017–22 growth averaging 2¾ percent.
  - Fiscal consolidation measures projected to produce a primary balance of 4½ percent of GDP by 2020.
  - Government debt projected to peak in 2019 at 81 percent of GDP and fall thereafter.
- Downside external risks:
  - Large external financing needs, especially in 2019–21 as large Eurobonds must be rolled over, expose Montenegro to changes in global financial conditions.
  - Vulnerability of tourism to external demand downturns and improvements in competitors’ security situations.
  - Significant decline in FDI could cause balance-of-payments pressures if not matched by lower imports.
- Domestic downside risks:
  - Narrow parliamentary majority could jeopardize fiscal consolidation if political support is lost.
  - Government financing difficulties could harm government bondholders.
  - Large, unexpected budget overruns (e.g., judicial claims) could jeopardize adjustment.
  - Fiscal consolidation could reduce banking-sector profitability through slower growth.
  - Delays in investment implementation or prolonged cuts to non-highway capital spending could undermine growth.
- Upside risks:
  - Improved global (particularly European) growth could boost Montenegro.
  - Authorities project larger gains from fiscal adjustment than staff, potentially creating more fiscal space.
  - Construction of the Serbian part of the Belgrade-to-Montenegro highway—expected to start in 2018—could improve growth.

### Key statistics and projections (preserved exactly as in source)
- Highway segments: first 41 km under construction; remaining 136 km.
- Domestic subcontracting: 30 percent of the work.
- Original highway cost: €809 million (20 percent of GDP).
- Revised highway cost: nearly €1 billion (¼ of GDP).
- Construction start: May 2015; expected completion: 2019.
- Growth: 2.5 percent in 2016; projected 3 percent in 2017; average 2¾ percent over 2017–22.
- Deflation in 2016: -0.3 percent on average.
- Wage growth in 2016: 4 percent.
- Unemployment: 18 percent.
- Private sector credit growth: 6 percent.
- NPLs: 11 percent of gross loans (9.5 percent at end-June 2017).
- Current account deficit: 13 percent of GDP in 2015; 19 percent of GDP in 2016; projected 21 percent by 2018; projected average 14 percent over 2020–22.
- FDI: 10 percent of GDP in 2016.
- External debt: 167 percent of GDP (increase of 4 percentage points).
- Fiscal deficit: nearly 6 percent of GDP in 2016.
- Current spending increase: 2¼ percentage points of GDP (drivers include Mothers’ Law cost nearly 2 percent of GDP).
- General government debt including guarantees: 78 percent of GDP (authorities’ definition without guarantees: 67.5 percent).
- Highway spending in 2017: expected doubling to 6 percent of GDP.
- Fiscal multiplier used for adjustment impact: -0.5 (staff estimate, with a note staff usually assumes -0.3).
- Projected highway cost relative to 2014 GDP: 28 percent of 2014 GDP.
- Projected GDP differential in 2023 with highway: 4¼ percentage points of 2014 GDP higher.
- Projected overall fiscal deficit over 2017–19: average 5¾ percent of GDP.
- Projected general government debt peak: 81 percent of GDP by 2019.
- Projected primary balance by 2020: 4½ percent of GDP.
- VAT increase in 2018 projected to add approximately 1 percentage point to inflation.
- Inflation projections: 2¼ percent average in 2017; 2 percent over 2019–22.

*International Monetary Fund staff report: Montenegro, "Montenegro’s Highway Project" (excerpt).*

### 9.      Policy discussions focused on three key challenges: (i) designing a medium-term fiscal

### 9. Policy discussions focused on three key challenges: (i) designing a medium-term fiscal adjustment strategy to contain fiscal sustainability and refinancing risks; (ii) safeguarding financial-sector stability and supporting financial development; and (iii) improving competitiveness and the business environment.

### A. Fiscal Policies

- Recent fiscal trajectory and pressures
  - Government debt (including guarantees) rose from 32 percent of GDP in 2008 to 72 percent in 2014.
  - Government debt reached 78 percent of GDP in 2016.
  - Highway decision and, in 2016, approval of a new mothers’ benefit and public-sector wage increases added to expenditure pressures.
  - Without any adjustment, debt would likely have risen above 95 percent of GDP by 2020 (considered unsustainable for an emerging market economy).
  - Large Eurobond refinancing needs in 2019-21: between 6 and 11 percent of GDP each year.

- 2017 budget and estimated adjustment
  - 2017 budget measures estimated to deliver 2 percent of GDP in adjustment, split nearly evenly between revenues and expenditures; about one-third temporary.
  - Revenue measures highlighted:
    - Extension through 2019 of the 11 percent top rate for the personal income tax.
    - Increase in excise tax on fuels.
    - Steps to improve tax administration (yield shown below).
  - Expenditure measures highlighted:
    - Reduction in wages of senior public officials and freeze of parts of other public employee wages.
    - Monthly mothers’ benefit reduced by about 20 percent.
    - Reduction in discretionary expenditures including non-highway capital spending.
  - Table of estimated yields from 2017 budget measures (Estimated yield, percent of GDP; “Measure / Staff / Authorities / Permanent Impact (Staff)” formatting in source condensed):
    - Tax administration: 0.1 / 0.4 / 0.1
    - Excises on fuel: 0.7 / 0.8 / 0.7
    - Total revenue measures: 0.9 / 1.2 / 0.9
    - Public sector wage freeze/cuts: 0.2 / 0.2 / 0.2
    - Reduce Mothers Law benefits: 0.2 / 0.2 / 0.2
    - Capital expenditure cuts: 0.3 / 0.3 / ...
    - Other one-off expenditure cuts: 0.5 / 0.9 / 0.1
    - Total expenditure measures: 1.1 / 1.5 / 0.5
    - Total adjustment: 2.0 / 2.7 / 1.4
  - Staff estimate: policies in 2017 budget would result in a primary surplus of 2½ percent of GDP in 2020; government debt would peak at 89 percent of GDP in 2019 under that scenario.
  - If primary balance held at 2 percent of GDP over longer term, debt would fall slowly, reaching 70 percent of GDP in 2030.

- Staff recommendations and medium-term Fiscal Strategy
  - Staff recommended targeting a primary surplus of 4½ percent of GDP by 2020 to fully address fiscal challenges; such a large surplus not feasible before 2020 if highway spending continues through 2019.
  - Authorities adopted in July 2017 a medium-term “Fiscal Strategy” aiming to place debt on a strong downward path.
  - Staff assessment of the Fiscal Strategy: would deliver an additional 2¼ percent of GDP in net non-highway fiscal adjustment by 2020, with 1½ percent of GDP in measures implemented in 2017 and 2018.
  - Strategy weighted more heavily towards revenue gains than expenditure reduction.

- Fiscal Strategy: specific revenue measures and yields
  - VAT increase: VAT will rise from 19 to 21 percent; lower-rate VAT of 7 percent will not change. VAT increase will raise an additional 1 percent of GDP. Parliament approved the VAT increase in July 2017; it will take effect on January 1, 2018.
  - Excises: Excise taxes on cigarettes, sweetened carbonated beverages, and alcohol will be increased progressively through 2020.
    - Specific excise on cigarettes would be raised from €24 per 1000 currently to €50 by 2019.
    - Authorities plan to introduce an excise on coal at the EU minimum level in 2019, with a further increase in 2020.
    - Parliament approved these rates in July 2017.
  - Tax debt rescheduling: program permitting tax debts (14 percent of GDP) to be repaid over five years; interest/penalties forgiven with full repayment.
    - Taxpayers with debts representing 4 percent of GDP entered the program.
    - Staff projects that two-thirds will be collected.
    - Note: interest on tax debts is around 12 percent per year (includes penalty element); cancelation of combined interest and penalties results in a partial amnesty.

- Fiscal Strategy: specific expenditure measures and yields
  - “Mothers’ Law” reform: Constitutional Court ruled lifetime benefit unconstitutional; new benefits designed and approved in June 2017 provide time-limited monthly benefits with no permanent fiscal cost; represent net savings of almost ¾ percent of GDP through 2022.
  - Increase in targeted social assistance to the poor and families with children by 0.2 percent of GDP.
  - Public-sector wage bill: wages of senior officials reduced by 6 percent on top of an 8 percent 2017 cut; freeze workforce and refrain from discretionary wage increases.
  - Discretionary spending cuts: intend to cut current and capital spending by ¼ percent of GDP through 2020.

- Staff assessment of the Fiscal Strategy’s macro-fiscal outcomes
  - With full implementation, staff projects government debt would peak at 81 percent of GDP in 2019 and fall rapidly thereafter.
  - After achieving a primary surplus of 4½ percent of GDP in 2020, authorities could relax the fiscal stance by increasing capital spending on high-return projects; unlikely fiscal space to complete further highway phases through debt.
  - Staff projects general government debt (including guarantees) would reach 66 percent of GDP in 2022.
  - After 2023, authorities should maintain a primary surplus of 3 percent of GDP to ensure continued rapid decline in debt, preferably to below 40 percent in the long-term.

- Financing and market-access implications
  - Unidentified financing needs (not covered by identified domestic/external financing) would average 9 percent of GDP over 2019–21 without the strategy and would likely need to be covered by Eurobond markets.
  - The Fiscal Strategy would reduce unidentified financing needs by 2–3 percentage points of GDP each year over 2019–21.
  - Implementation track record should place Montenegro in a significantly stronger market-refinancing position.

- Quantitative comparisons: Summary of fiscal projections (selected rows; percent of GDP unless otherwise noted)
  - Former baseline (with 2017 budget measures only):
    - Real GDP growth (percent): 3.3 / 3.4 / 2.7 / 2.4 / 3.0 / 3.1 (for years 2017–2022 sequence in source table)
    - Primary fiscal balance: -4.9 / -5.9 / -3.8 / 2.5 / 2.8 / 2.9
    - Non-highway primary fiscal balance: 1.3 / 2.0 / 2.5 / 2.5 / 2.8 / 2.9
    - Unidentified fiscal financing need: 3.6 / 2.0 / 8.1 / 11.4 / 7.5 / 4.8
    - General government debt, including guarantees: 82.0 / 86.2 / 88.9 / 86.0 / 82.5 / 79.9
  - New baseline (adding Fiscal Strategy measures):
    - Real GDP growth (percent): 3.0 / 2.8 / 2.7 / 2.2 / 3.0 / 3.1
    - Primary fiscal balance: -3.9 / -2.9 / -2.2 / 4.4 / 4.2 / 4.0
    - Non-highway primary fiscal balance: 1.9 / 3.5 / 4.3 / 4.4 / 4.2 / 4.0
    - Unidentified fiscal financing need: 0.0 / 1.0 / 4.8 / 9.1 / 5.2 / 0.5
    - General government debt, including guarantees: 79.3 / 81.0 / 81.1 / 76.2 / 70.8 / 65.8

- Debt-management and other medium-term reforms
  - Authorities intend to strengthen debt-management capabilities, including a debt-management strategy to smooth refinancing profile, improve transparency, and investor relations.
  - Consideration of a market-friendly, proactive liability-management operation (LMO) to smooth 2019–21 Eurobond redemptions; IMF technical assistance on LMO provided.
  - Additional reforms suggested by staff to strengthen growth and address long-term challenges:
    - Reduce public-sector employment, especially at local government level; improve taxation and revenue sharing; increase reliance on real-estate value taxation.
    - Introduce full cost-recovery tariffs for water and waste.
    - Pension reforms: eliminate early retirement schemes; initial pensions wage-valorized and CPI-indexed; link retirement age to life expectancy.
    - Accelerate coal-excise introduction to finance a reduction of social contributions and reduce labor-tax wedge; implicit coal subsidies estimated at 14 percent of GDP (mostly local pollution costs).

- Authorities’ views
  - Authorities agreed on need for fiscal adjustment and that strategy would place debt on downward path, bolster market access, and improve credit rating.
  - Authorities broadly agreed with staff on growth and revenue assumptions but expect lower capital spending, pensions, interest payments, and wage bill over medium term.
  - Authorities prefer to maintain low personal and corporate income tax rates to preserve FDI attractiveness.
  - Authorities cautious on high excises disrupting energy industry and imposing costs on consumers; expect more revenue from tax-debt restructuring and reductions in gray economy.
  - Authorities agree public-sector employment should be reduced but require time for comprehensive civil-service reform; World Bank PBG includes employment reduction targets.
  - Authorities agree there is no fiscal space to complete final highway phases through debt financing; may pursue concession or public-private partnership.

### B. Credit and Financial Sector Policies

- Structure and size of financial sector
  - Fully euroized financial system dominated by banks, which account for about 90 percent of system assets—equivalent to about 100 percent of GDP.
  - Foreign subsidiaries hold over ¾ of the sector’s assets.
  - Loan composition: households (mostly mortgages) 42 percent of loans; trade sector 14 percent; nonresident loans 13 percent.
  - Insurance sector small (2 percent of GDP) but grew steadily during 2000–15.
  - Non-bank financial system plays a minor role; stock exchange market capitalization significant but turnover very low; bond market thin.
  - Six micro-credit institutions total assets below 2 percent of GDP; leasing market insignificant and declining since crisis.

- Stability, liquidity, capitalization, and risks
  - Banking sector appears stable, liquid, and adequately capitalized on average.
  - At end-June 2017, aggregate capital assets ratio (CAR) exceeded the 10 percent minimum by 7 percentage points.
  - System assets grew 11 percent year-on-year; capital, liquid assets, and deposits increased by 3, 4, and 11 percent, respectively.
  - Share of liquid assets in assets was 21 percent at end-June 2017.
  - Key challenges:
    - Persistent, though declining, NPLs.
    - Competitive pressures.
    - Low profitability: return on equity was 2 percent at end-2016 (0.3 percent on assets), with improvements noted in 2017.

- Financial-sector performance indicators (as presented)
  - Non-Performing Loans (in percent): graphical shows decline from peak levels (source charts in original).
  - Banks' net profits: returned to tentative profitability in 2016; net profit figures shown in charts (percent of average capital; percent of average assets).
  - Bank lending: credit growth remains low, overcoming dearth of profitable projects and high interest rates; effective lending-deposit rate spread declining while deposit returns also falling.

*Source: IMF staff estimates and Montenegrin authorities (extracted from chapter 9 of the IMF country report).*

### 25.      Private-sector credit is recovering.

### 25.      Private-sector credit is recovering.

### Credit recovery and trends
- Private-sector credit declined from nearly 90 percent of GDP before the financial crisis to 50 percent of GDP in 2012 and has remained there since.
- Credit growth has been positive since 2015: 6 percent in 2016, and projected at 8 percent in 2017.
- Household credit grew faster than corporate credit and is close to its pre-crisis peak.
- Lending is likely to remain somewhat subdued until balance sheets strengthen and the economy improves sustainably.

### Non-performing loans (NPLs) and NPL resolution
- NPLs peaked at more than a quarter of gross loans in mid-2011.
- NPLs have been declining steadily since 2012 to 9.5 percent at end-June 2017.
- Much of the decline reflects shifting NPLs to asset management companies (AMCs) owned by foreign banks’ mother houses (NPLs must be written off after 24 months).
- In 2015, together with the Law on Voluntary Financial Restructuring of Debts to Financial Institutions, the Central Bank of Montenegro (CBM) obliged banks to adopt three-year strategies for managing NPLs, including annual operating targets.
- The restructuring law was extended until May 2018 with revisions to broaden asset coverage and increase participation incentives (following FSAP recommendations).

### Banking sector structure, competition, and profitability
- Currently, 15 banks are operating in Montenegro.
- With one bank for every 40,000 residents, the system appears to be “overbanked”.
- Banks report that margins are under pressure and some banks appear to be fighting for market share.
- Staff analysis suggests lending activities are unprofitable system-wide mainly because of high provisioning; this could lead to a reversal of the declining NPL trend.
- Interest rate spreads have declined since 2014; the effective average lending rate declined to 7 percent.
- Given ample liquidity, the declining trend of interest rates might continue.
- Increasing the minimum capital from €5 million to €10 million might facilitate consolidation of the sector and boost capital buffers.
- Larger banks typically have higher-than-average lending margins but also lower lending rates; the lending market is fragmented with four banks holding a slim majority position.

### Supervision, audits, and asset quality review (AQR)
- The CBM monitors banks through off- and on-site inspections.
- The three banks with qualified audits are subject to strict supervisory action plans, with one bank supervised daily; these banks are not systemically important, and their CARs exceed required levels.
- If action plans do not produce results, these banks would be resolved within a year; staff encouraged steadfast implementation of the action plans.
- Supervisors lack the capacity to challenge banks’ real-estate collateral valuations and there might be under-provisioning, particularly for the weaker banks.
- The application of IFRS-9 norms for loan classification might reveal losses.
- An asset quality review (AQR) should be conducted as soon as practicable; an AQR would review loan classification and provisioning practices and should start with the banks with qualified audits.
- Banking-system stress tests suggest banks are most vulnerable to credit and liquidity risks; market risk was assessed as low.
- Sensitivity analysis of interest rate changes revealed manageable impairment of the systemic capital adequacy ratio.
- The exposure of the Montenegrin banking system to direct foreign exchange risk is low because most non-resident exposure is in euros.

### Exposure to government, reserves, and ELA options
- In March 2017, the CBM disallowed holding T-bills for required reserves (previously up to 25 percent), while lowering the reserve requirement by 2 percentage points to 7 percent.
- At end-March 2017, system-wide exposure to the government amounted to €510 million (13 percent of GDP).
- In an emergency, the CBM can lower required reserves; currently the banking sector is highly liquid.
- The nine foreign-owned banks, which account for ¾ of assets/liabilities, would likely receive assistance from their owners.
- For residual needs, per FSAP recommendations, the CBM should ask for credit lines from foreign banks, but this has not been pre-arranged.
- Under EU regulations, fiscal funds can be used in a systemic crisis, but fiscal capacity is limited.
- The CBM is considering a resolution fund with risk-based contributions from banks to supplement and back-stop ELA efforts.

### Legal and regulatory reforms (FSAP recommendations)
- The CBM is implementing FSAP recommendations, to be incorporated into six new laws and related directives:
  - (i) Central Bank Act;
  - (ii) Banking Law;
  - (iii) Law on Financial Institutions;
  - (iv) Law on Recovery and Resolution of Banks;
  - (v) Law on Voluntary Loan Restructuring; and
  - (vi) Deposit Insurance Law.
- The CBM expects the laws to be adopted by end-2017.
- FSAP recommendations include: defining systemically-important banks; organizing rehabilitation units; strengthening prudential provisions for NPLs; improving the regulatory framework for liquidity and credit risks; regulating consolidated supervision of banks, insurance, and factoring companies; and meeting EU requirements on deposit guarantee schemes.
- The laws will elevate CBM directives and regulations for prudential supervision to the level of national legislation.
- Laws (iv) and (vi) require review by the European Commission, which could lead to delays.

### Authorities’ views and planned actions
- Authorities stressed the banking system was stable, solvent, and highly liquid, and expected continued improvement.
- They identified relatively high NPL ratios and low credit demand as the two most important vulnerabilities.
- Authorities agreed banks needed to control credit risk and reduce operational costs to improve profitability and believed proposed legislation on NPLs would accelerate resolution.
- Authorities are reviewing staff’s suggestion to raise minimum capital requirements to encourage consolidation.
- The authorities intended to implement a system-wide AQR in 2018/19, citing CBM capacity constraints and costs borne by banks as reasons to start with systemically-important banks.
- They thought AQR benefits would be greater following adoption of planned supportive legislation and IFRS-9 implementation (planned for 2018).
- The CBM is intensely engaged with auditors of the three weakest banks and believes their action plans will lead to improvements.
- Authorities appreciate the need to develop a framework for ELA and believe current vulnerabilities are relatively low.

### Structural reforms affecting credit demand and competitiveness
- Montenegro’s Doing Business score has been improving along with peers, but its ranking fell from 48th to 51st place.
- High indirect and administrative costs are worsening price competitiveness and are damaging exports; “trading across borders” is administratively expensive.
- Labor market rigidities cause high levels of long-term and youth unemployment and disincentives for open-ended employment:
  - Long-term unemployment accounts for three-fourths of total unemployment.
  - Montenegro has one of the highest rates of temporary employment in Europe, disproportionately affecting young workers.
  - High tax burdens on low-income workers and a relatively high minimum wage drive a quarter of the workforce into informality.
  - Public sector employment is high and pays more than the private sector.
- Recommendations to improve labor markets and job creation:
  - Allow firms to adjust their workforce to encourage hiring with open-ended contracts.
  - Reduce the tax burden on low-paid individuals to encourage hiring and lessen informal employment.
  - Carefully review the level of the minimum wage as it is relatively high compared to peers and likely binding for a significant share of young workers.
  - Reallocate Active Labor Market Policy (ALMP) funding to the most promising programs and align curricula with labor needs.
  - Enforce active job-search verification and participation in activation programs to receive unemployment benefits.
- External competitiveness concerns:
  - Current account deficit of 19 percent of GDP in 2016 was weaker than that consistent with medium-term fundamentals.
  - The real effective exchange rate has appreciated; staff considers the real exchange rate to be moderately overvalued.
  - Labor productivity has stagnated as an inflexible labor market has driven up unit-labor costs.
  - Productivity gains are limited by low levels of R&D spending.
  - The goods-export base is increasingly concentrated in low value-added sectors; export shares to the euro area and the world have fallen despite euroization and convergence towards EU standards.
  - Tourism is productive but vulnerable to high costs and price sensitivity of source markets.
- Montenegro’s heavy dependence on external financing reinforces the importance of fiscal and structural reforms to safeguard market access.

*Source: IMF staff report excerpt (cr17276).*

### 41.      Some state-owned enterprises (SOEs) are a drag on public finances and

### 41.      Some state-owned enterprises (SOEs) are a drag on public finances and

### SOE performance and privatization
- Privatization process has slowed recently; the tender for the Port of Bar was cancelled.
- There are SOEs without public policy functions that are loss making and/or have significant tax arrears (Montenegro Airlines, Plantaže winery, etc.).
- Municipal SOEs are often the employer of first resort.
- The pending exit of a minority foreign investor in EPCG, the electricity utility, requires finding a new strategic investor or purchasing shares valued at €250 million (6 percent of GDP).
- Staff recommendation: reaccelerate the privatization process and merge some municipal SOEs to achieve efficiency gains.

### Authorities’ infrastructure and energy strategy
- Authorities are addressing underdeveloped infrastructure with substantial investments in electricity generation and transport.
- Key projects and expected benefits cited by authorities:
  - Construction of an undersea cable with Italy.
  - Improving interconnections with Serbia.
  - Building a second thermal power-plant.
  - Completing smaller hydro-stations.
  - These measures are expected to improve energy-network stability and help develop regional energy markets.
- The Bar-Boljare highway is expected to connect underdeveloped northern regions with the capital and alleviate transport bottlenecks.
- Other infrastructure projects amounting to €1.1 billion over three years are described as being in line with EU priorities under an agreed-upon connectivity agenda.
- Authorities believe they have improved the AML/CFT framework and that their ratings in the next MONEYVAL report could be upgraded.

### Labor law, labor-market reforms, and public wages
- Authorities envisage approval of a new labor law in 2017/18.
  - The present labor law is already in line with EU directives; a new law is expected to improve competitiveness and is envisaged for the World Bank PBG.
  - The labor-law working group includes social partners debating:
    - How to improve labor-market flexibility.
    - How to improve sanctions for unregistered work.
    - How to better target AMLPs.
    - How to increase market participation.
- Authorities plan to maintain discipline over public-sector wages.
- Authorities state that their privatization program is on track.

### Staff appraisal: fiscal stance, debt, and public finances
- Economic growth expected to gather speed and maintain momentum, despite a moderate drag from fiscal consolidation driven partly by highway construction and other large investment projects.
- After a post-crisis debt build-up—caused partly by the highway—the authorities’ focus on fiscal adjustment is judged appropriate.
- Key fiscal recommendations and projections:
  - Government debt is reaching levels that may not be sustainable; debt needs to be reduced urgently.
  - Authorities should front-load significant fiscal adjustment to meet large refinancing needs and reduce debt quickly after construction of the highway finishes.
  - Fiscal space does not exist to finance the remaining phases of the highway with debt.
  - Fiscal and structural reforms are paramount to safeguard market access and ensure external stability given Montenegro’s dependence on external financing.
  - The authorities’ medium-term fiscal adjustment plan is characterized as well specified, growth friendly, and socially balanced; steadfast political efforts required to implement.
  - Including measures already implemented in the 2017 budget, staff projects the authorities’ fiscal strategy should result in a primary surplus of 4½ percent of GDP by 2020, leading debt to fall quickly after peaking at 81 percent of GDP in 2019 (74 percent without guarantees).
  - After 2020, the primary surplus could be relaxed gradually while maintaining a primary surplus of 3 percent of GDP over the longer term.
  - Potential future fiscal space should be used for high-quality projects and only after debt is firmly on a downward path.
  - Authorities should limit government guarantees for SOEs and reinvigorate the privatization process.

### Structural reforms and social policy recommendations
- Over the medium term, recommended measures to improve sustainability and competitiveness:
  - Reduce the public-sector workforce.
  - Restrict early-retirement pensions; eliminate early-retirement pensions to strengthen pension sustainability.
  - Lower social contributions; consider using resources from an increased coal excise to lower social contributions and/or shift some burden away from employers.
  - Implement a well-designed civil-service reform to reform salary structures and right-size the public-sector workforce.
  - Shift pensions to wage-valorization and CPI-indexation to ensure long-term fiscal and social sustainability.
  - Strengthen local government finances by increased reliance on real-estate value taxes.
- Expected social and labor-market effects:
  - Measures to increase formalization and reduce the informal economy should expand employment and boost economic growth.
  - Public-sector wages should be carefully calibrated to support cost competitiveness.

### Financial sector recommendations
- Support banks’ efforts to reduce NPLs.
- Steadfastly implement supervisory action plans for problem banks.
- Asset quality reviews (AQRs) should be undertaken as soon as practically possible.
- The banking system is described as overbanked; consider an increase of the minimum capital requirement to prompt consolidation and improve competitive outcomes.
- Central Bank of Montenegro (CBM) intention to expand supervision to cover the non-bank financial system (factoring companies and insurance providers) is welcomed.
- Explore options to improve emergency liquidity assistance (ELA) in line with best practice and EU requirements.
- Continue to improve the AML/CFT framework and implement outstanding recommendations of the 2015 FSAP.

### Competitiveness and productivity
- Montenegro faces competitiveness challenges and its external position is weaker than that consistent with medium-term fundamentals.
- With euroization and fiscal-adjustment needs constraining the capacity to absorb shocks, authorities should accelerate structural reforms.
- Greater labor-market flexibility and improved productivity are needed to sustain longer-term growth.
- Improvements to the business environment, including advances in energy infrastructure and improvements in governance, can support productivity growth.

* IMF staff appraisal and authorities’ views as presented in the source document. *

### 2. Expense

### 2. Expense

### Expense composition (series of values as presented)
- Gross salaries and other personal income: 41.3, 41.8, 39.0, 40.8, 39.2, 43.1, 38.8, 40.9, 40.1, 39.2, 38.9, 38.6, 38.4
- Use of goods and services: 11.9, 11.3, 11.4, 11.1, 10.6, 11.6, 10.6, 11.2, 10.7, 10.4, 10.4, 10.4, 10.3
- Interest payments: 7.2, 4.1, 4.1, 5.2, 4.0, 4.9, 3.8, 4.4, 4.3, 4.1, 4.0, 4.3, 4.5
- Subsidies to enterprises: 1.9, 2.1, 2.3, 2.4, 2.4, 2.3, 2.4, 2.5, 2.6, 2.7, 2.6, 2.3, 2.1
- Other current outflows: 0.8, 0.5, 0.5, 0.6, 0.6, 0.7, 0.6, 0.7, 0.7, 0.7, 0.7, 0.7, 0.7
- Social security transfers: 0.5, 1.0, 1.1, 1.2, 1.2, 1.3, 1.2, 1.3, 1.4, 1.2, 1.2, 1.2, 1.2
- Other transfers: 15.2, 14.4, 14.2, 13.5, 14.5, 14.7, 14.4, 14.2, 13.9, 13.7, 13.5, 13.4, 13.2
- Repayment of guarantees: 2.4, 4.6, 4.4, 6.4, 5.5, 7.0, 5.3, 6.0, 6.0, 5.9, 5.8, 5.8, 5.8
- Reserves: 0.8, 3.2, 0.5, 0.0, 0.0, 0.0, 0.0, 0.0, 0.0, 0.0, 0.0, 0.0, 0.0
- (An additional reserves line appears:) 0.7, 0.5, 0.5, 0.5, 0.4, 0.6, 0.4, 0.5, 0.5, 0.5, 0.5, 0.5, 0.5

### Fiscal balances and investment
- Gross operating balance (= 1 - 2): -1.6, -0.7, 4.3, -0.3, 2.8, 0.1, 2.9, 2.6, 4.9, 5.9, 6.1, 6.3, 6.4
- Net acquisition of nonfinancial assets: 4.2, 3.7, 5.2, 5.4, 12.0, 6.0, 11.9, 9.1, 10.5, 10.8, 4.2, 4.4, 4.5
  - Capital revenue: -0.2, -0.3, -0.2, -0.2, -0.2, -0.1, -0.2, -0.1, -0.1, -0.1, -0.1, -0.1, -0.1
  - Capital expenditure: 4.3, 3.9, 5.5, 5.7, 12.2, 6.2, 12.1, 9.2, 10.6, 10.9, 4.3, 4.5, 4.6

- Net lending (+) / borrowing (-) (= 3 - 4): -5.7, -4.4, -1.0, -5.8, -9.2, -5.9, -9.0, -6.5, -5.6, -4.8, 1.9, 1.9, 1.9

### Financial transactions and liabilities
- Net acquisition of financial assets: 0.3, -1.3, -0.1, 0.0, -1.8, -0.8, 0.1, -0.4, -0.3, 0.0, 0.0, 0.0, 0.0
  - Domestic: 0.3, -1.3, -0.1, 0.0, -1.8, -0.8, 0.1, -0.4, -0.3, 0.0, 0.0, 0.0, 0.0
  - Currency and deposits: 0.4, -0.7, 0.5, 0.2, -1.6, -0.6, 0.3, -0.2, -0.1, 0.0, 0.0, 0.0, 0.0
  - Loans: 0.1, 0.1, -0.3, 0.1, -0.1, 0.1, -0.1, 0.0, 0.0, 0.0, 0.0, 0.0, 0.0
  - Equity and investment fund shares: -0.2, -0.8, -0.3, -0.3, -0.1, -0.3, -0.2, -0.2, -0.2, 0.0, 0.0, 0.0, 0.0

- Net incurrence of liabilities: 6.0, 3.0, 0.9, 5.8, -1.3, 5.1, 2.8, 6.0, 4.4, -0.3, -11.4, -7.0, -2.4
  - Domestic: -0.2, -1.1, -2.0, -0.1, 0.2, 2.4, -0.1, -0.5, 0.0, 0.4, 0.4, 0.6, -0.8
  - Foreign: 6.2, 4.1, 2.8, 5.9, -1.5, 2.8, 2.9, 6.5, 4.4, -0.7, -11.8, -7.6, -1.6

- Discrepancy (= 5 - 6 + 7): 0.0, 0.0, 0.0, 0.0, -8.8, 0.0, -6.3, -0.1, -0.9, -5.1, -9.6, -5.1, -0.5

### Memorandum items (selected)
- Primary balance: -3.9, -2.2, 1.3, -3.4, -6.9, -3.7, -6.6, -4.0, -2.9, -2.2, 4.5, 4.2, 4.0
- Nonhighway primary balance: -3.9, -2.2, 1.3, -1.4, ..., -1.0, ..., 1.9, 3.6, 4.4, 4.5, 4.2, 4.0
- Current balance: -2.1, -1.0, 4.0, -0.6, ..., 5.0, ..., 2.0, 4.5, 5.6, 5.9, 6.1, 6.2

*Sources: Ministry of Finance; and Fund staff estimates and projections. 1/ Includes republican budget and local governments.*

### Annex I. Risk Assessment Matrix

### Annex I. Risk Assessment Matrix

### Overview and methodology
- The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).
- The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more).
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

### 1. Structurally weak growth in key advanced economies
- Relative Likelihood: High
- Impact if Realized:
  - Low productivity growth (U.S., the Euro Area, and Japan), a failure to fully address crisis legacies and undertake structural reforms, and persistently low inflation (the Euro Area, and Japan) undermine medium-term growth in advanced economies.
  - High: A protracted slowdown in the EU and neighboring countries could adversely impact the appetite for external and public financing (especially FDI flows and tourism infrastructure developments). Further “low-flation” could be imported from the euro area which, if protracted, would adversely impact debt dynamics, consumption, and bank profitability.
- Policy Response:
  - Let automatic fiscal stabilizers work, within limited fiscal space.
  - Accelerate structural reforms to increase competitiveness and reduce structural bottlenecks that impede credit to the private sector.

### 2. Financial conditions: tighter global financial conditions
- Relative Likelihood: High
- Impact if Realized:
  - Fed normalization and tapering by ECB increase global rates and term premia, strengthen the U.S. dollar and the euro vis-à-vis the other currencies, and correct market valuations. Adjustments could be disruptive if there are policy surprises. Higher debt service and refinancing risks could stress leveraged firms, households, and vulnerable sovereigns, including through capital account pressures in some cases.
  - High: Montenegro is highly reliant on external financing. Gross public financing needs average 15 percent of GDP during the next five years, with large Eurobond rollover needs in 2019–21.
- Policy Response:
  - Let automatic fiscal stabilizers work, within limited fiscal space.
  - Continue to implement the medium-term fiscal consolidation plan that puts debt on a strongly downward trajectory.

### 3. Intensification of the risks of fragmentation/security dislocation
- Relative Likelihood: High
- Impact if Realized:
  - Intensifying conflicts in the Middle East increased the number of terrorist attacks on European soil and refugee flows into Europe. Heightened security concerns may weaken confidence and disrupt socio-economic activities. The lack of a common cooperative policy to deal with asylum seekers to the European Union (EU) could stop the relocation of refugees within the Union, triggering domino effects by increasing processing times and restricting the free movement of goods, services, and labor across the single market. Limited integration of asylum seekers into the labor force could raise unemployment rates, put pressure on national budgets, and put social cohesion at risk. The failure to collectively address the refugee surge could further raise euroskepticism.
  - Medium: Given important tourism and real estate links, such restrictive developments could undermine FDI inflows and thus weaken growth prospects, depress real estate prices, and further limit Montenegro’s capacity to absorb shocks.
- Policy Response:
  - Let automatic fiscal stabilizers work, within limited fiscal space.
  - Speed up structural reforms to improve the business environment and competitiveness.
  - Accelerate structural reform and policies to facilitate the resolution of problem loans and encourage a revitalization of bank lending.

### 4. Insufficient fiscal discipline
- Relative Likelihood: High
- Impact if Realized:
  - The authorities do not have a strong track record concerning fiscal consolidation. The highway is a source of fiscal pressures. It will be politically difficult to maintain the primary surpluses needed to keep public debt on a strong downward path. The ruling coalition has a small majority in parliament.
  - High: Given high and increasing public debt, a loss of fiscal discipline could lead to financing difficulties and potentially result in debt distress.
- Policy Response:
  - Sustain medium-term fiscal consolidation plans; reduce public wage and pension spending over time, strengthen tax administration, and reduce tax exemptions.
  - Improve public communication regarding the need for fiscal adjustment.

### 5. Delays and withdrawals from capital investment projects
- Relative Likelihood: Medium
- Impact if Realized:
  - Ongoing geopolitical tensions, weak administrative procedures on land development, and concerns regarding public fiscal sustainability could threaten capital investments in tourism and industry.
  - Medium: Construction and activity associated with large-scale investment projects (both tourism and infrastructure based) are key drivers of growth.
- Policy Response:
  - Put in place a credible strategy to safeguard fiscal sustainability and implement structural reforms to improve the business environment and strengthen anti-corruption and AML/CFT frameworks.

### 6. Supervisory action plans fail to improve the banks with qualified audit reports
- Relative Likelihood: Low
- Impact if Realized:
  - Inability of weak banks to comply with minimum supervisory requirements and with required capital increases.
  - High: Could negatively affect the perceptions of the system’s stability.
- Policy Response:
  - Steadfastly implement agreed supervisory action plans. Require shareholders to contribute additional capital. Adjust action plans as needed.

*International Monetary Fund — Annex I. Risk Assessment Matrix (as provided in the source content).*

### 3.      Standard stress tests

### 3.      Standard stress tests

### Scenarios and projected impacts
- Growth shock:
  - Real output growth rates are lowered during 2018 and 2019 by one standard deviation (4.5 percentage points), also lowering inflation and raising interest rates.
  - The public debt ratio increases peaks at 99 percent of GDP in 2019 before falling to 84 percent of GDP in 2022.
  - The gross financing needs ratio in 2019 increases 9 percentage points of GDP relative to the baseline.
- Interest rate shock:
  - Increase in interest rates on new debt by 200 basis points (in addition to the baseline assumption of 100 bps) in 2018–22.
  - Debt increases by 3 percentage points in 2022 in this scenario relative to the baseline.
  - Financing needs are affected only marginally.
- Combined macro shock:
  - Comprises a recession in 2018 and 2019, a 200 basis-point increase in interest rates, a real exchange rate shock, and a sharp rise in expenditures.
  - Pushes the debt to GDP ratio up by 22 percentage points to 88 percent of GDP by 2022 and substantially impacts gross financing needs.
- Financial contingent liability shock:
  - Expenditures increase in 2018 equivalent to 10 percent of the size of the banking sector, combined with a shock to GDP and interest rates.
  - The shock results in a sharp increase in the debt ratio by 17 percentage points to 83 percent of GDP by 2022.
  - Gross financing needs would peak at 27 percent of GDP in 2019 and stay well above the baseline over the medium term.
- Primary balance shock:
  - Assumes an expenditure shock and a rise in interest rates leading to a greater than two percentage point deterioration in the primary balance in 2019 and 2020.
  - The combined shocks lead to deterioration in the debt ratio by about 5 percent of GDP by 2022.
  - Impact on gross financing needs peaks at 3 percentage points of GDP in 2019.
- Real exchange rate shock:
  - Assumes a 13 percent depreciation of the real exchange rate in 2018.
  - The Chinese ExIm loan would be issued piecemeal over the course of highway construction.
  - The debt ratio would fall by 2 percent of GDP from the baseline by 2020, based on a larger GDP deflator, with the impact depending critically on the extent of exchange rate pass-through to inflation.

### Baseline indicators and selected projections (as reported)
- Nominal gross public debt series (in percent of GDP): 50.1 (2015), 76.8 (2016), 78.0 (2017), 79.7 (2018), 80.9 (2019), 80.7 (2020), 75.9 (2021), 70.8 (2022), 65.9 (projection table heading).
- Of which: guarantees (in percent of GDP): 6.6 (2015), 7.5 (2016), 7.9 (2017), 7.7 (2018), 7.3 (2019), 7.0 (2020), 6.7 (2021), 6.4 (2022), 6.1 (projection table heading).
- Public gross financing needs (in percent of GDP): 4.5 (2015), 14.0 (2016), 21.5 (2017), 16.6 (2018), 14.7 (2019), 22.1 (2020), 20.4 (2021), 16.6 (2022), 11.1 (projection table heading).
- Real GDP growth (in percent): 3.2 (2015), 3.4 (2016), 2.5 (2017), 3.0 (2018), 2.8 (2019), 2.7 (2020), 2.2 (2021), 3.0 (2022), 3.1 (projection table heading).
- Inflation (GDP deflator, in percent): 4.3 (2015), 1.4 (2016), 1.6 (2017), 2.2 (2018), 2.6 (2019), 2.0 (2020), 1.7 (2021), 1.8 (2022), 1.9 (projection table heading).
- Nominal GDP growth (in percent): 7.8 (2015), 4.8 (2016), 4.1 (2017), 5.2 (2018), 5.5 (2019), 4.7 (2020), 4.0 (2021), 4.9 (2022), 5.1 (projection table heading).
- Effective interest rate (in percent): 3.6 (2015), 3.9 (2016), 3.4 (2017), 3.8 (2018), 3.9 (2019), 3.9 (2020), 3.9 (2021), 3.8 (2022), 3.9 (projection table heading).

### Contribution to public debt changes and fiscal dynamics
- Change in gross public sector debt (cumulative): 3.9 (2015), 5.3 (2016), 1.2 (2017), 1.8 (2018), 1.2 (2019), -0.2 (2020), -4.8 (2021), -5.1 (2022), -5.0 (projection), -12.1 (cumulative).
- Identified debt-creating flows (in percent of GDP): -0.2 (2015), 4.7 (2016), 2.9 (2017), 2.6 (2018), 1.5 (2019), 0.2 (2020), -4.6 (2021), -5.0 (2022), -4.8 (projection), -10.1 (cumulative).
- Primary deficit (in percent of GDP): 0.7 (2015), 3.5 (2016), 3.8 (2017), 3.9 (2018), 2.9 (2019), 2.2 (2020), -4.4 (2021), -4.2 (2022), -4.0 (projection), -3.5 (cumulative).
- Primary (noninterest) revenue and grants (in percent of GDP): 44.3 (2015), 40.7 (2016), 43.3 (2017), 43.5 (2018), 45.1 (2019), 45.2 (2020), 45.1 (2021), 45.0 (2022), 44.9 (projection), 268.9 (cumulative).
- Primary (noninterest) expenditure (in percent of GDP): 45.0 (2015), 44.2 (2016), 47.1 (2017), 47.5 (2018), 48.1 (2019), 47.4 (2020), 40.7 (2021), 40.9 (2022), 40.9 (projection), 265.3 (cumulative).
- Automatic debt dynamics contribution (in percent of GDP): -1.0 (2015), -0.6 (2016), 0.0 (2017), -1.0 (2018), -1.2 (2019), -0.6 (2020), -0.1 (2021), -0.8 (2022), -0.8 (projection), -4.6 (cumulative).
  - Real interest rate contribution: 0.1 (2015), 1.7 (2016), 1.7 (2017), 1.2 (2018), 0.9 (2019), 1.4 (2020), 1.6 (2021), 1.4 (2022), 1.3 (projection), 7.8 (cumulative).
  - Real GDP growth contribution: -1.1 (2015), -2.3 (2016), -1.8 (2017), -2.2 (2018), -2.1 (2019), -2.1 (2020), -1.7 (2021), -2.2 (2022), -2.1 (projection), -12.3 (cumulative).
- Other identified debt-creating flows (in percent of GDP): 0.1 (2015), 1.8 (2016), -0.9 (2017), -0.3 (2018), -0.3 (2019), -1.4 (2020), 0.0 (2021), 0.0 (2022), 0.0 (projection), -2.0 (cumulative).
  - Privatization and deposits (negative): -0.5 (2015), 1.8 (2016), -0.9 (2017), -0.3 (2018), -0.3 (2019), 0.0 (2020), 0.0 (2021), 0.0 (2022), 0.0 (projection), -0.7 (cumulative).
  - Contingent liabilities: 0.6 (2015), 0.0 (2016), 0.0 (2017), 0.0 (2018), 0.0 (2019), 0.0 (2020), 0.0 (2021), 0.0 (2022), 0.0 (projection), 0.0 (cumulative).
  - Use of foreign account receivable: 0.0 (2015), 0.0 (2016), 0.0 (2017), 0.0 (2018), 0.0 (2019), -1.3 (2020), 0.0 (2021), 0.0 (2022), 0.0 (projection), -1.3 (cumulative).
- Residual, including asset changes (in percent of GDP): 4.1 (2015), 0.6 (2016), -1.7 (2017), -0.8 (2018), -0.3 (2019), -0.3 (2020), -0.2 (2021), -0.2 (2022), -0.2 (projection), -2.0 (cumulative).

### Alternative scenarios and selected stress-test parameter values
- Baseline, Historical, and Constant Primary Balance scenario tables report:
  - Baseline Real GDP growth (2017–2022): 3.0, 2.8, 2.7, 2.2, 3.0, 3.1.
  - Baseline Inflation (2017–2022): 2.2, 2.6, 2.0, 1.7, 1.8, 1.9.
  - Baseline Primary Balance (2017–2022): -3.9, -2.9, -2.2, 4.4, 4.2, 4.0.
  - Constant Primary Balance scenario sets Primary Balance at -3.9 for 2017–2022.
- Stress-test specific assumed paths (selected):
  - Primary Balance Shock: Real GDP growth 3.0, 2.8, 2.7, 2.2, 3.0, 3.1; Inflation 2.2, 2.6, 2.0, 1.7, 1.8, 1.9; Primary balance -3.9, -5.2, -4.4, 4.4, 4.2, 4.0; Effective interest rate 3.8, 3.9, 4.0, 4.1, 4.0, 4.1.
  - Real GDP Growth Shock: Real GDP growth 3.0, -1.7, -1.9, 2.2, 3.0, 3.1; Inflation 2.2, 1.5, 0.9, 1.7, 1.8, 1.9; Primary balance -3.9, -5.7, -7.8, 4.4, 4.2, 4.0; Effective interest rate 3.8, 3.9, 4.0, 4.3, 4.2, 4.3.
  - Real Interest Rate Shock: Effective interest rate path includes 3.8, 3.9, 4.3, 4.6, 5.0, 5.5 for 2017–2022.
  - Real Exchange Rate Shock: Inflation path includes 2.2, 7.1, 2.0, 1.7, 1.8, 1.9 for 2017–2022; primary balance unchanged relative to baseline in reported table.
  - Combined Shock: Real GDP growth 3.0, -1.7, -1.9, 2.2, 3.0, 3.1; Primary balance -3.9, -5.7, -7.8, 4.4, 4.2, 4.0; Effective interest rate 3.8, 4.0, 4.2, 4.6, 5.0, 5.4.
  - Contingent Liability Shock: Primary balance path includes -3.9, -9.9, -2.2, 4.4, 4.2, 4.0; Effective interest rate 3.8, 4.2, 4.2, 4.1, 4.0, 4.1.

### Stress-test findings, risk assessment, and realism checks
- Standardized stress tests indicate external debt is particularly sensitive to currency depreciation.
- Current account shocks—possibly related to highway project cost overruns—and a combined deterioration in the macroeconomic environment would also affect external sustainability, with significant implications for gross financing needs.
- External debt: increased by 35 percentage points of GDP since 2008, to an estimated 167 percent of GDP in 2016.
  - Under the baseline, external debt is projected to peak at 175 percent of GDP, before declining to 165 percent in 2022.
  - The projected debt trajectory is highly sensitive to various shocks, particularly a depreciation of the euro.
- Risk assessment heat map and thresholds referenced:
  - Benchmarks include 200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.
- Forecast track record and realism assessments:
  - Distributional forecast errors and percentile ranks are reported for Real GDP Growth, Primary Balance, and Inflation (Deflator) for 2007–2015 with Montenegro percentile ranks reported as: Real GDP Growth median forecast error -0.22 (62% percentile rank), Primary Balance median forecast error 0.00 (58% percentile rank), Inflation (Deflator) median forecast error -0.14 (40% percentile rank).
  - Assessment of fiscal adjustment realism: 3-year CAPB adjustment and 3-year average CAPB level percentile ranks reported (examples: 3-year CAPB adjustment has a percentile rank of 2%; 3-year average CAPB level has a percentile rank of 10%).

*Source: IMF staff.*

### 2.      Standard stress tests

### 2.      Standard stress tests

### Stress test scenarios
- Growth shock
  - Baseline real GDP growth is permanently reduced by a one-half standard deviation calculated over the recent 10-year period ending in 2016.
  - This corresponds to an average growth rate during 2018–22 of 0.5 percent, compared with baseline average growth of 2.3 percent.
  - Under this scenario, the external debt ratio increases by 13 percentage points (compared to the baseline) to 180 percent of GDP in 2022.
- Interest rate shock
  - Scenario examines implications of an increase in nominal external interest rates on new debt (relative to the baseline) by a one-half standard deviation during 2018–22.
  - Stable average external interest rates historically imply only a modest average increase in interest rates of 22 basis points in this scenario.
  - Consequence: a reduction in external debt by 0.4 percentage point to 166.5 percent of GDP by 2022.
- Non-interest current account shock
  - Scenario permanently increases the non-interest current account by one-half standard deviation in 2018–22.
  - Given historically-high current account deficits, this amounts to an increase of 6.1 percentage points.
  - In the absence of offsetting non-debt-creating flows, external debt increases by 27 percentage points to 193 percent of GDP by 2022.
- Combined macro shock
  - Permanent 1/4 standard deviation shock applied to the real interest rate, the growth rate, and the current account deficit during 2018–22.
  - The combined shock pushes the external debt ratio up by 21 percentage points to 188 percent of GDP.
  - Gross financing needs increase by 26 percent of GDP cumulatively over the shock period.
- Real exchange rate shock
  - Assumes a one-time 30 percent devaluation in the real exchange rate in 2018 applied to the stock of external debt.
  - Second-round impacts are not considered.
  - Given the large stock of external debt, the shock increases the external debt-to-GDP ratio by 84 percentage points of GDP in 2018.
  - Gross financing needs are higher by about 20 percent of GDP on average over 2018–22 relative to the baseline.

### Key results and indicators (selected figures from text)
- Estimated gross external debt reached a new high of 167 percent of GDP at end-2016 and is projected to reach a peak of 175 percent by 2019.
- Composition and short-term exposure
  - One-third of external debt is government debt, which has expanded 12 percentage points of GDP since 2012.
  - One-half of government debt corresponds to non-bank private sector (mostly Eurobonds).
  - Short-term debts of the private sector (maturing in less than one-year) account for only 4 percent of total private external debt.
- Table highlights (baseline and scenario end points called out in text and figures)
  - Baseline external debt (various years shown in table): values include 155.9, 153.5, 163.1, 163.1, 166.8, 169.8, 173.5, 174.5, 171.6, 168.5, 164.8 (in percent of GDP for 2012–2022 as displayed).
  - Scenario outcomes in figure captions:
    - Interest rate shock: scenario average 166 (baseline 165 shown in figure context).
    - Non-interest current account shock: 193 (scenario) vs Baseline 165.
    - Combined shock: 188 (scenario) vs Baseline 165.
    - Real depreciation shock (30%): 244 (scenario) vs Baseline 165.
  - Gross external financing need (in percent of GDP or levels) rises substantially under shocks (e.g., about 20 percent of GDP average over 2018–22 for the real depreciation shock; combined shock increases gross financing needs by 26 percent of GDP cumulatively).

### Assessment of vulnerabilities and data limitations
- Data and IIP
  - The authorities are in the early stages of constructing international investment position (IIP) statements and TA missions for this effort are planned for this year.
  - In the absence of comprehensive IIP data, staff cannot assess underlying vulnerabilities related to foreign assets and liabilities, nor whether there is a mismatch between currencies and maturities.
  - Given high levels of external debt and current account deficits, IIP data would be crucial for assessing external sustainability.
- Current account and competitiveness
  - Current account deficits reached 19 percent of GDP in 2016 and are forecast to widen to 21 percent of GDP by 2018.
  - From a savings-investment perspective, non-government savings fell 1 percent of GDP and non-government investment grew by 4½ percentage points to 19 percent of GDP.
  - EBA-lite model estimates:
    - Current account gap of -9.7 percent of GDP for 2016 with cyclically-adjusted CA norm of -9.2 percent of GDP (model caveats noted).
    - Considering model uncertainties, staff assesses the CA gap to be in the range of -3 to -4 percent of GDP for 2016, consistent with a CA norm in the range of 14 to 15 percent of GDP.
    - Averaging 2013–2015 current account deficits yields a proxy CA-norm of 14 percent of GDP, implying a 5 percent of GDP current account gap in 2016 and an overvaluation of 10 percent.
  - Real effective exchange rate (REER)
    - CPI-based REER appreciation: modest 3 percent since 2007, recently 2 percent above its 10-year average.
    - EBA-lite REER regression estimates: REER undervalued by 13 percent; CA regression suggests REER overvalued by 20 percent; average implies a 3.5 overvaluation.
    - Staff judgment: REER overvalued by perhaps 10 percent due to large current account deficits, high unit labor costs, stagnating productivity, and weak export performance.

### Policy recommendations and implications
- Fiscal policy
  - The government’s fiscal consolidation plans over the medium-term should help improve the current account by boosting national savings.
- Structural reforms and competitiveness
  - Structural reforms to reduce the cost of doing business, labor market reform, and productivity enhancing reforms would help to restore competitiveness and address the external imbalance.
  - A real depreciation through wage constraint and structural reforms to strengthen competitiveness would help reduce economic imbalances in the medium term.
- Data and capacity building
  - Completing IIP statements and addressing data limitations are important to assess external sustainability and currency/maturity mismatches.
- Financial stability and external financing
  - Large external financing needs in the public and private sector leave Montenegro vulnerable to sudden changes in market sentiment and spillovers from Europe; policies to reduce vulnerabilities and broaden financing sources are implied.

*Source: IMF staff analysis and tables/figures in "2.      Standard stress tests" (cr17276).*

### 3.      The government’s main motivation for this large project is the need to improve

### cr17276 - 3.      The government’s main motivation for this large project is the need to improve

### Bar‑Boljare Highway: objectives, financing, and construction
- Government motivations:
  - Improve connectivity, particularly to Europe through Serbia.
  - Boost tourism and trade.
  - Improve road safety.
  - Strengthen national security.
  - Provide a much safer and more efficient transport route, especially in the northern part of the country.
- Original and revised costs:
  - Original cost: €809 million (20 percent of 2017 GDP).
  - Increased to nearly €1 billion (1/4 of 2017 GDP) because the dollar‑denominated loan from China’s ExIm Bank was not hedged.
- Financing structure:
  - ExIm Bank financing 85 percent of the first segment with a 20‑year US dollar loan, with a fixed 2 percent interest rate and a six‑year grace period on repayment of principal.
  - Remaining 15 percent financed by the government.
- Construction timeline and contractors:
  - Construction started in May 2015 and is scheduled to be completed in 2019.
  - China Road and Bridge Corporation (CRBC) is leading the construction.
  - Domestic companies subcontracted for 30 percent of the works.
  - Authorities intend to help fund repayments with toll revenues once the segment is completed.
- Serbia connection:
  - Serbia plans construction of a connecting highway from Belgrade.
  - In May 2017, the Serbian infrastructure ministry signed a memorandum of understanding with CBRC.
  - Works expected to start in 2018.
  - CRBC has expressed interest in completing phases 2&3 of the Montenegrin highway, but funds are lacking.

### Macroeconomic effects and modelling assumptions
- Short‑run demand effects during construction:
  - Staff generally assumes a fiscal multiplier of 0.3 for Montenegro given its status as a small, open economy with a fixed exchange rate.
  - Given the large import content of the project, staff used an instantaneous demand multiplier of 0.2 during the construction phase.
  - The construction is expected to generate instantaneous demand spillovers for local goods and services with a multiplier effect through the economy.
- Supply effects after completion:
  - Highway completion in 2019 expected to generate positive supply effects.
  - Staff used estimates from the IMF’s 2014 October WEO on the impact of infrastructure investment adjusted for Montenegrin public investment efficiency and considering a low estimated economic rate of return.
  - A World Bank report estimated the return of the whole highway at about half of the normal benchmark of 12 percent used for Bank investment projects.
  - Staff estimates the total supply multiplier to be 0.5 spread over five years—1/3 of the output effects estimated in the 2014 WEO.
- GDP impact and cost effectiveness:
  - Total GDP including the highway in 2023—the year with the largest difference—would be about 4¼ percentage points of 2014 GDP higher than without it.
  - This is a modest increase given the cost of 28 percent of 2014 GDP.
  - Growth thereafter would be slightly lower in the scenario with the highway because the higher capital stock would imply larger depreciation.
  - In the very long run, GDP would be the same in the two scenarios.
  - If the authorities had invested the same amounts in highly productive investment projects, GDP could have been 13 percent of 2014 GDP higher instead of 4¼ percent.
- Debt sustainability and policy implications:
  - The highway threatened Montenegro’s debt sustainability and crowded out more productive spending.
  - Without the highway, debt would have declined to 60 percent of GDP by 2022 based on the policies of the 2017 budget.
  - With the highway, debt was projected to grow to 89 percent of GDP in 2019 and would have stayed at high levels.
  - The high projected debt levels necessitated the launching of the authorities’ fiscal strategy.
  - The DSA shows Montenegro cannot afford a debt‑financed completion of phases 2&3 of the highway, and would have to rely on concessional financing or public‑private partnerships.

### Pension system: current position and baseline projections
- Current funding gap and spending:
  - Pension system has a consistently large funding gap, reaching 3.1 percent of GDP in 2016.
  - Pension spending at 10.4 percent of GDP is higher than averages in advanced economies (9 percent) and emerging economies (5 percent).
- Demographics and early retirement:
  - Number of old‑age pensioners increased by 36 percent since 2008.
  - Since the last major reform in 2010, about 70 percent of new pensioners were early retirees below the statutory retirement age of 66 for men and 61 for women.
  - Early‑retirees constitute about one third of pensioners.
  - Low levels of labor participation and formal employment constrain pension contributions.
- Baseline projections:
  - Staff baseline projections suggest pensions would become socially unsustainable in the long run.
  - In the baseline scenario with no reforms, pension spending is projected to decrease from 10.7 percent of GDP in 2015 to 7.4 percent by 2050.
  - The pension deficit is projected to turn into surplus by 2040 in the baseline, as spending declines and contributions stabilize.
  - However, falling pension expenditure comes at the expense of falling replacement rates and poorer income for pensioners.

### Pension reform objectives and recommended measures
- Primary reform focus:
  - Stabilize replacement rates at socially sustainable levels while preserving fiscal sustainability.
- Recommended measures (summary):
  - Valorize new pensions with wage growth and index existing pensions with CPI growth.
    - Rationale: wage valorization ensures new pensions reflect lifetime earnings and productivity; CPI indexation preserves purchasing power.
  - Restrict early retirement:
    - Eliminate the possibility to retire with 40 contribution years without penalty.
    - Limit early retirement to 2–3 years instead of 5 years.
    - Introduce an actuarial penalty for early retirement.
  - Hazardous‑occupation pensions:
    - Restrict to only health‑damaging occupations and make them ineligible for additional early retirement options.
    - Ensure contributions are actuarially fair.
  - Accelerate planned retirement age increases for women to reach 67 by 2025 instead of 2042.
    - Link statutory retirement age to expected life expectancy to stabilize the ratio of pension years to contribution years.
- Complementary reforms:
  - Gradually shift contributions from employers to employees to reduce the grey economy and improve coverage.
  - Reforms to improve labor market participation to strengthen pension social protection.
  - Higher‑paid pensioners could contribute to the healthcare system and personal income tax, since pension income is currently tax free and pensioners are the largest users of the health system.

### Quantified reform projections (Table 3 figures)
- Valorizing new pensions at 100% wage growth:
  - Costs 2% GDP per year by 2050 and 10.5% by 2100.
- Indexing existing pensions at 100% CPI:
  - Save up to 0.35% of GDP per year by 2050.
- Reducing or eliminating early retirement schemes:
  - Save 1% GDP per year.
- Accelerating retirement age phase‑in for women:
  - Save up to 1.1% GDP per year during phase‑in period.
- Linking statutory retirement age to life expectancy:
  - Save up to 0.8% GDP per year by 2050.
- Increases in contribution rates:
  - Long‑term revenue source.
- Introduction of healthcare contribution and PIT for higher‑earning pensioners:
  - Long‑term revenue source.
- Policy package projected outcomes:
  - Pension revenues would increase from around 7.3 percent of GDP today to 10.3 percent by 2100.
  - Under the policy package, the pension deficit would turn into surplus by 2025 compared to 2040 for the baseline.
  - Pension spending would decline to 6 percent by 2040 under the reform package (with later stabilization).

*Source: MONSTAT; and Fund staff projections.*

### Appendix III. Macro-Financial Linkages

### Appendix III. Macro-Financial Linkages

### Financial development and inclusion
- Montenegro’s financial development and financial inclusion compares well with its regional and income based peers. Further financial sector deepening spread equitably among the population is likely to aid growth. Lending decisions should prudently incentivize ongoing corporate and household balance sheet repair and avoid excessive indebtedness.
- Financial policies in Montenegro aim to reap the benefits of continued financial development. Given Montenegro’s starting point, increased financial development would likely support higher growth.
- The estimated degree of financial development is below the estimated turning point where the relationship between the financial development and growth becomes negative.
- The level of financial inclusion in Montenegro is consistent with its level of economic development and has improved in recent years.
- Financial penetration in Montenegro is still below the new EU member states (NMS)—where about 80 percent of adults maintain a bank account—but is in line the size of the economy.
- There is room to improve financial inclusion across different sections of the population: the poor, women, rural areas, and less educated are still underserved. There is also a need to incentivize a movement from the gray economy to legitimate financial services.

### Credit dynamics and sectoral exposure
- Credit growth in Montenegro is highly correlated with contemporaneous economic activity. The correlation is the highest among Western Balkan states, and noticeably larger than for regional comparators and developed European states.
- Bank lending is important for the construction, retail, and tourism sectors.
- Credit conditions are slowly improving following the 2008 crisis:
  - Corporate lending by domestic banks is at 58 percent of its pre-crisis level.
  - Household lending is at 101 percent of its pre-crisis level and has recovered to its pre-crisis level.
- Households are taking on new debt, and implied private sector leverage is estimated to have increased since the crisis.
  - The ratio of credit to the private sector and the index of real estate prices suggests that the leverage of the overall private sector is broadly unchanged compared to the peak of the crisis.
  - The implied leverage of households is much higher than for corporate borrowers.

### Nonperforming loans, corporate balance sheets, and external financing
- Corporate balance sheets have somewhat improved alongside banks’ tackling of NPLs.
  - NPLs are around 10 percent and are bound to continue declining even if hampered by the lack of a vibrant secondary market for distressed assets and slow judicial proceedings.
- Corporates have substituted indebtedness to non–residents for domestic credit, and nominal total domestic and foreign indebtedness of the corporate sector has broadly recovered to its pre-crisis peak.

### Macro-financial interactions and policy implications
- The recovery of lending to households, higher implied household leverage, and sectoral credit concentration call for vigilance and prudence in lending and supervision.
- The implementation of the fiscal strategy could impact banking sector profitability:
  - The strategy entails a reduction of consumption over time, which might affect credit growth negatively.
  - Staff does not see this as a central case, but the authorities should follow developments in this area closely.

*Source: Appendix III. Macro-Financial Linkages (cr17276).*

### 0.3 percent of 2017 GDP in revenues in the first month of operation (end August 2017). The

### 0.3 percent of 2017 GDP in revenues in the first month of operation (end August 2017). The

### Tax administration and revenue measures
- The Montenegrin Tax Administration (MTA) followed the assessment of the Tax Administration Diagnostic Assessment Tool (TADAT) in late 2015 and made improvements with tax debt management, with a decline in tax debts as well as tax arrears.
- Next planned activities include addressing an inadequate penalty regime and the lack of a criminal investigation function as inhibitors to the effective treatment of deliberate non-compliance.
- Revenues amounted to 0.3 percent of 2017 GDP in the first month of operation (end August 2017).

### Expenditure measures and fiscal consolidation (FSC / FCS)
- Expenditure measures include abolishing the Mothers’ lifetime benefit and adopting time-limited provisions to compensate formerly-employed mothers.
- Measures also include an additional reduction in wages of senior officials supported by a freeze in public sector employment.
- The FSC includes an increase of targeted social spending despite sizable fiscal consolidation in motion.
- To avoid compromising the primary balance target in 2020, the FCS a priori provides a buffer of 0.4 percent of the 2017 GDP for envisaged additional expenditures, which could be delayed if some measures underperform.
- Given that the Bar-Boljare highway has exhausted non-highway capital spending, the authorities will not engage in new major debt-financed investment projects over the medium-term, including the second phase of the highway.
- The FSC implementation is supported:
  - exogenously: the FSC is embedded in the prior actions policy matrix of the World Bank’s Policy Based Guarantee (PBG) currently under negotiation;
  - endogenously: measures outlined in the FCS, although most are designed to take place in the medium term, have already been extensively discussed with targeted stakeholders, and adopted by the Parliament.

### Structural fiscal reform, pensions, and public sector staff
- The authorities share staff’s view that medium-term fiscal consolidation could be used as the backbone for additional streamlining of public expenditures more conducive to medium-term growth.
- With WBG support, the authorities are assessing the size of needed public sector staff rationalization over the medium-term.
- Pension system reform regained focus; in 2017 the authorities acquired the World Bank’s Pension Reform Options Simulation Toolkit (PROST) model to help make informed policy choices.
- “Low hanging fruits” to be considered first: elimination of early retirement and acceleration of an increase in retirement age.
- Authorities welcomed recommendations to lower social contributions (reducing tax wedge) and making upper band of the personal income tax (PIT) permanent, to be considered in the context of ongoing IMF TA on tax policy.

### Sovereign debt dynamics and debt management strategy
- Dollar-denominated highway investments increased commercial foreign currency disbursements.
- Debt has a short maturity and is increasingly reliant on external market financing amidst risks of normalization of monetary policies in the US and the EU.
- The very liquid banking system holds manageable levels of government bonds and loans; however, it has limits including internal exposure limits for foreign banks and private sector crowding out considerations.
- Refinancing risk exists given Eurobond redemptions of about Euro 1bn concentrated in 2019-2021 and unidentified fiscal financing needs.
- Authorities’ active steps to strengthen market refinancing prospects:
  - (i) FCS implementation;
  - (ii) formalizing a pro-active, forward looking Medium-Term Debt Management Strategy 2018-2021 and well-articulated market relations strategy, with the help of IMF TA, by end October 2017;
  - (iii) finalizing the World Bank Policy Base Guarantee (PBG).
- With FCS implementation, authorities will substantially address unidentified fiscal financing needs and blunt the peak of general government debt (including guarantees) in 2019:
  - projected peak after the first stage of consolidation: 89% percent;
  - projected peak with FCS implementation: 81% percent;
  - projected fall to 66 percent of GDP by 2022.
- Authorities are formulating a Debt Management Strategy 2018-2021 and considering a market-friendly Liability Management Operation to reduce Eurobond debt redemption concentration over 2019-2021.

### Financial system and policies: banking sector health and vulnerabilities
- Banking system indicators (end June 2017 and related dates):
  - capital adequacy ratio: 17.6 percent;
  - liquidity coefficient: 21.2 percent;
  - annual lending growth: 7.4 percent (end June 2017).
- The banking system is described as stable, solvent, and highly liquid.
- Elevated NPL levels and low profitability are prominent vulnerabilities:
  - NPLs declined from 25.6 percent of gross loans at end 2011 to 10.3 percent at end 2016, and to 8.2 percent end July 2017.
- Parliamentary action to reduce NPLs: Amendments to the Law on Voluntary Loan Restructuring broadening restructuring asset coverage and increasing participation incentives.
- CBM will supervise factoring companies under a new Law on Financial Institutions to expedite resolution of NPLs offloaded into factoring companies.
- Collateral execution and judicial proceedings are slow, but data on resolved cases show acceleration.
- Banking sector structure and profitability:
  - 15 banks may indicate overcapacity, dragging on profitability;
  - ROA amounted to 0.84 end June 2017.
  - 5 new banks since 2014 have compressed interest margins and replenished lending.
  - Authorities monitor market behavior closely, especially smaller banks and new entrants.
- Planned and contingent supervisory actions:
  - Authorities plan system-wide AQRs in 2019.
  - Implementation in 2018 of the International Financial Reporting Standard 9 (IFSR 9) will affect bank balance sheets through stricter impairment loss models, leading to higher provisioning requirements and potentially new recapitalization needs.
  - Authorities prefer conducting AQRs after IFSR 9 adjustments are fully reflected in banks’ balance sheets.
  - Three not systemically-important solvent banks with qualified audits remain under special supervision and fully adhere to corrective measures of their supervisory action plans, ranging from additional recapitalizations to keeping solvency ratios constant and well above prescribed minima.
- Limitations in funding Emergency Liquidity Assistance (ELA) resources due to euroization and scarce fiscal space will be reduced by establishing a resolution fund with risk-based contributions planned in the Law on Recovery and Resolution of Banks.

### Regulatory and AML/CFT progress
- Significant progress implementing the 2016 FSAP recommendations through regulatory frameworks aligned with EU standards, including:
  - Central Bank Act — fully aligned with the ESCB/ECB Treaty and the Statute;
  - Banking Law — defines systemically-important banks, assumes rehabilitation units and mechanisms for early intervention, strengthens prudential provisions for NPLs;
  - Law on Financial Institutions — consolidates financial oversight responsibilities by putting factoring companies under CBM supervision;
  - Law on Recovery and Resolution of Banks — establishes recovery and resolution framework and creates a resolution fund with risk-based contributions from banks;
  - Deposit Insurance Law — adheres to EU requirements on deposit guarantee schemes.
- These Laws will be adopted by the Parliament in 2017.
- CBM reforms and IMF TA:
  - Following 2016 FSAP recommendations, CBM benefited from MCM TA to establish a macroprudential policy framework and is reforming its macroprudential policy mandate.
  - During 2017/2018, Montenegrin authorities will rely on IMF TA to strengthen consolidated banking supervision (including assessing group-wide risks) and fortify insurance risk-based supervisory framework, including implementation of the Solvency II regime.
- AML/CFT improvements:
  - New Law on Prevention of Money Laundering and Financing of Terrorism harmonizes with MONEYVAL recommendations, the new Recommendation of the FATF from 2012, and EU Directive 2015/849; strengthens risk based approach and treatment of politically exposed persons.
  - The Law will be adopted in Q4 2017.
  - In June 2017, Parliament adopted Amendments to the Law on International Restrictions compliant with the standards of Recommendation 6 of FATF.

### Structural policies to boost productivity and job creation
- Authorities focus on facilitating private sector job creation through increasing productivity and competitiveness.
- Labor market challenges: high (long-term) unemployment, especially of the youth; low female labor force participation; a large informal economy.
- Draft legislation prepared:
  - Draft Labor Law to reduce excessive state influence, abolish general collective agreement, ease entrance and exit procedures (including for collective dismissals), and extend the length of fixed-term contracts for hard-to-employ individuals. The Law is to be adopted by end 2017.
  - Draft Law on Civil Servants and State Employees (with European Commission help) targeting professionalization of civil servants, performance grading, and easier dismissal procedures of state employees.
- Business-enabling reforms to compensate limited productive base and lack of economies of scale:
  - Significant reforms in the year related to reliability of energy supply, tariff transparency, and getting construction permits.
  - Authorities believe ongoing robust investments in transport and energy address core structural constraints of Montenegro as a small state, bringing returns over the medium term.

*IMF staff report content as provided in the source document.*

---


_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17276.pdf_