OREANDA-NEWS.

An International Monetary Fund mission visited Podgorica from October 22 to November 3 to conduct the 2015 Article IV consultations. The concluding meetings with the authorities also covered Montenegro’s evaluation under the Financial Sector Assessment Program, conducted in September.

Strong growth this year looks set to continue into the medium term, driven by the authorities’ plans to boost development and transport linkages. Although infrastructure development is clearly needed, the emphasis on large investment projects carries risks, notably to the public finances. The authorities intend to mitigate those risks through the use of concessions and public private partnerships. Staff encourages the authorities to take additional measures to contain escalating public debt and ensure access to external funding on the most advantageous terms possible. The financial supervisor should stay alert to ensuring that lenders properly price risks.

1. The economy has rebounded strongly. Tourism arrivals have enjoyed double digit growth. Industrial production has recovered, largely driven by increased manufacturing. Construction has strengthened as tourism and energy projects move ahead and the Bar-Boljare highway project gets underway. Staff projects growth to be around 4 percent this year, after having fallen to 1.75 percent in 2014.

2. Growth momentum is expected to continue over the medium term. Large, foreign-financed capital investment projects will continue to be the major drivers of growth, and will generate spillovers into the rest of the economy. Concomitantly, given the substantial import content of infrastructure projects, the current account deficit is expected to widen further. Low inflation in the euro area is expected to help restrain price pressures.

3. The government has adopted a major growth initiative to boost economic development and connectivity. The initiative follows consensus reached between Western Balkan and European leaders in Berlin and is viewed by the authorities as a vital complement to Montenegro’s EU accession plans. The plan focuses on exploiting comparative advantages in tourism, increasing strategic transport rail and road linkages, and building capacity to serve as a regional energy hub.

4. The strategy can bring substantial gains, but also poses potentially sizeable risks. Montenegro has a significant need for infrastructure. However, such projects present large upfront costs before output benefits start to be realized. In the intervening years, public debt will rise further above the Maastricht level and expose the economy to shifts in international financial market conditions, while temporary shocks to growth—such as from a bad tourist season or weak hydroelectric electricity production—could see debt rapidly escalate further. Using fiscal and financial policies to boost growth incentives can result in misallocated capital. And rapid investment-led growth can contribute to an under-pricing of risk that can undermine financial and fiscal sector stability.

5. The authorities have taken steps to contain underlying fiscal stresses and are committed to managing debt vulnerabilities in the period ahead. Pension reform introduced in 2011 has successfully been increasing the average starting age of receiving pensions. In addition, new fiscal rules have converged toward Maastricht criteria, while the newly-introduced Economic Reform Program (ERP) acknowledges the need to stem the acceleration in public debt. The authorities have also expressed their desire to improve local government finances.

6. However, some recent measures raise questions about the ability to sustain fiscal discipline. The crisis tax has been cut, new social spending measures have been introduced, some ERP measures have been delayed, and the intention to contain expenditures over the medium term lacks specifics. A wide range of giveaways on taxes and social security contributions to support investment in specific sectors raise concerns about fairness and ability to remove such subsidies.

7. Staff projects public debt to continue to increase further, and then to fall gradually. Fiscal deficits will widen with highway spending; based on current policies, public debt would peak at around 77 percent of GDP over the next three to four years, from 70 percent this year, before decreasing to around 73 percent of GDP in 2020.

8. To limit the risks to the public finances and to maintain favorable conditions for funding, staff recommends fiscal consolidation measures. Staff calculates that additional measures of 1.5 percentage points of GDP sustained through 2025 would bring debt below the Maastricht threshold of 60 percent of GDP by the end of the period. Measures that can quickly yield returns include increasing tourism taxes, unwinding VAT exemptions, and temporarily freezing public wages and pensions. Options over the longer term include reducing the number of employees across government, introducing new strategies to improve tax collection, divesting from public sector enterprises, and refraining from investment subsidies.

9. New measures should be complemented by comprehensive and yearly medium-term fiscal plans. Such plans should reflect the most likely fiscal revenue and expenditure outcomes (including anticipating direct, indirect and hidden costs incorporated in policy measures), explicitly cost policy measures, and articulate contingency plans to deal with unanticipated shocks. Public financial management and fiscal transparency can be strengthened by fostering a fiscal council, fiscal risk management techniques, performance budgeting, and accrual reporting and accounting.

10. Financial conditions are slowly improving. Banks are highly liquid and average capital ratios exceed regulatory minimums, albeit with large variation across institutions. Profitability for most banks has increased, but remains weak despite high interest margins and declining nonperforming loans (NPL). Credit to the private sector has increased, after shrinking for a sustained period, although not as fast as might be expected given high liquidity and the rebound in growth. This reflects persistent problems with non-performing loans, weak accounting and reporting practices, and slow collateral execution.

11. The authorities consider boosting credit to be essential to support the government’s growth strategy. The voluntary debt resolution framework is now in place. A law that restricts lending rates has also been drafted and is under review, and the central bank has approved a number of new bank licenses to boost competition. Staff is concerned that some of these measures could have unintended consequences. Banks could be induced into imprudent lending to preserve or gain market share; this would be particularly worrisome if banks have weak business plans or low levels of capital. Banks could respond to caps on lending rates by restricting credit, particularly to SMEs for which lending risk is naturally higher.

12. The IMF’s recent Financial Sector Assessment Program for Montenegro identifies a number of steps to mitigate risks to the financial system. These include improving the management of nonperforming assets and liquidity risk, and reducing operational, funding, and credit concentration risks. Decisive actions to deal with weaker banks are important for preserving financial stability. An independent asset quality review of all banks is recommended to review loan classification and provisioning practices. Staff also encourages the central bank to continue to work on resolution plans with the objectives of maintaining financial system stability, protecting insured depositors, and minimizing cost to taxpayers. The recently-introduced consumer bankruptcy legislation is problematic and should be amended or repealed; for example, it could be interpreted as precluding mortgage enforcement on a bankrupt debtor’s house. This could create moral hazard, significantly deter new secured lending, and, if enforced retroactively, prevent the collection of collateral in cases of existing NPLs.

13. Staff recommends that options to bolster the financial safety net should be explored. A credible and transparent public backstop may be needed to deal with systemic cases in the absence of private sector-funded resolution, and the bank resolution framework should ensure that public support is given only after shareholders and hybrid capital and subordinated debt holders are written off. Emergency liquidity assistance should be brought under a single framework.

14. Improved labor productivity and economic flexibility are crucial to complement the authorities’ investment-led growth strategy. Given the country’s capacity to absorb shocks is limited by the currency regime and limited fiscal space, the authorities should build on current reform initiatives, such as improving the flexibility of labor market outcomes, reducing labor market informality, and continuing to improve the business climate (e.g., contract enforcement). The high level of long-term unemployed remains a pressing concern—the authorities could consider using funds directed at subsidizing the hiring of university graduates for retraining, which could be used to help the long-term unemployed re-enter the labor force, reduce pressures on the pension system from those taking early retirement, and alleviate pressures on social spending.

The mission thanks the authorities and other counterparts for very open and constructive discussions.