June 22, 2006
INTERNATIONAL MONETARY FUND
Concluding Statement of the Mission
June 22, 2006
1. Independence marks a new start for Montenegro. In that context, our aim is to offer suggestions on how to make best use in the macroeconomic area of this unique opportunity.
2. Much is going well. Inflation is low, public debt is trending downwards, VAT strongly underpins revenue, FDI is up with more coming, the banks have been privatized, credit is booming, access to EU markets is on preferential terms, and prospects for SAA agreement and WTO and PfP membership are good.
3. Your ambitions are appropriate. You seek sustained increases in economic growth, employment, and real incomes, both in their own right and as a foundation for eventual EU accession.
4. These goals are attainable. They will require first, action to ensure maintenance of orderly conditions for economic activity in the context of independence, and second, emphasis of medium- over short-term considerations in the design of macroeconomic policies, notably in regard to flexibility, sustainability, and the supply side. We take these in turn.
5. Your nationhood should be fully reflected in the legal arrangements governing your international economic relationships. Agreements formerly between Serbia and Montenegro and the international community on matters such as regional free trade, vetinary standards, double taxation etc, need to be established in your own right in order to secure continued orderly economic conditions.
6. Alongside, the legal framework for economic relations with Serbia needs to be clarified. Key matters include residency status for each others’ citizens, and eligibility for social benefits and work permits. A FTA would secure unhindered continuation of former trade arrangements.
7. And a complete calculation of the former net fiscal transfer to the Union is recommended. This should subtract from the budget transfer to the Union the costs you will now bear as Union functions shift to the Montenegrin budget. This will assist implementation of the 2006 and design of the 2007 budgets.
8. The euro and open capital accounts set the context in which economic policies will be framed. Your commitment to the sole legal tender status of the euro safeguards against disturbances to the exchange rate; but it also rules out scope to adjust the exchange rate in the face of economic shocks. This puts a premium on flexibility of the economy in all other aspects—including labor, corporate, fiscal, and financial structures—supported by diversification of economic activity so as to diminish exposure to shocks. Further, open capital accounts eliminate scope for an independent monetary policy. Instead, domestic interest rates are determined by euro area rates plus a “Montenegro risk premium”, the latter reflecting markets’ assessments of aggregate risk. Banking data suggest that this premium could be some 250-300 basis points currently.
9. We see need for considerably increased flexibility. Regional, natural, terms of trade, tourism, and transition shocks are likely to recur over the medium term. But economic performance in the face of such shocks in recent years—including GDP growth rates below those of your regional peers, high unemployment, and exceptionally low labor force participation rates—is symptomatic of multiple inflexibilities. Measures to address these matters could encompass:
Labor market structures. High dismissal costs—6 months of average salary—and inflexible employment contracts discourage hiring, especially of young people. And wage determination mechanisms constrain sector and skill variation and nominal wage flexibility. These factors are compounded by the high tax wedge—about 41 percent of total labor costs—impeding employment. Actions on these matters, alongside strengthened active labor market policies for the unemployed, would form appropriate parts of labor reforms that you are considering.
Corporate governance. Privatization to strategic investors is key to diversification, flexibility, and long-term growth. Envisaged sales of many firms is welcome as are your intentions to proceed swiftly. These initiatives should be supported by your active use of exit—notably bankruptcy—arrangements.
Financial sector. Commercial finance for those adversely affected by temporary macroeconomic shocks can minimize the negative effects. So we suggest you review arrangements for collateral assignation and collection from this perspective, that corporate accounting standards are strengthened, and that efforts continue to bolster further the banking system—including via additional foreign bank entry. These issues can be pursued in the forthcoming Financial Sector Assessment Program (FSAP) missions.
Automatic fiscal stabilizers. Budget balances should be allowed to weaken during economic downturns—as revenue falls and spending on unemployment benefits rise—so as to cushion the downturns, and vice versa during economic upswings.
10. Given open capital accounts, market confidence in sustainability is key to a low risk premium. The beneficial effects of any policies—including tax cuts—can be undone if they drive up the premium and borrowing costs.
A fiscal anchor
11. We support your aim to anchor fiscal policy with a target for total budget sector debt. The objective should encompass all debts and arrears of the central government, the municipalities, the extra-budgetary funds, and the debts of any public and municipal enterprises not run on a strictly commercial basis. Given the intention to allow automatic fiscal stabilizers to operate, we suggest that the target be a 5 year average relative to GDP, rather than a target for a specific year. A separate target could be set for public guarantees.
12. We advise adoption of an ambitious debt target. The stock is estimated at some €740 million at end 2005 (44.5 percent of GDP, including borrowing from banks and excluding debts of public enterprises) with possibly more to emerge from the ongoing accounting of restitution, military, and municipal debt. To allow automatic stabilizers free rein, and given prospective privatization receipts—which we estimate at well over 15 percent of 2006 GDP over the next five years, we consider that Montenegrin public indebtedness can be significantly reduced in the medium term. And international evidence of economic instability in developing countries with public debts above 30 percent of GDP underscores the case for reducing debt.
13. We propose a public debt target of 35 percent of GDP on average between 2007-2011. This assumes strong structural reforms—yielding average annual GDP growth of 5½ percent over this period—and implementation of the second pension pillar. It is consistent with 3 percent per annum growth in real public spending, public debt below 30 percent of GDP in 2011, and it anticipates labor tax revenue reductions of over 2 percentage points of GDP due to rate cuts over that period. If growth is faster than anticipated in this framework, this would increase further the scope to lower the tax burden. The debt target should be adjusted in mid course if privatization receipts from planned sales and second pillar costs differ markedly from projections, if nominal GDP estimates are raised to reflect the grey economy, if permanent unanticipated real external shocks occur, and if estimates of the initial debt stock alter. We suggest that you adopt and announce this fiscal framework and target with the 2007 budget.
14. The pace at which public debt is lowered during this five year period will reflect several factors. Most critically, if high return public investment projects are ready to go ahead now, the trajectory to the medium-term target should be back loaded so that implementation of the investment projects can proceed. But if implementation capacity is now limited, as it seems to be and if privatization receipts are expected early, the downward trajectory should be front-loaded.
15. The health of the financial system is also reflected in the country risk premium. Considerable progress is evident in this area in recent years—reflected in sharp increases in private sector deposits, work underway on the new banking law incorporating new standards, and progress in strengthening risk-based supervision and compliance monitoring. But accounting standards and a possible deterioration in credit quality during the recent credit boom raise concerns. A fuller assessment of these matters and policy responses will be made by the forthcoming FSAP mission.
16. Considerable scope for improvement is evident in this area. Poor statistics cloud investors’ ability to measure risk—and that is reflected in the risk premium. Despite progress in fiscal and monetary statistics, the national accounts are not available beyond 2003 and external data are unstable. Efforts to strengthen national accounts data are urgent.
The Supply Side
17. Supply side reforms are the key to your prosperity. With flexibility and sustainability secured as noted above, elimination of those factors which have hindered growth in the past—state ownership, former-Yugoslav labor institutions, implicit energy subsidies, weak enterprise exit procedures—will release Montenegro’s productive potential.
18. We applaud your intention to tackle these decisively. We particularly welcome your ambitious program of privatization and plans to modernize labor legislation. Furthermore, we see need to improve public sector productivity and lower the tax burden, especially on labor, and agree that public investment needs to be raised considerably. This will require significant increases in your capacity to design and implement capital projects so as to guard against waste as investment spending rises. And while we support ambitious privatization, we caution that procedures should not only be efficient and fair, but should be seen to be so. Doubts on this in any quarter, but particularly among the general public, undermine the sales themselves by discouraging investor participation.
19. We recognize that this agenda will not be welcome by all. But with FDI already rising strongly, and creating new jobs, we urge that full advantage be taken of the unique opportunity provided by independence to take decisive and possibly difficult steps. Alongside, appropriate provision should be made for a social safety net for those adversely affected in the short-term.
A Strategic choice
20. Implicit in our suggestions is an assessment of the best use of large prospective privatization receipts. With public debt declining in this context, some may prefer to postpone other reforms, both in the real sector and in budget structures. If so, the public debt reductions will prove temporary, and a fiscal sustainability problem will emerge when privatization flows stop. And even before then, growth and employment performance will continue to disappoint (Text Table 1). For these reasons, we conclude that privatization receipts are not a means to postpone or stop broader real and budgetary reform. On the contrary, if privatization is accompanied by ambitious structural reforms and reductions of non-productive budget spending, then a permanent increase in growth is in prospect, alongside robust real growth in public spending and reductions in the tax burden (Text Table 2). We commend you to choose this path.
21. Policies for 2006-07 can set you on this track. We project GDP growth at 5½ and 6 percent in 2006 and 2007, buoyed by past structural reforms, exports, and strong bank credit growth. This pace is reflected in strong revenues so far in 2006, and we welcome that expenditure discipline has been maintained even through the recent referendum period. Data for the first quarter show a surplus €15 million, which is better than expected, largely due to strong VAT collections. We suggest that policies for the remainder of 2006 be focussed on maintaining the strong fiscal performance so far, consistent with a deficit outturn of 0.2 percent of GDP and an end-2006 public debt stock of 37 percent of GDP.
22. The budget for 2007 should demonstrate your commitment to implement a strong medium-term framework. Thus, we urge efforts now to accelerate preparations for key public investment in 2007. And we welcome your intention to proceed with an ambitious reform to personal income tax. However, we suggest that the budgeted revenue loss from that reform, which we estimate at 1.8 percent of GDP, be matched by corresponding reductions in current expenditure. This will signal, congruent with the medium term framework, that tax cuts are made possible by expenditure efficiencies and strong activity, not privatization receipts or compression of capital spending. Appropriate arrangements should also be made for the effects on municipalities of the PIT reform. With public investment assumed at 3.8 percent of GDP in 2007, the budget should target a deficit of consolidated general government of 0.3 percent of GDP, consistent with the medium-term public debt target (Text Table 3). Alongside, structural reforms noted above should commence vigorously.
23. Strong policies are recommended. These are aimed to establish a high growth, high employment, low tax, low debt and flexible economy, led by the private sector. It can be done.
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We are grateful to you for the warmth of the welcome we have received during our visit.