## _cr11100 — EXECUTIVE SUMMARY

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---

### Background and recent developments
- Since independence in 2006 Montenegro experienced a boom followed by a bust; large capital inflows (many debt-creating) fueled a domestic demand and real estate boom that overstretched the financial sector.
- The economy contracted sharply during the crisis; reported decline in GDP was 6 percent.
- Fiscal and policy buffers were exhausted at the onset of the crisis:
  - Structural fiscal deficit of some 6 percent of GDP in 2008.
  - By 2009 public and publicly guaranteed debt had risen to nearly 55 percent of GDP.
- Unilateral euroization has constrained monetary policy options and at times imported inappropriate monetary conditions.
- The crisis featured deposit runs and loss of financing access in Fall 2008; foreign parent banks met liquidity and solvency needs while the government provided liquidity support to a large domestic bank via temporary injections and direct placement of public sector deposits.
- The recovery is tentative:
  - 2010 GDP growth is estimated at 1.1 percent; output remained below its 2008 level.
  - Adjustment in 2010 included halving of the current account deficit to around 26 percent of GDP.
  - September 2010 Eurobond issuance of €200 million and a further €180 million issuance in April 2011 occurred amid spread tightening.

### Economic outlook and risks
- Baseline projections:
  - Projected GDP growth rises from 2 percent in 2011 to close to 4 percent by 2016.
  - Current account deficit projected to shrink to around 9 percent of GDP by 2016, financed by FDI inflows.
  - Inflation is expected to remain below that of trading partners.
- Near-term risks (tilted to the downside) include:
  - External environment shocks: another sudden stop, renewed sovereign and banking stress in the euro-area periphery, increased competition for tourists from more competitive Mediterranean neighbors, and more difficult privatizations.
  - Reform fatigue and legacy structural problems: uneven bank restructuring, household deleveraging risks, intermittent production stoppages in heavy industry, and a potentially more difficult political context for reform given recent income declines.
- Policy priorities to avoid relapse into recession:
  - Strengthen the health of the banking system.
  - Remove impediments to restructuring the economy and deleveraging.

### External rebalancing and role of FDI
- FDI is central to re-launching growth and to external rebalancing; policy actions are required to remove impediments to investment (Annex I).
- Relying solely on macroeconomic policies (internal devaluation via fiscal and incomes policies) without productivity- and capacity-enhancing investment would require excessive domestic adjustment.
- Small economy dynamics: a handful of projects can drastically alter prospects; the current account may not be a reliable indicator in any single period (CGER assessment inconclusive).
- Staff suggested prudence in viewing the real exchange rate as somewhat overvalued; authorities emphasized structural reform and fiscal consolidation as means to improve competitiveness.
- Agreed strategy for sustainable growth:
  - Enable private sector-led growth.
  - Ensure healthy banks.
  - Aim for a smaller government and deregulation to improve competitiveness.
- Montenegro’s EU candidacy and unique geography/climate offer untapped potential (tourism, hydro-electricity) that could trigger larger-than-projected FDI; even with larger FDI, policies are needed to lessen Dutch disease risks.

### Fiscal, structural, and banking constraints
- Fiscal history and vulnerabilities:
  - Early surpluses reflected temporarily buoyant tax collections from high imports; surpluses were placed in the domestic banking system, facilitating further credit expansion.
  - Fiscal stance relaxed at the boom peak through tax cuts and public sector wage increases, contributing to the 2008 structural deficit of some 6 percent of GDP.
  - Large loan guarantees to aluminum and steel companies created substantial contingent liabilities.
- Structural reform gaps:
  - Excessively restrictive employment protections and an unduly rigid centralized collective bargaining system contributed to fast wage growth, limited corporate flexibility, and stifled hiring, raising unemployment.
  - Privatization occurred later than in other Eastern European countries; sales during a thin market led to government retaking significant equity stakes in some enterprises.
- Banking sector stresses:
  - Deposit withdrawals and credit contraction were pronounced.
  - Bank restructuring has been uneven and some banks remain in difficult positions, with implications for intermediation and confidence.

### Budget financing, pensions, and fiscal consolidation
- Budget financing risks and public funds:
  - Eurobond proceeds have met a large part of the 2011 budget financing requirement.
  - Uptake of market debt was fast: "13 percent of GDP over two years."
  - Staff cautioned that rapid market debt uptake underscores the need for fiscal adjustment to secure future market access and repayment capacity.
  - Policy recommendation: place public funds safely while achieving reasonable returns; public sector fund placement should be guided exclusively by prudent financial management principles rather than to support banks.
- Pension reform (Box 4) — key figures and measures:
  - Social security financing gap widened from "1.3 percent of GDP in 2007" to "5.1 percent in 2009".
  - Adjustments in 2010 reduced the gap to an estimated "2.6 percent of GDP", accounting for nearly "70 percent of the overall fiscal deficit" in that year.
  - Measures included:
    - increase in the retirement age for both men, from "65", and women, from "60", to "67" (the new retirement age for men will be fully implemented in "2025", and for women in "2041");
    - re-indexation of pension benefits to "75 percent of living cost index and 25 percent of general wage level", compared with "50–50 percent" previously;
    - reduction in the frequency of pension benefit index calculation, from biannually to once a year.
  - Recommendation: consider accelerating introduction of increased retirement ages and/or reducing indexation to wages, and tightening eligibility criteria.
- Fiscal consolidation targets and measures:
  - Authorities aim to balance the budget by "2012" and to achieve a sizeable surplus thereafter.
  - Near-term additional measures: implement some "1 and 2½ percent of GDP in 2011 and 2012" in additional high quality measures to secure targets.
  - Revenue-raising scope in a growth-friendly way:
    - property is rather lightly taxed; collections could be raised via higher rates, better valuation, and an improved cadastre;
    - small increases in income tax and VAT rates would yield significant additional revenue while keeping Montenegro regionally favorable;
    - flanking rate increases by reducing poverty traps—e.g., introducing an Earned Income Tax Credit—would boost formal employment and tax collection.
  - Expenditure containment recommendations:
    - cuts in government employment and tight wage policy to lower the large wage bill;
    - tight public sector wages and pensions to anchor incomes policies and boost external cost competitiveness;
    - eschew direct budget support to private companies;
    - closely monitor potential expenditure arrears, especially at the municipal level.
- Public fund placement and freeing parked deposits:
  - Public sector fund placement should be governed exclusively by prudent financial management principles rather than to support banks.
  - Freeing currently parked deposits can help reduce the costs and risks involved in tapping capital markets.

### Banking system repair and supervision
- Completing repair of the banking system is the key near-term priority.
- Confidence has begun to return due to timely actions and support by parent banks.
- Next steps:
  - focus on fully restoring system soundness to allow renewed lending growth for quality projects;
  - require adequate solvency and liquidity buffers and phase out temporary regulatory relaxations quickly;
  - properly prepare and welcome the envisaged move to IFRS;
  - owners must promptly address slippages from regulations, especially capital or liquidity shortfalls, or face immediate and forceful central bank intervention in line with recently strengthened legislation.
- Use of the euro and buffer requirements:
  - Use of the euro requires greater buffers: central bank liquidity support operations are severely constrained in the euroized monetary framework.
  - Banking liquidity and solvency problems could impose large fiscal demands.
  - Policy recommendations:
    - aggressively safeguard the banking system, including by mandating higher-than-Basel capital and liquidity buffers;
    - accumulate fiscal reserves as an essential backstop for confidence.

### Labor market, business environment, and structural priorities
- Investment and business environment:
  - Investment is key to economic growth and job creation; foreign investment is particularly important.
  - Policy recommendations:
    - leverage foreign investment with improved domestic flexibility and cost competitiveness to avoid renewed overheating pressures;
    - spark domestic investment, notably in labor-intensive SMEs;
    - further improve the business environment.
- Labor market recommendations:
  - Resist demands to restrict flexibility and availability of fixed term contracts.
  - Authorities should engage social partners to facilitate opt-out clauses from collective bargaining arrangements.
  - Address poverty and unemployment traps; make employment protection and severance packages affordable.
- Statistical improvements needed:
  - Further progress on improving the statistical base is essential.
  - Positive steps: transparent high-frequency publication of fiscal statistics, adoption of a single treasury account and mandatory commitment reporting.
  - Remaining weaknesses hamper analysis and policy making; priority areas include national accounts, external sector, and labor market statistics.

### Box 1 — External competitiveness (summarized)
- CGER-type methodology for Montenegro does not reveal conclusive evidence of competitiveness problems; data limitations and short samples constrain assessments.
- REER and prices:
  - After substantial appreciation during 2007–09, the REER has remained broadly unchanged during 2010.
  - Economy-wide wage and producer price data indicate a further erosion of competitiveness; wages and producer prices seem to be one of the highest in the region.
- Tourism competitiveness:
  - The tourism sector has achieved continuous gains in its competitiveness ranking; World Economic Forum tourism ranking excerpts show Montenegro improving (series reported).
- Caution: external sustainability approach estimates should be treated as rough guides given assumptions about debt stabilization.

### Key selected indicators and projections (2007–16)
- Nominal GDP (millions of €): 2,680; 3,086; 2,981; 3,023; 3,111; 3,259; 3,427; 3,610; 3,822; 4,047.
- Real GDP (annual percent change): 10.7; 6.9; -5.7; 1.1; 2.0; 3.5; 3.7; 3.7; 3.8; 3.8.
- Consumer prices (period average): 4.2; 8.5; 3.4; 0.5; 3.1; 2.0; 1.8; 2.0; 2.0; 2.0.
- Gross national saving (percent of GDP): -5.7; -10.0; -3.1; -3.6; -2.5; 0.4; 3.8; 7.3; 10.7; 14.1.
- Gross investment (percent of GDP): 32.3; 38.2; 26.8; 22.0; 22.0; 22.5; 23.0; 23.0; 23.0; 23.0.
- Current account balance (percent of GDP), excl. grants: -39.6; -50.9; -30.4; -26.2; -25.4; -23.0; -20.1; -16.6; -13.2; -9.8.
- Foreign direct investments (net, percent of GDP): 20.8; 17.9; 30.8; 17.9; 15.4; 14.4; 13.4; 11.9; 10.9; 9.4.
- General government gross debt (end of period, percent of GDP): 27.5; 31.9; 40.7; 44.1; 44.0; 42.3; 40.5; 38.7; 36.8; 35.4.
- Banking system (Dec. 2010): Foreign banks: number 9, market share loans 89, deposits 85; Domestic banks: number 2, market share loans 11, deposits 15; Total number 11, market share 100.
- Financial soundness highlights (series reported): NPLs (percent of gross loans): 3.2; 7.2; 13.5; 14.9; 16.8; 17.6; 21.0. Regulatory capital as percent of risk-weighted assets (Dec. 2007–Dec. 2010 snapshots): 17.1; 15.0; 15.7; 14.3; 16.5; 14.6; 15.9.

### Annex I — FDI in Montenegro (highlights)
- Montenegro attracted very high levels of FDI in relative terms; over 2005–10 it had the highest FDI per capita and FDI as percent of GDP among listed emerging market economies of Central and South Eastern Europe.
- FDI concentrated in tourism, real estate, financial and energy sectors; both greenfield and privatization-driven.
- Banking sector around 90 percent foreign-owned; all energy sector companies have substantial foreign ownership.
- FDI determinants and policy priorities:
  - Political stability, EU integration progress, use of the euro, liberal trade and exchange systems, geographic location and natural endowments favor FDI.
  - To improve FDI quality and distribution: improve business environment for SMEs, labor and product market reforms, better education, transport infrastructure, and stable domestic financial markets.

### Institutional and Fund relations (Annex)
- Membership: Joined 01/18/07; Article VIII.
- Quota: 27.50 SDR Million (100.00 percent).
- Fund holdings of currency: 20.90 SDR Million (76.00 percent).
- Reserve position in Fund: 6.60 SDR Million (24.00 percent).
- SDR Department net cumulative allocation: 25.82 SDR Million (100.00 percent); Holdings: 26.17 SDR Million (101.34 percent).
- Outstanding purchases and loans: None. Financial arrangements: None.
- Exchange rate arrangement: Montenegro does not issue its own currency, has been using the euro as legal tender since 2002, and has accepted the obligations under Article VIII.
- Technical assistance (selected): MFD/FAD July 2005; FAD April 2006; STA June 2006; FAD January 2007; FAD March 2007; FAD April 2007; STA April 2007; MCM October 2007; MCM March 2008; MCM January 2009; LEG/MCM February 2009; STA Aug. 2009–July 2010; LEG April 2010; FAD June 2010; STA Dec. 2010; FAD February 2011; FAD March 2011; FAD March 2011.
- Montenegro is on a 12-month Article IV cycle; a Financial Sector Assessment Program was concluded during the 2007 Article IV consultation.

*Source: IMF staff report — EXECUTIVE SUMMARY (selected tables, boxes, and annexes from the provided chapter/mission report).*

### EXECUTIVE SUMMARY

### _cr11100 - EXECUTIVE SUMMARY

### Background and recent developments
- Since independence in 2006 Montenegro experienced a boom followed by a bust; large capital inflows (many debt-creating) fueled a domestic demand and real estate boom that overstretched the financial sector.
- The economy contracted sharply during the crisis; reported decline in GDP was 6 percent.
- Fiscal and policy buffers were exhausted at the onset of the crisis:
  - Structural fiscal deficit of some 6 percent of GDP in 2008.
  - By 2009 public and publicly guaranteed debt had risen to nearly 55 percent of GDP.
- Unilateral euroization has constrained monetary policy options and at times imported inappropriate monetary conditions.
- The crisis featured deposit runs and loss of financing access in Fall 2008; foreign parent banks met liquidity and solvency needs while the government provided liquidity support to a large domestic bank via temporary injections and direct placement of public sector deposits.
- The recovery is tentative:
  - 2010 GDP growth is estimated at 1.1 percent; output remained below its 2008 level.
  - Adjustment in 2010 included halving of the current account deficit to around 26 percent of GDP.
  - September 2010 Eurobond issuance of €200 million and a further €180 million issuance in April 2011 occurred amid spread tightening.

### Economic outlook and risks
- Baseline projections:
  - Projected GDP growth rises from 2 percent in 2011 to close to 4 percent by 2016.
  - Current account deficit projected to shrink to around 9 percent of GDP by 2016, financed by FDI inflows.
  - Inflation is expected to remain below that of trading partners.
- Near-term risks (tilted to the downside) include:
  - External environment shocks: another sudden stop, renewed sovereign and banking stress in the euro-area periphery, increased competition for tourists from more competitive Mediterranean neighbors, and more difficult privatizations.
  - Reform fatigue and legacy structural problems: uneven bank restructuring, household deleveraging risks, intermittent production stoppages in heavy industry, and a potentially more difficult political context for reform given recent income declines.
- Policy priorities to avoid relapse into recession:
  - Strengthen the health of the banking system.
  - Remove impediments to restructuring the economy and deleveraging.

### Medium-term external rebalancing and role of FDI
- FDI is central to re-launching growth and to external rebalancing; policy actions are required to remove impediments to investment (Annex I).
- Relying solely on macroeconomic policies (internal devaluation via fiscal and incomes policies) without productivity- and capacity-enhancing investment would require excessive domestic adjustment.
- Small economy dynamics: a handful of projects can drastically alter prospects; the current account may not be a reliable indicator in any single period (CGER assessment inconclusive).
- Staff suggested prudence in viewing the real exchange rate as somewhat overvalued; authorities emphasized structural reform and fiscal consolidation as means to improve competitiveness.
- Agreed strategy for sustainable growth:
  - Enable private sector-led growth.
  - Ensure healthy banks.
  - Aim for a smaller government and deregulation to improve competitiveness.
- Montenegro’s EU candidacy and unique geography/climate offer untapped potential (tourism, hydro-electricity) that could trigger larger-than-projected FDI; even with larger FDI, policies are needed to lessen Dutch disease risks.

### Fiscal, structural, and banking constraints highlighted
- Fiscal issues and past policy choices:
  - Early surpluses reflected temporarily buoyant tax collections from high imports; surpluses were placed in the domestic banking system, facilitating further credit expansion.
  - Fiscal stance relaxed at the boom peak through tax cuts and public sector wage increases, contributing to the 2008 structural deficit of some 6 percent of GDP.
  - Large loan guarantees to aluminum and steel companies created substantial contingent liabilities.
- Structural reform gaps:
  - Excessively restrictive employment protections and an unduly rigid centralized collective bargaining system contributed to fast wage growth, limited corporate flexibility, and stifled hiring, raising unemployment.
  - Privatization occurred later than in other Eastern European countries; sales during a thin market led to government retaking significant equity stakes in some enterprises.
- Banking sector stresses:
  - Deposit withdrawals and credit contraction were pronounced (figures and cross-country comparisons depicted in the full report).
  - Bank restructuring has been uneven and some banks remain in difficult positions, with implications for intermediation and confidence.

### Agreed mission context and consultations
- Staff team visited Podgorica from February 9–23, 2011 (Messrs. Bell (head), Castro, and Stepanyan (all EUR), Lundback (MCM) and Zeng (FAD); Mr. Tomic (Advisor to the Executive Director) joined discussions).
- Meetings included Prime Minister Luksic, Minister of Finance Katnic, Central Bank Governor Zugic, other ministers and senior officials, Parliament, financial and business sectors, academia, and trade unions.
- The authorities broadly agreed with staff’s assessment and key policy recommendations.
- Montenegro has used the euro as legal tender since 2002 and has accepted obligations under Article VIII; maintains an exchange system free of restrictions on payments and transfers for current international transactions except for pre-1992 blocked foreign currency savings accounts and unspecified security-related restrictions.

*Source: IMF staff report — EXECUTIVE SUMMARY (visit and mission details and Annex references as provided in the report).*

### Box 1. External Competitiveness

### Box 1. External Competitiveness

### Main findings on external competitiveness
- The application of CGER-type methodology for Montenegro does not reveal conclusive evidence of competitiveness problems.
- Limitations in data availability and length of sample:
  - Do not allow the application of the equilibrium real exchange rate approach.
  - Introduce a large margin of error in the external sustainability approach.
- The estimated equilibrium balance in the external sustainability approach should be taken only as a rough guide because it assumes debt stabilization at an arguably too high level.
- The improvement of the external current account in 2009–10 does not so much stem from competitiveness gains, but rather from recovering export production and some import contraction.

### Real exchange rate, prices, and wages
- CPI-based REER estimates:
  - After a period of substantial appreciation during 2007–09, the REER has remained broadly unchanged during 2010.
- Producer prices and wages:
  - Economy-wide wage and producer price data analysis indicate a further erosion of competitiveness.
  - The level of wages and producer prices seems to be one of the highest in the region (as shown in Figure 5).
- Index references present in source:
  - REER estimate, 2005= 100
  - Producer prices index, 2005=100
  - Average wage index, 2005=100

### Tourism competitiveness
- The tourism sector has managed to achieve continuous gains in its competitiveness ranking, which is essential given its growing share in the Montenegrin economy.
- World Economic Forum competitiveness ranking excerpt (as presented in source):
  - 2009201120092011 20092011 20092011
  - Spain68292281056
  - Cyprus2124252313143744
  - Greece2429183427292729
  - Italy2827464526272215
  - Malta292611931225254
  - Croatia3434434237364343
  - Slovenia3533382933336153
  - Slovakia4654343954575552
  - Bulgaria5048565448444651
  - Montenegro5236503266493536
  - Turkey5650636660554428
  - Romania6663615164667766
  - Serbia8882786780849694
  - Albania90717753104916661
  - Source: World Economic Forum. Note: A rise in the ranking indicates improvement.
- The overall competitiveness ranking in tourism has improved substantially (figure and series shown in source).

### Data limitations and interpretation cautions
- Data limitations and short sample length constrain application of standard methodologies and increase uncertainty of results.
- The external sustainability approach’s equilibrium balance assumes a debt stabilization target that may be unreasonably high, so its estimates should be treated cautiously.

*Source: IMF staff compilation from the source PDF content.*

### 25.      Budget financing going forward entails risks. Eurobond proceeds have met a large

### _cr11100 - 25.      Budget financing going forward entails risks. Eurobond proceeds have met a large

### Budget financing risks and public funds
- Eurobond proceeds have met a large part of the 2011 budget financing requirement.
- Uptake of market debt was fast: "13 percent of GDP over two years."
- Staff cautioned that rapid market debt uptake underscores the need for fiscal adjustment to secure future market access and repayment capacity.
- Policy recommendation: place public funds safely while achieving reasonable returns; public sector fund placement should be guided exclusively by prudent financial management principles rather than to support banks.
- The Fund stood ready to help if needed.

### Box 4. Pension Reform — findings and measures
- The social security financing gap widened from "1.3 percent of GDP in 2007" to "5.1 percent in 2009" largely due to rapid pension benefit increases from court-mandated increases.
- Adjustments to the compulsory contribution requirement in 2010 reduced the gap to an estimated "2.6 percent of GDP", still accounting for nearly "70 percent of the overall fiscal deficit" in that year.
- Pension reform measures included:
  - increase in the retirement age for both men, from "65", and women, from "60", to "67" (the new retirement age for men will be fully implemented in "2025", and for women in "2041");
  - re-indexation of pension benefits to "75 percent of living cost index and 25 percent of general wage level", compared with "50–50 percent" previously;
  - reduction in the frequency of pension benefit index calculation, from biannually to once a year.
- Recommendation: consider accelerating introduction of increased retirement ages and/or reducing indexation to wages, and tightening eligibility criteria to bring beneficial effects forward.

### Growth outlook and inflation
- Real GDP projections: growth of "some 2 percent in 2011" after an estimated "1.1 percent in 2010".
- Inflation is expected to remain below the level of that in trading partners.
- Drivers of recovery: high world prices and demand for Montenegro’s industrial exports, new tourism projects, and increased confidence in the financial system.

### Remaining risks (near-term and external)
- Substantial risks linger due to an unfinished reform agenda: poor labor relations and persistent financial problems could prevent industry from profiting from global demand.
- Banking system repair is not yet completed; fiscal buffers remain depleted despite recent budget consolidation.
- The external environment harbors large risks.

### External adjustment and savings
- Policies should aim to advance external adjustment to make future growth sustainable.
- The very large current account deficit requires improved cost competitiveness and a significant increase in domestic savings.
- Analysis: external rebalancing need not sacrifice growth if Montenegro’s large potential is tapped.

### Investment and business environment
- Investment is key to economic growth and job creation; foreign investment is particularly important.
- Policy recommendations:
  - leverage foreign investment with improved domestic flexibility and cost competitiveness to avoid renewed overheating pressures;
  - spark domestic investment, notably in labor-intensive SMEs;
  - further improve the business environment.

### Labor market recommendations
- The labor market should be invigorated.
- Policy guidance: resist demands to restrict flexibility and availability of fixed term contracts.
- Authorities should engage social partners to facilitate opt-out clauses from collective bargaining arrangements.
- Address poverty and unemployment traps; make employment protection and severance packages affordable.

### Banking system repair and supervision
- Completing repair of the banking system is the key near-term priority.
- Confidence has begun to return due to timely actions and support by parent banks.
- Next steps:
  - focus on fully restoring system soundness to allow renewed lending growth for quality projects;
  - require adequate solvency and liquidity buffers and phase out temporary regulatory relaxations quickly;
  - properly prepare and welcome the envisaged move to IFRS;
  - owners must promptly address slippages from regulations, especially capital or liquidity shortfalls, or face immediate and forceful central bank intervention in line with recently strengthened legislation.

### Use of the euro and buffer requirements
- Use of the euro requires greater buffers: central bank liquidity support operations are severely constrained in the euroized monetary framework.
- Banking liquidity and solvency problems could impose large fiscal demands.
- Policy recommendations:
  - aggressively safeguard the banking system, including by mandating higher-than-Basel capital and liquidity buffers;
  - accumulate fiscal reserves as an essential backstop for confidence.

### Fiscal consolidation, targets, and measures
- Authorities aim to balance the budget by "2012" and to achieve a sizeable surplus thereafter.
- These targets are judged appropriate to bolster sustainability, lower financing risk, and boost resilience.
- Near-term additional measures: implement some "1 and 2½ percent of GDP in 2011 and 2012" in additional high quality measures to secure targets.
- There is scope to boost revenue in a growth-friendly way:
  - property is rather lightly taxed; collections could be raised via higher rates, better valuation, and an improved cadastre;
  - small increases in income tax and VAT rates would yield significant additional revenue while keeping Montenegro regionally favorable;
  - flanking rate increases by reducing poverty traps—e.g., introducing an Earned Income Tax Credit—would boost formal employment and tax collection.

### Expenditure containment and fiscal governance
- Expenditure should be contained durably.
- Recommendations:
  - cuts in government employment and tight wage policy are essential to lower the large wage bill;
  - tight public sector wages and pensions will help anchor incomes policies and boost external cost competitiveness;
  - direct budget support to private companies should be eschewed;
  - close monitoring of potential expenditure arrears is imperative, especially at the municipal level.

### Public fund placement and freeing parked deposits
- Given the high opportunity cost of budget financing, every effort should be made to place public funds safely while achieving reasonable returns.
- With the crisis passed, public sector fund placement should be governed exclusively by prudent financial management principles rather than to support banks.
- Freeing currently parked deposits can help reduce the costs and risks involved in tapping capital markets.

### Statistical improvements needed
- Further progress on improving the statistical base is essential.
- Positive steps: transparent high-frequency publication of fiscal statistics, adoption of a single treasury account and mandatory commitment reporting.
- Remaining weaknesses hamper analysis and policy making; priority areas for improvement include national accounts, external sector, and labor market statistics.

*Source: IMF staff appraisal and Box 4 content from the provided chapter excerpt.*

### 38.      It is expected that the next Article IV Consultation will take place based on the

### _cr11100 - 38. It is expected that the next Article IV Consultation will take place based on the

### Overview
- The document provides selected economic indicators and staff estimates and projections for Montenegro for 2007–16 (tables and figures).
- Sources cited within the tables: Ministry of Finance, Central Bank of Montenegro, Statistical Office of Montenegro, Employment Agency of Montenegro; and IMF staff estimates and projections.

### Real economy: levels and projections
- Nominal GDP (millions of €): 2,680; 3,086; 2,981; 3,023; 3,111; 3,259; 3,427; 3,610; 3,822; 4,047 (2007–16).
- Real GDP (annual percent change): 10.7; 6.9; -5.7; 1.1; 2.0; 3.5; 3.7; 3.7; 3.8; 3.8 (2007–16).
- GDP deflator (annual percent change): 12.7; 7.7; 7.2; 2.4; 0.3; 0.9; 1.2; 1.4; 1.6; 2.0; 2.0 (series reported).
- Consumer prices (period average): 4.2; 8.5; 3.4; 0.5; 3.1; 2.0; 1.8; 2.0; 2.0; 2.0 (2007–16).
- Consumer prices (end of period): 7.7; 7.2; 1.5; 0.7; 3.0; 1.8; 1.8; 2.0; 2.0; 2.0 (2007–16).
- Average net wage (12-month) 1/: 19.9; 23.4; 11.3; -1.8 (2007–10; note: 2007-2009 wage data adjusted to reflect methodology change by Monstat starting January 1, 2010).
- Tourism: Arrivals: 18.8; 4.8; 1.6; 6.0 (years reported). Nights: 22.9; 6.9; -3.1; 5.0 (years reported).
- Industrial production: 0.1; -2.1; -32.2; 15.0 (years reported).

### Saving, investment, external accounts (selected)
- Gross national saving (percent of GDP): -5.7; -10.0; -3.1; -3.6; -2.5; 0.4; 3.8; 7.3; 10.7; 14.1 (2007–16).
- Gross investment (percent of GDP): 32.3; 38.2; 26.8; 22.0; 22.0; 22.5; 23.0; 23.0; 23.0; 23.0 (2007–16).
- Gross domestic savings (percent of GDP): -8.5; -13.8; -6.2; -6.7; -4.7; -2.0; 1.3; 4.1; 7.2; 10.6 (2007–16).
- Current account balance (percent of GDP), excl. grants: -39.6; -50.9; -30.4; -26.2; -25.4; -23.0; -20.1; -16.6; -13.2; -9.8 (2007–16).
- Current account balance (millions of euros): -1,078; -1,584; -896; -775; -761; -721; -657; -566; -472; -362 (2007–16).
- Trade balance (millions of euros): -1,607; -2,102; -1,372; -1,315; -1,335; -1,358; -1,384; -1,410; -1,431; -1,441 (2007–16).
- Exports (millions of euros): 483; 450; 296; 357; 418; 465; 501; 539; 586; 634 (2007–16).
- Imports (millions of euros): -2,091; -2,552; -1,668; -1,671; -1,752; -1,823; -1,885; -1,949; -2,017; -2,076 (2007–16).
- Services account receipts (millions of euros): 673; 751; 680; 747; 807; 881; 972; 1,071; 1,181; 1,302 (2007–16).
- Foreign direct investments (net, percent of GDP): 20.8; 17.9; 30.8; 17.9; 15.4; 14.4; 13.4; 11.9; 10.9; 9.4 (2007–16).
- External debt (end of period, stock, percent of GDP) estimates: ......; 93.3; 98.9; 99.3; 97.8; 94.3; 89.3; 82.5; 73.8 (series reported; private debt statistics not officially published).

### Fiscal accounts and projections (general government, percent of GDP)
- Revenues and grants: 47.7; 48.3; 42.4; 42.2; 42.3; 42.3; 42.2; 42.1; 42.1; 42.0 (2007–16).
- Expenditure (including discrepancy): 40.9; 48.6; 47.7; 46.0; 45.7; 44.8; 44.2; 43.9; 43.6; 43.2 (2007–16).
- Overall balance: 6.7; -0.3; -5.3; -3.9; -3.4; -2.5; -2.0; -1.8; -1.6; -1.3 (2007–16).
- Primary balance: 7.8; 0.5; -4.4; -2.8; -1.8; -0.8; -0.1; 0.4; 0.8; 1.2 (2007–16).
- Privatization receipts: 4.0; 1.2; 4.4; 0.8; 0.7; 0.7; 0.6; 0.6; 0.6; 0.5 (2007–16).
- General government gross debt (end of period, stock, percent of GDP): 27.5; 31.9; 40.7; 44.1; 44.0; 42.3; 40.5; 38.7; 36.8; 35.4 (2007–16).

Additional fiscal detail (Table 6 consolidated general government, percent of GDP, 2009–16 projections):
- Total revenues and grants (2009–16): 42.4; 42.2; 42.3; 42.3; 42.2; 42.1; 42.1; 42.0.
- Total expenditures and net lending (2009–16): 47.7; 46.0; 45.7; 44.8; 44.2; 43.9; 43.6; 43.2.
- Primary balance (2009–16): -4.4; -2.8; -1.8; -0.8; -0.1; 0.4; 0.8; 1.2.
- Financing (2009–16): 6.0; 5.8; 3.4; 2.5; 2.0; 1.8; 1.6; 1.3.
- Privatization receipts (2009–16): 4.4; 0.8; 0.7; 0.7; 0.6; 0.6; 0.6; 0.5.

### Financial sector: banking system and central bank indicators
- Banking system concentration and foreign ownership (Dec. 2010): Foreign banks: number 9, market share loans 89, deposits 85; Domestic banks: number 2, market share loans 11, deposits 15; Total number 11, market share 100.
- Financial soundness indicators (2007–10, selected):
  - Non-performing loans (NPL), in percent of gross loans: 3.2; 7.2; 13.5; 14.9; 16.8; 17.6; 21.0 (series reported).
  - Provisions, in percent of NPL: 73.6; 55.6; 46.3; 45.7; 44.9; 44.9; 30.7.
  - Provisions, in percent of total loans: 2.3; 4.0; 6.3; 6.8; 7.5; 7.9; 6.4.
  - NPL net of provisions, in percent of capital: 7.9; 32.0; 52.0; 52.5; 62.5; 63.4; 74.0; 102.8 (series reported).
  - Regulatory capital as percent of risk-weighted assets (Dec. 2007–Dec. 2010 snapshots): 17.1; 15.0; 15.7; 14.3; 16.5; 14.6; 15.9 (selected dates).
  - Capital as percent of assets: 8.0; 8.4; 11.0; 10.4; 11.4; 10.2; 10.6.
  - Loans, in percent of deposits: 107.4; 140.5; 131.4; 133.3; 129.1; 126.9; 122.9 (series reported).
  - Net interest margin 1/: 3.0; 3.8; 4.9; 1.1; 2.4; 3.7; 4.9 (series reported).
- Distribution of bank credit by borrower (Dec. series): Private companies, entrepreneurs: 60.6; 59.2; 56.4; 56.1; 56.8; 55.9; 54.8. Citizens: 34.5; 35.8; 36.6; 34.7; 36.1; 36.4; 37.1.
- Asset quality and earnings show stress: gross profits and net profits indicators are negative in crisis years in the series reported (e.g., Gross profits, in percent of average assets (ROAA): 0.8; -0.6; -0.6; -3.4; -3.2; -4.2; -2.7).

### Balance of payments and international indicators
- Memorandum items (percent of GDP, 2007–16):
  - Current account balance: -39.5; -50.6; -30.3; -25.6; -24.5; -22.1; -19.2; -15.7; -12.3; -8.9.
  - Net exports of goods and services: -42.3; -54.5; -33.3; -28.7; -26.7; -24.5; -21.7; -18.9; -15.8; -12.4.
  - Gross external debt (estimate): ......; 93.3; 98.9; 99.3; 97.8; 94.3; 89.3; 82.5; 73.8.
- Capital and financial account (millions of euros, 2007–16): 1,440; 1,435; 850; 649; 580; 568; 507; 421; 350; 216 (series reported).
- Change in official reserves (- denotes increase, millions of euros): -151; 155; -85; -174; 0; 118; 4; -204 (series reported).
- Memorandum — Aluminum price (€ per tonne): 1,926; 1,752; 1,198; 1,583; 1,655; 1,779; 1,868; 1,957; 1,967; 1,967 (2007–16).

### High-frequency indicators and narrative findings (figures)
- Figures indicate: massive deposit withdrawals have brought credit to a halt; NPLs have been rising fast and are now one of the highest (December 2010 comparisons); recovery signs in 2010 in industrial production, tourism overnight stays, and stabilized merchandise imports; VAT revenue may not yet have bottomed out.
- Labor market: unemployment rate rising (figure series 2007–10); domestic employment declining (figures and series reported).
- Inflation pressures declining (CPI and wage series show slowing inflation and mixed wage developments).

*Italic: Sources as cited in tables and figures within the document: Ministry of Finance; Central Bank of Montenegro; Statistical Office of Montenegro; Employment Agency of Montenegro; and IMF staff estimates and projections.*

### ANNEX I. FOREIGN DIRECT INVESTMENT IN MONTENEGRO

### ANNEX I. FOREIGN DIRECT INVESTMENT IN MONTENEGRO

### A. Background
- Montenegro attracted very high levels of FDI in relative terms; for the last five years it had the highest FDI per capita as well as FDI as percent of GDP among the emerging market economies of Central and South Eastern Europe.
- The FDI boom mostly targeted the tourism, real estate, financial and energy sectors.
- FDI took the form of both greenfield investments and privatization of state-owned enterprises; prominent privatizations included investments in the aluminum smelter and the steel works.
- The banking sector continued to attract FDI after initial equity acquisitions, largely due to recapitalization needs following the financial crisis.
- As a result:
  - All energy sector companies have substantial foreign ownership.
  - Most major hotels and industrial enterprises are substantially foreign-owned.
  - The banking sector is around 90 percent foreign-owned.
- Origins of FDI were diversified, with Italy and Russia topping the list of investor countries.
- Figures presented (sources: IFS; CBM) illustrate:
  - FDI per capita, US dollars, average for 2005-10 — Montenegro highest among listed economies.
  - FDI as percent of GDP, average for 2005-10 — Montenegro highest among listed economies.
  - Time-series distribution of FDI in millions of Euro for 2005–2010 by type (Investment in companies; Sale of real estate; Investment in banks; Other) and by country of origin.

### B. Literature on FDI and Its Relevance to Montenegro
- Empirical research indicates FDI is sensitive to host-country political and economic conditions, including:
  - political situation in the country and the region;
  - education level of the labor force;
  - overall market size;
  - factor costs;
  - quality of infrastructure;
  - general business climate.
- Several studies find FDI is lower in countries with higher corporate tax rates and suggest the host-country taxation regime influences FDI decisions.
- Regarding FDI and economic growth:
  - Many studies failed to provide conclusive evidence on FDI–growth links.
  - Studies that account for initial conditions in recipient countries (e.g., Dabla-Norris et al (2010)) find linkages, highlighting factors that help countries benefit from FDI externalities:
    - level of financial sector development;
    - quality of institutions and macroeconomic policies;
    - capital endowments.
- Relevance to Montenegro since 2006 (post-independence):
  - Political stability and good relations with neighbors.
  - Substantial progress on EU integration.
  - Unilateral adoption of the euro as legal tender anchored investor expectations (more than half of countries of FDI origin use euro).
  - Liberal trade and exchange systems likely aided FDI decisions.
  - Geographic location and natural endowments boosted tourism competitiveness.
    - World Economic Forum’s 2011 assessment: Montenegro ranks 36th amongst 139 countries in the travel and tourism competitiveness index.
  - Montenegro has one of the lowest income taxation rates in the region (see corporate income tax rates as of 2010).

### C. FDI Prospects in Montenegro
- FDI prospects largely determine Montenegrin economic prospects.
- Sector-specific potential:
  - Tourism and energy sectors present clear potential for large projects:
    - development of the coastal line;
    - transformation of Montenegro into a hub for the regional electricity exchange.
- For broad-based growth with substantial employment generation, investment in medium and small businesses is needed.
- Policy and structural priorities to improve FDI quality and distribution:
  - Further improve the business environment for medium and small enterprises.
  - Reforms in labor and product markets and in market regulation (identified as near-term priorities).
  - Improve the quality of education to better align skills with market needs.
  - Develop transport infrastructure.
  - Well-developed and stable domestic financial markets and sound macroeconomic policies to create a general stimulus for FDI.

*Prepared by Vahram Stepanyan. Source: ANNEX I. FOREIGN DIRECT INVESTMENT IN MONTENEGRO (staff report content provided).*

### Annex I. Fund Relations

### Annex I. Fund Relations

### I. Membership Status
- Joined: 01/18/07
- Article VIII

### II. General Resources Account
- Quota: 27.50 SDR Million (100.00 percent)
- Fund Holdings of Currency: 20.90 SDR Million (76.00 percent)
- Reserve position in Fund: 6.60 SDR Million (24.00 percent)

### III. SDR Department
- Net cumulative allocation: 25.82 SDR Million (100.00 percent)
- Holdings: 26.17 SDR Million (101.34 percent)

### IV. Outstanding Purchases and Loans
- None

### V. Financial Arrangements
- None

### VI. Exchange Rate Arrangement
- Montenegro does not issue its own currency, has been using the euro as legal tender since 2002, and has accepted the obligations under Article VIII.
- Montenegro maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions, except with respect to pre-1992 blocked foreign currency savings accounts and restrictions maintained for security purposes that have not been notified to the Fund.

### VII. Article IV Consultation
- Montenegro is on a 12-month cycle.

### VIII. FSAP Participation and ROSCs
- A Financial Sector Assessment Program, initiated in July 2006 jointly with the World Bank, was concluded during the 2007 Article IV consultation.

### IX. Technical Assistance
- MFD/FAD July 2005: Management of Proceeds of Privatization and Review of PFM (Montenegro)
- FAD April 2006: Assessment of state-owned enterprises under the World Bank Public Expenditure Review
- STA June 2006: Monetary and financial statistics
- FAD January 2007: Peripatetic advisor on debt management
- FAD March 2007: Fiscal risk assessment of Private Public Partnership
- FAD April 2007: Tax administration
- STA April 2007: Real sector statistics
- MCM October 2007: Emergency liquidity management
- MCM March 2008: Enforcement of securities regulation
- MCM January 2009: Crisis preparedness and management
- LEG/MCM February 2009: Exchange system
- STA Aug. 2009–July 2010: Resident advisor for real sector statistics
- LEG April 2010: Bank Resolution Framework
- FAD June 2010: Debt management
- STA Dec. 2010: Real sector statistics
- FAD February 2011: Tax policy
- FAD March 2011: Tax administration
- FAD March 2011: Medium-term budget framework

### X. Resident Representative
- None

*Source: _cr11100 - Annex I. Fund Relations (As of March 31, 2011).*

### 4. Although there are encouraging signs of stabilization, such as deposit growth and

### _cr11100 - 4. Although there are encouraging signs of stabilization, such as deposit growth and

### Banking system stabilization and vulnerabilities
- Encouraging signs: deposit growth and recent small credit increase.
- Severe damages observed despite relatively tight prudential regulations:
  - Deposit run, collapse of credit, increase in NPLs, and decreasing profitability.
- Authorities’ and foreign parents’ response:
  - Swift support to domestic banks and adequate reaction from foreign parent banks succeeded in preserving overall confidence.
- Balance-sheet cleaning:
  - NPLs remain high, but a reduction and cleaning of balance sheets of major banks is underway.
- Regulatory and supervisory developments:
  - With technical support from the WB and the IMF, several important laws adopted in 2010, including:
    - a law on commercial banks,
    - a law on bankruptcy,
    - a law on the central bank.
  - The Central Bank, under the new mandate, has stepped up on-site inspection and is carefully monitoring developments in the financial system.
- Lesson: An even more conservative approach to implementation of banking sector regulation would have been appropriate; this will shape future supervisory and regulatory actions.

### Policy stance on financial-sector recovery and prudential priorities
- Authorities’ view:
  - Setting the financial system on a solid footing is a precondition for continued macroeconomic stability.
  - Limited role envisaged for the ‘lender-of-last-resort’ function of the Central Bank.
  - Awareness of the buffers on public finance needed to maintain confidence.
- Trade-off acknowledged:
  - Although in theory there may be short-run macroeconomic benefits from a faster credit recovery, the authorities value full recovery of the financial system as a more important goal and will refrain from any action that could water down prudency in credit approval.
- Ongoing cooperation:
  - Further improvements in the financial sector are continuously discussed with both the Fund and the WB staff; authorities stand ready to implement best international practice.

### External sector, FDI, and current account dynamics
- Small open-economy specificities:
  - Help explain the large and volatile current account.
  - Several big pipeline projects requiring import of goods not locally produced may further add to the current account volatility but should not be seen exclusively as negative for the savings-investment imbalance.
- FDI role:
  - Montenegro has the highest per capita FDI in Europe and a very diversified origin of FDI.
  - The country has relied and will continue to rely on FDI as a major source of growth.

### Labor market, structural reforms, and competitiveness
- Need for flexible labor market given macro framework:
  - Flexibility needed not only in tourism (which also relies on labor import) but in other sectors.
- Staff recommendations welcomed:
  - Introduce opt-out clauses from collective bargaining agreements to allow for more efficient restructuring.
  - Consider recommendations to increase labor supply through earned income tax credits.
- Administrative and legal reforms:
  - Work on removing administrative barriers is underway.
  - Together with labor law reforms, these measures should secure positive developments in competitiveness.

### Political context and integration
- Political stability is expected to continue.
- EU and NATO integration processes:
  - Progressing integration is expected to increase attractiveness to foreign investors.
  - Authorities consider integration processes as business development opportunities and will fine-tune policies to realize full economic potential.

### Executive Board assessment and recommendations
- Overall view:
  - Recovery gaining momentum, but limited policy space and incomplete reforms pose risks to the outlook.
  - Directors encouraged efforts to reconstitute fiscal, external, and financial buffers and to address rigidities in product and labor markets.
- Fiscal policy:
  - Welcome for start of fiscal consolidation and support for balancing the central government budget by 2012 and running surpluses thereafter.
  - Durable fiscal adjustment should encompass both revenue and expenditure measures, including:
    - steps to increase the yield from property taxes,
    - curbing the public sector wage bill,
    - early implementation of pension reform,
    - efforts to avoid expenditure arrears and direct budget support to private companies.
- Banking sector and prudential stance:
  - Stress on restoring soundness of the banking system to bolster resilience and promote private sector-led growth.
  - Welcome for recent steps to reinforce legal and prudential frameworks and encouragement for stronger supervisory practices.
  - Noting full euroization limits central bank liquidity support, Directors called for:
    - conservative capital and liquidity requirements,
    - an early unwinding of regulatory forbearance.
- Structural reforms:
  - Strengthened competitiveness and external stability require structural reforms as a top priority.
  - Greater flexibility in wage setting and employment protection would support job creation in the private sector.
  - Addressing unemployment and poverty traps would boost labor participation and market attachment.
  - Improvements in the business environment and investment climate remain part of the unfinished agenda.
- Statistics:
  - Directors cautioned that long-standing weaknesses in economic statistics hamper policy design and evaluation and encouraged further progress.

### Selected economic indicators (2008–11) — key figures (under current policies)
- Nominal GDP (millions of €): 2008: 3,086; 2009: 2,981; 2010: 3,023; 2011: 3,111.
- Gross national saving (percent of GDP): 2008: -10.0; 2009: -3.1; 2010: -3.6; 2011: -2.5.
- Gross investment (percent of GDP): 2008: 38.2; 2009: 26.8; 2010: 22.0; 2011: 22.0.
- Real GDP (annual percentage change): 2008: 6.9; 2009: -5.7; 2010: 1.1; 2011: 2.0.
- Industrial production (annual percentage change): 2008: -2.1; 2009: -32.2; 2010: 15.0; 2011: ...
- Tourism arrivals (annual percentage change): 2008: 4.8; 2009: 1.6; 2010: 6.0; 2011: ...
- Tourism nights (annual percentage change): 2008: 6.9; 2009: -3.1; 2010: 5.0; 2011: ...
- Consumer prices (period average): 2008: 8.5; 2009: 3.4; 2010: 0.5; 2011: 3.1.
- Consumer prices (end of period): 2008: 7.2; 2009: 1.5; 2010: 0.7; 2011: 3.0.
- GDP deflator (annual percentage change): 2008: 7.7; 2009: 2.4; 2010: 0.3; 2011: 0.9.
- Average net wage (12-month): 2008: 23.4; 2009: 11.3; 2010: -1.8; 2011: ...
- Bank credit to private sector (end of period, 12-month): 2008: 24.7; 2009: -15.1; 2010: -8.9; 2011: 4.0.
  - Enterprises: 2008: 20.9; 2009: -15.4; 2010: -15.0; 2011: ...
  - Households: 2008: 32.0; 2009: -10.9; 2010: -7.0; 2011: ...
- Private sector deposits (end of period, 12-month): 2008: -14.2; 2009: -4.1; 2010: 6.0; 2011: 6.0.
- General government finances (cash) (percent of GDP):
  - Revenue and grants: 2008: 48.3; 2009: 42.4; 2010: 42.2; 2011: 42.3.
  - Expenditure (incl. discrepancy): 2008: 48.6; 2009: 47.7; 2010: 46.0; 2011: 45.7.
  - Overall balance: 2008: -0.3; 2009: -5.3; 2010: -3.9; 2011: -3.4.
  - Primary balance: 2008: 0.5; 2009: -4.4; 2010: -2.8; 2011: -1.8.
  - Privatization receipts: 2008: 1.2; 2009: 4.4; 2010: 0.8; 2011: 0.7.
- General government gross debt (end of period, stock, percent of GDP): 2008: 31.9; 2009: 40.7; 2010: 44.1; 2011: 44.0.
- Current account balance, excl. grants (percent of GDP): 2008: -50.9; 2009: -30.4; 2010: -26.2; 2011: -25.4.
- Foreign direct investments (percent of GDP): 2008: 17.9; 2009: 30.8; 2010: 17.9; 2011: 15.4.
- External debt (end of period, stock): 2009: 93.3; 2010: 98.9; 2011: 99.3.
- REER (CPI-based; annual change; + indicates appreciation): 2008: 1.5; 2009: 5.9; 2010: 0.2; 2011: ...

*Public Information Notice (PIN) No. 11/51 — May 6, 2011. IMF Executive Board Concludes 2011 Article IV Consultation with Montenegro.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11100.pdf_