Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). 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, and as part of other staff reviews of economic developments.

International Monetary Fund
Republic of Montenegro
2008 Article IV Consultation
Preliminary Conclusions of the Mission

December 16, 2008

Strong performance in recent years, but slowdown ahead

1. Montenegro has made significant progress in overhauling its economy. The last five years have seen inflation performance improved through the adoption of the euro as sole legal tender; banking sector restructuring; significant privatization; strengthened market infrastructure; and progress in fiscal consolidation. These efforts have been rewarded by strong foreign investor interest, particularly in tourism, construction, and banking. Credit growth has soared, stimulated by surging deposits and keen competition in the largely foreign owned banking sector. Demand has boomed, supported by credit, increased wealth from real estate sales to foreign investors, and expectations of continued strong economic growth. As a result, GDP, employment and wages have grown strongly, while the registered unemployment rate has halved from 20 percent in 2005 to under 11 percent recently.

2. However, the boom has also generated substantial macroeconomic vulnerabilities, and the rapidly dimming global economic outlook elevates the risks from these vulnerabilities. Banks' non performing loans are rising even faster than their overall loan portfolio. Substantial foreign financing from parent banks has increased the vulnerability of the banking system to a sudden stop or reversal of foreign financing inflows in the event that a parent bank falls victim to the global financial turmoil. Booming demand has led to the emergence of an extremely large current account deficit, raising the exposure to a broader array of external shocks. And much of the recent surge in fiscal revenues will disappear as demand drops to more sustainable levels, raising the prospect of large fiscal deficits and rising public debt.

3. And rapid wage growth, in the context of a euroized economy, is reducing competitiveness. A continued erosion in competitiveness will ultimately limit Montenegro's attractiveness as a destination for FDI, making it more difficult to broaden the production base of the economy.

4. A sharp deceleration in growth is expected in the near term as the global outlook dims. With limited bank financing from parents because of global financial turmoil and a reduced risk appetite, credit growth is expected to decline to low single digits at best in 2009. Global recession is also likely to have an adverse impact on tourism, FDI, and confidence. In addition, falling aluminum prices have depressed production and generated losses in the aluminum company. Thus, we project that GDP growth will decline to around 2 percent in both 2009 and 2010, albeit with a substantial margin of uncertainty around this forecast. Downside risks include the possibility of sharp increases in bad loans-particularly those related to the real estate sector-and disruption in banks foreign financing. On the other hand, upside risks include the possibility of larger than expected FDI, as in a small economy like Montenegro a few large projects can make a significant difference.

5. Over the medium term, growth is unlikely to return to recent high levels. While FDI is likely to remain strong over the medium term, the recent exceptionally high levels are not likely to be repeated. Similarly, credit growth is also unlikely to return to the extremely high levels observed in recent years. Thus, we project a modest rebound in GDP growth to around 4½ percent as global recession ends.

6. In this context, the focus of policy should be on safeguarding financial sector and fiscal stability, while continuing to lay the foundation for sustained long term growth by improving public infrastructure and administration, the business environment, and the flexibility of the labor market.

Need to safeguard fiscal stability through the downturn

7. While the headline fiscal balance has improved, fiscal policy has been strongly pro-cyclical, reducing fiscal cushions and leaving little room for discretionary countercyclical policy as the economy weakens. Moreover, on announced policies, persistent and widening deficits are projected for 2009 and beyond, leading to unfavorable debt dynamics. The strong deceleration in demand expected as credit and FDI slowdown will weaken revenues significantly. And since a return to the demand boom is unlikely, much of the revenue loss will be permanent. Plans for fiscal stimulus will also widen the deficit significantly. Thus, we project a substantial fiscal deficit in 2009, with the position worsening further 2010 as additional tax cuts are implemented.

8. Such a major deterioration in the fiscal position will undermine macroeconomic stability, and should be avoided. Moreover, with potentially substantial public contingent liabilities linked to the blanket guarantee of bank deposits, potential recapitalization of banks, and the aluminum company, and the need to prepare for future pressures from population aging, there is need to build up fiscal cushions. And plans to sharply increase capital spending should not come at the expense of reducing the value-for-money of such spending.

9. Moreover, the envisaged fiscal stimulus is unlikely to have a major impact on GDP growth over the near and medium term. Given the relatively narrow production base, much of the stimulus will leak out via increased imports. The prospect of unfavorable public debt dynamics could cause consumers to increase savings rather than consumption. And tight credit conditions will also limit the scope for demand growth. Improving public infrastructure will help improve growth prospects over the medium and long term, but an important pre-condition for the realization of such growth is continued macroeconomic stability.

10. There has been broad agreement that gross public debt should be reduced to below 30 percent of GDP over the medium term. However, given large government deposits net public debt would be a better guide for preserving the net worth of government, and would help reduce pressures to draw down government deposits. On this basis, the corresponding objective should be to reduce net debt to 20 percent of GDP by 2013. Given the contingent liabilities, this improvement should be considered the minimum needed. Such improvement would require a reconsideration of the size and timing of all planned measures that weaken the structural balance-including capital expenditure increases and tax and contribution cuts-plus additional restraint on current expenditure.

11. In a euroized economy, countercyclical fiscal policy is the main instrument available to help alleviate the buildup of macro imbalances. Thus, the net debt anchor should be supported by a structural approach to fiscal planning, creating scope for the free operation of automatic stabilizers while supporting consolidation efforts. This will require a well designed medium term expenditure framework. The overall expenditure envelope should be one that-alongside conservative structural revenue assumptions-generates the needed structural improvement and delivers the targeted level of net debt. In order to be credible, the expenditure envelope should be underpinned by the development of a coherent planning framework backed by tangible measures and expenditure reforms. Strong implementation coupled with transparency will also be important to establish credibility.

Financial sector risks to be managed carefully

12. The central bank has recently taken several welcome steps to strengthen financial sector soundness. In January 2008 it tightened reserve requirements, imposed temporary ceilings on credit growth, and introduced a centralized credit registry to help banks' improve credit assessments. Stronger capital, liquidity, and provisioning regulations are being phased in. The central bank has also been pro-active in seeking understandings with parent banks and home supervisors regarding the handling of potential liquidity and solvency problems. These efforts have been aided by the passage of a new law on banking in February 2008.

13. And in October 2008 the authorities took resolute steps to reduce the risks emanating from global financial turmoil. These included a one year blanket guarantee for all bank deposits and an increase in the coverage of the deposit insurance scheme. In addition, a law was passed authorizing the government to provide support to banks as needed.

14. These steps have helped stabilize the financial sector, but vulnerabilities remain high. While all parent banks have supported their daughters with additional funding, non-performing loans are likely to rise significantly in the near term, and banks' provisions appear relatively low. The blanket guarantee of deposits has slowed deposit withdrawals significantly. However, confidence is fragile. Continued vigilance and strong implementation of prudential measures will be needed to enhance bank soundness. And a uniform debt-income ratio ceiling for bank borrowers would help further strengthen credit quality.

Structural reforms need to be invigorated

15. Future growth will depend critically on further improvement of the regulatory framework and institutions.

16. The new labor law reduces labor market rigidities and is in the right direction, but employment protections remain significant. Such protections will continue to limit the options for enterprise restructuring, thus hampering their development and reducing GDP and employment growth. They will also tend to reduce the demand for employees on open-ended contracts in favor of those with fixed term contracts. Thus, further steps are needed to increase labor market flexibility. The government should also use its role in collective bargaining negotiations to encourage moderation in wages and severance payments. We also welcome the government's intention to pass a law allowing for a broader representation of trade unions in the collective bargaining process. However, to encourage further labor market flexibility collective agreements should in general only be binding on the signatories to the agreement.

17. Another critical area for structural improvement is the electricity sector. After a promising start, progress in this area appears to slipped in recent months. We welcome the intention to intensify efforts to unbundle EPCG and open up the sector to private investment. We also encourage the prompt settlement of arrears in licensing fees from EPCG to the energy regulator, to strengthen its independence and financial viability. Finally, we welcome progress in reducing the cross subsidization of electricity tariffs.

18. Progress in improving the business environment at the central government level has not been matched at the local government level. There is strong need to reduce red tape, especially at the local government level. Setting up one stop shops should help greatly improve the attractiveness of Montenegro as a business destination.

19. While there have been significant improvements in economic statistics, there remain significant weaknesses, which hamper policymaking. National accounts and balance of payments data (particularly trade data and credit flows from abroad) are weak, and there are no data on the expenditure side of real GDP.

* * *

We thank the authorities for their generous hospitality and the frank discussions, and wish them well with their endeavors.


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