Republic of Montenegro

Monthly Macroeconomic Report

December 2002 and January 2003

Summary: The economy still exhibits some signs of growth, although a significant fiscal retrenchment coupled with tight monetary policy has seriously curtailed demand. This is particularly evident in stagnant imports and sluggish retail sales, even in the presence of a good tourist season. Inflation has dropped into single digits and nominal wages have remained stable for six months, such that real wages have again returned to the same level as in early 2000. More recently, trades unions have begun to call for increases in the base wage and this will be a crucial policy area in 2003. The fiscal sector has undergone substantial adjustment, largely as the result of lagged increases in nominal wages and benefits in the context of continued moderate inflation (and, therefore, higher revenues), and is probably now on a sustainable footing. The budget for 2003, as agreed with the IMF, will concentrate on improving the allocation of expenditure more than on achieving further overall adjustment. The conclusion of a comprehensive public-sector employment and wage policy will be a particularly important and difficult element in preserving fiscal balance in the face of increased debt service costs and transfers to cover the costs of the new Union structures.

Montenegro has secured the first tranche of a World Bank Structural Adjustment Credit and has reached ad referendum agreement with IMF staff on financial targets and structural measures to be undertaken in 2003-2005. These agreements, combined with undertakings to the EU and USAID in the context of budget assistance, have set the reform agenda for the coming years. At the same time, the approval of the Constitutional Charter in the beginning of February should serve to clarify economic competencies and further plans to harmonise and improve economic relations between Serbia and Montenegro are in preparation. An Action Plan is to be completed by end March.

Recent events

On January 8, a new government under Prime Minister Djukanovic was approved by Parliament and the government has undertaken to present a detailed plan of economic reforms within its first 100 days. A first round of presidential elections, held on the 22 December, failed due to a low turnout. A second round failed on February 9.
On 27 January, the Serbian parliament and on the 29 January, the Montenegrin parliament ratified the Constitutional Charter and its law on implementation. The State Union of Serbia and Montenegro was finally born on 4 February when the Federal Parliament adopted the Charter and the accompanying Law on Implementation of the Constitutional Charter.
An "Action Plan" for the harmonization of the economies of Serbia and Montenegro is due to be completed by the end of March.
An IMF mission visited Serbia and Montenegro in late-January and early-February to conclude negotiations for the completion of the first formal review under the Extended Fund Facility (EFF) supporting the government's 3-year program. Concerning Montenegro, the IMF endorsed the budget that was approved by parliament in December.
World Bank discussions on a Transition Assistance Strategy for Serbia and Montenegro were held in Belgrade and Podgorica in early February.
A World Bank Structural Adjustment Credit (SAC) of USD 15 million for Montenegro (which was approved by the Board of World Bank in August) was approved by the Chamber of Citizens of the Federal Assembly in November and was finally released after ratification by the Chamber of Republics on 24 January 2003.
Final bids in a tender for eleven hotels were received on January 31.
The tender for Montenegro banka closed in January and negotiations with a foreign strategic investor are proceeding.
The second Regional Meeting of the South-Eastern European Ministers of Finance took place in February in Zagreb (Box 1).

Box 1 Regional Meeting of South-Eastern European Ministers of Finance

The second Regional Meeting of the South-Eastern European Ministers of Finance took place on 7 February in Zagreb. (The first meeting was held in Belgrade in March 2002 and the third will be in Skopje in September 2003). Representatives from Croatia, Serbia and Montenegro, BiH, Albania, Bulgaria and FYROM attended. The main conclusions were that the political situation in the region is more stable, positive economic trends are evident, and a strong political consensus in favour of reforms does exist and forms the basis for future regional co-operation.

The meeting discussed practical measures to promote regional fiscal sustainability and economic growth through increased intra-regional trade and investment and heightened co-operation to prevent smuggling. The following five projects were established: (1) harmonisation of taxation of interest, dividends and corporate taxes; (2) technical co-operation and assistance on implementing VAT; (3) customs co-operation; (4) promoting co-operation between business and financial institutions; and (5) the formulation of a common SEE policy for the World Economics Forum in Athens in May and for the Thessaloniki Summit in June. A number of working groups, to be led by Croatia, were established to pursue these aims.

Wage and Price Developments

Prices, as measured by the cost-of-living index, have been practically stable since June. The annual rate of inflation fell to 9.2 percent in December from about 25 percent per annum in mid-2002 (Chart 1). Meanwhile, nominal wages have been steady for the past six months, reflecting the fact that there has been no change in the official "minimum wage" since August (Chart 2). (Current average wage data is still not available due to a change in methodology). The real minimum wage is still at the same level as in early 2000 (Chart 3).

Economic Activity

Average industrial production for 2002 was only 0.6 percent above the average level for 2001, but was handicapped by a 6.6 percent drop in production in the energy sector (which measures 25 percent of the index and is heavily affected by weather conditions). When energy is removed from the index, the other sectors grew by about 3 percent in 2002 (Chart 4). Construction activity, having declined significantly at the beginning of 2002, continued to display signs of improvement toward the end of the year. Likewise, road transportation activity began to increase toward the end of 2002, having suffered from the reopening of southern routes to Kosovo earlier in the year (Chart 5). Retail sales suffered a significant decline early in 2002 and had just managed to recover to about the same level as in the previous year after the summer season (Chart 6). Overall, the decline in retail sales reflects a strong correction in fiscal policy in 2001-02 and the stringent wage policy, which effectively froze real wages for two years.

Fiscal Developments

In order for the public finances (made up of the budget and social funds) to be sustainable over the medium term, the government cannot rely on large grants and privatisation revenues that will, by their nature, decline over time. In addition, the government has had to make provision for rising interest charges, and transfers to finance the new Union structures that will come into operation in 2003. Therefore, medium-term fiscal planning dictated a substantial improvement in the balance of other revenues and expenditures. This underlying structural balance (of other revenues and expenditures) needed to decline to about 3 ½ percentage points of GDP in 2002 (see earlier Monthly Reports) and 1 ½ percentage points of GDP in 2003 in order to set a path to medium-term fiscal sustainability (in line with medium-term macroeconomic planning-see Box 2).

Preliminary data on government revenues and expenditure in 2002 confirm a continued rapid consolidation in the underlying fiscal position (Table 1 and charts 8 and 9). The structural deficit has fallen from 8 percentage points of GDP in 2000 to 1 ½ percentage points of GDP already in 2002 (against a target of 3 ½ percentage points) and a target of 1 ½ percentage points of GDP for 2003 has been agreed with the IMF and enshrined in the budget passed in December. Tax revenues are expected to grow by about 2 percentage points of GDP in 2003, continuing the improvements in revenue collection achieved in 2002 and boosted further by the planned introduction of VAT in April. Meanwhile, expenditures will increase somewhat in proportion to GDP in 2003, reversing some of the over-achievement in 2002. The public sector repaid Euro 46 million to the domestic banking system in 2002, more than twice the target (Euro 17 million) originally agreed with the IMF under the current program. Borrowing from domestic banks will resume in 2003.

The Central Government budget, which excludes the social funds, was the main source of overall fiscal adjustment in 2002 (Table 2). A substantial surplus was achieved because of large privatisation revenues but the underlying position, excluding privatisation revenues, also performed better than anticipated. The deficit, without privatisation revenues and grants, fell to 1.9 percentage points of GDP instead of the planned 4.7 percentage points. Tax revenues appear (from Table 2) to have been less than anticipated but this is because some taxes on international trade were redirected to the social funds and direct (social) contributions to the funds were concomitantly lower. Taxes on domestic activity actually increased by 15 percent (Chart 7) compared to 2001.

The budget for 2003, as agreed with the IMF, envisages that:

Taxes will grow in percent of GDP, due to improved efficiency in tax collection and the introduction of VAT (by April); but taxes previously earmarked for the social funds will now accrue directly to the government (before transfer to the social funds), which makes the inter-year comparison of central government revenues and expenditure misleading.
Overall current domestic expenditures will decline in percent of GDP, with a constant relative level of net salaries and benefits.
The budget deficit (before privatization and grants) will increase substantially in proportion to GDP, but this is due to the introduction of transfers for Union operations (Euro 40 million) and increased debt service (Euro 12 million).

The tight budget for 2003, which is consistent with the medium-term macroeconomic plan, will present a number of serious challenges to the government. In particular, the public sector wage bill has been identified as a serious structural problem in many studies, and this will need to be quickly tackled if it is not to undermine fiscal sustainability. A comprehensive public sector wage and employment policy will need to be formulated by a newly appointed government commission, and this policy will need to include both layoffs in the public sector and moderate wage increases. In combination with public sector wages, other domestic current expenditure will need to decline by one percentage point of GDP (Table 2).

Box 2 Macro-Economic Programme, 2003-06

The government is considering a draft macro-economic programme for 2003-06. The chief medium-term goal is to increase the standard of living of the Montenegrin population and reduce unemployment (to about 17 percent of workforce by 2005-06). The reform programme seeks to achieve sustainable high rates of economic growth (5 percent of GDP per annum in 2003-2006) with price stability (moderate inflation, gradually converging on average European rates). These objectives will be pursued by a judicious combination of improved fiscal control, limits on government expenditure (to give room for tax cuts), incentives for the grey economy to enter the formal sector, wage restraint and structural reforms in the context of the operation of the euro as the single monetary unit and medium of exchange. Continued economic liberalization and privatisation, combined with a restructured banking system, should spur investment and productivity in the private sector.

Developments in Trade and Banking

Exports of goods have grown by 32 percent in the first nine months of 2002 compared to the same period in the previous year; largely reflecting increased exports to Serbia. It is particularly noteworthy that, after nine months of 2002, exports had already reached the same level as for the whole of 2001 (Chart 10). On the other hand imports have increased only slightly compared to the same period in 2001, despite a significant increase in imports from Serbia. The balance of goods and services has improved significantly (Chart 11), partly due to increased transport and foreign tourism revenues, and the recorded current account deficit has fallen from about 17 percentage points of GDP in the first nine months of 2001 to approximately 12 percentage points in the same period in 2002. This external adjustment may be somewhat exaggerated by data deficiencies but is, nevertheless, consistent with a substantial fiscal adjustment in the context of tight monetary policy.

Sight deposits at banks appear to have levelled off (Chart 12), pending some further restructuring in the banking system. A tender for the privatisation of Montenegro banka closed at the end of January and negotiations for the sale of the bank to a foreign strategic investor should be completed in late-February or early-March. In addition, the one remaining troubled bank (Beranska banka) has been merged with a stronger bank, and the government has committed itself to disposing of its majority shareholding in Podgorica banka during the course of 2003. This last sale, in addition to the other restructuring operations and sales, would put almost all of the banking system in private hands.

Developments in Relations with International Financial Institutions and Donors

The first formal review by the IMF Board of a three-year IMF Extended Fund Facility (EFF) has been delayed to end-March, pending approval of a revised budget for Serbia for 2003. Negotiations in October/November 2002 found that fiscal and reform targets were basically on track and follow-up discussions in January/February 2003 updated targets for 2003 and beyond. The fiscal targets for Montenegro are consistent with the budget and plans for 2003 as presented in Tables 1 and 2. This agreement, in conjunction with understandings reached with USAID, the EU and the World Bank, has established the overall structural reform agenda for 2003-2005, as presented (with time-tables for implementation) in the November Monthly Report.

The World Bank Structural Adjustment Credit (SAC) of US$ 15 million for Montenegro was finally ratified in January and the first tranche (of US$ 7.5 million) has been released. The second tranche is dependent upon passage of a number of reform measures, including a new Labour Law and Pension Law, which should be achieved by mid-year. The World Bank Transition Support Strategy for Serbia and Montenegro envisages reaching agreement on a second SAC for Montenegro during 2003.

On 21 November, the European Investment Bank approved a loan of euro 70 million for Serbia and Montenegro for repairing and improving electricity infrastructure and some euro 11 million will be targeted to Montenegro.