Mission Concluding Statement 

Montenegro: Concluding Statement of the 2014 Article IV Consultation Mission

November 6, 2014

Growth looks likely to continue, driven by large investment projects. However, the planned highway will place a large burden on the public finances and increase already-sizeable financing needs. New measures are needed to contain fiscal risks; revenue increases can help in the short run, but fundamental expenditure reform will be needed. In addition, contingency plans to curtail the highway project in case financing conditions tighten should be prepared. Initiatives to address NPLs should be complemented by reforms to ensure more timely and predictable collateral execution. Because Montenegro lacks independent monetary policy and fiscal space will become very limited, structural reforms are crucial to ensure the ability to withstand external shocks.

Recent Economic Developments and Outlook: Further Growth, but with Risks

1. Moderate growth is continuing, but the nominal economy is fragile. Real GDP rebounded by 3¼ percent in 2013, but has been weaker in 2014 and looks likely to be around 2 percent for the year. Inflation has fallen substantially, and credit growth remains moribund.

2. Growth momentum is expected to strengthen over the medium term. A number of large-scale investment projects are likely to take place, including the start of the first stage of the Bar-Boljare highway, from Smokovac to Matesovo.

3. External risks could hamper the outlook. Montenegro is vulnerable to downturns in external demand. Reliance on capital inflows, as well as substantial public financing needs, exposes the economy to shifts in risk aversion and disruptions to global financial markets.

Fiscal Policy: Offsetting Measures Needed

4. Progress on deficit reduction has been laudable but fiscal discipline needs to be maintained. Public debt has doubled since the global financial crisis, and is now 58 percent of GDP. Important steps—including higher taxes, a freeze on pensions, and measures to fight the grey economy—were taken during 2013 and 2014 that contributed to a significant reduction in the primary deficit. A surplus would have been expected next year if these policies were carried forward, which would eventually have seen debt stabilize and fall.

5. The highway will stress the public finances. Spending on the first stage of the highway is the equivalent of a quarter of current national output. Even with the fiscal stance unchanged from 2014 levels, public debt is likely to increase from 58 percent currently to at least 70 percent of GDP. Debt levels could easily increase further, especially in the event of shocks to external demand, further fiscal slippage, or a depreciation of the euro against the dollar (in which the loan for the highway is denominated).

6. Medium-term financing needs are considerable. Even aside from the additional burden from the highway, there are substantial repayments due, ranging from 10 to 15 percent of GDP over the next five years. With the highway, that range is likely to increase to 15 to 20 percent.

7. Offsetting measures are therefore needed to contain fiscal risks. To constrain debt and ensure it returns to a sustainable level, measures are needed to limit the deterioration in the fiscal position. Although there is some room for additional revenue measures over the short run, such as from VAT, a credible and reliable consolidation would necessitate fundamental expenditure reform, including on the pension system (which is persistently underfunded) and public sector wages (which are high by regional standards). Cuts to non-highway capital budget items that are important for development should be avoided, as this would undermine long-term potential growth.

8. Additional measures would be needed if risks eventuate. The authorities should also lay out additional contingent consolidation plans in the event that there are unanticipated shocks to growth, revenues and expenditures, or refinancing and highway costs. The first recourse should be to cut or delay spending on the highway

9. The fiscal rule should be strengthened. The objective of emulating Maastricht criteria is laudable, but enforcement mechanisms are weak, and the rule’s exemption for “strategically-important” projects undermines its credibility.

10. Important progress in divesting from state-owned industries has been made, but is not yet complete. Consistent with Fund advice, the loss-making aluminum producer, KAP, has been sold but payment has not yet been received. The state is also still involved with some smaller companies that it has tried, unsuccessfully, to sell, and other guarantees remain. The authorities should refrain from providing more support to enterprises, whether direct or indirect.

Financial Sector: Complementary Policies to Reduce Lending Risk

11. Banking system health is gradually improving, but NPLs remain a problem. Liquidity is plentiful. But NPLs, at 17 percent of total loans, remain a substantial drag on asset returns, implying that banks have to seek higher returns from new loans than would otherwise be the case. A low system-wide provisioning level raises questions about the valuations of collateral against which NPLs can be netted, and the extent to which provisioning practices may be allowing banks to avoid resolving problem loans.

12. The draft law on voluntary restructuring appropriately recognizes that NPLs have to be dealt with. Such a framework can be potentially useful for solvent firms with temporary cash flow or liquidity problems. Pushing banks with relatively low provisioning coverage to boost provisions could increase capacity to take advantage of restructuring incentives.

13. Although deposit rates have decreased, lending rates have been slower to fall. With average deposit rates at around 2 percent, the average effective lending rate of 9½ percent is striking, especially as falling prices mean real rates have been increasing. Lending rate caps are under consideration—to the extent that rates reflect credit risk, these measures would likely reduce credit supply to newer or smaller enterprises.

14. Lending rates reflect scale inefficiencies and high risk premia. Relatively high costs per loan are to be expected in a small market. But banks also have to cover lending risks that are unnecessarily high, owing to difficulties in reliable credit information, securing collateral, and inconsistent application of regulations (e.g. tax administration). The recent creation of dedicated public enforcement officers is a valuable step towards resolution of some claims, but further progress will depend on more timely court decisions, with penalties for delays, and improved administration.

15. A range of complementary policies would make supervision more effective:

• Reform of factoring companies. The supervisor lacks any oversight over factoring companies, which reduces the transparency of the financial system. A factoring law should grant the supervisor powers of direction over the use of factoring companies (and other SPVs) and create transparent and verifiable standards for recording assets held by such vehicles.
• Simplification of provisioning. The current system is in line with standards in other countries, but potentially provides room for “evergreening” troubled loans. A simpler classification—such as the four-tier method applied by the ECB as part of its Comprehensive Assessment, or greater automaticity of classifications, could be considered. The supervisor should continue to pay special attention to the valuations attached to collateral.

Structural Reforms: Policies to Ensure Adaptability and Boost Long-run Growth Potential

16. Structural reforms are essential to raise potential growth rates and improve flexibility and competitiveness. Montenegro is a small economy, highly dependent on foreign demand for its services and on FDI. Some useful initiatives have been taken to simplify the processes for foreign investment. But without an exchange rate instrument to mitigate shocks, and with fiscal space rapidly diminishing, flexibility in the real economy is crucial.

17. Labor market reforms are particularly important:

• Employment and participation are persistently low, which lowers potential growth and, given an aging population, threatens the sustainability of the social security system. Labor mismatches indicate a lack of flexibility in wage bargaining. The system shows signs of duality, with “insiders” on open-ended contracts, and those lacking skills and experience forced to accept serial short-term contracts.
• The goal should be that wages evolve with productivity developments, and that labor resources go to where they are most productive. Attention should be paid to whether current labor laws lead to onerously-long appeal proceedings against dismissal. Measures to eliminate the incentives to operate outside the formal labor market are complementary; the planned implementation of a “social card” system, consolidating all benefits in a single system, will greatly increase transparency and deter fraudulent claims.

The mission is grateful to the authorities and all other counterparts for their excellent cooperation and open engagement.