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INTERNATIONAL MONETARY FUND
MONTENEGRO
2012 Article IV Consultation
Preliminary Conclusions of the Mission
March 5, 2012
Three years after the global crisis, economic output has almost recovered and financial
sector conditions are stabilizing. In other ways, though, the crisis and its repercussions are
still acute, most visibly in the sizeable and continuing build up of public debt and a
tightening liquidity squeeze in the economy. The immediate priority is a substantial reduction
in the fiscal financing requirement, while invigorating structural reform, most importantly in
labor markets, but also including continued progress in financial regulation and supervision.
The authorities have adopted relevant targets; the focus now must be on the identification of
the required policy measures and their expeditious implementation.
***
1.
Since the financial crisis and its aftermath, valuable progress was made. With
GDP growth estimated at some 2½ percent in 2011, real output has almost reached its precrisis level in 2008. In addition, deposits are continuing to grow, the current account deficit
was cut, inflation has receded to the level seen in trading partners, further progress was made
on structural reform, and foreign direct investment remained above one tenth of GDP.
2.
Montenegro’s recent experience reflects the challenges of its demanding policy
framework and the economy’s high openness. Without an exchange-rate and monetary
policy tool, fiscal policy was overburdened by the task of preventing overheating during the
pre-2008 inflow-driven economic boom. Since then, government dissaving partly offset the
drag on domestic demand due to private sector deleveraging, but at the cost of rapidly
accumulating public debt and still large external imbalances. Moreover, some earlier reforms
ran into difficulties, as evidenced by the troubled privatizations in the metallurgy sector.
3.
The recovery is at risk of stalling. Economic activity indicators slowed sharply in
the fourth quarter of 2011 as the boost from tourism wore off, problems in the metals sector
re-emerged, and the international environment, notably in the euro area, turned more
challenging. Moreover, liquidity is tight and the debt overhang hampers credit growth. With
access to external financing markets becoming more difficult, fiscal policy is now
constrained from supporting demand. Accordingly GDP is not projected to grow in 2012.
4.
In the period ahead, the lessons learned must be taken fully on board. The task is
twofold: boosting growth by resuming—and seeing through—ambitious structural reform
and continued stabilization of the financial sector; and regaining sustainable public finances
by aligning the budget with post-boom reality.
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5.
Current policies imply the risk of sub-par economic performance. While the
economy’s small size and high openness impart a large degree of uncertainty on forecasts
and projections, medium-term prospects are imperiled by large fiscal and external
imbalances, even if the international context turns more auspicious. The good news is that
ambitious structural reform can unleash Montenegro’s large potential, e.g., in the energy and
tourism sectors, thereby achieving the essential rebalancing without sacrificing growth.
A. Boosting growth
6.
Labor market reform needs to target employment creation. The 20 percent
unemployment rate (Labor Force Survey definition) is accompanied by very low labor force
participation and a growing share of the long-term unemployed. Meanwhile, the market for
non-resident employment adjusts freely. While the recent revision of the labor law made
progress in simplifying dismissals, it also restricted flexibility in the use of “fixed-term”
contracts, under which almost all private sector jobs had been created. The regulations
governing regular contracts have to be correspondingly made more attractive for employers,
including by giving greater scope to opt out from collective bargaining arrangements.
7.
The business environment needs nurturing and improvement. Montenegro has
recorded steady progress in various business environment surveys. Still, the complaints about
regulatory shortfalls or legal proceedings by foreign investors in the metals and energy sector
could imply adverse repercussions for Montenegro’s reputation as an investment destination.
In addition, the time required to obtain construction permits and complete registration
procedures, particularly at the municipal level, continues to hamper new investment. The
authorities are thus encouraged to demonstrate their commitment to arm’s length and rulesbased relation with business while continuing to streamline investment procedures.
Continued improvements in economic statistics are also essential.
8.
Despite stabilization, the banking system still has some way to go. While deposits
have begun to return, the system is burdened by high non-performing loans (NPLs) and
lagging in provisioning. Continued vigilance is necessary to foster stability and create a
sustainable foundation for a more broad-based resumption of lending. Direct efforts to force
more lending are unlikely to work and would probably require resources from the already
stretched budget. Much rather, reviving credit growth in a sustainable fashion will require the
budget to live within its means. Priority tasks are:

intense supervisory presence in banks and aggressive enforcement of regulations
across the system: The risk profile and capital needs of individual banks should be
carefully examined, including through the recently upgraded stress testing
framework. Bank owners must meet capital shortfalls expeditiously or face sanctions.

continued efforts to improve asset quality: The recent sharp decline in NPLs—from
26 to 15 percent of gross loans—to a large extent reflects banks offloading troubled
assets to factoring companies, other investors, and parent banks. Such transactions
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need tight monitoring, though, and the recent CBCG adoption of relevant regulations
and the authorities’ work to formulate legislation are steps in the right direction.
Further efforts by the government, CBCG, and other relevant entities to improve the
framework and processes related to the execution of collateral are also essential.

raising and monitoring liquidity: Use of the euro essentially rules out significant
central bank liquidity injections, putting a premium on sufficient liquidity levels in
banks. The CBCG’s stepped up efforts to monitor liquidity are thus welcome.
Conversely, proposals to raise the share of reserve requirements that may be held in
treasury bills would impart additional risks and distort incentives for credit extension.

keeping credit risk regulations ahead of developments: The CBCG plans to soon
phase out temporary regulatory relaxations and in their place adopt a permanent
framework, which should be fully in line with international best practice.
B. Confronting the budget with post-boom reality
9.
The steep upward trajectory of public debt must be reversed. Public debt stands
at 46 percent of GDP, up from 27 percent at end-2007; in addition, loan guarantees of some 5
percent of GDP were incurred to support KAP and the Niksic steel mill.
10.
This requires bringing taxation and spending closer in line. At its core, the rise in
debt reflects persistent fiscal deficits, notwithstanding the strong efforts at expenditure
control by the central budget. 2011 illustrated the pattern: while consolidated government
spending (including arrears) could be cut by 2.7 percent of GDP, significant loan guarantees
were called and revenue collections fell sharply. This pushed the 2011 fiscal deficit to an
estimated 6.3 percent of GDP compared to 4.7 percent in 2010, and also substantially in
excess of the targeted 2.3 percent.
11.
Specific deficit-cutting measures must be identified without delay. While the
budget targets—lowering the deficit to 1.2 percent of GDP in 2012 and achieving balance in
2013—are appropriate, they will likely be missed again unless high-quality deficit reducing
measures are taken urgently. If carefully selected between revenue increases and expenditure
cuts, these measures need not harm growth.
12.
The more sizeable adjustment should come from expenditure cuts. The revenue
share remains at a comparatively elevated level, while expenditure stands at the high end of
emerging Europe. Although the government has made laudable progress in improving
commitment controls, more deep-seated problems also need action:

At some 12 percent of GDP, personnel spending is very large. Last year’s adoption
of the Personnel Policy paper and the resulting 2 percent staff cut are an encouraging
start in trimming these outlays. The recent agreement with public sector unions
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should help contain wage increases in 2012, yet its complex triggers carry risks going
forward.

Further progress on entitlement spending is needed, in the first place by advancing
pension reform, which already made important headway in reducing longer-term
aging costs. This would lower the pension deficit (4.5 percent of GDP in 2011) more
rapidly. Similarly, the authorities should be ambitious in reforming social protection
in order to ensure that benefits target the neediest and no longer serve as impediments
to labor market participation.

The fiscal drain from the aluminium and steel plants must be arrested. For public
finances, the first best option is to end all fiscal support. This could trigger
liquidations, but would permit whatever parts of the enterprises remain viable to be
sold, and—other than perhaps one-off closing costs—would put an end to fiscal
losses. Moreover, by now these companies’ direct employment effect is small as is
their contribution to value added and the balance of payments, if properly measured.
An only second-best option would be raising new revenue to cover these plants’
losses through a dedicated new tax; deficit financing of support should be eschewed
in any event.
13.
There remains scope to raise tax rates. The VAT and income tax rates are below
levels in the region. The same is true for the tax wedge on labor. Limited rate increases
would thus not significantly impede new employment. Moreover, flanking any rate increases
by reducing poverty traps—for example by introducing an Earned Income Tax Credit—
would provide an important boost for formal employment and tax collection. There is also
considerable scope to increase revenue for property taxation by a combination of higher
rates, better valuation, and an improved cadastre. On the other hand, care needs to be taken in
raising indirect taxes in order not to heighten cost in the tourism sector.
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We thank the authorities for their generous hospitality and the excellent discussions, and we
wish them continued success.