Press Releases 2012 - March
09.03.2012 - Preliminary Conclusions of the IMF Mission
INTERNATIONAL MONETARY FUND
Podgorica, 09 March 2012
2012 Article IV Consultation
Preliminary Conclusions of the Mission
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 pre-crisis 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.
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 rules-based 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 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 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.
We thank the authorities for their generous hospitality and the excellent discussions, and we wish them continued success.