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Preliminary Conclusions of the Mission, February 21, 2011

Preliminary Conclusions of the Mission, February 21, 2011
Published date: 22.02.2011 16:26 | Author: Ivona Mihajlović

Ispis Print

Regaining a footing after the crisis
1. Growth is finally resuming. After contracting 22 months, industry began to grow again in the second half of 2010, and tourism registered a relatively strong rebound during the summer of 2010. Going forward, the recovery is projected to gain momentum, supported by high world prices and demand for Montenegro’s industrial exports, new tourism projects, and increased confidence in the financial system. Accordingly, real GDP is projected to grow some 2 percent in 2011 after an estimated 1.1 percent in 2010, while inflation is expected to remain below the level of trading partners.
2. Substantial risks still linger, and the lessons from the boom-bust episode must be taken on board. GDP remains below its 2008 level, as the economy landed hard from overheating, which occurred when large capital inflows were not easily absorbed in a still transitioning economy. This experience demonstrates the crucial importance of persevering with reform, strengthening resilience and building policy buffers. The near-term risks are testament to an unfinished reform agenda: poor labor relations and persistent financial problems could yet prevent industry from profiting from the global demand boom; the repair of the banking system, though having advanced, is not yet completed; and, notwithstanding recent welcome budget consolidation, fiscal financing risks remain elevated.
3. Above all, policies must aim to advance external adjustment in order to make future growth sustainable. The size of the task is illustrated by a current account deficit above 25 percent of GDP, which requires a significant increase in domestic savings. Luckily, Montenegro’s large potential, e.g., in the energy and tourism sectors, can be tapped, such that external rebalancing need not sacrifice growth. With the global crisis having passed, Montenegro must return to the path of earlier reforms, which have gone some way in introducing flexibility, strengthening banking supervision, and consolidating the budget.
Unleashing Montenegro’s potential
4. Private investment holds the key to economic growth and job creation. Given Montenegro’s small size, foreign investment is particularly important. It must be leveraged by improved domestic flexibility and cost competitiveness in order to avoid renewed overheating pressures and to spark off domestic investment, notably in labor-intensive SMEs. In order to benefit from swiftly recovering global capital flows Montenegro must quickly redress any impediments to investment and flexibility.
5. The labor market must be invigorated. The contrasting experiences of the tourism and heavy industry sectors offer salient lessons: the former, in which liberalized foreign employment is essential, was nimble in adjusting to the global recession and registered growth throughout the crisis. Meanwhile, heavy industry is subject to rigid labor regulation, contributing to the sector’s fitful relaunch, despite buoyant world markets. Priority areas are:
• Demands to restrict the flexibility and availability of fixed term contracts must be resisted. These contracts have mitigated employment deterioration during the crisis and introduced needed flexibility.
• Opt-out clauses from the collective bargaining arrangements should be broadened. The separate agreement for the public sector will mark important progress and similar flexibility should be granted to other employers.
• Poverty traps need to be addressed. At present, the unemployed stand to lose a host of benefits when taking on formal employment, a large disincentive for work in the formal sector. The recent more-than-doubling of the minimum wage (compared to the previous “minimum price of labor”) aggravated this problem by depressing demand for low-skilled workers, thereby further marginalizing this vulnerable group.
• Severance packages need to become affordable. The KAP package amounted up to €20,000, delaying needed restructuring to the detriment of viable job creation, especially if extended to other enterprises.

6. The business environment needs to be further improved, especially by upgrading technical and administrative skills of government agencies that provide business services, and by streamlining construction licensing by municipalities. Improved economic statistics are also essential to bolster investment and economic policy making.
Rekindling financial intermediation
7. Thanks to the authorities’ timely actions and the extension of support by parent banks, confidence is returning, evidenced by the renewed increase in deposits. Still, deposits are below levels in the third quarter of 2007 and NPLs have not leveled off. The next steps should focus on fully restoring soundness across the system in order to allow for renewed lending growth once credit demand for quality projects returns. Stagnant lending at the current juncture reflects the dearth of such projects and the authorities should continue to resist calls to force credit growth.
8. Use of the euro makes significant Central Bank liquidity support operations impossible. In fully euroized economies, banking liquidity and solvency problems could thus well impose fiscal demands. Aggressive safeguarding of the banking system is one requirement to avoid this from happening, while the accumulation of fiscal reserves via fiscal consolidation can provide the backstop for confidence.
9. The Central Bank must be uncompromising in redressing any weakness in the system. This calls for continued high-frequency and risk-based audits, and fast follow up. Adequate solvency and liquidity buffers should be required and regulations need to be ahead of developments. Recent temporary regulatory relaxations should be phased out quickly and be replaced with permanent regulations that are fully in line with best international practice. The envisaged move to IFRS—properly prepared—is welcome, as are efforts to streamline legislation and strengthen regulations related to collateral execution.
10. Parent banks and owners must promptly address any slippages from regulations, especially capital or liquidity shortfalls. Apart from the obvious dangers to an individual bank, any delay would imperil the reputation of supervisors, in turn potentially eroding the quality of operations in other banks as well. Thus, any owners’ failure to heed supervisory demands and measures should trigger immediate and forceful Central Bank intervention in line with the recently strengthened legislation.
Advancing budget consolidation
11. The required fiscal consolidation has commenced, and the authorities’ budget targets for 2011 and the medium term are appropriate. The budget deficit in 2009 amounted to some 5⅓ percent of GDP. In addition, loan guarantees to the aluminium and steel companies during the recession created some 5 percent of GDP in additional contingent liabilities, driving public and publicly guaranteed debt above 50 percent of GDP. Against this background, the 2010 fiscal deficit (on an accrual basis) is estimated to have declined to 3.9 percent and the authorities appropriately aim at balancing the budget in 2012 and achieving a sizeable surplus thereafter. This target will bolster sustainability, lower financing risk, and boost the economy’s resilience to unforeseen shocks.
12. It is now time to specify the needed measures. In the near term, the authorities’ plans are predicated on very tight control of discretionary spending, chances for which appear somewhat optimistic, given the recent substantial arrears accumulation by the same agencies that bear the brunt of the envisaged cuts. Accordingly, there could be overshooting of the authorities’ deficit targets by some 1 and 2½ percent of GDP in 2011 and 2012, respectively. High quality measures should be considered, which would also help secure the required significant surpluses after 2012.
13. There is scope to raise revenue collections in a growth-friendly way. Property appears to be rather lightly taxed in an international comparison, and collections could be boosted by a combination of higher rates, better valuation, and an improved cadastre. Small increases in income- and VAT tax rates would result in significant additional revenue, while still leaving intact Montenegro’s regional favorable taxation regime. Moreover, flanking rate increases by reducing poverty traps—for example by introducing an Earned Income Tax Credit (EITC)—would provide an important boost for formal employment and tax collection.
14. Expenditure should be contained in a durable fashion. Experience shows that the most durable and effective way to bring down the share of public expenditure in GDP is to cut the size of the civil service, which has been already initiated by the Government by adoption of the Personnel Policy paper. Montenegro’s wage bill is large even in a regional comparison. Staff cuts could also help avoid excessive reliance on wage cuts, which have adverse effects on morale. Other current spending also harbors scope for savings:
• The need to finance high transfers through contributions largely explains the high tax wedge. The recent pension reform marked important progress in improving the long-term sustainability of public finances but still leaves a pension deficit of 2½ percent of GDP in the near term. Accelerating the introduction of increased retirement ages and/or reducing the indexation to wages, as well as tightening eligibility criteria, could be considered. In the longer term, a comprehensive reform that establishes a strong link between contributions and benefits could further reduce the tax wedge, as contributions become more like savings rather than taxes.
• Direct budget support to private companies, while perhaps inevitable in a severe crisis, is inconsistent with past reforms that were rightly predicated on the primacy of the private sector in allocating resources. Instead, more flexible labor regulations and mobilizing resources through market-based and sound financial intermediation are a better way to enable entrepreneurs to restructure.
• Past experience makes monitoring of potential expenditure arrears imperative. The transparent high-frequency publication of fiscal statistics, adoption of a single treasury account and mandatory commitment reporting are welcome. The latter needs to be closely followed to ensure effectiveness, especially at the municipal level.

15. Given the high opportunity cost of budget financing, every effort should be made to place public funds safely, while achieving reasonable returns. With the crisis having passed, the placement of public sector funds should now be exclusively governed by prudent financial management principles, rather than with an eye to support banks. Freeing currently parked deposits can also help reduce the costs and risk involved in tapping capital markets.
16. Having emerged from a deep recession, Montenegro faces the twin task of tackling still heavy legacy burdens and accelerating forward-looking reforms. The crisis marked an exceptional time when unorthodox measures could at times not be avoided. However, the return to normality should trigger a return to the pre-crisis strategy centered on creating an enabling environment for private sector-led growth, smaller government, and deregulation. The crisis taught that, given Montenegro’s small size and high openness, any weaknesses must be quickly redressed, lest large dislocations can occur. The suggestions above aim to distill relevant lessons to guide Montenegro’s sustainable rise to its potential.
We thank the authorities for their generous hospitality and the excellent and frank discussions, and we wish them continued success.