Montenegro: Preparing for Prosperity

Abstract

This report is intended to provide analytical support to the Government of Montenegro and inform its development strategy as it embarks on the next stage of the EU integration process. It provides answers to specific questions of importance for charting Montenegro’s macroeconomic and structural policies for the years ahead. For example, what have been the relative roles of different growth drivers, and how will they need to change in the international environment? How can fiscal policy help ensure sustainability? What challenges must financial sector reforms overcome to ensure robust credit recovery? How can Montenegro best go about becoming better connected to world markets? Do exports have potential to be a driver of growth and diversification? How can Montenegro better connect, internally and externally, to unlock productivity gains based on competitive advantages? What regulatory, investment climate, and institutional reforms will be needed to support more sustainable future growth? This executive summary provides an overview of the main conclusions and the resulting broad policy agenda; detailed analysis can be found in the chapters devoted to the three building blocks of the future growth model for Montenegro: sustainability, connectivity, and flexibility.Montenegro has made major progress in recent years in increasing per capita income and reducing poverty, advancing structural reforms, and preparing for EU membership, which is the government’s main objective. Since 2003 Montenegro has trebled its gross national income per capita (World Bank Atlas method), from $2,400 to $7,160 in 2012. It now has the highest per capita income among the six South East European countries. The national poverty headcount fell from 11.3 percent in 2005 to 6.6 percent in 2010, the last year for which official data are available, and it still has less inequality of income (Gini coefficient 24.3) than the average for Europe and the Central Asian countries (31.9). Structural reforms in the public sector, the financial sector, and the investment climate have helped it advance on many comparative metrics, such as World Bank governance indicators, financial sector soundness measures, and Doing Business indicators. In 2011 Montenegro became the member of the World Trade Organization (WTO) and in June 2012 it entered into formal negotiations on accession to EU membership.Yet despite considerable progress, the global crisis has exposed Montenegro’s vulnerabilities and called into question the sustainability of its growth pattern. The period 2006-08 in the immediate aftermath of independence was characterized by unsustainably large inflows of foreign direct investments (FDI) and inexpensive capital, which fueled a domestic credit consumption boom and a real estate bubble. With the economy overheated and growing at 7 percent, the bubble burst late in 2008. In 2009 real GDP shrank by almost 6 percent, triggering a painful deleveraging and a difficult recovery that is not yet complete. As a result, growth in 2010-11 averaged only 2.9 percent and for 2012 is only half a percent, and unemployment is very high at almost 20 percent. Moreover, the base for Montenegro’s growth is narrow. It has relied on factor accumulation rather than productivity, and exports are concentrated in a handful of metal products with little value added. As a result, with the new normal international environment of more limited capital inflows and slow credit recovery, with unemployment high and consumer debt suppressing consumption, and with external demand sluggish, it has become clear that the old pattern cannot deliver the growth performance seen a few years ago. What kind of growth model could drive Montenegro’s next stage of development in what is bound to be a much more competitive international environment? This report addresses this question using an eclectic approach to analyzing Montenegro’s growth constraints that combines several analytical approaches, such as growth accounting, sectoral analyses, and institutional and microeconomic analyses using firm and household surveys. This growth analytics approach recognizes that no single method of analyzing growth constraints is likely to provide comprehensive answers to the main growth questions. The report provides insights into growth-oriented fiscal and financial sector policies, exports, investment climate, and infrastructure policies that have the potential to improve growth prospects and prepare Montenegro for the next stage of prosperity. The overarching approach is to analyze macrofinancial as well as structural constraints and bottlenecks to growth and use the analysis as a basis for formulating actionable policy recommendations that will help Montenegro better prepare for the next stage of prosperity. Specifically, the report emphasizes the critical role of fiscal and financial sector sustainability in ensuring the macroeconomic stability and sustainability that are fundamental to long-term growth. At the same time, it recognizes the importance of Montenegro’s connectivity –– via trade, infrastructure (physical and informational), and human capital –– with world markets, and of regulatory and institutional flexibility for improving Montenegro’s long-term growth.