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Preliminary Conclusions of the Mission IMF, February 2, 2010

Published date: 03.02.2010 17:07 | Author: IZVJEŠTAJI MMF-a

Ispis Print


A need to adjust after the sudden end of the boom

1. Developments in 2009 appear to have confirmed lingering doubts about the sustainability of Montenegros past growth. Despite resilience in the important tourism sector and continued privatizations, GDP is preliminarily estimated to have contracted by 7 percent (a steeper drop than elsewhere in the region); overall employment (including foreign employment) is estimated to have fallen by 15 percent; and the budget deficit and public debt deteriorated to 3 and 39 percent of GDP, respectively. Meanwhile, and notwithstanding signs that the contraction is easing, there are few signs of an imminent recovery.

2. However, with the right policies, the Montenegrin economy should be able to quickly return to healthy growth, but the need for policy adjustment is urgent and far ranging. Fundamentally, there has to be a transition out of the previous growth model that was based on very large capital inflows, high leverage, booming real estate, and, more recently, procyclical fiscal policy. The immediate challenge is to manage the still needed balance sheet corrections. In addition, sustained efforts are called for to further strengthen the banking system, to make public finances more sustainable, and to advance with growth enhancing structural reforms, especially in the labor and product markets.

Growth in times of leaner (net) inflows

3. Domestic vulnerabilities built-up over the boom years greatly amplified the adverse external shocks on the heels of the post-October 2008 global financial turmoil. Heretofore buoyant inflowsreflecting ample global liquidity and exuberant assessments of Montenegros longer term potentialslowed sharply, while demand for and prices of Montenegros exports tumbled. At the same time, the economy was left with little buffers to absorb the severity of the external shock: the banking system had weakened, following years of exorbitant credit growth that compromised the quality of loan portfolios, the current account deficit and related financing need had ballooned, wage and cost competitiveness had eroded, and a sizeable underlying structural fiscal deficit emerged.

4. On the macroeconomic front, it is imperative to increase domestic savings. The massive global financial flows of the recent past are unlikely to return. At the same time, debt accumulated during the boom yearsby both households and the public sectorwill need to be serviced and dividends on past FDI be generated. This requires increased savings, from both the government and the private sector, which will bring the current account balance to sustainable levels.

5. While the adjustment has begun, it needs to be broadened by enhanced competitiveness in order to support growth. The 2009 current account deficit is projected to have more than halved to about 20 percent of GDP, but this mostly reflected a collapse in domestic demand and imports. Going forward, the required further adjustment should in turn rely more on export expansion (including tourism and other services) and import substitution. Improved competitiveness will be key to take advantage of the projected global recovery. Since use of the euro precludes adjusting the nominal exchange rates, this places a premium on cutting costs and raising productivity, with clear implications for reducing the size of government and boosting the flexibility of the economy.

Managing risks from ongoing deleveraging in the financial sector

6. Vulnerabilities in the banking system will have to be worked out in a challenging setting. The fallout of the international financial turmoil has hit banks hard; it exposed vulnerabilities and triggered a sharp decline in deposits and a downsizing of their balance sheets. The situation is stabilizing but the adjustment is likely not yet over. In the short run, greater stress can be expected from the ongoing correction of the real-estate market that has still some way to go. Moreover, rising unemployment and tougher competition also put pressure on debt-servicing prospects of households and companies. Meanwhile, a scarcity of quality projects to finance and slow deposit growth are further slimming profitability prospects, at the same time as capital and liquidity buffers need to be rebuild.

7. Supervisory and regulatory vigilance is essential in guarding financial stability. The Central Bank has acted quickly to tackle problems in the banking system. Yet it is essential that its effectiveness be further strengthened by the expeditious adoption of a new Central Bank Law and legislation on banks and bankruptcy that are in accordance with international best practice. Also, existing central bank measures on the weakest banks need to remain in force and tightened as appropriate, while the implementation of recent counter-cyclical regulatory changes needs to be carefully monitored and kept under constant review. The Investment Development Fund should eschew expanding its operations and be brought under Central Bank supervision.

8. There is no substitute for prompt support by parent banks and shareholders to redress any liquidity and solvency concerns. Close cooperation between banks and supervisors is imperative. The support of foreign parent banks of their local subsidiaries has been encouraging and followed the welcome pattern elsewhere in Eastern Europe. It is important that this support be maintained while domestic shareholders must not lag in their commitment.

The budget: the central policy tool

9.There are multiple demands for tighter public finances. In the first place, and most obviously, the fiscal financing requirementwhich in Montenegros case in addition to the deficit and large debt roll-over needs also includes planned repayments of ex-Yugoslav related nonbank debt and pension arrearsmust be brought in line with available financing. In addition, fiscal policy is practically the only remaining macroeconomic policy tool given euroization, and must be used to effect the required improvement in Montenegros competitiveness. Last, but not least, the experience of 2009 underscores the need to build up fiscal buffers that can be used the next time adverse external shocks hit the economy.

10. To meet these challenges, fiscal adjustment efforts need to be sustained and placed in a medium-term perspective. The downturn revealed the extent of the structural fiscal deterioration as past headline fiscal surpluses had masked the true extent of the underlying state of public finances over recent years. Clawing back past slippages cannot be achieved in a single year, and the authorities have appropriately adopted a medium-term fiscal framework, targeting a balanced budget by 2012. It is now essential that the required policies be adopted without delay.

The inconsistency between the level of public expenditure and tax rates needs to be urgently resolved. At some 48 percent of GDP, Montenegros government is among the largest in the region, while VAT and especially income tax rates (17 and 9 percent, respectively) are low. New expenditure commitments related to corporate subsidies only aggravate the imbalance and the structural deficit is estimated at 6 percent of GDP.

Taxation needs to adapt to the post-boom environment. Recent steps to broaden the tax base are welcome, notwithstanding their limited impact on revenue collections. More fundamentally, though, the steep drop in import-based taxes has been a major factor in the recent revenue weakness. As this tax base is unlikely to recover to boom levels, past tax cuts need to be reconsidered.

Beyond taxation, the budget has an important role to play in boosting competitiveness. Large public sector employment and comparatively high wages, as well as elevated spending on social transfers stand in the way of rebuilding competitiveness and need to be urgently tackled. While recently hiked social security contributions redress some of the financial drain related to a significant transfer dependency ratio (60 percent), it will also be important to review eligibility for transfer programs and to target them appropriately on the most needy.

A greater reliance on extending government guarantees is not helpful. Recently some of the assistance for corporate restructuring has been provided in the form of loan guarantees. While reducing the immediate cash flow needs, such guarantees carry substantial future risk and lack transparency and such expenditure should be on budget. Similarly, additional borrowing, if not flanked by the initiation of fiscal adjustment will only aggravate future fiscal burdens that are already exacerbated by the large unfunded longer term pension liability.

Enhancing flexibility through structural reform

11. Greater strides are especially needed in labor market deregulation. This is of particular importance given that use of the euro precludes the use of the exchange-rate instrument to help adjustment and puts a premium on labor flexibility. The new labor law addressed some shortcomings, but others remain and would, perhaps, best be addressed by the adopting opt-out clauses from collective bargaining arrangements; easing rules with regarding adjusting employment levels; and reducing disincentives to hiring. Given the greater adjustment need in the public service, a separate public sector collective bargaining agreement could be useful.

12. There is also a need to improve the business environment. Since independence, a lot of progress has been achieved in redressing legacy structural weaknesses. Still, recent problems with large past FDI in the metals sector could cast doubts in the minds of prospective investors. Tackling red tape, especially at the municipal level, and infrastructure bottlenecks are important, as is redressing perceived weaknesses regarding the rule of law and corruption. Of course, faster progress in Montenegros EU candidacy will also be important, and this will notably require steps forward along the same lines.

13. A regular and transparent flow of quality macroeconomic information is a prerequisite for policy-making, transparency, accountability, and informed public debate on economic policy. Despite some progress, international trade and national accounts statistics remain weak, the lack of expenditure deflators and quarterly national accounts complicate economic analysis, and detailed and higher-frequency information on the budget is not publicly available.

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14. With these policies in place, Montenegros outlook should be bright. 2010 is likely to be another challenging year in light of still unwinding imbalances and a fragile external environment, and GDP is projected to register a small further contraction. However, starting 2011, the economy should witness a more vigorous recovery and participation in the projected global upswing. Though still short of what was seen in the boom, medium-term growth can rebound to some 4 percent. Of course, reflecting Montenegros large potential and small size, there is a substantial upside from large-scale FDI but, if the last year taught anything, it is that such upside should not be taken for granted.

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