Montenegro: IMF Executive Board Concludes 2018 Article IV Consultation

On May 18, 2018 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Montenegro 1 and considered and endorsed the Staff Appraisal on a lapse-of-time basis. [1]

Montenegro’s economy is growing strongly, boosted by the implementation of large investment projects, including the construction of the Bar-Boljare highway. Growth should continue over the medium term, albeit at a more moderate pace as highway construction ends. Staff projects the economy to expand by 3 percent in 2018 and 2½ percent in 2019, with fiscal consolidation also acting as a moderate drag on growth.

While the implementation of large publicly financed infrastructure projects has added to economic growth, the accompanying use of fiscal resources has contributed to a large increase in government debt, which reached 75 percent of GDP in 2017. Large refinancing needs over 2019-21 have also been a source of fiscal vulnerability.

Recognizing the need to reduce public debt, the government is continuing the implementation of its medium-term fiscal consolidation strategy, announced in 2017. Most of the fiscal measures have already been implemented, and the underlying fiscal position improved in 2017. If carried out in full, the strategy will considerably strengthen the fiscal position, generating a primary fiscal surplus of 4½ percent of GDP by 2020, allowing government debt to fall to 53 percent of GDP by 2020.

Conditions in the banking sector continue to strengthen, with improving asset quality, recovering credit growth, and high liquidity. However, the sector appears to be crowded, presenting a challenge for bank profitability.

The lack of an independent currency and limited fiscal space constrain Montenegro’s ability to absorb shocks, which underscores the need for an improvement in economic flexibility to sustain growth over the long run. Low labor productivity and employment levels and a large informal sector limit potential growth. The government’s plans to reform labor laws and the labor tax wedge provide an opportunity to improve the flexibility of labor market outcomes, boost participation rates, and reduce informality.

Executive Board Assessment

Economic growth should remain strong in 2018, notwithstanding fiscal consolidation, and maintain momentum over the medium term. Growth should slow moderately as fiscal consolidation continues and highway construction ends next year, but the possible supply side boost of the highway section and other large investment projects should sustain growth.

The authorities are appropriately focused on fiscal adjustment to lower government debt to safer levels. While infrastructure development is needed, the construction of the first section of the Bar-Boljare highway has had a key role in raising debt to high levels. The authorities’ front-loaded fiscal adjustment is appropriately timed to complete the underlying fiscal adjustment before construction of the highway concludes. Fiscal space does not exist to finance the remaining phases of the highway with debt, and the authorities should ensure that the completion of the highway via PPP meets standard cost-benefit criteria and does not introduce large contingent liabilities.

The medium-term fiscal adjustment plan is well specified and socially balanced, and concerted political efforts will be needed to maintain fiscal discipline. The authorities legislated most of the fiscal measures in 2017, and most of the underlying adjustment should be completed this year. If the plan continues to be implemented, government finances will regain a sustainable footing. Staff projects a primary surplus of 4½ percent of GDP in 2020, leading general government debt (including guarantees) to fall quickly after peaking at 80 percent of GDP in 2019. The maintenance of primary surpluses after 2020 will be necessary for debt to fall rapidly, although surpluses could decline to around 3 percent of GDP. To support sound fiscal policy decisions in the future, the authorities should strengthen fiscal institutions, including fiscal rules and budgetary processes.

Over the medium term, the authorities should implement fiscal reforms to improve the composition of revenues and expenditures. The authorities should implement a strategy to right-size the public-sector workforce and implement a civil service reform. Central oversight over local government finances should be strengthened, and municipalities’ incentives and capacity to raise their own revenues should be increased. Tightening eligibility for early retirement should strengthen pension sustainability, and shifting pensions to wage valorization and CPI indexation would improve long-term fiscal and social sustainability. The authorities should also review the fiscal cost of tax exemptions. Taken together, these reforms would increase fiscal space over the medium term for greater high-productivity capital spending and well-targeted social spending or provide offsets for unforeseen fiscal slippages, which are a domestic risk.

The authorities should continue their efforts to improve the health of the financial sector. The authorities have closed supervisory gaps by bringing non-bank financial institutions under the supervision of the central bank. While the overall banking sector is stable, the authorities should steadfastly implement supervisory action plans for weak banks and intervene, if necessary. Asset quality reviews would improve loan classification and provisioning practices and should be implemented as soon as possible. The authorities should also adopt a definition of non-performing loans that does not exclude impaired assets that have adequate collateral. With many banks relative to the size of the market, the authorities should be cautious in granting new banking licenses and promote consolidation. The authorities should continue to improve the AML/CFT framework and seek to implement the outstanding recommendations of the 2015 FSAP.

A comprehensive strategy is needed to improve labor market outcomes and raise productivity growth. Montenegro faces competitiveness challenges, and its external position is weaker than that consistent with medium-term fundamentals. Structural labor market impediments discourage greater labor force participation and the generation of formal sector employment, and the authorities should implement a unified strategy by reducing the labor tax wedge, reforming the withdrawal of social benefits, and adopting amendments to the labor law that balance the need for worker protection with a needed increase in labor market flexibility. The authorities should also review the involvement of the state in the economy to ensure that it is limited to areas of market failures and strengthen the framework for public-private-partnerships to minimize the risk of large liabilities being transferred to the public sector.

It is expected that the next Article IV consultation with Montenegro will be held on the standard 12-month cycle.