February 28, 2017
PRESS OFFICER: Wiktor Krzyzanowski
Phone: +1 202 623-7100Email: MEDIA@IMF.org
An International Monetary Fund mission visited Podgorica from February 15 to March 1 to conduct the 2017 Article IV consultations.
Adverse fiscal developments in 2016 have worsened the fiscal outlook and reduced the authorities’ future investment capacity. This will impact growth adversely, despite some positive effects from the highway. The authorities recognize the need for strong fiscal adjustment to limit the projected increase in public debt and put the public finances on a sustainable footing. The 2017 budget was an important first step in addressing fiscal challenges and will reduce the non-highway budget deficit. The authorities have already identified some medium-term measures, and additional measures will be announced as part of a fiscal strategy in the second quarter of 2017. The financial sector appears to be improving, but the planned fiscal adjustment process could affect bank profitability, and the supervisory authorities should continue to monitor any emerging risks. Further efforts in reducing the grey economy and improving competitiveness could support the authorities’ adjustment efforts.
1. Real economic growth in 2016 is estimated at a lower-than-expected 2.4 percent, partly due to a delay in the highway project. Tourism enjoyed another strong season, while energy and mining grew. Construction strengthened as tourism, infrastructure, and energy projects were implemented. Private sector credit expanded by 6.4 percent after a few years of subdued lending activity. End-year inflation was low at 1 percent on account of declining food, household, and transport prices. The external current account deficit increased to 19 percent, partly reflecting machinery imports for the highway, tourism and energy projects.
2. The estimated fiscal deficit of 5¼ percent of GDP was substantially smaller than expected, but the underlying fiscal position deteriorated. Capital spending was 5 percent of GDP instead of a previously projected 12 percent because of the highway delay. However, current spending grew by more than 3 percentage points of GDP on account of lifetime benefits to mothers of three or more children, public sector wage increases, and one-off transfers. The decision to grant benefits to mothers had unfortunate side effects, notably its high fiscal cost (2 percent of GDP), its poor targeting in terms of social protection, and the negative impact on female labor participation. On the positive side, the tax-to-GDP ratio increased by 1½ percentage points on account of strong performance with the personal income tax and VAT. Also, nontax revenues increased due to a one-time communications fee of 1½ percent of GDP. General government debt increased to 71 percent of GDP, (79 percent of GDP including guarantees).
3. The economy is projected to expand by 3¼ percent in 2017, which reflects the positive demand effect from the highway and other private investments, but also some negative impulse from the adjustment in the non-highway budget. Growth would be driven by investment and to a smaller extent by private consumption, with an expected negative contribution from the external sector. The current account deficit is projected to increase due to the import needs related to capital investments. Credit to the private sector is expected to increase by 5 percent. Inflation is projected to increase by slightly less than 2 percent on average.
4. Economic growth over the medium term is affected by the highway project through immediate demand and subsequent supply effects. With an estimated cost of €1.0 billion (higher than initially expected due to exchange rate effects), it is projected to increase 2023 GDP by about €150 million. Economic growth is expected to average 3 percent over the next five years. Other large, foreign-financed capital investment projects are also projected to contribute to growth, but also to an elevated current account deficit. Following the banking system’s efforts to reduce non-performing loans, banks should be in a position to support the economy through increased private sector lending. Low inflation in the euro area is expected to help restrain price pressures.
5. While the highway will bring with it some economic benefits, its very high costs will limit the government’s ability to undertake other important investments and expose the economy to risks. General government debt is projected to increase to 82 percent of GDP by 2019 (89 percent of GDP including guarantees). However, non-highway capital spending over the next five years may only amount to some €125‑150 million (around 3½ percent of GDP) per year. This compares to estimated investment needs in the environmental area alone (water sanitation, air pollution, and global warming) of possibly almost €1½ billion in order to meet EU standards. Moreover, funding for other high-return investments in public infrastructure, health, education, and social protection will also be very limited. The country’s capacity to respond to temporary external or domestic economic shocks has likewise been diminished because of the high level of debt. Finally, large projected government refinancing needs for maturing debt will require some recourse to external markets and will expose Montenegro to more volatile international financial markets.
6. The authorities recognize the challenges related to increasing debt and have already taken significant steps in the context of the 2017 budget. In the mission’s view, the budget contains more than 2 percent of GDP in fiscal measures. On the revenue side, the new measures include an extension of the 11 percent rate for the personal income tax, an increase in gasoline excises, improvements in tax administration, and collections from a tax debt restructuring program. The tax debt program, while allowing viable companies to pay their overdue tax obligations in a more growth-supporting manner, does contain elements of a tax amnesty, because it forgives interest, with possible moral hazard effects. On the expenditure side, the authorities limited the financial impact of the mothers’ law and reduced wages for senior public officials, but also limited the non-highway capital budget, which is already low. The overall budget deficit in 2017 is projected to increase to 7½ percent of GDP, mainly on account of highway spending, which is expected to more than double to 6 percent of GDP. General government debt will likely end this year at 75 percent of GDP (82 percent of GDP including guarantees).
7. The authorities are committed to a medium-term fiscal consolidation plan that would put debt firmly on a downward path after the highway is finished in 2019. The authorities’ consolidation plan already targeted a primary fiscal surplus of 3 percent of GDP for 2020. The authorities have already identified measures that focus on reducing expenditures, including the public sector wage bill and mothers’ benefits, with some gains related to improvements in tax administration, collection of tax arrears, and regularization of buildings without permits.
8. The mission recommends a primary surplus target of 4½ percent of GDP for 2020. The authorities agree with the mission that this very high primary balance is needed to reduce the large financing requirement that would otherwise materialize in 2019 and 2020. As part of the fiscal adjustment strategy, the mission recommends creating room for increased capital spending of ½ percent of GDP and well-targeted social spending of ¼ percent of GDP to support growth and soften the impact of adjustment on the most vulnerable parts of the population. The mission estimates that fiscal adjustment measures of 2¾ percent of GDP would be needed to reach the target. This is in addition to the 1½ percent of GDP in measures already identified by the authorities, who intend to work with Fund and World Bank staff to identify the remaining measures in a fiscal strategy document planned for the second quarter of 2017. Starting in 2021, the primary surplus could be reduced gradually, while keeping debt on a downward trend. This would allow for an increase in priority spending, and debt could be lowered to 66 percent of GDP by 2022 (72 percent of GDP including guarantees).
9. The mission believes that the major adjustment effort should be on the expenditure side. The public sector wage bill and pension spending are high by international comparisons and should be reduced over the medium term.
The mission is encouraged by the fact that the authorities are working with the EU on a public administration reform focusing on right-sizing government employment and shifting towards merit-based pay. Public wage increases should be constrained until a comprehensive public administration reform can be adopted.
The mothers’ benefit should be changed such that mothers who left their jobs are compensated in a way that encourages them to rejoin the work force. Mothers who were previously unemployed or retired should be returned to the social protection system (and be subject to means-testing) or the pension system, although they could be given an additional year of service for the pension calculation.
At the same time, the social protection system should be changed to better target the vulnerable parts of the population. Social protection spending is significant, but it is currently not well-targeted and it provides disincentives for joining the labor market.
The pension system is not inherently generous, but past ad-hoc decisions created early retirement opportunities that the system could not afford. The mission believes that pension costs could be reduced in a fair manner in the short term by including pensions in the taxable base for the personal income tax, which would only affect high earners. Also, pensioners could pay a health insurance contribution to be assessed against the amount that their pensions exceed the average pension, which would also primarily affect better-off pensioners. The mission concurs with the World Bank’s recommendation to increase the early retirement decrement (penalty), abolish eligibility for retirement with 40 years of service, reduce the early retirement period to 2 years, and make accelerated pensions contributions actuarially fair.
10. The authorities want to maintain a competitive tax system with low rates. Given the need to reduce the deficit relatively quickly, the mission recommends a number of revenue measures that will reduce negative externalities related to pollution or chronic diseases, broaden the tax base, and contribute to social fairness.
The burning of coal contributes significantly to local pollution and global warming. The mission estimates preliminarily that the local pollution cost of using coal is a multiple of its current price and its global warming cost is about half of its current price. An introduction of an excise on coal would internalize these costs and lead to the reduction of health-related costs, while generating revenues for the budget and stimulating investment in cleaner energy sources. The excise should be introduced gradually and eventually raised to the full level of associated externalities. The increased cost of coal should be fully reflected in electricity prices, and transitional arrangements for affected industries should be considered.
Excises for cigarettes, alcohol, fuel products, and sugary drinks could be increased, bringing them in line with EU standards where applicable, while ensuring that they do not significantly exceed similar excises in neighboring countries.
At the local level, tariffs for water and waste disposal should be raised to full cost recovery level including, over time, future costs of capital improvements. Currently, tariffs do not even cover current maintenance costs and contribute to the poor fiscal performance of local governments and environmental degradation. Working with multi-lateral and bilateral donors in this area could also help mobilize further resources. Consideration should also be given to increasing collections for the value-based real estate tax by improving the legal and administrative framework (including better databases and valuation), and potentially by raising rates.
The lower VAT rate could be moved to half of the regular rate, and the VAT for hotel services and marina services could be moved to the regular rate.
The mission recommends raising the higher rate on personal income tax to 13 percent and extending it through 2022 to ensure a fair contribution to the adjustment by those with higher incomes, as during the financial crisis.
11. Regarding fiscal financing, the mission encourages the authorities to accelerate their privatization program and improve the debt repayment profile. The privatization of Montenegro Airlines and other public enterprises without a public policy function would add to financing resources and reduce the future drain on budgets. The authorities should also continue their efforts at developing the local T-bill and longer-term bond market.
12. Financial conditions have improved during 2016. Banks are highly liquid and average capital ratios exceed regulatory minimums, albeit with some variation across institutions. Profitability for most banks has increased, but remains weak despite noticeably declining nonperforming loans (NPLs) and high interest margins, which are partly explained by a high cost structure and country risk premia. Credit to the private sector has increased, after shrinking for a sustained period, although not as fast as might be expected given high liquidity. This reflects problems with collateral execution, weak enterprise accounting practices, particularly in the SME sector, and relatively high lending standards in the aftermath of high NPLs.
13. The authorities consider strong credit growth to be essential to support the government’s growth strategy. To that end, the voluntary debt resolution framework (Podgorica approach) is expected to be extended until 2018 and enhanced by including more classes of NPLs and providing greater incentives for participation. Notwithstanding the authorities’ desire to see stronger credit growth, banks should be allowed to respond to market conditions without administrative interference. The mission supports the authorities’ intention of moving away from interest rate caps as such measures could have unintended consequences.
14. The authorities are continuing to implement recommendations from the Financial Sector Assessment Program (FSAP) to mitigate risks to the financial system. These include improving the management of nonperforming assets and liquidity risk, reducing operational risks, and limiting risks related to funding and credit concentration. The authorities are closely monitoring weaker banks and are preparing resolution plans in the context of contingency planning. They are drafting a new banking law and intend to introduce International Financial Reporting Standard (IFSR) 9 regulations in 2018, which should result in more stringent provisioning practices, and they have requested Fund TA to help with this process. They plan to roll out asset quality reviews in 2018/19. Given the high fixed costs of complying with accounting and reporting requirements, an increase of the minimum required capital might be considered as it would help banks realize economies of scale and could lead to greater competition.
15. The authorities need to be especially vigilant in monitoring threats to financial stability in the absence of monetary policy tools and limited fiscal space. In the process of fiscal retrenchment, banks’ profitability may suffer and the central bank should monitor closely the potential impact on individual banks and the system. Banks with no access to emergency funding should receive particular attention. The authorities are drafting a bank resolution law, where recourse to public financial support would be considered only after shareholder equity, hybrid capital, and subordinated debt are written off. The authorities are also drafting a new financial institutions law, which should lead to the elimination of supervisory gaps.
16. The authorities plan to revise the labor law to increase labor market participation and encourage the formalization of the informal economy. Given the absence of monetary policy tools and severely limited fiscal space, they should focus on increasing the flexibility of labor markets, reducing labor market informality, and continuing to improve the business climate (e.g., contract enforcement). In particular, the approval process for permits and licenses could be accelerated. More active labor market policies could also be considered to diminish the high level of long-term unemployment. It will also be important to improve the practical skills of university graduates to facilitate their faster integration in the labor market. Finally, public outreach to explain the benefits that come from government spending could boost revenue and reduce the grey economy.
The mission would like to thank the authorities for their generous hospitality and their and other counterparts’ very open and constructive discussions.
