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Montenegro: Staff Concluding Statement of the 2018 Article IV Mission

March 7, 2018

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

An International Monetary Fund mission visited Podgorica from February 21 to March 7 to conduct the 2018 Article IV consultations.

The mission welcomes the authorities’ fiscal adjustment efforts, which have significantly improved Montenegro’s debt sustainability. The economy is currently performing well and the financial sector is improving. However, many short- and medium-term challenges need to be addressed to achieve higher levels of inclusive growth and lower levels of economic vulnerabilities.

Key Points

  • The challenge going forward will be to generate and maintain the large primary surpluses required to reduce debt and fiscal and external deficits to safer levels. Fiscal institutions should be strengthened to safeguard debt sustainability and prevent short-term oriented policy making.
  • The authorities should make the tax system more growth compatible by reducing labor taxation and relying more on other forms of taxation, notably consumption and environmental taxes. Expenditure efficiency could be raised through public administration, pension, and local government reforms, while increasing productive capital spending and improving the social safety net.
  • The authorities should continue their efforts to improve banking supervision and encourage more financial intermediation. Safeguarding financial stability through strong supervision is particularly important in a unilaterally euroized economy.
  • Labor market reforms are necessary to reduce the informal economy and structural unemployment. Social partners should ensure that the labor code promotes job creation and allows wages to respond to macroeconomic conditions (productivity and inflation) to improve and preserve competitiveness.
  • Productivity growth should be supported by improving the business environment and the rule of law. State involvement in the economy should be reviewed to reduce fiscal and productivity losses.

Recent Developments and Outlook

1. In 2017, the economy grew strongly even though the authorities began implementing a medium-term fiscal adjustment strategy. The underlying non-highway primary balance improved by 2 percentage points (p.p.) of GDP to a surplus of 1.2 percent of GDP due to the implementation of fiscal adjustment measures. The estimated primary fiscal deficit increased marginally due to the acceleration of the Bar-Boljare highway project, which contributed to an estimated 4.2 percent economic growth, together with another record season for tourism.

2. The measures taken in the context of the fiscal adjustment strategy have stabilized the macroeconomic outlook. In 2018, the economy is projected to grow 3 percent, supported by private sector demand and notwithstanding some drag from further fiscal adjustment. Average inflation is projected at 2.8 percent, reflecting energy price increases and tax increases as part of the fiscal adjustment. Nevertheless, due to capital investment imports, the current account deficit is projected to remain high at 19 percent of GDP—a level that requires substantial external support.

3. The primary fiscal deficit in 2018 should improve by 3 percentage points of GDP to 1.6 percent of GDP. Capital spending will remain high and includes 6 percent of GDP in highway investment. The authorities have implemented revenue increases of 1½ p.p. of GDP, reflecting VAT and excise tax increases. Current spending is projected to decline by 1½ p.p. due to 2017 reforms to a poorly targeted lifetime benefit for mothers and continued public sector wage restraint. As a result, the non-highway primary surplus should improve an additional 3 p.p. to 4¼ percent of GDP. General government net debt is projected to decline by 2 p.p. in 2018. Gross debt including guarantees is projected to increase by 2½ p.p. to 77 of GDP, reflecting strong accumulation of government deposits to build fiscal buffers.

4. The implementation of the adjustment strategy will require continual efforts by the authorities to address fiscal and external risks. Provided the strategy is implemented, general government gross debt including guarantees would fall significantly to a more sustainable level of 56 percent of GDP in 2023. The end of highway spending would automatically lower capital expenditures by 6 p.p. of GDP by 2020, and an overall primary surplus of 4½ percent of GDP would be reached with minor additional fiscal adjustment. The mission projects that the primary surplus target will be reduced gradually after 2020 to create room for high priority spending on physical and human capital to improve growth prospects. The authorities agree with the mission that phases 2-4 of the highway should not involve the assumption of new government debt.

Public Debt Management Reforms

5. The authorities are taking steps to improve the debt maturity profile as part of their soon-to-be published Medium-Term Debt Strategy (MTDS). Facing significant Eurobond redemptions in 2019-21, they are considering strategies to pre-finance the outstanding Eurobonds. The authorities received a firm financing proposal from a consortium of international banks—supported by a World Bank Policy-Based Guarantee—for €250 million (with 12-year maturity and 2.95 percent interest rate). Financing needs are now projected to be closed for 2018 and 2019, including the amortization of the 2019 Eurobond. Additional steps are being contemplated to cover 2020 and 2021 financing needs and extend average Eurobond maturities, greatly reducing rollover risk. The mission supports the authorities’ efforts to improve public debt management.

Medium-Term Fiscal Reforms

6. The authorities face significant medium-term fiscal challenges that require comprehensive reforms. Fiscal institutions should be strengthened to ensure fiscal discipline and to support Montenegro’s goal of EU membership. The tax system is not inherently buoyant and places a heavy burden on labor, which fosters the grey economy. The public-sector wage bill and pension spending are high by international comparison, and municipal finances are weak. If successful, the savings from these reforms could be used for high priority spending or further labor tax adjustments.

7. Fiscal institutions should be strengthened to reduce the temptations of short-term policy choices. A true medium-term budgeting framework should be implemented in which medium-term expenditure limits are more binding. Every budget should justify deviations from past limits. Public investment project selection should be improved to ensure that only those projects with the highest social returns receive funding. The Fiscal Responsibility Law has facilitated the return to debt sustainability but did not prevent past fiscal slippages. While debt and deficit limits are appropriate, its expenditure rules could be improved when the law needs to be adapted to accrual accounting. The law should specify that any legislation with budgetary consequences must receive a formal assessment by the Ministry of Finance before approval and require a revised budget if the impact exceeds a threshold.

8. The plan to develop the domestic bond market is a useful part of the authorities’ debt management strategy. The stock of existing domestic government securities is small and consists primarily of T-bills, which are mostly held by banks. A more regular offering of longer-maturity domestic bonds would allow for the diversification of financing sources and provide new financial instruments for insurance companies, corporates, banks, and retail customers. It would also likely reduce excess liquidity in the banking system.

9. The design of social assistance and tax policy discourages formal sector employment. Social benefits are withdrawn at a fast rate at lower wage levels. Combined with a labor tax wedge of close to 40 percent, any employment in the formal sector results in a net loss of income for low income workers, providing a strong disincentive for formal work. The authorities should consider introducing a non-taxable allowance for the personal income tax and shifting a larger share of the financing of universal health care coverage to general taxation. Such measures should be designed carefully for medium-term implementation.

10. Revenue losses from reforms to labor taxation could be replaced by increased environmental taxes and lowered tax expenditures. While a coal excise will be introduced at a very low level in 2019, the excise will only cover a small fraction of the pollution and environmental costs of burning coal, leaving ample room to increase the excise rates. A higher coal excise would promote investment in cleaner energy sources and tax an activity with negative externalities (coal burning) rather than a desired activity (work). Reductions in tax expenditures for the VAT and corporate tax also hold significant revenue potential. The mission is concerned that the base of the VAT is narrowing.

11. The public-sector wage bill should be reduced by a comprehensive public administration reform. The authorities are designing a public-sector staffing optimization plan and intend to limit public wage increases until a comprehensive public administration reform can be adopted. It will also be important to assume tighter control over employment levels throughout the entire public sector, including enterprises and local governments.

12. Pension reform would render the system more sustainable and fairer. The authorities are preparing reforms that would change the valorization and indexation of pensions. This would result in moderate short-term savings and long-term costs. However, these costs are necessary to ensure the social sustainability of pensions, which would decline to poverty levels in the absence of reform. Eligibility for early retirements, which have resulted in a substantial increase in pensioners in recent years, would be tightened but could be restricted further to ensure that pensions are actuarially fair.

13. Municipal finances require more central oversight. Several municipalities have accumulated significant debts and have very high wage costs. The authorities are revising the local finance law to improve central oversight for financially imprudent municipalities and increase their incentives and capacity to generate own revenues, including real estate taxes. Water and sewage tariffs should be raised to cost recovery levels, which will help finance necessary investment in water and sanitation infrastructure. Consolidating municipal utilities into a few regional companies would increase economies of scale and overall efficiencies.

Financial Sector

14. Financial developments in 2017 were positive. System-level liquidity and profitability improved with other important parameters of banking operations, reflecting in part declining nonperforming loans (NPLs). Lending interest rates fell and private sector credit grew moderately.

15. The authorities have improved the legal framework for financial supervision. The Central Bank of Montenegro (CBM) has closed nonbank supervisory gaps. The adoption of the bank resolution law will further strengthen the legal framework. The authorities introduced International Financial Reporting Standards (IFRS9), which should result in more stringent provisioning practices. The mission encourages the CBM to adopt a definition of non-performing loans that does not include a possibility of improved classification based on adequate collateral and to conduct asset quality reviews for weak banks. The mission welcomes CBM’s initiative to improve the coverage and timeliness of the credit registry.

16. The authorities should be more forceful in intervening earlier in nonviable banks or those in substantial non-compliance with supervisory requirements. The banking system appears to have many banks relative to the market size of Montenegro. Profitability tends to be weak for banks with limited operations, which face high fixed costs. These costs are likely to increase, reflecting regulatory requirements and IT system costs. The mission believes that the banking system would be stronger with a smaller set of more profitable banks, which would also facilitate closer supervision. New licenses should only be given to investors with a business plan that would significantly contribute to the development and efficiency of the overall banking system. The minimum capital amount of banks could also be reviewed.

17. International reserve adequacy is in line with standard metrics for emerging markets. The authorities need to be especially vigilant in monitoring threats to financial stability in the absence of monetary policy tools and limited fiscal space. Resources for Emergency Liquidity Assistance (ELA) mainly comprise required reserves and government deposits and currently appear sufficient. A dedicated CBM account for ELA support by the government should be created.

Structural Reforms

18. The draft labor law could be improved to facilitate employment creation and reduce the informal economy. The restrictions on multiple jobs, forced retirement, and the lack of simplified rules for small business are not conducive to employment creation and encourage informal employment. Improving child care options could increase female labor force participation. Adjusting parental leave practices in line with international standards could also help re-integrate parents into the labor market.

19. Improving productivity will be key for higher long-term growth. The authorities should implement their Economic Reform Program to improve the business climate and increase the economy’s productive capacity. A continual strengthening of the rule of law, judicial systems, and the AML/CFT framework is essential to reduce uncertainties for investors.

20. The state involvement in the economy should be reviewed. Several public enterprises do not appear to solve market failures, impose important costs on the budget, and reduce economic efficiency. At the same time, the framework for public-private-partnerships (PPPs) should be strengthened to ensure that such PPPs do not result in large public liabilities.

The mission would like to thank the authorities for their generous hospitality and their constructive discussions.






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