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Beyond the Peak: Growth Policies and Fiscal Constraints (Public Expenditure and Institutional Review)

Preface

This report is released at a time of great economic uncertainty. The effects of the global financial crisis, which erupted in October 2008 (that is, after this report had been written), are not yet fully clear. It will take a few more months for the dust to settle and reveal an unobstructed view on the effects for Montenegro’s economy. As argued on a different occasion (see Monitor of October 24, 2008), Montenegro’s situation—on first glance—looks precarious, with a set of indicators that would make its economy highly susceptible to the effects from the crisis. In particular, the dynamic rates of post-independence economic growth were largely fueled by tourism, foreign direct investment, and (external) private-sector debt, all factors likely to be affected in the aftermath of the current crisis.

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Executive Summary [129kB]
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1. The Post-Independence Boom

When Montenegro secured its internationally recognized statehood in mid-2006, it was able to build on the foundation of comprehensive pre-independence reforms. The implementation of a privatization and structural-reform agenda, the provision of a low-tax, pro-business environment, and a clearly defined European perspective represented factors that allowed—once political uncertainties had been removed—for a surge of pent-up investment, fueling domestic demand and economic growth, at rates much faster than expected. The considerable inflows of foreign capital helped to transform an economy—which had been constrained by a succession of economic crises and set back by regional conflicts and international sanctions—into Europe’s most dynamic one. For 2007, real growth has been estimated at double-digit rates. Commercial banks supported these activities with very large increases in credit to the economy, which permitted the financing of higher imports, leading to a rapid widening in the current-account deficit. These trends explain the unforeseen tax-revenue abundance, especially since Montenegro’s “regionally competitive” tax regime relies on trade as a primary source of fiscal revenue. The deteriorating international environment (the global credit crunch, rising energy and food prices, and increased regional instability) and the natural process of a maturing business cycle necessitate care in framing fiscal policies over the medium-term horizon, not least because real-estate sales to non-residents and the high rates of external bank borrowing cannot be maintained, thus exposing the economy to vulnerabilities and the risk of a full-blown boom-bust cycle—particularly if recurrent spending is not contained and key (and politically difficult) challenges not addressed while revenues are still buoyant. Fiscal policies, which already have to absorb a 30-percent increase in public-sector salaries and the regularization of pension arrears, will have to play a key role.

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2. Fiscal Constraints and Golden Rules

This chapter describes how broad principles underlying the design of fiscal policies over a medium-term horizon could help to achieve both overriding policy objectives—macroeconomic stabilization and socio-economic development. At the same time, such an approach would provide a certain degree of flexibility for instances in which external shocks prove larger than currently expected. Illustrative simulations are based on three such guidelines. First, unilateral euroization and Montenegro’s objective to eventually formalize this arrangement imply that the fiscal criteria in the Growth and Stability Pact are binding. Second, tax revenues net of those derived from temporary factors need to be able to finance current expenditure (implying that Government can only borrow to finance investments). This “modified golden rule” should help to avoid committing to recurrent expenditures (for instance, on the wage bill) that cannot be maintained over the entire span of a business cycle. Third, having already accepted additional demands into the 2008 budget, and with a view to creating the necessary fiscal space for the ultimate realization of planned public investments, recurrent spending will be curtailed, thereby providing (i) a buffer for abrupt economic downturns; and (ii) an increasingly larger fiscal space for the implementation of planned public investments over the medium term. Depending on the timing and severity of the eventual downturn, the consistent application of these broad principles would imply (i) moderately counter-c yclical fiscal policies, with overall fiscal surpluses during years, in which capital inflows remain large, and temporary deficits in periods of large and negative external shocks; (ii) a clearly defined fiscal space for public investments; and (iii) and fiscal incentives for the acceleration of institutional reforms aimed at increasing the effectiveness of public administration. The fiscal discipline inherent in this approach should result in the gradual decline in sovereign risk premia and an eventual upgrading of Montenegro’s grades by international credit rating agencies.

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3. Public Investments

Following the transition towards a functioning market economy, the demands on public infrastructure—weakened by decades of neglect—have increased considerably. Supply constraints have become increasingly evident and, in the absence of further investments, are threatening to asphyxiate the growth momentum. These supply constraints are particularly evident in (i) the energy sector, as evidenced in the growing energy deficit; (ii) the transport sector, with increasing traffic jams (during the peak season) and a very high incidence of accidents; and (iii) the water sector, including waste water; and (iv) sanitary solid waste deposits. As Montenegro aims at developing a high-end tourism sector that is to provide the economy’s growth engine, it is crucial that the necessary investments—within the available fiscal envelope—are made to eliminate these bottlenecks quickly. On the whole, public infrastructure has not received sufficient attention in recent years, especially in sectors requiring very large amounts of budgetary funds for rehabilitation and modernization purposes. Insufficient maintenance has led to an accelerating rate of capital depreciation, and Government has recognized the need to reverse this trend. This chapter summarizes identified investment needs in the electricity and transport sectors (which require the largest investments). At the same time, the overall budget envelope defines limits to the capital budget, despite efforts aimed at increasing the fiscal space, necessitating intensified efforts to (i) attract private-sector co-financing; (ii) devise criteria according to which capital expenditures could be prioritized; and (iii) assess available options—if need be—to downsize or delay public investments.

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Appendix - Beyond Prestige Objects: Challenges of Road Safety
Long periods of negligence incur large social and economic costs, necessitating Government to undertake considerable investments for the existing road network as well. With large growth rates in (i) international trade; (ii) tourism; and (iii) domestic car ownership, existing roads have not been constructed for the demand for road infrastructure. The result are economic costs in terms of time foregone (traffic jams) and, particularly, the social and economic costs of car accidents. The following section, by means of example, highlights the challenges and recommends policies to remedy this situation.

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4. Public Administration: Employment and Wages

The wage bill—comprising more than one-fourth of all government expenditure—faces conflicting pressures. A set of policy measures will have to be implemented that can achieve the following objectives concomitantly, viz., to (i) increase effectiveness and professionalism of the public administration in key areas critical for achieving the EU integration objective; (ii) prevent a “brain drain” towards the private sector among the high-skilled; and (iii) contain the overall expenses for public-sector employees to a level that is consistent with the realization of the Government’s broader fiscal policy priorities. This chapter discusses policy measures that could foster public-administration development. Much progress has been made over recent years, but the reform process will have to continue. The assessment of current challenges within the public administration have revealed that overall effectiveness could be increased by linking more closely pay and performance, defining job requirements and performance indicators, making recruitment more competitive, continuing the process of aligning priorities with staff, and outsourcing non-core functions to the private sector.

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Related Links
Article: Economy On a Diet(CGEkonomist, December 2008)

Round Table
Podgorica, Montenegro
April 2, 2009









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