## cr18121

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### Montenegro’s Highway Project
- Project description and financing:
  - Bar-Boljare highway connects Montenegro’s coast with Serbia; only first 41-km segment (Podgorica–Kolašin) under construction at a cost of nearly €1 billion.
  - China Road and Bridge Corporation started construction of the first segment in 2015; completion expected in 2019.
  - Domestic contractors allocated 30 percent of the work.
  - China Ex-Im Bank providing a USD-denominated loan for 85 percent of the total cost of the first phase of €809 million (19 percent of 2017 GDP).
  - Loan features: 2 percent interest rate; 20-year repayment period; six-year grace period on principal payments (principal payments begin in 2021).
  - USD appreciation and unhedged currency risk increased the total cost by 13 percent.
  - Remaining 136 km likely cost somewhat more than the first segment; phases 2 and 3 are in design; phase 4 would connect to the port of Bar (none of them in the baseline).
  - Corridor to Belgrade requires Serbia to extend a road an additional 100 kilometers; that Serbian project is in the conceptual design phase.
- Fiscal and debt implications:
  - Counterfactual fiscal impact: Had phase 1 not been built, Montenegro’s debt-to-GDP would have declined to 59 percent of GDP in 2019 instead of rising to 78 percent of GDP.
  - Highway expenditures were a driver of the 2017 increase in the overall fiscal deficit and made China Ex-Im Bank an important new creditor.
  - Financing phases 2–4 with public debt would again endanger debt sustainability.
- Growth and macro effects:
  - Demand effects while construction continues (moderated by high import content).
  - Supply effects begin after completion in 2019 but are reduced by low economic rate of return due to low traffic projections.
  - Staff estimates: total GDP in 2023 will be about 3 p.p. of 2014 GDP higher with the highway than without it.
  - Highway phases 2–4, debt-financed scenario: assumed cost €1.2 billion equally spent over 2021–23; low spending multiplier 0.2; economic growth effect: increase of ¾ percentage point on average in 2021–23 relative to the baseline; debt outcome: public debt ratio increases to 73 percent of GDP by 2023 (compared to 53 percent in the baseline); gross financing needs peak at 17 percent of GDP in 2023, 12 percentage points higher than baseline.

### Recent Economic Developments (2016–2017) and Outlook
- Recent developments (selected):
  - Real GDP growth: 2.9 percent in 2016; 4.4 percent in 2017 (driven by highway construction and a strong tourism season).
  - Inflation (end of period): 1.0 percent in 2016; 1.9 percent in 2017.
  - Unemployment rate: declined to 16 percent in 2017 from 18 percent in 2016.
  - Wage growth: slowed to 2.3 percent in 2017 from 4.0 percent in 2016.
  - Overall fiscal deficit: 6.2 percent of GDP in 2016; 7.0 percent of GDP in 2017.
  - Non-highway primary balance: deficit of 1.1 percent of GDP in 2016; surplus of 1.2 percent of GDP in 2017.
  - General government gross debt (including guarantees) increased 1 p.p. to 75 percent of GDP in 2017.
  - Current account deficit: increased by 1 p.p. in 2017 to 19 percent of GDP.
  - FDI increased 1½ p.p. to 11 percent of GDP, covering 60 percent of the current account deficit.
  - External debt increased 1½ p.p. to 160 percent of GDP.
- Outlook and key assumptions:
  - 2018 projected real GDP growth: 3 percent.
  - Over 2018–2023, growth might average 3 percent (higher than the 2 percent average of the last decade).
  - Highway spending expected to remain near 2017 levels through 2018; construction completes in 2019.
  - Fiscal adjustment: further measures of 1¼ percent of GDP to be implemented in 2018 (compared to 1¾ percent of GDP in 2017), with a further ¾ percent of GDP in 2019; assuming a fiscal multiplier of -0.5, highway effects will only partially offset fiscal adjustment drag.
  - Inflation projected to increase to 2¾ percent (end-of-period) in 2018; with euroization, inflation should be contained around 2 percent over 2019–23.
  - Current account deficit projected to remain at 19 percent of GDP in 2018, moderating to 12 percent on average over 2020–23.
  - Government debt projections: general government debt with guarantees projected to peak at 80 percent of GDP in 2018 and decline to 53 percent of GDP by 2023, conditional on sustained fiscal consolidation; budget projected to move into surpluses exceeding 2 percent of GDP as highway spending winds down after 2019.

### Fiscal Position, DSA, and Scenarios
- Baseline and medium-term fiscal path:
  - Staff’s baseline assumes full implementation of additional fiscal measures over 2018-20, with the non-highway primary balance improving by 3¼ percentage points of GDP.
  - Staff projects a primary surplus of 4½ percent of GDP in 2020.
  - Staff’s baseline assumes the government does not take on additional debt to construct further phases of the Bar-Boljare highway.
  - Nominal general government debt, with guarantees (selected percent of GDP series): 2017 Prelim. 74.6; 2018 Last SR 81.0; 2018 Prelim. 80.1; 2019 78.2; 2020 68.0; 2021 63.1; 2022 58.1; 2023 53.4.
- Alternative primary-balance paths and stress tests:
  - A fiscal adjustment of 3.4 percent of GDP over 2019-23 would lead debt to increase to 87 percent of GDP by 2023.
  - If the primary balance stayed at the projected 2018 level of -0.7 percent, debt would fall slowly to 71 percent of GDP by 2023, compared to 53 percent in the baseline.
  - Standard stress tests impacts (selected):
    - Growth shock: debt ratio peaks at 84 percent of GDP in 2019 before falling to 65 percent in 2023.
    - Interest rate shock: debt increases by 3 percentage points in 2023 relative to baseline.
    - Combined macro shock: debt-to-GDP rises by 8 percentage points to 87 percent in 2019.
    - Financial contingent liability shock: debt ratio increases sharply to 89 percent in 2019; gross financing needs peak at 20 percent of GDP in 2019.
    - Primary balance shock: deterioration by 2 p.p. in primary balance over 2019-20 leads to about 3 p.p. higher debt by 2023.
- Public financing operations and deposit buffers:
  - Authorities borrowed €250 million from a syndicate of international banks (2.95 percent, 12-year maturity) leveraging a World Bank PBG.
  - Issued a seven-year €500 million Eurobond (coupon 3.375 percent), using €362 million to buy back existing Eurobonds maturing 2019-21.
  - These operations will increase government deposits at the central bank by 6.5 percent of GDP to amortize remaining Eurobonds in 2019 and 2020.
  - Baseline includes a second World Bank PBG for €140 million in 2019 and assumes rolling over remaining 2021 Eurobond by issuing a new €150-200 million Eurobond in 2020/21.
  - Replacement of more expensive previous Eurobonds lowers effective interest rate from 3.9 percent in 2017 to 2.8 percent by 2020.

### External Sector, Reserves, and External Debt Vulnerabilities
- External debt levels and composition:
  - External debt about 160 percent of GDP at end-2017; projected to increase to 166 percent of GDP by 2019, before declining to 145 percent of GDP by 2023.
  - One-third of external debt is government debt.
  - About one-half of external debt falls into the non-bank private sector (inter-company debt to a large extent).
  - Recently and going forward, most of the increase in external debt is due to government debt related to highway construction.
- External sector performance and REER:
  - Large current account deficits persisted, about 19 percent of GDP in 2017; peaked at nearly 50 percent of GDP in 2008.
  - EBA-lite REER regression model estimates REER undervalued by 17 percent; current account regression model suggests REER overvalued by 18 percent; staff assessment: on balance the real exchange rate is overvalued by 10 percent.
  - Goods export volume declined by 36 percent between 2007 and 2017; services exports more than doubled since 2007 driven by tourism.
- External stress test scenarios (selected impacts):
  - Growth shock (permanent one-half standard deviation): average growth 2019–23 = 1.1 percent (vs baseline 3.0 percent); external debt ratio increases by 10 percentage points to 156 percent in 2023.
  - Interest rate shock (one-half standard deviation): external debt increases by 2.0 percentage points to 146 percent by 2023.
  - Non-interest current account shock (increase of 5.4 percentage points): external debt increases by about 25 percentage points to 170 percent by 2023.
  - Combined macro shock (permanent 1/4 s.d. to real interest rate, growth, current account): external debt rises by about 20 percentage points to 164 percent; gross financing needs increase by 4.5 percent of GDP on average over 2019-23.
  - Real exchange rate shock (one-time 30 percent devaluation in 2019): external debt-to-GDP ratio increases by 13 percentage points in 2019; gross financing needs rise by 8 percentage points on average over 2019–23.
- Reserves and reserve adequacy:
  - Gross international reserves (millions of USD): 2017 Prelim. 1,037.
  - Gross international reserves were nearly €900 million (21 percent of GDP) at end-2017; conservative measure excluding banks’ excess reserves: €380 million (9 percent of GDP).
  - Reserves are 170 percent of the standard IMF metric for reserve adequacy at end-2017 and projected to exceed the ARA metric in 2018 even after subtracting excess reserves.
  - Recommendation: increase fiscal buffers and ELA resources; consider government sub-account at the CBM for ELA purposes.

### Labor Market, Structural Issues, and Policy Recommendations
- Labor market outcomes:
  - Inactivity rate (ages 15-64): about 37 percent.
  - Unemployment rate: 16 percent; about 80 percent of unemployed out of work for more than a year.
  - Informal economy employs about 1/4 of the workforce; about 78 percent of employees formally-employed and 22 percent informally-employed.
  - Informally-employed earn, on average, almost 30 percent less than formally-employed.
- Structural diagnosis:
  - Weak labor market outcomes are structural rather than cyclical; disadvantaged groups include women, youth (15–24 years), and low-education individuals.
  - Tax wedge on labor around 40 percent; effective withdrawal of social benefits creates disincentives to work.
  - New Labor Law draft aims to increase flexibility; OECD-style indicators show higher-than-average employment protection rigidity.
- Policy recommendations (selected):
  - Reduce the tax wedge on labor, especially for low income earners; consider re-introducing a basic allowance for wage income and/or targeted earned income tax credits or lower employer contributions.
  - Gradually withdraw social assistance and family benefits when beneficiaries enter formal employment.
  - Labor law refinements: allow employees to work for more than one employer; reduce burden on SMEs by simplifying internal organization requirements; do not automatically terminate employment contracts at 67 years if both parties wish to continue; complement compliance actions with incentives for formalization.
  - Collective agreement reforms: make collective agreements time bound and provide firm-level flexibility.
  - Align education with labor demand; improve active labor market policies and coordination between Ministry of Finance and Ministry of Labor.

### Financial Sector, Supervision, and Implementation Status
- Banking sector health and trends:
  - NPLs fell from 11 percent of total loans to 8 percent during 2017; under new NPL methodology estimated end-2017 figure would be 7.3 percent.
  - Private sector credit expanded 8 percent in 2017 (enterprises 6 percent; households 10 percent).
  - Bank profitability: return on assets 0.9 percent; return on equity 7.4 percent.
  - Capital ratios exceed regulatory minima; banks are highly liquid.
- Supervision and reforms:
  - Authorities brought non-bank financial institutions under central bank supervision.
  - Recommended: asset quality reviews (AQR) as soon as possible; adopt a definition of non-performing loans that does not exclude impaired assets with adequate collateral; be cautious in granting new banking licenses and promote consolidation.
  - Implementation status: CBM plans an AQR in 2019; supervisory action plans for vulnerable banks adopted; transition to IFRS-9 started in January 2018.
  - Continue to improve AML/CFT framework and implement outstanding FSAP recommendations.
- Reserve and ELA capacity:
  - CBM’s own capital position covers 2 percent of banks’ short-term liabilities; excluding Euro Area parent banks, ELA resources would cover 8 percent of short-term liabilities for remaining banks.
  - Banks’ liquidity ratio: liquid assets to short-term liabilities = 36 percent; overall liquidity buffers = 40 percent of short-term liabilities at end-2017.
  - Recommendation: maintain government deposits at least one month of spending (€150 million benchmark, 3.6 percent of GDP); create a government sub-account at the CBM dedicated to ELA.

### Key Fiscal and Macro Figures (selected, preserved as in source)
- Nominal GDP (millions of €): 2017 Prelim. 4,237; 2018 Last SR 4,187; 2018 Prelim. 4,492; 2019 4,692; 2020 4,917; 2021 5,165; 2022 5,444; 2023 5,718.
- Real GDP growth (percent): 2017 Prelim. 4.4; 2018 Last SR 2.8; 2018 Prelim. 3.0; 2019 2.4; 2020 3.0; 2021 3.1; 2022 3.4; 2023 3.0.
- Consumer prices (end of period): 2017 Prelim. 1.9; 2018 Last SR 2.6; 2018 Prelim. 2.7; 2019 1.8; 2020 1.8; 2021 1.9; 2022 2.0; 2023 2.0.
- Revenue and grants (percent of GDP): 2017 Prelim. 40.9; 2018 Last SR 45.1; 2018 Prelim. 43.4; 2019 42.4.
- Expenditure (percent of GDP): 2017 Prelim. 47.8; 2018 Last SR 50.7; 2018 Prelim. 46.1; 2019 44.4.
- Overall fiscal balance (percent of GDP): 2017 Prelim. -7.0; 2018 Last SR -5.6; 2018 Prelim. -2.7; 2019 -2.0.
- Primary balance (percent of GDP): 2017 Prelim. -4.5; 2018 Last SR -2.9; 2018 Prelim. -0.7; 2019 0.1; 2020 4.4.
- General government gross debt (percent of GDP): 2017 Prelim. 67.2; 2018 Last SR 73.6; 2018 Prelim. 72.5; 2019 70.9; 2020 61.1; 2021 56.5; 2022 51.8; 2023 47.4.
- General government debt, including loan guarantees (percent of GDP): 2017 Prelim. 74.6; 2018 Last SR 81.0; 2018 Prelim. 80.1; 2019 78.2; 2020 68.0; 2021 63.1; 2022 58.1; 2023 53.4.
- Current account balance (percent of GDP): 2017 Prelim. -18.9; 2018 Last SR -21.2; 2018 Prelim. -18.8; 2019 -17.6; 2020 -13.4; 2021 -12.6; 2022 -11.3; 2023 -10.1.
- External debt (end of period, percent of GDP): 2017 Prelim. 159.7; 2018 Last SR 173.5; 2018 Prelim. 164.2; 2019 166.3; 2020 158.6; 2021 155.4; 2022 150.3; 2023 144.7.
- Gross international reserves (millions of USD): 2017 Prelim. 1,037; 2018 Last SR 967; 2018 Prelim. 1,454; 2019 1,532.

### Staff Appraisal and Recommended Next Steps
- Overall judgment:
  - Growth outlook: strong in 2018 and medium term, though slowing as fiscal consolidation continues and highway construction ends.
  - Fiscal policy: authorities appropriately focused on fiscal adjustment to lower government debt; front-loaded adjustment timed to complete underlying adjustment before highway construction concludes.
  - Debt and PPP cautions: fiscal space insufficient to finance remaining highway phases with debt; completion via PPP should meet cost-benefit criteria and avoid large contingent liabilities.
- Priorities and recommendations:
  - Maintain medium-term fiscal consolidation and ensure primary surpluses after 2020 to reduce debt rapidly.
  - Right-size public-sector workforce and implement civil service reform; strengthen central oversight over local government finances.
  - Tighten eligibility for early retirement; shift pensions to wage valorization and CPI indexation.
  - Review fiscal cost of tax exemptions and reduce corporate profit tax holidays.
  - Strengthen PPP framework and avoid transferring residual fiscal risks to the government.
  - Continue financial sector reforms: implement AQR, strengthen supervision, improve AML/CFT framework, and consider bank consolidation where appropriate.
  - Implement a unified strategy to address informal employment and inactivity, including reducing the tax wedge and aligning education with labor market needs.
- Expected follow-up:
  - Next Article IV consultation with Montenegro to be held on the standard 12-month cycle.

*International Monetary Fund staff summary based on the provided Montenegro chapter content.*

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

### 1. Montenegro’s Highway Project

### Context and Project Description
- Montenegro is a small, open, euroized economy concentrated in tourism, real estate, and agriculture.
- The Bar-Boljare highway will connect Montenegro’s coast with Serbia.
- Only the first 41-km segment (Podgorica–Kolašin) is under construction at a cost of nearly €1 billion.
- Remaining 136 km likely cost somewhat more than the first segment; phases 2 and 3 are in design; phase 4 would connect to the port of Bar (none of them in the baseline).
- Corridor to Belgrade requires Serbia to extend a road an additional 100 kilometers; that Serbian project is in the conceptual design phase.
- China Road and Bridge Corporation started construction of the first segment in 2015; completion expected in 2019.
- Domestic contractors are allocated 30 percent of the work.
- China Ex-Im Bank is providing a USD-denominated loan for 85 percent of the total cost of the first phase of €809 million (19 percent of 2017 GDP).
- USD appreciation and unhedged currency risk increased the total cost by 13 percent.
- Loan features: 2 percent interest rate; 20-year repayment period; six-year grace period on principal payments (principal payments begin in 2021).
- Counterfactual fiscal impact: Had phase 1 not been built, Montenegro’s debt-to-GDP would have declined to 59 percent of GDP in 2019 instead of rising to 78 percent of GDP.
- Financing phases 2–4 with public debt would again endanger debt sustainability.

### Highway Impact on Growth and Debt (as described)
- Staff estimates: total GDP in 2023 will be about 3 p.p. of 2014 GDP higher with the highway than without it.
- Projected paths shown include: Non-highway scenario with only 2017 budget measures; including highway phase 1 with all adjustment measures (baseline); addition of highway phases 2–4 financed with public debt (these scenarios show divergent debt-to-GDP outcomes).

### Fiscal Implications Highlighted
- The highway project significantly increased public debt and made China Ex-Im Bank an important new creditor.
- Highway expenditures were a driver of the 2017 increase in the overall fiscal deficit.
- The project motivated the medium-term fiscal adjustment strategy adopted in 2017.

---

### Recent Economic Developments (2016–2017)
- Real GDP growth: 2.9 percent in 2016; 4.4 percent in 2017 (driven by highway construction and a strong tourism season).
- Inflation (end of period): 1.0 percent in 2016; 1.9 percent in 2017 (driven primarily by fuel, cigarettes, and accommodation).
- Unemployment rate: declined to 16 percent in 2017 from 18 percent in 2016.
- Wage growth: slowed to 2.3 percent in 2017 from 4.0 percent in 2016 (partly due to partial public-sector wage freeze).
- Fiscal balance:
  - Overall fiscal deficit: 6.2 percent of GDP in 2016; 7.0 percent of GDP in 2017 (driven by increased highway expenditures).
  - Current spending fell by 2¾ percentage points of GDP in 2017.
  - Tax revenues increased by 0.5 p.p. of GDP.
  - Non-highway primary balance: deficit of 1.1 percent of GDP in 2016; surplus of 1.2 percent of GDP in 2017.
  - General government gross debt (including guarantees) increased 1 p.p. to 75 percent of GDP in 2017.
- Banking sector:
  - NPLs fell from 11 percent of total loans to 8 percent during 2017 (authorities working on new NPL methodology under which estimated end-2017 figure would be 7.3 percent).
  - Private sector credit expanded 8 percent in 2017.
  - Credit growth to enterprises: 6 percent; to households: 10 percent.
  - Bank profitability: return on assets 0.9 percent; return on equity 7.4 percent.
  - Capital ratios exceed regulatory minima; banks are highly liquid.
- External sector:
  - Current account deficit: increased by 1 p.p. in 2017 to 19 percent of GDP.
  - Tourism: overnight stays increased 11 percent on average.
  - FDI increased 1½ p.p. to 11 percent of GDP, covering 60 percent of the current account deficit.
  - Net government external borrowing: 6 percent of GDP.
  - External debt increased 1½ p.p. to 160 percent of GDP.

---

### Outlook and Risks (Projections and Key Assumptions)
- 2018 projected real GDP growth: 3 percent (driven by domestic demand).
- Highway spending expected to remain near 2017 levels through 2018; construction completes in 2019.
- Over 2018–2023, growth might average 3 percent (higher than the 2 percent average of the last decade and estimated longer-run potential growth).
- Highway effects:
  - Demand effects while construction continues (moderated by high import content).
  - Supply effects begin after completion in 2019 but are reduced by low economic rate of return due to low traffic projections.
  - Staff estimate: GDP in 2023 about 3 p.p. of 2014 GDP higher with highway than without.
- Fiscal adjustment:
  - Further fiscal adjustment measures of 1¼ percent of GDP to be implemented in 2018 (compared to 1¾ percent of GDP in 2017), with a further ¾ percent of GDP in 2019.
  - Assuming a fiscal multiplier of -0.5, highway effects will only partially offset fiscal adjustment drag.
- Inflation and current account:
  - Inflation projected to increase to 2¾ percent (end-of-period) in 2018, with a 2 p.p. VAT increase and excise increases adding approximately 1 p.p. to inflation.
  - With euroization, inflation should be contained around 2 percent over 2019–23.
  - Current account deficit projected to remain at 19 percent of GDP in 2018, moderating to 12 percent on average over 2020–23.
- Government debt projections:
  - General government debt with guarantees projected to peak at 80 percent of GDP in 2018 and decline to 53 percent of GDP by 2023, conditional on sustained fiscal consolidation.
  - As highway spending winds down after 2019, the budget is projected to move into surpluses exceeding 2 percent of GDP.

---

*MONTENEGRO — INTERNATIONAL MONETARY FUND*

### Box 2. Potential Growth and Output

### Box 2. Potential Growth and Output

### Output gap and current position
- The output gap has closed, and the economy is currently operating slightly above potential.
- Both in 2017 and 2018, output is estimated to be almost 1 percent above potential.
- The output gap is assumed to be closed by 2023.

### Growth accounting—historical contributions
- Growth over 2006-17 was 3 percent on average.
- Contributions to average growth (2006-17):
  - Capital contributed 2.2 percent.
  - Labor contributed 1.3 percent.
  - Total factor productivity (TFP) contributed -0.5 percent.
- Low TFP partly reflects large negative shocks during the 2009 and 2012 recessions.

### Long-term drivers and constraints
- Standard growth accounting suggests that capital accumulation will drive long-term growth.
- Going forward, in the absence of structural reform, TFP growth is likely limited, but could improve greatly with structural reforms, including due to EU accession.
- Negative demographic trends will lower growth prospects.

### Baseline projection and policy-based scenarios
- Baseline: average growth could fall to about ¾ percent over 2018-50.
- Policy-based best case: with improvements to TFP, education, labor markets, and investment, average growth would be around 2 percent (and more on a per-capita basis).
- The box references scenario graphs for:
  - Baseline
  - High growth policy-based scenario
  - Low growth policy-based scenario
  (Percent series shown across 2015–2050 in source figures.)

### Key implications
- Capital accumulation is the primary engine of long-term growth unless TFP improves.
- Structural reforms (TFP, education, labor markets, investment) are necessary to reach policy-based growth near 2 percent.
- Demographic trends are a material downside risk to potential growth.

*Source: IMF staff estimates and projections, Box 2: Potential Growth and Output.*

### Box 3. Fiscal Pro-Cyclicality and Fiscal Impulse

### Box 3. Fiscal Pro-Cyclicality and Fiscal Impulse

### Fiscal pro-cyclicality: findings
- Structural fiscal balance and fiscal impulse analysis suggests that fiscal policies have been pro-cyclical in Montenegro.
- Until 2016, the fiscal impulse had generally been expansionary when output was above potential, and contractionary when output was below potential.
- Growing revenues created pressures to spend, and financing constraints prevented counter-cyclical spending during downturns.

### Fiscal adjustment over 2018–20 and stance relative to the cycle
- The current fiscal adjustment plan is appropriately tuned to the economic cycle.
- With output slightly above potential, the fiscal adjustment over 2018-20 will be counter-cyclical.
- The non-highway budget will continue strong adjustment in 2018-19.
- In 2020, the end of highway spending will represent a large negative fiscal impulse.
- The adjustment of the non-highway budget is being appropriately phased to avoid coinciding with the end of highway spending, avoiding an even larger drag on growth in 2020.

### Key fiscal projections and quantitative points
- Authorities projected a general government primary surplus greater than 7 percent of GDP in 2020, based on lower spending on wages, social security transfers, capital expenditures, and transfers to other public-sector institutions.
- Authorities plan to adopt by end-June 2018 a plan to reach optimum staffing levels.
- A pension reform that would restrict early retirements and modify the formula for valorization/indexation should be adopted in 2018.
- The authorities plan to amend the law on local government finances in 2018 to change the distribution of funds from the central government to promote distribution according to need and incentivize own-source revenues where possible.
- The authorities agreed that fiscal space did not exist to assume further debt to continue the Bar-Boljare highway and plan to complete the highway through a concession or public-private partnerships (PPPs).

### Policy recommendations to improve fiscal composition and create fiscal space
- Tax policies:
  - Tax exemptions, especially for the VAT, risk undermining the tax base and should be rationalized.
  - Corporate profit tax holidays should be reduced.
  - The use of multiple positive VAT rates and zero-rating of intermediate inputs should be reviewed, taking into account distributional impacts.
- Public sector wage bill:
  - The overall public-sector wage bill remains high compared to peers.
  - While authorities intend to severely limit wage increases in the near term, a more comprehensive strategy is required to reduce the wage bill and assume tighter control over employment levels throughout the entire public sector.
- Pension reform:
  - Eligibility for early retirements should be tightened.
  - The authorities should valorize pensions by wages and index benefits to inflation.
  - These two reforms would produce near-term savings. The valorization of pensions by wages raises pension spending in the long run but is essential to ensure that replacement rates remain socially sustainable.
- Municipal finances:
  - Several municipalities have significant debts and very high wage costs.
  - Central oversight should be strengthened, and incentives and capacity for municipalities to raise their own revenues, particularly on real estate, should be increased.
- Contingency measures:
  - Additional medium-term reforms would create fiscal space to increase social and capital spending and bolster growth and labor market outcomes in the medium term.
  - These reforms could also serve as contingency measures should there be slippages in the fiscal adjustment.

### Authorities’ views (as reported)
- The authorities broadly agreed with staff’s fiscal projections and outlined plans to address several structural fiscal issues.
- They believed that fiscal adjustment measures were yielding the anticipated results and concurred that the measures should place debt on a firm downward path.
- The authorities pointed to their recent success in securing the World Bank PBG-backed bank loan and issuing a new Eurobond as evidence that their strategy would maintain market access and facilitate the completion of the medium-term fiscal financing program.
- The authorities believe that their fiscal strategy already includes contingency measures and consider staff projections to be conservative.
- On tax policy, they intend to quantify the fiscal cost of tax exemptions.
- The authorities have published a Medium-Term Debt Strategy and intend to develop the domestic government debt market further, which will require regulatory coordination with the Securities Commission and stock exchange.
- The authorities agreed that fiscal space did not exist to assume further debt to continue the Bar-Boljare highway and plan to complete the highway through a concession or public-private partnerships (PPPs) and are preparing the legal framework for PPPs.

*Source: IMF staff; Montenegrin authorities.*

### 0.3 percent and 1.3 percent, respectively, in

### cr18121 - 0.3 percent and 1.3 percent, respectively, in

### External position and real exchange rate
- EBA-lite REER regression model estimates the REER to be undervalued by 17 percent.
- Current account regression model suggests the REER is overvalued by 18 percent.
- Staff assessment: on balance, the real exchange rate is overvalued by 10 percent due to persistently large current account deficits and weak export performance.
- From a medium-term perspective (2008-17):
  - Unit labor costs have not increased, even showing a decline in recent years.
  - Labor productivity has only shown a modest increase.
- The external position is weaker than suggested by medium-term fundamentals and desirable policies.
- The planned fiscal adjustment should help reduce current account deficits.
- Gross international reserves appear adequate (Appendix II).

### Labor market outcomes and structural issues
- Labor market indicators:
  - Inactivity rate (ages 15-64): about 37 percent.
  - Unemployment rate: 16 percent.
  - About 80 percent of the unemployed were out of work for more than a year on average.
  - Informal economy employs about 1/4 of the workforce.
- Participation is low despite recent increases; inactivity is lower than Western Balkan average (excl. MNE) but much higher than EU and New Member States averages.
- Weak labor market outcomes reflect structural rather than cyclical characteristics.
- Disadvantaged groups highlighted: women, youth (15–24 years), and those with low education.

### Policy recommendations: comprehensive strategy to address informal employment and inactivity
- Cross-cutting factors: tax policy, social benefits design, and employment policy call for a unified strategy.
- Tax policy recommendations:
  - Reduce the tax wedge on labor (currently around 40 percent).
  - Reduce the tax wedge especially on low income earners, with a gradual withdrawal of social assistance benefits.
  - Re-introduce a basic allowance for wage income and/or implement targeted earned income tax credits or lower employer contributions.
  - When beneficiaries of social assistance and family benefits enter formal employment, withdraw assistance gradually to encourage formal work.
  - Make reforms revenue-neutral through increased environmental taxes or lower tax expenditures.
- Labor law and regulations:
  - Draft new Labor Law would simplify dismissal procedures and extend fixed-term contracts to 36 months.
  - Suggested refinements:
    - Allow employees to work for more than one employer.
    - Reduce burden on SMEs by allowing brief description/specification of work in employment contract instead of full rulebook on internal organization and job classification.
    - Do not automatically terminate employment contracts at 67 years if employer and employee wish to continue.
    - For cases where an inspector finds a worker without a formal contract, compliance actions should be complemented by incentives for formalization rather than only issuing an open-ended contract.
  - General Collective Agreement (GCA) reforms:
    - Collective agreements should be time bound with possibility of extension by consent.
    - Provide reasonable firm-level flexibility to adjust to different economic situations, especially recessions.
    - Address provisions that multiply the minimum wage by coefficients depending on education level to avoid multiple minimum wages and large spillovers to public sector wages and pensions.

### State involvement, SOEs, PPPs, and privatization
- Some public enterprises do not solve market failures and impose continuous drain on the budget.
- Recommendations:
  - Accelerate privatization within an appropriate regulatory framework.
  - Merge some municipal SOEs for efficiency gains.
  - Hold a transparent tender for the sale of EPCG shares following exit of a foreign investor.
  - Strengthen PPP framework to avoid transferring residual fiscal risks to the government.
- Authorities’ stated actions:
  - Working to restructure Montenegro Airlines and intend to resell EPCG shares to a private investor via a transparent process.
  - Drafting a new Law on PPPs and seeking IFI comments; IFC advising on airport concessions.

### Financial sector health and supervision
- Authorities have brought non-bank financial institutions under central bank supervision.
- Banking sector:
  - Overall stable, but supervisory action plans for weak banks should be steadfastly implemented and interventions made if necessary.
  - Asset quality reviews are recommended to improve loan classification and provisioning practices and should be implemented as soon as possible.
  - Adopt a definition of non-performing loans that does not exclude impaired assets that have adequate collateral.
  - Exercise caution in granting new banking licenses and promote consolidation given many banks relative to market size.
- Continue to improve AML/CFT framework and implement outstanding recommendations of the 2015 FSAP.

### Fiscal outlook, adjustment, and public debt
- Staff projection and assessment:
  - Economic growth should remain strong in 2018 and maintain momentum over medium term; growth should slow moderately as fiscal consolidation continues and highway construction ends next year.
  - The first section of the Bar-Boljare highway has raised debt to high levels; fiscal space does not exist to finance remaining phases with debt.
  - Completion of highway via PPP should meet standard cost-benefit criteria and avoid large contingent liabilities.
  - Medium-term fiscal adjustment plan is well specified and socially balanced; concerted political efforts needed to maintain fiscal discipline.
  - Staff projects a primary surplus of 4½ percent of GDP in 2020, leading general government debt (including guarantees) to fall quickly after peaking at 80 percent of GDP in 2019.
  - Maintenance of primary surpluses after 2020 will be necessary for debt to fall rapidly; surpluses could decline to around 3 percent of GDP.
- Fiscal reforms advised:
  - Right-size public-sector workforce and implement civil service reform.
  - Strengthen central oversight over local government finances; increase municipalities’ incentives and capacity to raise own revenues.
  - Tighten eligibility for early retirement to strengthen pension sustainability.
  - Shift pensions to wage valorization and CPI indexation to improve long-term fiscal and social sustainability.
  - Review fiscal cost of tax exemptions.
  - These reforms would increase fiscal space for high-productivity capital spending and well-targeted social spending or provide offsets for unforeseen fiscal slippages.

### Key statistics and projections (selected figures preserved as in source)
- Real economy:
  - Nominal GDP (millions of €): 2017 Prelim. 4,237; 2018 Last SR 4,187; 2018 Prelim. 4,492; 2019 4,692; 2020 4,917; 2021 5,165; 2022 5,444; 2023 5,718.
  - Gross national saving (percent of GDP): 2017 Prelim. 10.4; 2018 Last SR 9.9; 2018 Prelim. 11.1; 2019 9.6; 2020 10.0; 2021 11.6; 2022 13.4; 2023 15.2.
  - Gross investment (percent of GDP): 2017 Prelim. 29.3; 2018 Last SR 31.1; 2018 Prelim. 29.9; 2019 27.2; 2020 23.4; 2021 24.2; 2022 24.6; 2023 25.2.
  - Unemployment rate (percent): 2017 Prelim. ...; 2017 (table) 16.1 (noted elsewhere in text as 16 percent).
  - Real GDP growth (percent): 2017 Prelim. 4.4; 2018 Last SR 2.8; 2018 Prelim. 3.0; 2019 2.4; 2020 3.0; 2021 3.1; 2022 3.4; 2023 3.0.
- Prices and wages:
  - Consumer prices (period average): 2017 Prelim. 2.4; 2018 Last SR 2.6; 2018 Prelim. 2.8; 2019 1.8; 2020 1.7; 2021 1.9; 2022 2.0; 2023 2.0.
  - Consumer prices (end of period): 2017 Prelim. 1.9; 2018 Last SR 2.6; 2018 Prelim. 2.7; 2019 1.8; 2020 1.8; 2021 1.9; 2022 2.0; 2023 2.0.
- Public finances (percent of GDP):
  - Revenue and grants: 2017 Prelim. 40.9; 2018 Last SR 45.1; 2018 Prelim. 43.4; 2019 42.4; 2020 42.3; 2021 42.2; 2022 42.1; 2023 42.0.
  - Expenditure: 2017 Prelim. 47.8; 2018 Last SR 50.7; 2018 Prelim. 46.1; 2019 44.4; 2020 39.8; 2021 40.0; 2022 40.0; 2023 40.1.
  - Overall fiscal balance: 2017 Prelim. -7.0; 2018 Last SR -5.6; 2018 Prelim. -2.7; 2019 -2.0; 2020 2.5; 2021 2.2; 2022 2.1; 2023 1.9.
  - Primary balance: 2017 Prelim. -4.5; 2018 Last SR -2.9; 2018 Prelim. -0.7; 2019 0.1; 2020 4.4; 2021 3.9; 2022 3.6; 2023 3.3.
  - General government gross debt: 2017 Prelim. 67.2; 2018 Last SR 73.6; 2018 Prelim. 72.5; 2019 70.9; 2020 61.1; 2021 56.5; 2022 51.8; 2023 47.4.
  - General government debt, including loan guarantees: 2017 Prelim. 74.6; 2018 Last SR 81.0; 2018 Prelim. 80.1; 2019 78.2; 2020 68.0; 2021 63.1; 2022 58.1; 2023 53.4.
- Balance of payments:
  - Current account balance (percent of GDP): 2017 Prelim. -18.9; 2018 Last SR -21.2; 2018 Prelim. -18.8; 2019 -17.6; 2020 -13.4; 2021 -12.6; 2022 -11.3; 2023 -10.1.
  - Foreign direct investment (percent of GDP): 2017 Prelim. 11.2; 2018 Last SR 10.4; 2018 Prelim. 11.3; 2019 11.3; 2020 11.3; 2021 11.1; 2022 10.8; 2023 10.6.
  - External debt (end of period, stock): 2017 Prelim. 159.7; 2018 Last SR 173.5; 2018 Prelim. 164.2; 2019 166.3; 2020 158.6; 2021 155.4; 2022 150.3; 2023 144.7.
- Reserves and import coverage:
  - Gross international reserves (millions of USD): 2017 Prelim. 1,037; 2018 Last SR 967; 2018 Prelim. 1,454; 2019 1,532; 2020 1,308; 2021 1,356; 2022 1,402; 2023 1,447.
  - Months of imports: 2017 Prelim. 3.7; 2018 Prelim. 4.8; 2019 5.1; 2020 4.2; 2021 4.2; 2022 4.2; 2023 4.2.
- Other memoranda:
  - GDP per capita (USD): 2013 7,189; 2014 7,390; 2015 6,517; 2016 7,028; 2017 (Prelim.) ...; 2017 Prelim. 7,678 (noted in table).

### Staff appraisal: overall judgment and next steps
- Growth outlook: strong in 2018 and medium term, though slowing moderately as fiscal consolidation continues and highway construction ends.
- Fiscal policy: authorities appropriately focused on fiscal adjustment to lower government debt to safer levels; front-loaded adjustment timed to complete underlying adjustment before highway construction concludes.
- Debt and PPP cautions: fiscal space insufficient to finance remaining highway phases with debt; completion via PPP must meet cost-benefit criteria and avoid large contingent liabilities.
- Institutional recommendations: strengthen fiscal institutions including fiscal rules and budgetary processes.
- Labor and competitiveness: unified strategy needed to reduce labor tax wedge, reform benefit withdrawal, and adopt labor law amendments to balance worker protection with increased flexibility; review state involvement in the economy and strengthen PPP framework.
- Financial sector: continue reforms, supervision, asset quality reviews, and AML/CFT improvements.
- Expected next Article IV consultation with Montenegro to be held on the standard 12-month cycle.

*Italic: International Monetary Fund staff summary based on the provided Montenegro chapter content.*

### 1. Revenue

### 1. Revenue

### Revenue levels and composition (absolute values)
- Total revenue (levels): 1,381; 1,497; 1,469; 1,630; 1,724; 1,726; 1,886; 1,944; 1,982; 2,071; 2,175; 2,285; 2,391
- Taxes: 864; 950; 926; 1,013; 1,107; 1,104; 1,226; 1,253; 1,331; 1,393; 1,461; 1,533; 1,603
  - Personal income tax: 124; 137; 136; 160; 170; 146; 179; 157; 168; 169; 177; 185; 192
  - Corporate income tax: 41; 45; 42; 45; 50; 49; 53; 58; 58; 60; 63; 65; 67
  - Property taxes: 14; 15; 15; 13; 14; 15; 15; 16; 17; 18; 19; 20; 21
  - Value added tax: 429; 498; 457; 501; 540; 549; 615; 637; 672; 704; 739; 776; 811
  - Excises: 161; 156; 170; 183; 214; 225; 240; 256; 280; 299; 314; 331; 347
  - Taxes on international trade: 22; 22; 23; 24; 25; 25; 27; 27; 28; 29; 30; 32; 34
  - Local government taxes: 67; 71; 76; 77; 81; 86; 86; 92; 95; 100; 105; 110; 116
  - Other taxes: 5; 6; 7; 9; 12; 9; 12; 11; 14; 14; 15; 15; 14
- Social security contributions: 357; 401; 392; 414; 453; 442; 481; 470; 470; 491; 516; 544; 572
- Nontax revenues: 152; 137; 138; 186; 143; 149; 161; 201; 167; 175; 184; 194; 204
- Grants: 10; 9; 14; 17; 21; 30; 17; 20; 14; 12; 13; 13; 13

### Revenue composition (percent of GDP)
- Total revenue: 41.1; 43.3; 40.2; 41.2; 43.4; 40.7; 45.0; 43.3; 42.2; 42.1; 42.1; 42.0; 41.8
- Taxes: 25.7; 27.5; 25.3; 25.6; 27.9; 26.1; 29.3; 27.9; 28.4; 28.3; 28.3; 28.2; 28.0
  - Personal income tax: 3.7; 4.0; 3.7; 4.0; 4.3; 3.4; 4.3; 3.5; 3.6; 3.4; 3.4; 3.4; 3.4
  - Corporate income tax: 1.2; 1.3; 1.2; 1.1; 1.3; 1.2; 1.3; 1.3; 1.2; 1.2; 1.2; 1.2; 1.2
  - Property taxes: 0.4; 0.4; 0.4; 0.3; 0.3; 0.4; 0.3; 0.4; 0.4; 0.4; 0.4; 0.4; 0.4
  - Value added tax: 12.8; 14.4; 12.5; 12.7; 13.6; 13.0; 14.7; 14.2; 14.3; 14.3; 14.3; 14.2; 14.2
  - Excises: 4.8; 4.5; 4.7; 4.6; 5.4; 5.3; 5.7; 5.7; 6.0; 6.1; 6.1; 6.1; 6.1
  - Taxes on international trade: 0.7; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6
  - Local government taxes: 2.0; 2.1; 2.1; 2.0; 2.0; 2.0; 2.0; 2.0; 2.0; 2.0; 2.0; 2.0; 2.0
  - Other taxes: 0.2; 0.2; 0.2; 0.2; 0.3; 0.2; 0.3; 0.2; 0.3; 0.3; 0.3; 0.3; 0.2
- Social security contributions: 10.6; 11.6; 10.7; 10.5; 11.4; 10.4; 11.5; 10.5; 10.0; 10.0; 10.0; 10.0; 10.0
- Nontax revenues: 4.5; 4.0; 3.8; 4.7; 3.6; 3.5; 3.8; 4.5; 3.6; 3.6; 3.6; 3.6; 3.6
- Grants: 0.3; 0.3; 0.4; 0.4; 0.5; 0.7; 0.4; 0.5; 0.3; 0.2; 0.3; 0.2; 0.2

---

### 2. Expense

### Expense levels and composition (absolute values)
- Total expense (levels): 1,404; 1,350; 1,479; 1,624; 1,622; 1,615; 1,681; 1,646; 1,673; 1,734; 1,810; 1,902; 1,988
- Gross salaries and other personal income: 380; 395; 403; 434; 445; 453; 446; 454; 462; 488; 512; 540; 568
- Use of goods and services: 140; 140; 188; 187; 175; 173; 180; 180; 182; 188; 209; 231; 248
- Interest payments: 71; 78; 86; 85; 100; 103; 111; 92; 99; 96; 86; 82; 80
- Subsidies to enterprises: 18; 19; 20; 28; 28; 29; 29; 28; 29; 30; 32; 34; 35
- Other current outflows: 35; 37; 45; 51; 50; 54; 60; 59; 53; 56; 58; 61; 64
- Social security transfers: 483; 492; 488; 556; 565; 539; 581; 544; 562; 579; 603; 627; 653
- Other transfers: 153; 154; 230; 263; 240; 243; 250; 267; 263; 273; 286; 300; 314
- Repayment of guarantees: 107; 18; 0; 0; 0; 0; 0; 0; 0; 0; 0; 0; 0
- Reserves: 16; 16; 19; 21; 19; 22; 23; 22; 23; 24; 25; 26; 28

### Expense composition (percent of GDP)
- Total expense: 41.8; 39.0; 40.5; 41.1; 40.9; 38.1; 40.1; 36.6; 35.6; 35.3; 35.0; 34.9; 34.8
- Gross salaries and other personal income: 11.3; 11.4; 11.0; 11.0; 11.2; 10.7; 10.7; 10.1; 9.9; 9.9; 9.9; 9.9; 9.9
- Use of goods and services: 4.2; 4.1; 5.1; 4.7; 4.4; 4.1; 4.3; 4.0; 3.9; 3.8; 4.0; 4.3; 4.3
- Interest payments: 2.1; 2.3; 2.4; 2.2; 2.5; 2.4; 2.6; 2.1; 2.1; 2.0; 1.7; 1.5; 1.4
- Subsidies to enterprises: 0.5; 0.5; 0.6; 0.7; 0.7; 0.7; 0.7; 0.6; 0.6; 0.6; 0.6; 0.6; 0.6
- Other current outflows: 1.0; 1.1; 1.2; 1.3; 1.3; 1.3; 1.4; 1.3; 1.1; 1.1; 1.1; 1.1; 1.1
- Social security transfers: 14.4; 14.2; 13.3; 14.1; 14.2; 12.7; 13.9; 12.1; 12.0; 11.8; 11.7; 11.5; 11.4
- Other transfers: 4.6; 4.4; 6.3; 6.6; 6.0; 5.7; 6.0; 5.9; 5.6; 5.6; 5.5; 5.5; 5.5
- Repayment of guarantees: 3.2; 0.5; 0.0; 0.0; 0.0; 0.0; 0.0; 0.0; 0.0; 0.0; 0.0; 0.0; 0.0
- Reserves: 0.5; 0.5; 0.5; 0.5; 0.5; 0.5; 0.5; 0.5; 0.5; 0.5; 0.5; 0.5; 0.5

---

### 3. Balances and fiscal position

### Operating and capital balances (absolute values)
- Gross operating balance (= 1 - 2): -23; 147; -10; 6; 102; 111; 205; 298; 310; 337; 365; 383; 403
- Net acquisition of nonfinancial assets: 124; 181; 212; 247; 360; 398; 438; 415; 398; 209; 243; 261; 289
  - Capital revenue: -9; -7; -8; -4; -4; -6; -5; -7; -7; -7; -8; -8; -8
  - Capital expenditure: 132; 189; 220; 251; 364; 405; 442; 421; 405; 217; 250; 268; 297
- Net lending (+) / borrowing (-) (= 3 - 4): -147; -34; -221; -241; -258; -288; -233; -117; -88; 128; 122; 122; 114

### Balances (percent of GDP)
- Gross operating balance (= 1 - 2): -0.7; 4.3; -0.3; 0.2; 2.6; 2.6; 4.9; 6.6; 6.6; 6.9; 7.1; 7.0; 7.0
- Net acquisition of nonfinancial assets: 3.7; 5.2; 5.8; 6.2; 9.1; 9.4; 10.5; 9.2; 8.5; 4.3; 4.7; 4.8; 5.0
  - Capital revenue: -0.3; -0.2; -0.2; -0.1; -0.1; -0.1; -0.1; -0.1; -0.1; -0.1; -0.1; -0.1; -0.1
  - Capital expenditure: 3.9; 5.5; 6.0; 6.4; 9.2; 9.6; 10.6; 9.4; 8.6; 4.4; 4.8; 4.9; 5.2
- Net lending (+) / borrowing (-) (= 3 - 4): -4.4; -1.0; -6.1; -6.1; -6.5; -6.8; -5.6; -2.6; -1.9; 2.6; 2.4; 2.2; 2.0

---

### 4. Financial operations and debt

### Net acquisition of financial assets (absolute values)
- Net acquisition of financial assets: -34; 9; 32; -11; -15; 32; -11; 366; -39; -209; 2; 11; 7
  - Domestic: -34; 9; 32; -11; -15; 32; -11; 366; -39; -209; 2; 11; 7
    - Currency and deposits: -11; 31; 37; -3; -7; 34; -5; 296; 30; -209; -4; 5; 1
    - Loans: 4; -10; 4; 4; -2; 7; 1; 5; 6; 6; 6; 6; 6
    - Equity and investment fund shares: -27; -12; -10; -11; -6; -9; -7; 65; -75; -5; 0; 0; 0

### Net incurrence of liabilities (absolute values)
- Net incurrence of liabilities: 196; 117; 186; 200; 240; 293; 186; 483; 49; -336; -120; -112; -108
  - Domestic: 58; 19; -43; 76; -19; 37; 1; -54; 23; 43; 46; 51; 22
  - Foreign: 139; 98; 229; 123; 258; 256; 185; 537; 26; -379; -166; -163; -130

### Financial discrepancy
- Discrepancy (= 5 - 6 + 7): 83; 74; -67; -31; -4; -26; -36; 0; 0; 0; 0; 0; 0
  - Note in source: "Historical discrepancy refers to differences between reported financing and that derived from monetary and debt data. Projected discrepancy refers to unidentified future financing needs."

### Memorandum items (absolute and percent of GDP)
- Primary balance (absolute): (not provided in levels table)
- Primary balance (percent of GDP): -76; 44; -135; -155; -158; -185; -122; -24; 11; 224; 208; 204; 194
- Nonhighway primary balance (percent of GDP): -76; 44; -50; -37; 75; 62; 149; 240; 215; 224; 208; 204; 194
- Current balance (absolute): (not provided in levels table)
- Current balance (percent of GDP): -33; 138; -23; -11; 81; 80; 188; 278; 296; 325; 351; 370; 390
- Nominal general government debt (absolute levels, selected): 1,972; 2,191; 2,513; 2,625; ...; 2,848; ...; 3,258; 3,329; 3,003; 2,920; 2,821; 2,711
- Nominal general government debt, with guarantees (absolute levels, selected): 2,241; 2,473; 2,784; 2,923; ...; 3,160; ...; 3,598; 3,668; 3,343; 3,260; 3,161; 3,051
- Nominal GDP (absolute levels): 3,362; 3,458; 3,655; 3,954; 3,970; 4,237; 4,187; 4,492; 4,692; 4,917; 5,165; 5,444; 5,718

---

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

### 8. Discrepancy (= 5 - 6 + 7) 2/

### 8. Discrepancy (= 5 - 6 + 7) 2/

### Discrepancy series (level)
- 2.5
- 2.1
- -1.8
- -0.8
- -0.1
- -0.6
- -0.9
- 0.0
- 0.0
- 0.0
- 0.0
- 0.0
- 0.0

### Memorandum items — Primary and related balances (level)
- Primary balance:
  - -2.2
  - 1.3
  - -3.7
  - -3.9
  - -4.0
  - -4.4
  - -2.9
  - -0.5
  - 0.2
  - 4.6
  - 4.0
  - 3.8
  - 3.4
- Nonhighway primary balance:
  - -2.2
  - 1.3
  - -1.4
  - -0.9
  - 1.9
  - 1.5
  - 3.6
  - 5.3
  - 4.6
  - 4.6
  - 4.0
  - 3.8
  - 3.4
- Current balance:
  - -1.0
  - 4.0
  - -0.6
  - -0.3
  - 2.0
  - 1.9
  - 4.5
  - 6.2
  - 6.3
  - 6.6
  - 6.8
  - 6.8
  - 6.8

### Notes on definition and projection
- Sources: Ministry of Finance; and Fund staff estimates and projections.
- 1/ Includes central government budget and local governments.
- 2/ Historical discrepancy refers to differences between reported financing and that derived from monetary and debt data. Projected discrepancy refers to unidentified future financing needs.

*Source: cr18121 - 8. Discrepancy (= 5 - 6 + 7) 2/ (IMF staff estimates and projections).*

### Annex I. Risk Assessment Matrix

### Annex I. Risk Assessment Matrix

### Major Risks and Relative Likelihoods
- Structurally weak growth in key advanced economies — Relative Likelihood: High
  - Impact if Realized:
    - Low productivity growth (U.S., euro area and Japan), high debt, and failure to fully address crisis legacies by undertaking structural reforms amidst persistently low inflation (euro area and Japan) undermine medium-term growth.
    - 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).
    - A protracted period of low inflation in the Euro Area, if imported to Montenegro, 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.

- Tighter global financial conditions — Relative Likelihood: High
  - Impact if Realized:
    - Continued monetary policy normalization and stretched valuations could prompt abrupt changes in global risk appetite (e.g., due to higher-than-expected inflation in the U.S), leading to sudden, sharp increases in interest rates and tighter financial conditions.
    - Higher debt service and refinancing risks could stress leveraged firms, households, and vulnerable sovereigns, including through capital account pressures in some cases.
    - Montenegro is highly reliant on external financing, but financing needs are covered until 2020. Gross public financing needs average 12 percent of GDP in 2018-21. Montenegro just finalized a successful liability management operation and will likely return to the Eurobond market in 2020 or 2021.
  - 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. Intensify adjustment if tighter conditions are permanent.
    - Continue implementing the medium-term debt strategy with an emphasis on developing the domestic bond market.

- Intensification of risks of fragmentation/security dislocation in parts of the Middle East, Africa, Asia, and Europe, leading to socio-economic disruptions — Relative Likelihood: High
  - Impact if Realized:
    - Intensification of conflicts could lead to sharp rises in migrant flows into Europe; lack of a common cooperative policy to deal with asylum seekers and other migrants could deepen political divisions.
    - Border controls could restrict movement of goods, services and labor in the single market. Limited integration of asylum seekers into the labor force could raise unemployment, pressure national budgets, and threaten social cohesion.
    - Montenegro is not a transit country for refugees and thus the direct impact should be muted.
  - Policy Response:
    - Let automatic fiscal stabilizers work, within limited fiscal space.
    - Speed up structural reforms to improve the business environment and competitiveness.
    - Intensify reforms to improve the labor markets with a focus on job creation.
    - Accelerate policies to facilitate the resolution of problem loans and encourage a revitalization of bank lending.

- Insufficient fiscal discipline — Relative Likelihood: Medium
  - Impact if Realized:
    - Authorities do not have a strong track record concerning fiscal consolidation. The highway remains a source of fiscal pressures. Political difficulty to maintain primary surpluses required to keep public debt on a strong downward path; ruling coalition has a small majority in parliament.
    - Given high public debt, a loss of fiscal discipline could lead to future financing difficulties and potentially result in debt sustainability problems.
  - Policy Response:
    - Sustain medium-term fiscal consolidation plans; reduce public wage and pension expenditure over time, strengthen tax administration, and reduce tax exemptions.
    - Improve public communication regarding the need for fiscal adjustment.
    - Ensure that any further phases of the highway are not financed with public debt.

- Delays and withdrawals from capital investment projects — Relative Likelihood: Medium
  - Impact if Realized:
    - Geopolitical tensions, weak administrative procedures on land development, and fiscal sustainability concerns could threaten capital investments in tourism and industry.
    - Construction and activity associated with large-scale investment projects (both tourism and infrastructure based) are key drivers of growth.
  - Policy Response:
    - Sustain the medium-term fiscal consolidation effort to safeguard fiscal sustainability and implement structural reforms to improve the business environment and strengthen anti-corruption and AML/CFT frameworks.

- Supervisory action plans fail to improve banks with qualified audit reports — Relative Likelihood: Medium
  - Impact if Realized:
    - Inability of weak banks to comply with minimum supervisory requirements and with required capital increases.
    - Failure to address weak banks could negatively affect perceptions of the banking system’s stability.
  - Policy Response:
    - Steadfastly implement agreed supervisory action plans. Require shareholders to contribute additional capital.
    - Adjust action plans as needed and require intervention in the absence of a viable business plan or material non-compliance.
    - Ensure a clear public communication strategy to ringfence any spillovers from any necessary interventions in weak banks.

- Note on RAM interpretation:
  - The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path. The relative likelihoods are staff’s subjective assessment: "low" indicates a probability below 10 percent, "medium" a probability between 10 and 30 percent, and "high" a probability of 30 percent or more.

### Annex II — Public Debt Sustainability: Key Findings and Baseline Projections
- Current and projected debt levels:
  - General government debt (including guarantees) increased from 36 percent of GDP in 2006 to 75 percent of GDP in 2017.
  - In the baseline, gross debt is projected to peak at 81 percent of GDP in 2018.
  - Net debt (adjusted for government deposits) declines by 1 percentage point of GDP in 2018 as authorities pre-finance Eurobonds falling due over 2019-21.
  - Gross debt would fall to 53 percent of GDP in 2023, based on front-loaded fiscal adjustment measures and the end of highway spending that will improve the fiscal deficit substantially by 2020.
  - Gross financing needs remain high, though the liability management operation earlier this year has reduced financing needs over 2019-21.

- Baseline macro and fiscal assumptions:
  - Growth projections:
    - Growth is projected to slow to 3 percent in 2018.
    - Growth is projected to slow marginally to 2¾ percent in 2019–20.
    - Growth would then increase above 3 percent in 2021-23.
  - Fiscal scenario:
    - Staff’s baseline assumes full implementation of additional fiscal measures over 2018-20, with the non-highway primary balance improving by 3¼ percentage points of GDP.
    - Staff projects a primary surplus of 4½ percent of GDP in 2020.
    - Staff’s baseline assumes the government does not take on additional debt to construct further phases of the Bar-Boljare highway.
  - Pre-financing and liability operations:
    - Authorities borrowed €250 million from a syndicate of international banks, with a 2.95 percent interest rate and 12-year maturity, leveraging a World Bank Policy-Based Guarantee (PBG).
    - They issued a seven-year €500 million Eurobond, of which €362 million was used to buy back existing Eurobonds set to mature in 2019-21. The Eurobond carries a coupon rate of 3.375 percent.
    - These two operations will increase government deposits at the central bank by 6.5 percent of GDP, which will later be used to amortize remaining Eurobonds in 2019 and 2020.
    - The baseline also includes a second World Bank PBG for €140 million in 2019.
    - Authorities should be able to roll over the remaining 2021 Eurobond by issuing a new €150-200 million Eurobond in 2020/21.
    - Replacement of more expensive previous Eurobonds (which carried coupon rates as high as 5.75 percent) with lower rate loans is projected to lower the government’s effective interest rate from 3.9 percent in 2017 to 2.8 percent by 2020.

- Vulnerabilities and realism:
  - Heat map and debt profile vulnerabilities:
    - Risks from the debt level are deemed high as debt exceeded the 70 percent of GDP benchmark for the first time in 2014. Debt only falls below the benchmark in the baseline projections in 2020 and expands in some shock scenarios.
    - Gross financing needs exceed the 15 percent benchmark in 2018, though the liability management operation has reduced medium-term refinancing risks.
    - Public debt held by non-residents (mostly Eurobonds and the Chinese Ex-Im loan) constitutes a vulnerability.
    - Economic growth shocks have a very large impact on the debt profile.
  - Realism of baseline assumptions:
    - Median forecast errors for real GDP growth and inflation in 2007–2015 suggest an average optimistic bias in past projections.
    - Median forecast error for the primary balance suggests staff projections have been in line with outcomes on average.
    - Projected adjustment in the cyclically-adjusted primary balance is large; key risks are high dependence on external financing and vulnerability to macro shocks.
    - Projected adjustment in the primary balance of 9 percent of GDP over 2017-20 includes the reduction in highway spending. The primary balance without the highway adjusts by 3¼ percentage points of GDP over the same period.
    - Most of the underlying fiscal adjustment should be completed by end-2018.

- Domestic debt market development:
  - The stock of government securities is small and consists primarily of T-bills, mostly held by domestic banks.
  - A more regular offering of longer-maturity domestic bonds would permit diversification of financing sources and provide new financial instruments for insurance companies, corporates, banks, and retail customers. This has been partly integrated into the baseline.

### Alternative Scenarios (summary)
- Alternative scenarios show worse outcomes, reflecting historically weak fiscal outcomes and the beginning of a phased adjustment.
  - Under the historical scenario, projections are based on the average level of the primary balance over the past ten years (details of scenario outcomes are provided in the main analysis).

*Source: Annex I. Risk Assessment Matrix; Annex II. Public Debt Sustainability Analysis (cr18121).*

### 3.4 percent of GDP over 2019-23 would lead debt to increase to 87 percent of GDP by 2023. If

### cr18121 - 3.4 percent of GDP over 2019-23 would lead debt to increase to 87 percent of GDP by 2023. If

### Baseline projections and alternative primary-balance paths
- A fiscal adjustment of 3.4 percent of GDP over 2019-23 would lead debt to increase to 87 percent of GDP by 2023.
- If the primary balance were to stay at the projected 2018 level of -0.7 percent (when fiscal adjustment would not yet be complete), debt would fall slowly to 71 percent of GDP by 2023, compared to 53 percent of GDP in the baseline scenario.
- Baseline table excerpts (selected indicators and projections, in percent of GDP unless otherwise indicated):
  - Nominal gross public debt: 2018: 74.6; 2019: 80.8; 2020: 78.3; 2021: 67.7; 2022: 62.5; 2023: 57.3
  - Public gross financing needs: 2018: 15.3; 2019: 17.3; 2020: 12.3; 2021: 10.8; 2022: 8.0; 2023: 4.2
  - Real GDP growth (in percent): 2018: 4.4; 2019: 3.0; 2020: 2.4; 2021: 3.0; 2022: 3.1; 2023: 3.0
  - Inflation (GDP deflator, in percent): 2018: 2.7; 2019: 2.9; 2020: 2.0; 2021: 1.7; 2022: 1.9; 2023: 1.9
  - Primary Balance (baseline): 2018: -4.6; 2019: 0.7; 2020: 0.0; 2021: -4.4; 2022: -3.8; 2023: -3.6
- Change in gross public sector debt (cumulative figures shown): cumulative change to 2023: -21.8 percent of GDP (projection column).

### Montenegro-specific stress tests (highway project)
- Highway Phases 2-4 (debt-financed construction scenario):
  - Assumed cost: €1.2 billion, equally spent over 2021–23.
  - Assumed low spending multiplier of 0.2 during construction (at least 70 percent of inputs are imported).
  - Economic growth effect: increase of ¾ percentage point on average in 2021–23 relative to the baseline.
  - Fiscal effect: primary balance declines in line with highway spending.
  - Debt outcome: public debt ratio increases to 73 percent of GDP by 2023 (compared to 53 percent in the baseline).
  - Gross financing needs: peak at 17 percent of GDP in 2023, 12 percentage points higher than in the baseline.
- Conclusion: "This demonstrates that the authorities cannot afford to take on new debt to complete the remainder of the highway over the medium term."

### Standard stress tests (summarized impacts)
- Growth shock:
  - Real output growth rates lowered in 2019 and 2020 by one standard deviation (3.7 percentage points), lowering inflation and raising interest rates.
  - Public debt ratio peaks at 84 percent of GDP in 2019 before falling to 65 percent of GDP in 2023.
  - Gross financing needs ratio in 2020 increases 6 percentage points of GDP relative to the baseline.
- Interest rate shock:
  - Increase in interest rates on new debt by 388 basis points in 2019–23.
  - Debt increases by 3 percentage points in 2023 relative to the baseline.
  - Financing needs increase by 1 percentage point of GDP in 2023.
- Combined macro shock:
  - Comprises a recession in 2019 and 2020, a 388 basis-point increase in interest rates, a real exchange rate shock, and a sharp rise in expenditures in 2019-20.
  - Debt-to-GDP ratio rises by 8 percentage points to 87 percent of GDP in 2019 and substantially increases gross financing needs.
- Financial contingent liability shock:
  - Expenditures increase in 2019 equivalent to 10 percent of the size of the banking sector, combined with a shock to GDP and interest rates.
  - Debt ratio increases sharply to 89 percent of GDP in 2019.
  - Gross financing needs peak at 20 percent of GDP in 2019 and remain well above the baseline over the medium term.
- Primary balance shock:
  - Assumes an expenditure shock and a rise in interest rates leading to a 2 p.p. deterioration in the primary balance over 2019-20.
  - Deterioration in the debt ratio by about 3 percent of GDP by 2023.
  - 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 2019.
  - Debt ratio would fall marginally from the baseline because the impact from a larger GDP deflator on total debt outweighs the increase in the relatively modest foreign currency debt.
  - Depends critically on an exchange rate pass-through to inflation of 25 percent.

### Risk assessment, profile, and realism of assumptions
- Public DSA risk assessment highlights:
  - Gross financing needs benchmark: 15 percent of GDP (cells flagged if exceeded under shocks or baseline).
  - Debt level benchmark: 70 percent of GDP.
  - Other benchmarks noted (used for heat map and indicators): bond spreads 200 and 600 basis points; external financing requirement 5 and 15 percent of GDP; change in share of short-term debt 0.5 and 1 percent; public debt held by non-residents 15 and 45 percent; share of foreign-currency denominated debt 20 and 60 percent.
- Realism of baseline assumptions:
  - Forecast track record charts for Montenegro show percentile ranks for median forecast errors (2007–2015) for Real GDP Growth, Primary Balance, and Inflation (Deflator).
  - "Has a percentile rank of:" values included in charts (example ranks shown in figures: 62%, 58%, 40% for respective indicators in figure captions).

### External debt (Annex III highlights)
- External debt increased by about 38 percentage points of GDP since 2007, to an estimated 160 percent of GDP in 2017.
- Increase driven partly by sharp rise in public external debt ratio, which almost tripled over the period and comprises 34 percent of total external debt.
- Under the baseline, external debt is projected to peak at 166 percent of GDP, before declining to 145 percent in [projection horizon end shown in source].

*Source: IMF staff (as provided in the content unit).*

### 2023. The projected debt trajectory is highly sensitive to various shocks, particularly to a non-interest

### cr18121 - 2023. The projected debt trajectory is highly sensitive to various shocks, particularly to a non-interest

### External debt levels and composition
- External debt was "about 160 percent of GDP at end-2017" and is projected to increase to "166 percent of GDP by 2019", before declining to "145 percent of GDP by 2023".
- One-third of external debt is government debt.
- Government debt grew by "about 24 percentage points since 2010".
- About one-half of external debt falls into the non-bank private sector (inter-company debt to a large extent).
- Non-government long-term debt has fallen by "around 7 percentage points since 2014".
- Short-term external debt has shown a small decline.
- Recently and going forward, most of the increase in external debt is due to government debt related to the construction of the highway.

### Stress tests and shock scenarios (standardized)
- Overall finding: external debt is particularly sensitive to a variety of shocks, notably current account shocks (e.g., highway project cost overruns), a combined deterioration in the macroeconomic environment, and a depreciation of the euro.
- Growth shock:
  - Scenario: baseline real GDP growth permanently reduced by a one-half standard deviation (calculated over the recent 10-year period ending in 2017).
  - This corresponds to an average growth rate during 2019–23 of "1.1 percent", compared with baseline average growth of "3.0 percent".
  - Impact: external debt ratio increases by "10 percentage points (compared to the baseline) to 156 percent of GDP in 2023".
- Interest rate shock:
  - Scenario: increase in nominal external interest rates on new debt by a one-half standard deviation during 2019–23.
  - Historical stability implies an average increase of "20 basis points" in this scenario.
  - Impact: external debt increases by "2.0 percentage points to 146 percent of GDP by 2023".
- Non-interest current account shock:
  - Scenario: permanently increases the non-interest current account by one-half standard deviation in 2019–23.
  - Given historically-variable current account deficits, this amounts to an increase of "5.4 percentage points".
  - In the absence of offsetting non-debt-creating flows, external debt increases by "about 25 percentage points to 170 percent of GDP by 2023".
- Combined macro shock:
  - Scenario: permanent 1/4 standard deviation shock applied to the real interest rate, the growth rate, and the current account deficit during 2019–23.
  - Impact: external debt ratio rises by "about 20 percentage points to 164 percent of GDP" and increases gross financing needs by "4.5 percent of GDP, on average, over 2019-23 relative to the baseline".
- Real exchange rate shock:
  - Scenario: one-time "30 percent devaluation in the real exchange rate in 2019" applied to estimated stock of external debt in foreign currency (not in euros).
  - For the public sector, the highway represents "1/4 of public external debt".
  - For the private sector, an upper-bound assumption that "100 percent is non-euro external debt" is applied.
  - Impact: shock increases the external debt-to-GDP ratio by "13 percentage points of GDP in 2019".
  - Gross financing needs rise by "8 percentage points of GDP, on average, over 2019–23 relative to the baseline".

### Quantitative baseline and projections (selected figures from Table 1)
- Baseline: External debt by year (in percent of GDP): 2017 "159.7", 2018 "164.2", 2019 "166.3", 2020 "158.6", 2021 "155.4", 2022 "150.3", 2023 "144.7".
- Change in external debt (percent of GDP): 2018 "4.5", 2019 "2.1", 2020 "-7.6", 2021 "-3.2", 2022 "-5.1", 2023 "-5.6".
- Current account deficit, excluding interest payments (percent of GDP): 2017 "16.5", 2018 "16.1", 2019 "14.9", 2020 "10.6", 2021 "9.8", 2022 "8.4", 2023 "7.2".
- Deficit in balance of goods and services (percent of GDP): 2017 "24.2", 2018 "23.6", 2019 "22.1", 2020 "17.8", 2021 "17.0", 2022 "15.6", 2023 "14.3".
- Net non-debt creating capital inflows (negative, percent of GDP): 2017 "-11.2", 2018 "-11.3", 2019 "-11.3", 2020 "-11.3", 2021 "-11.1", 2022 "-10.8", 2023 "-10.6".
- Automatic debt dynamics contributions (percent of GDP):
  - Contribution from nominal interest rate (selected years): 2017 "2.4", 2018 "2.7", 2019 "2.7", 2020 "2.8", 2021 "2.8", 2022 "2.9", 2023 "2.9".
  - Contribution from real GDP growth (selected years): 2017 "-6.5", 2018 "-4.6", 2019 "-3.7", 2020 "-4.8", 2021 "-4.7", 2022 "-5.0", 2023 "-4.3".
- External debt-to-exports ratio (in percent): 2017 "389.2", 2018 "401.3", 2019 "406.7", 2020 "387.4", 2021 "379.1", 2022 "366.0", 2023 "351.6".
- Gross external financing need (in billions of US dollars): 2017 "1.5", 2018 "2.0", 2019 "1.9", 2020 "1.9", 2021 "1.9", 2022 "1.8", 2023 "1.8".
- Gross external financing need (in percent of GDP): 2017 "35.8" (table shows earlier years 2013-2016: "26.1", "29.2", "33.7", "39.0" respectively).

### External sector assessment: current account and REER
- Large current account deficits have persisted for years and reached "about 19 percent of GDP in 2017".
- The current account deficit peaked at "nearly 50 percent of GDP in 2008" and has persisted between "15 to 20 percent of GDP".
- In 2017, current account deficit was "19 percent of GDP", boosted by importation of construction goods for large-scale infrastructure projects which more than offset the tourism-driven service trade surplus.
- From a savings-investment perspective, non-government savings increased by "0.3 percent of GDP" and non-government investment increased by "0.1 percent of GDP" from 2016.
- The current account deficit is projected to remain at "19 percent of GDP in 2018".
- Goods export performance: goods export volume declined by "36 percent between 2007 and 2017" mainly due to reduction in aluminum exports after closure of KAP.
- Services exports more than doubled since 2007, driven by tourism.
- EBA-lite current account model results for 2017 (percent of GDP):
  - Actual CA: "-18.9"
  - Cyclically adjusted CA: "-19.1" (standard version) and "-16.1" (with adjustment)
  - CA norm: "-9.4"
  - CA gap: "-9.5" (standard) and "-6.5" (with adjustment)
  - REER gap (percent): "25.7" (standard) and "17.6" (with adjustment)
- Staff assessment: considering indicators, staff assesses Montenegro’s external position in 2017 was "weaker than implied by fundamentals and desirable policies".
- Staff believes the real exchange rate is overvalued by "10 percent" due to persistently large current account deficits, high unit labor costs, stagnant productivity, and weak export performance.
- Policy implication: "A real depreciation through wage restraint and productivity improvements from structural reforms to strengthen competitiveness would help reduce economic imbalances over the medium term."
- The current account should improve as authorities implement the fiscal adjustment strategy, particularly once spending on the highway ends.

### Foreign assets, liabilities, capital flows, and reserves
- Gross external debt is estimated to have reached "160 percent of GDP in 2017" and is projected to peak around "166 percent of GDP in 2019".
- One-third of external debt is government debt, which increased "12 percentage points of GDP since 2012".
- One-half of government debt corresponds to the non-bank private sector (mostly Eurobonds).
- Short-term private sector debt (maturing in less than one year) averaged "5 percent of GDP in 2015-16".
- FDI inflows finance most of the current account deficit: annual net FDI has averaged "13 percent of GDP since 2010", compared to average current account deficit of "17 percent of GDP" during this period.
- Since 2012, FDI related to real estate purchases has almost halved to "3.5 percent of GDP".
- Large government Eurobond issuances and external loans from China Ex-Im Bank for highway construction, plus an international syndicated bank loan in 2017, have increased portfolio and other investment flows.
- Banks’ external liabilities deleveraged over 2009-2012 and have been declining slowly since 2013.
- Gross international reserves stood at "21 percent of GDP at end-2017".
- Reserves are estimated at "170 percent of the standard IMF metric for reserve adequacy at end-2017" and are projected to exceed the ARA metric in 2018 even after subtracting excess reserves.

*Source: IMF staff report (cr18121).*

### Annex V. Implementation of Past IMF Recommendations

### Annex V. Implementation of Past IMF Recommendations

### Fiscal Policies
- Key recommendation: Implement fiscal consolidation strategy, aiming to deliver a primary fiscal surplus of 4½ percent of GDP by 2020.
- Implemented policies and outcomes:
  - Authorities continued implementation of the fiscal adjustment strategy.
  - Significant improvements in the non-highway primary balance.
  - Revenue performance in 2017 was broadly consistent with the fiscal strategy.
  - Non-highway expenditure developments were in line with the strategy.
  - The 2018 budget is consistent with the fiscal strategy, with implementation of the VAT increase and further excise increases.
  - Authorities have maintained discipline over public sector wages since 2017.
- Key recommendation: Reform public sector employment, the pension system, and local government finances. Reduce the labor tax wedge by shifting some taxation to coal excises.
- Implemented policies and status:
  - The new Ministry of Public Administration is assessing the optimal number of public sector employees (central and local government levels).
  - Authorities have not implemented pension system reforms but intend to approve a reform by the end of 2018.
  - Amendments to the law on local government finances are under discussion.
  - Authorities are studying the labor tax wedge issue with technical assistance from the Fiscal Affairs Department.

### Financial Sector Policies
- Key recommendation: Implement policy recommendations from the FSAP, including an independent asset quality review (AQR) for banks and measures to enhance emergency liquidity assistance (ELA) and bank resolution capacity.
- Implemented policies and status:
  - Authorities advanced implementation on several FSAP recommendations, including approval of key legislation.
  - Options to strengthen ELA capacity have been considered; ELA capacity has improved due to the government’s deposit accumulation.
  - The central bank tentatively plans to carry out an AQR in 2019.
- Key recommendation: Supervisory action plans (SAPs) for problem banks should be implemented forcefully.
  - The central bank has implemented SAPs for three banks with qualified audits.
  - For one bank that has not increased capital as required, the central bank will formulate next steps in the context of its supervisory action plan for the bank.
- Key recommendation: Consider measures to promote consolidation of the banking system such as an increase in the minimum amount of capital.
  - The central bank is studying the proposal but has not made decisions.
  - The CBM is considering whether consolidation could improve efficiency and stability of the banking system.

### Structural Policies
- Key recommendation: Improve labor market flexibility and the investment environment and reduce non-wage disincentives to employment. Maintain discipline over public sector wages to ensure cost competitiveness.
- Implemented policies and status:
  - Authorities are preparing a new labor law aiming to improve labor market flexibility, increase labor market participation, and reduce informal employment.
  - Authorities contained public sector wage growth in 2017-18.

### Annex VI / FSAP Recommendations — Implementation Status (selected)
- Prepare and implement time-bound supervisory action plans for vulnerable banks (CBM). Timing: I. Progress: Done.
  - SAPs for vulnerable banks were adopted; banks report to the CBM.
  - On-site examinations of two of the three vulnerable banks were conducted in 2017; one vulnerable bank is subject to daily examination.
- Conduct an Asset Quality Review for all banks (CBM). Timing: I. Progress: Not Done.
  - Authorities intend to implement an AQR in 2019; argue banks should first comply with EU directives and transition to IFRS-9.
- Introduce a macroprudential mandate consistent with EU/ESRB framework (MOF/CBM/FSC). Timing: MT. Progress: In progress.
  - A framework for macroprudential policy prepared and expected to be adopted by 2018Q2.
- Introduce effective consolidated supervision; improve regulatory and supervisory framework for liquidity and credit risks (CBM). Timing: NT, I. Progress: Not Done.
  - Prepared under “Twinning Project” financed by the EU; expected to start April 2018 and implement after adoption of a new Banking Law by end 2018.
- Tighten prudential norms for identification, classification, and reclassification of nonperforming assets (CBM). Timing: NT. Progress: In progress.
  - Decision on minimum standards for banks credit risk management amended.
  - Transition to IRFS-9 started in January 2018.
  - New Decision on chart of accounts for banks and Decision on reporting to the CBM adopted; remainder waiting for new Banking Law.
- Adopt risk-based supervision (ISA). Timing: I. Progress: Not done.
  - Development of a risk assessment framework is ongoing; further steps after adoption of new Insurance Law.
- Incrementally implement Solvency II (ISA). Timing: NT. Progress: Not done.
  - More comprehensive implementation after adopting a new Insurance Law.
- Strengthen CBM’s oversight over FMI (CBM). Timing: NT. Progress: Done.
  - October 2015: CBM adopted Decision establishing the "Framework for Payment System Oversight."
- Implement risk mitigation measures to minimize liquidity risks in the RTGS system and eliminate partial unwinding in the DNS system (CBM). Timing: I. Progress: In progress.
  - To be implemented through changes of Operational rules of Payment System and procedure for liquidity loans.
- Finalize national risk assessment and action plan for AML/CFT (CBM). Timing: NT. Progress: Done.
  - National risk assessment adopted in 2015.
  - July 2017: government adopted 12th report on implementation of the Strategy for the Prevention and Suppression of Terrorism, Money Laundering and Terrorism Financing 2015-2018 and measures from Action Plan 2017-2018.
  - November 2017: CBM prepared report on implementation of measures Jan-Nov 2017, submitted to the Administration for the Prevention of Money Laundering and Terrorist Financing.
- Strengthen voluntary debt-restructuring framework (MOF). Timing: I. Progress: Done.
  - Law on Voluntary Financial Restructuring of Debts towards Financial Institutions implemented and amended in June 2017.
  - Amendments to the Decision on Minimum Standards for Credit Risk Management in Banks adopted.
- Amend personal bankruptcy regime to clarify creditors’ rights regarding mortgages (MOF). Timing: I. Progress: Done.
- Set strict and objective criteria for determining systemic importance of banks (CBM/MOF). Timing: NT. Progress: In progress.
  - CBM preparing guidelines to be adopted within the Twinning project, likely by end of 2018.
- Strengthen resolution-funding options (MOF). Timing: NT. Progress: In progress.
  - 2017: CBM adopted drafts of Bank Resolution Law and Law on Amendments to the Banking Law implementing Directive 2914/49EC on recovery and resolution framework; drafts submitted for parliamentary approval.
- Organize a dedicated resolution unit within the CBM and initiate bank-specific resolution planning (CBM). Timing: I. Progress: In progress.
  - Will be implemented after adoption of the Bank Resolution Law, followed by training.
- Implement risk-based contributions and shorten the pay-out term for DPF (DPF/MOF). Timing: NT. Progress: In progress.
  - New Deposit Protection Law in drafting phase planned to be adopted in 2018.
- Streamline ELA policies and strengthen safeguards to protect CBM’s financial autonomy (CBM/MOF). Timing: NT. Progress: Done.
  - CBM’s financial autonomy strengthened by adopting Law on Amendments to the Central Bank of Montenegro Law.
  - CBM adopted decision on detailed conditions for granting liquidity loans to banks in 2017 and established a Credit Risk Management Committee as an advisory body.
- Strengthen FSC’s crisis preparedness and management mandate (FSC). Timing: I. Progress: Not Done.
  - Authorities are considering potential solutions.

### Appendix I — Impediments to Credit Deepening: Key Findings
- Credit growth has disappointed for nearly a decade following the Global Financial Crisis, suppressing investment and potential growth.
- Nonperforming loans (NPLs):
  - NPLs continue to decline but remain moderately high with considerable variation across banks.
  - Much of the decline is due to sale of NPLs to asset management companies owned by foreign parent banks.
  - NPLs require higher provisioning, lowering banks’ profits, increasing capital requirements, and increasing funding costs.
- Future provisioning and regulatory transition:
  - Banks currently value financial assets according to IAS-39 and apply additional CBM-imposed prudential filters.
  - These filters will continue after transition to IRFS9, which might require additional provisioning.
  - Currently, regulatory provisions for loans and receivables at the system level amounted to 76 percent in 2017-Q3 with a wide variation between banks, from 0 to 219 percent.
- Market structure and collateral constraints:
  - Banking system appears crowded; fierce competition over a small pool of qualified borrowers lowers profit margins.
  - SME sector’s financial reporting is underdeveloped; legal framework for land-ownership registration is weak, limiting eligible collateral.
  - State-owned Investment and Development Fund (IDF) offers subsidized loans to SMEs, further limiting bank clients and driving down profitability.
  - Large private investment projects frequently receive financing from abroad, reducing bankable projects.
- Legal and institutional impediments:
  - Existing bankruptcy laws and low effectiveness of the judicial system create uncertainty in lending.
  - Weak legal framework for debt enforcement causes delays in debt collection and raises cost of credit.
  - Reforms should improve legal certainty, strengthen credit discipline, and enhance supporting institutional infrastructure (including ongoing credit registry improvements).
- Grey economy and informality:
  - Grey economy is an impediment, especially in tourism; many transactions are in cash, making income verification and lending to the informal sector difficult.
  - Banks typically do not lend to the informal sector, which accounts for perhaps one quarter of employment.
- Interest rates and spreads:
  - Weighted average effective interest rate on total lending (WAEIR) declined to 7.0 percent in 2017Q3.
  - CBM cites increased competition as reason for lower interest rates.
  - Lending-deposit spread remains high to cover lending risks; wide variation between banks’ WAEIRs.

### Appendix II — Reserve Adequacy: Assessment and Recommendations
- Context and overall assessment:
  - Montenegro is a euroized economy lacking a lender of last resort; reserve adequacy should consider balance of payments needs, fiscal financing buffers, and bank ELA resources.
  - Gross international reserves appear adequate relative to standard metrics for balance of payments purposes.
  - CBM’s own resources for ELA are limited; government deposits were typically small until the recent liability management operation (LMO).
  - Recommendation: Increase fiscal buffers and resources for ELA, preferably by maintaining greater government deposits and creating a government sub-account at the CBM for ELA purposes.
  - Recommendation: CBM should use required reserves to ensure that standard reserve adequacy metrics are met.
- Reserve levels and composition:
  - At end-2017, CBM held nearly €900 million (21 percent of GDP) in reserves, more than double the level at end-2013.
  - Conservative measure excluding banks’ excess reserves: at end-2017 equaled €380 million (9 percent of GDP).
- IMF reserve adequacy metrics applied:
  - Standard IMF metric for fixed exchange rate (used formula in text); modified metric for euroized economy increases weight on bank deposits to 15 percent.
  - Reserves in range of 100 to 150 percent of the metric are considered adequate.
  - Against both standard and modified concepts, end-2017 reserve levels fall within or above recommended range. In conservative scenario without banks’ excess reserves, coverage is less comfortable.
  - Excluding deposits of Euro Area banks improves reserve coverage considerably.
  - CBM should adjust required reserves to keep international reserves at reasonable levels per standard metrics.
- Table 1. Montenegro: International Reserve Needs Estimate (2017, in percent of GDP unless otherwise noted)
  - Potential sources of liquidity need — ARA Concept / Modified ARA Concept:
    - Exports: 4.1 / 4.1
    - Short-term external debt: 2.2 / 2.2
    - Base money (bank deposits): 6.1 / 9.1
    - Target: 12.4 / 15.5
    - Without deposits of euro area banks: 8.4 / 9.4
  - Available resources:
    - Gross international reserves: 21.2
    - Percent of metric: 170% / 137%
    - Percent of metric, w/o euro area banks: 253% / 226%
    - Net of bank excess reserves: 9.0
    - Percent of metric: 72% / 58%
    - Percent of metric, w/o euro area banks: 107% / 95%
- Fiscal buffers and ELA capacity:
  - Average monthly government deposit balance in 2017: €70 million (1.7 percent of GDP).
  - Benchmark of one month of spending: €150 million (3.6 percent of GDP).
  - Pre-financing in 2018 of coming Eurobond amortizations increased deposits to well beyond one month of expenditures.
  - Banking sector liquidity:
    - Banks are liquid in aggregate with an overall ratio of liquid assets to short-term liabilities of 36 percent.
    - Overall liquidity buffers consist of banks’ own liquid assets (excess reserves and 50 percent of required reserves) plus the 50 percent of required reserves banks cannot withdraw freely; total buffers equaled 40 percent of short-term liabilities at end-2017.
  - CBM ELA resources:
    - CBM’s own capital position covers only 2 percent of banks’ short-term liabilities.
    - Excluding short-term liabilities of banks with Euro Area parents, ELA resources would cover 8 percent of short-term liabilities for remaining banks.
- Policy recommendations:
  - Fiscal buffers:
    - Authorities should consider maintaining government deposits in line with the benchmark of one month of expenditures.
  - ELA buffers:
    - Government should create a dedicated sub-account at the CBM to be used exclusively for ELA purposes.
    - CBM would use this account at its discretion (with safeguards); government should reimburse CBM for ELA-related losses.
    - Even if not funded immediately, the account would serve as recognition that the government is the final backstop for bank liquidity in a euroized economy.

*Source: Annex V. Implementation of Past IMF Recommendations (extracted content).*

### Appendix III. Labor Market Outcomes: Policies and Options

### Appendix III. Labor Market Outcomes: Policies and Options

### Stylized labor market outcomes
- Inactivity rate for the working-age population is about 37 percent; this is lower than the average for Western Balkan countries, but much higher than the average for EU member countries and New Member States (NMS).
- Inactivity rate is higher for women, youth, and individuals with low education.
- End-2017 unemployment rate of 16 percent; unemployment has been declining in recent years but remains high relative to EU and NMS averages.
- About 80 percent of the unemployed in Montenegro were out of work for more than a year (long-term unemployment dominates).
- About 10 percent of the population (15+) work in the informal sector and half of informal workers are inactive.
- Employee status composition: about 78 percent of employees are formally-employed and 22 percent are informally-employed.
- About 70 percent of the informally-employed are self-employed.
- Informally-employed people earn, on average, almost 30 percent less than formally-employed individuals.

### Labor market institutions, protections, and the minimum wage
- Individual and collective rigidity indicators (OECD Employment Protection Legislation rigidity index) are higher than the average for OECD and European countries.
- The new Labor Law draft should balance protection of work and job security while increasing incentives for flexibility, declaration of work, and labor participation. Suggested revisions include:
  - Establishing employment relationships: allow an employee to work for more than one employer even if the additional work is full time.
  - Internal organization and systematization act: reconsider requirement that all firms must have a Rulebook regarding internal organization and classification of jobs; for small firms, a brief description/specification of the work in the employment contract may suffice to reduce burden on SMEs.
- The minimum wage in Montenegro appears moderate by some measures:
  - Relative to the average wage and to value-added per worker, the minimum wage in Montenegro ranks low across the sample of European countries.
  - In practice there may be multiple minimum wages based on the level of education; this may adversely affect hiring decisions, especially for new workers with higher education levels.

### Taxation of labor and incentives
- The tax wedge on labor is described "at around 40 percent" and is relatively high in Montenegro.
- The tax wedge is largely independent of the income level (lack of progressivity) despite a low personal income tax rate.
- The effective tax wedge on labor (including the withdrawal of social benefits) generates significant adverse incentives: it discourages formal labor supply and/or labor demand, and contributes to involuntary unemployment and inactivity.
- Labor Tax Wedge context: chart referenced "Labor Tax Wedge by countries, 2016 (single 67 percent of the average gross wage)".

### Activation policies, education, and strategies
- Authorities have implemented different activation policies to improve knowledge, skills, and competencies of the labor force; implementation would benefit from better monitoring and assessment.
- A comprehensive and unified strategy is needed to address inactivity, long-term unemployment, and informality given potential cross-cutting common factors.
- Neither the new Labor Law nor changes in labor taxation alone would significantly improve current labor market outcomes; close coordination is needed between the Ministry of Finance and the Ministry of Labor on enforcement of the Labor Code, labor taxes and social benefits.
- Recommended strategic elements:
  - Better align the education system with future labor demands and avoid simple expensive retraining.
  - Nurture cooperation between higher education institutions and employers (e.g., cooperation for curricula design).
  - Use active labor market policies to reduce mismatches in the short term, while relying on education system reforms for long-term mismatch reduction.

### Policy options and recommendations (enumerated)
- Revise elements of the Labor Law to increase labor market flexibility and incentives for declaration of work and participation (see suggested changes above).
- Consider a reduction of the tax wedge, especially on low income earners.
- Consider a gradual withdrawal of social assistance and family benefits to limit effective marginal tax disincentives to work.
- Improve monitoring and assessment of activation and training programs.
- Develop a comprehensive, cross-cutting employment strategy with close coordination between Ministry of Finance and Ministry of Labor.
- Align education and training with labor demand; foster higher-education/employer cooperation for curricula design.
- Use active labor market policies to address short-term mismatches while reforming education for long-term alignment.

*Source: Appendix III. Labor Market Outcomes: Policies and Options.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18121.pdf_