Report No 46660-ME Montenegro Beyond the Peak: Growth Policies and Fiscal Constraints Public Expenditure and Institutional Review November 24, 2008 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CONTENTS PREFACE ....................................................................................................................................................... i EXECUTIVE SUMMARY i1 1. ............................................................................................................................... THEPOST-INDEPENDENCEBOOM ...................................................................................................... 1 A. MACROECONOMIC MANIFESTATION .......................................................................................... 1 B. INHERENTRISKS ......................................................................................................................... 9 C. FISCALPOLICIES ....................................................................................................................... 17 Tax Policy: Providing a Pro-BusinessEnvironment................................................................. 18 ExpenditurePolicy: IncreasingFactor Productivity ................................................................. 21 25 2. D. LOOKING FORWARD:CHALLENGESOF MANAGING BOOM THE ............................................... FISCALCONSTRAINTSAND GOLDEN RULES .................................................................................... 29 A. INTRODUCTION ......................................................................................................................... 29 B. STRUCTURAL TAXREVENUES .................................................................................................. 32 C. MEDIUM-TERM FISCAL PROGRAMMING................................................................................... 34 D. CONCLUDINGREMARKS........................................................................................................... 45 3. PUBLICINVESTMENTS ....................................................................................................................... 47 A. THEENERGYSECTOR ............................................................................................................... 47 Financial Performanceofthe Power Utility ............................................................................. 49 Implied Assumption of Infrastructure Improvements............................................................... 52 Summary and Conclusions ....................................................................................................... 53 B. THETRANSPORT SECTOR.......................................................................................................... 54 Background............................................................................................................................... 55 The Institutional Framework of the Sector ............................................................................... 56 Expenditures in the Sector ........................................................................................................ 59 Outputs in the Sectors............................................................................................................... 62 ExpenditureNeeds.................................................................................................................... 65 Key Recommendations............................................................................................................. 68 C. CONCLUDINGREMARKS........................................................................................................... 71 APPENDIX BEYONDPRESTIGE OBJECTS: CHALLENGES OF ROAD SAFETY 73 4. PUBLIC ADMINISTRATION: EMPLOYMENT WAGES AND ................................................................. ......................................... 82 A. BACKGROUND........................................................................................................................... 82 B. EFFECTIVENESSOF PUBLICADMINISTRATION ......................................................................... 84 Efficiency Considerations......................................................................................................... 87 Equity Considerations.............................................................................................................. -96 C. POLICY OPTIONS..................................................................................................................... 102 REFERENCES ............................................................................................................................................ 105 TABLES Table 1.1: Montenegro:Demand Stimuli. 2003-08 ...................................................................................... 2 Table 1.2:Montenegro:Foreign Direct Investments,2001-07 .................................................................... 3 Table 1.3:Montenegro:Credits. Deposits. and ExternalBank Debt. 2003-08 ............................................ 7 Table 1.5:Coastal Montenegro:Average Percent Increasesinthe Priceper Square Meter, 2005-07 .......11 Table 1.4:Montenegro:Selected SocialIndicators;2004-08 ...................................................................... 8 Table 1-6:South EasternEurope: Tourism and Travel Competiveness, 2008 ............................................ 14 Table 1.7: MontenegroandNeighboringCountries:PrincipalTax Rates, 2008 ........................................ 19 Table 1.8:RegionalComparisonof Budget Structures, 2007..................................................................... 21 Table 1-9:Montenegro:ConsolidatedGeneralGovernment FiscalOperations, 2003-07 ......................... 23 Table 1-10:Montenegro:ConsolidatedGeneral Government FiscalOperations, 2003-07 ....................... 24 Table 1.1 1: Montenegro: Strategies Adopted Since PEIR 1, 2007-08........................................................ 25 Table 1.12: Montenegro. Majority State-OwnedEnterprises, April 2008.................................................. 27 Table 2.1: Montenegro:StructuralFiscalBalance, 2003-07 (in millions of euro; unless otherwise indicated) ............................................................................................................................................ 33 Table 2.2: InternationalComparison of Fiscal Rules.................................................................................. 39 Table 2.4: Montenegro:Base Case Macro FrameworkWith Semi-AbruptEnd to TEDS, 2006-12 .........42 Table 2.3: Designof FiscalFrameworks .................................................................................................... 40 Table 3.2: Montenegro:Electricity Tariffs, 2007-08 ................................................................................. Table 3.1:Montenegro: EPCG Operationaland FinancialPerformance Indicators, 2006-1 1...................50 5 1 Table 3.3: Montenegro:EPCG InvestmentPlan, 2007-1 1......................................................................... 53 61 Table 3-5: Central and EasternEurope: Road InfrastructureCoverage(in millions of euro)..................... Table 3.4: Montenegro:Railway IncomeStatements, 2006-07 (in millions of euro) ................................ 63 Table 3.6: IndicativeMaintenance Cost Projectionsfor RoadNetwork, 2008-12 ..................................... 66 Table 3.7: Montenegro:Strategically ImportantRoad InfrastructureProjects........................................... 67 Table 3.8. Montenegro:Car Accidents, Injuries, and Casualties, 2004-07 ................................................ 74 Table 3.9: Montenegro:Accidents on Route M2, 2006-200731 ............................................................... 77 Table 3.10: Montenegro:Accident Rates on Route M2, 2006-2007-SI..................................................... 78 Table 3.1 1: Montenegro:Accident Densityon Route M2, 2006-2007-S1................................................. 78 80 Table 4.1: PEIR-I Recommendationsand Policy Reforms, 2007-08 ........................................................ Table 3.12: Montenegro: EconomicBenefitof Investmentby Section(M2). 2006-2007-S1.................... 84 Table 4.2: Selected Doing Business Indicators,2008................................................................................. 87 91 Table 4.4: Montenegro:Dispersionof Hourly Wages, 2006 ...................................................................... Table 4.3: Montenegro: RelativeStructure of Public Sector Employment, 2007....................................... 98 Table4.5: Montenegro:Hourly Wage by Sector and Occupation, 2006.................................................... 99 Table 4.6: Montenegro: Determinantsof Hourly Wage, 2006................................................................. 101 FIGURES Figure 1.1: Real GDP Growth Rates. 2007(in percent) ................................................................................ 4 5 Figure 1.3: Montenegro:Gross ForeignDirect Investment,2002-07 .......................................................... Figure 1.2: Net Per-CapitaForeignDirect Investments, 2006 (in U.S.dollars) ........................................... 6 Figure 1.4: Montenegro: Rangeof WeightedAverage LendingRates, September 2005-June 2008...........6 Figure 1.6: Montenegro:Stock ExchangeIndices; March2003-June 2008................................................. Figure 1.5:Montenegro:Range of Real WeightedAverage LendingRates, September 2005-June 2008 ..8 9 11 Figure 1.8: RealGrowth, 2004-07 and 2008-Q1........................................................................................ Figure 1.7: Apartment Prices Per SquareMeter in City Center, 2007/08................................................... 12 Figure 1.9: Montenegro:Depositsand Credits, December 2003-June 2008.............................................. 13 Figure 1.10. Montenegro:Private-SectorCredit Growth, December 2004-June 2008.............................. 13 Figure 1.12:Montenegro:Temporarily Available ExternalDemandStimuli and Imports,2003-07 ........20 Figure 1.11: Current-AccountBalance, 2007 (in percent of GDP)............................................................. 16 Figure 1.13:Montenegro:Importsand Tax Receipts, 2003-07 .................................................................. 20 Figure2.1: InherentRisksto Long-TermFiscalDynamics ........................................................................ 3 1 Figure 2.3: Montenegro:Non-SustainableExternalDemand Stimuli and Tax Receipts, 2003-07............33 Figure2.2: Montenegro: Stylized(First-Round)Pass-Throughof ForeignCapitalInflow........................ 31 Figure 2.4: Montenegro:The Size of TEDS, 2006-12 ............................................................................... 37 Figure 2.5: Montenegro:The Impactof TEDS on Taxes and FiscalBalances, 2006-12 ........................... 37 Figure 2.6: Montenegro:The Impactof TEDS and the Budget Structure, 2006-12 .................................. 41 Figure2.7: Montenegro:The Impactof TEDS and RelativeBudget Structure, 2006-1 2.......................... 41 Figure 3.1 : Montenegro:EPCG'sNet OperatingIncome,2006-1 1 ........................................................... 52 Figure3.2: Capital and Recurrent Expenditureinthe Road Sector, 2005-08 ............................................ 60 Figure3.3: Railway of MontenegroIncomeStatement Summary.............................................................. 62 Figure 3.4: South EasternEurope: ComparativeRankingof Infrastructureand RoadsAs Critical Element 64 Figure3.5: Select EuropeanCountries: Fatalitiesper One Million Inhabitants,2007................................ in DeterminingRegionalCompetitiveness, 2007............................................................................... 64 Figure3.6: Montenegro:Fatalitiesand Injuries in Montenegro,2004-07 .................................................. 64 68 Figure3.8: Montenegro:Public Investmentsand FiscalConstraints.......................................................... Figure3.7: Fuel PriceComparisons in (South) East Europe,November2006........................................... 72 Figure3.9: FatalitiesPer One Million Inhabitants,2000, 2005 .................................................................. 74 79 Figure 3.1 1: Montenegro:Euro RAP Ratingsfor Select Roads.................................................................. Figure3.10: Distribution of FatalityAccident Risk Rates.......................................................................... 79 Figure4.1: Government Effectivenessand RegulatoryQuality, 2007 ....................................................... 85 Figure4.2: General Government Wage Bill, 2006 ..................................................................................... 89 90 Figure4.4: Montenegro:General GovernmentWage Bill Structure, 2003-07 .......................................... Figure4.3: GeneralGovernment Wage Bill, 2002-07 ............................................................................... 94 96 Figure4.6: Montenegro:Hourly Wage by Sector and Education,2006..................................................... Figure4.5: Wage Dispersionfor Selected General Government Occupations, 2007................................. 97 Figure4.7: Montenegro:Hourly Wage by Sector and Major OccupationGroups, 2006 ........................... 99 Figure4.8: Montenegro:Hourly Wage by Sector and Region, 2006........................................................ 100 Box 1.1: HousingPrices. Credit Crunch. and the Endto EconomicBooms .............................................. 12 Box 1.2: Growth EngineTourism............................................................................................................... 14 18 Box 1.4: Strong Strategic PolicyAnchors .................................................................................................. Box 1.3; The ReformAgenda: Economic Constraintsand Political Objectives ........................................ 26 Box 2.1: Benefitsand Risksof Public-PrivatePartnerships....................................................................... 38 39 Box 2.3: Designinga Successful FiscalFramework in Montenegro.......................................................... Box 2.2: Can FiscalRules Helpto RealizeAmbitious Public InvestmentPlans?...................................... 40 Box 4.1: Public Sector RemunerationPoliciesin Montenegro................................................................... 88 ACKNOWLEDGEMENT The team comprised Jan-Peter Olters (ECCME, task team leader), Husam Beides, R. Martin Humphreys, Vickram Cuttaree, Stephen Muzira, Richard Wong, (all ECSSD), Jesper Mertner (consultant), Sanja Madiarevic-Sujster, Danijela Vukajlovic-Grba (both ECSPE), and Danijel NestiC (consultant). Very helpful comments, questions, and suggestions were received from Bernard Funck and Ardo Hansson (both ECSPE), ieljko BogetiC (ECSPE, peer reviewer), Marina Wes (ECSPE, peer reviewer), as well as by Jane Armitage (ECCU4), George Banjo (ECSSD), Franqois Boulanger(ECSSD), Anastassios Gagales (IMF), Franz Gerner (ECSSD), Ronald Hood (ECSPE), ElisabethHuybens (ECCU4), and Daniel Kanda (IMF) during the review meeting. Desktop publication was done by Mismake Galatis (ECSPE). All of their comments have improved the text, sharpened the analysis, and enhanced the presentation and are herewithgratefullyacknowledged. All remainingerrors are, of course, the task team leaders'. 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-sectordebt, all factors likely to be affected inthe aftermath ofthe current crisis. The crisisper se, however, has not invalidatedthe analysis presented in this second volume of the Public Expenditure and Institutional Review (PEIR). To the contrary, the lack of confidence and trust among financial institutions, constraining inter-bank lending internationally, with immediate effects on the real sector in North America, Europe, and elsewhere, increases-if anything-the probability that the two factors that have been identified as the most fragile for Montenegro's economy (viz., real-estate sales to non-residents and foreign debt by the domestic bankingsector) will prove centralto the understanding of any trend reversals to economic developments in Montenegro, including those explaining changes in growth rates and fiscal revenuecollection. Unfortunately, the internationalfinancial crisis has increased the likelihood that, over the medium-term horizon, the overall economic environment will resemble the "pessimistic scenario" outlined in Chapter 11, which would place particular responsibilities on policymakers in designing economic policies with a view to maintaining economic stability, increasing factor productivity, and advancing socio-economic development. For the time being, precautionary motiveswill have to play a key role in the corresponding decision-makingprocesses. This report would not have been possible without the very fruitful policy dialogue that the team has had with its counterparts in Government-and especially the Ministries of Finance, of Economic Development, of Educationand Science, of Health, Labor, and Social Welfare, and of Maritime Affairs, Transportation and Telecommunication-, the Central Bank of Montenegro, Monstat, the Tax Directorate, EPCG, the Energy Regulator, the Directorate of Public Roads, Montenegrin Railways, the airport and port director offices, the Employment Agency, Human Resource Management Authority, Human Dynamics, InstitutAlternativa, as well as all local governments. The team is indebtedto all experts and would like to take this opportunity to express its gratitude for the close cooperation, the frank discussions, the very valuable insights shared with, and the hospitality extendedto, the team. We hope to be able to "repay" this debt with a document that will prove usefuland help to advance in the internal debate on policy options and challenges facing Montenegro over the medium-termhorizon.Without implication, the authors would like to acknowledge the detailedcomments provided on an earlier draft of this text by the Ministry of Finance and the Central Bank's Chief Economist, Nikola Fabris. i "You can't always get what youwant But ifyoutry sometimesyou might find You get what you need" -The Rolling Stones (playingin Jaz/Budvaon June 9,2007) EXECUTIVE SUMMARY The MacroeconomicContext 1. In 2007, Montenegrowas one of the world's fastest growing non-oileconomies. The country reaped the benefits from its comprehensive, pre-independence reform program. After the international recognition of statehood had removed the lingering uncertainty over Montenegro's political status, investorsreassessedthe country's relative attractiveness as a site for business, respondingpositively to (i) the implementationof the privatizationand structural-reformagenda; (ii) the provision of a low-tax, pro- business environment; and (iii) a clearly defined European perspective.In response, investment surged. Capitalinflows from foreign direct investment (FDIblargely absent duringthe first half of this decade- reached a level of 30 percent of GDP in 2006 and 40 percent in 2007, fueling domestic demand and stimulating economic growth. Real GDP grew at double-digit rates in 2007, an outcome that stands in stark contrast to the period of economic anemia characterizingMontenegro's pre-independenceyears. In this buoyant environment, commercialbanks supported private-sectoractivities with very large increases in credit to the economy (with 12-monthgrowth rates exceeding 180 percent at end-2007).These helped to finance higher imports of goods and services, leadingto a rapid widening in the current-accountdeficit from 8.5 percent of GDP in 2005 to 40percent in 2007. The economic dynamism, exceeding all (published) projections, resulted in an unexpected abundance of fiscal revenues and-with generally effective control over public expenditures in 2007-a very substantialoverall surplus. 2. The post-independence economic boom has been fueled by very large-and, to a considerable extent, unsustainable-external capital inflows. Apart from tourism receiptsand foreign acquisitions of companies, banks, and shares of publicly traded enterprises, more than one-third of capital inflows consisted of elements that are temporary and will dissipate over the medium term-in particular, purchases of (coastal) real estate by foreigners (20 percent of GDP in 2007) and external borrowing by the domestic bankingsector (14 percent of GDP). With a coastline of less than 300 kilometers, the supply of beachfront property is-per definitionem-finite, This implies that purchases of Montenegrin-ownedcoastal real estate by non-residents (which represented more than one-half of total FDI in 2006 and 2007) cannot be maintainedat current levels and will dissipate as a source of capital inflows. Domestic banks will not be able to lend to the private sector as aggressively as they did during the immediate post-independence period. Credit to the economy had grown at unprecedented rates and, in 2007, considerably faster than deposits, necessitatingincreased foreign borrowingby domestic banks. Because ofthe financial institutions' rapidly increasing degree of external indebtedness, Standard & Poor's rated Montenegro'sbanking sector as the riskiest in the region. With the stock of external bank debt exceeding 20 percent of GDP at end-2007, and further increasing to 25 percent in mid-2008, the rating agency's critical assessment, made in early August 2008, will make foreign banks more careful to extend .. 11 further creditsto Montenegrin banks, especially in light of an economy that is startingto lose its growth momentum.As observed by other countries, once the economy has moved onto the downward-slopingportion of the business cycle, banks will find it increasingly more difficult to borrow externally to be able to lend domestically. Because of the fallout from the internationalfinancial crisis, this development could occur considerably more abruptly than currently foreseen, as liquidity in foreign markets tightens and banks become increasingly more risk averse. For endogenous reasons as well, the need for domestic banks to demand foreign loans will decline, largely because of the maturing of Montenegro's business cycle, which will be accompanied by a decrease in the demand for private-sector credits. In any case, banks have been precluded from increasing credits at rates comparable the immediate post-independence period, as the Central Bank of Montenegro(CBCG) adopted measures in late 2007 that aimed at strengthening prudential ratios, in the context of which policy the monetary authority defined quantitative credit limits in function of the respective banks' stock of outstanding credit. Thus, for both supply- and demand-side reasons, banks will find that they will neitherneed nor be able to borrowfrom banks abroad. Resultant Fiscal-PolicyChallenges 3. The abundance in tax revenues, which accompanied the economic boom, may have obscured the profundity of Montenegro's medium-term fiscal challenge. Abundant government resources inevitably generate political pressuresto spend a larger portion of current income than could be maintained beyond the economic expansion phase. Two factors, in particular, have the potential of changing the fiscal dynamics and jeopardizing Montenegro's ability to realize its medium-term policy objectives. 0 Montenegro's "competitive" tax regime adds an element of pro-cyclicality, obliging Government to increasingly rely on imports as a source of fiscal revenue. Like many other countries in Southeastern Europe, Montenegrohas been aggressively reducingits direct tax rates, having introduceda 9-percent flat tax for corporate income (the personal incometax rate will have been reduced to the same level in 2010). Concomitantly, Government eliminated capital gains taxation and kept social contributions at a minimum (rates are foreseen to be lowered even further). In terms of enhancing the relative attractiveness of Montenegro as site for (foreign) direct investment, this has been very beneficial. However, the flat tax has removed automatic stabilizers from the tax system, amplifying elements of pro-cyclicality. The low income tax rates, in particular, have made the budget more susceptible to external demand shocks and increased its reliance on imports as a source of fiscal revenue. This is especially significant as.lower capital inflows from the unsustainable sources mentioned above will lead to an almost correspondingreduction in imports and, in turn, considerably lower tax revenues than during the boom period. Subsequently, Montenegro's policymakers will need to base decisions on permanent spending obligations, includingthose on the wage bill, on its "structural" tax base-that is, on tax revenues net of influencesfrom temporary and unsustainableexternal demand stimuli, 0 A large-scale public investment program is being designed with a view to crowding in private investment and increasing the economy's growth potential. 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; (iii) ... 111 the water sector, including waste water, affecting principal tourist areas during the summer months; and (iv) sanitary solid-waste deposits, resulting in wild dumps, a spoiled tourism experience, and-ultimately-increased public health risks for Montenegrins. Of these, the former two investments are particularly expensive. As Montenegro aims at developing a high-end tourism sector, it is critical that the necessary investments-within the available fiscal envelope-are made to quickly eliminate these growth-retarding bottlenecks. Moreover, insufficientmaintenance has led to an accelerating rate of capital depreciation, and Government has recognizedthe needto reverse this trend. 4. With the euro as monetary anchor, fiscal policy is the only policy instrument of macroeconomicmanagement. As such, fiscal policy will have to play a double function-viz., to ensure continuedmacroeconomic stability and advance the country's socio-economic development (and politico- economic integration)objectives. Government's challenge to maintain macroeconomic stability is made more difficult by that fact that both the tax regime and external bank credits are being strongly pro- cyclical in their effects on the overalleconomy. For this reason it is importantthat the medium-termfiscal program reinforces-to the extent possible4ounter-cyclical elements, mainly by designing a fiscal program that allows for the implementation of critical public investments, possibly at the expense of moderate fiscal deficits, in an even less benign environment. Such an approach would provide policymakerswith some form of a fiscal buffer, given that-in a worst-case scenario with very large and sudden shocks-it i s considerably easier to adjust the capital budget than the current one. Similarly, for socio-economic development reasons, it is a central policy objective to protect the capital budget, given the need to reverse decades of negligence of public infrastructure and, in so doing, allow for the increase in the productivity of production factors employed by companies operating in Montenegro-a precondition for any policy approach that includes the crowding-in of private-sector investments as a central objective. To this end, Montenegroprepares to implementvery large projects in the transport and energy sectors. 5. To achieve its twin objectives (to maintain macroeconomic stability and advance socio- economic development), Government needs to lengthen its planning horizon and-as credibly as possible-commit to fiscal-policy benchmarks that would help to create the fiscal space that is necessary for the ultimate realization of these investment projects.Given Montenegro's particular macroeconomic situation and its policy objectives, the present document outlines one such fiscal framework, which is designed around three guiding principles. Fiscal policy stays within the constraints of the Stability and Growth Pact, a direct consequence of the unilateral euroization decision made in 1999. As Montenegro seeks to join the EU and eventually formalize the use of the euro as the country's legal tender, policymakers are bound-implicitly, at least-by the fiscal-policy constraints as defined by the Stability and Growth Pact (SGP). These were adopted in 1997 to maintainthe Economic and Monetary Union (EMU), aimed at achieving a balanced budget over the span of a business cycle. For any given fiscal year, these fiscal criteria limit (i) the overall budget deficit of general government to 3 percentof GDP; and (ii)public debt to 60 percent of GDP. Given Montenegro's end-2007 debt-to-GDP ratio of about one-half the SGP limit, committingto the deficit criterion implies that-under moderatelypessimisticassumptions of nominal growth rates and budget deficits-the debt-to-GDPratio should not increase beyond the current level. Since 2004, fiscal policies have remained consistently within SGP limits. In a worst-case scenario, with the aforementioned unsustainable external capital inflows dissipating abruptly, Government will have to curtail public investments as well to stay within the limits spelt out in the SGP. Tax revenues (net of those derived from temporary factors) finance current expenditure, implying that Government can only borrow to finance investments. This iv "modified golden rule" should help to prevent policymakers from committing to recurrent expendituresduring boom periodsthat it cannot be maintain during economic downturns. A similar rule-applied permanently-constrains fiscal policies in many other European countries, facilitating a more medium-term approach to the design of fiscal policies and supportinggovernments to achieve both macroeconomic stabilization and public investment objectives. Fiscal policies since 2005 have been consistent with this principle, as general government posted a (gradually increasing) current structural surplus as budgetary revenues net of temporary factors exceededpublic spendingnet of capitalexpenditures. 0 The ratio of recurrent expenditure to GDP declines gradually. In this document, for illustrative purposes, the related benchmark keeps recurrent spending constant in real terms, at least during the implementation phase of the aforementionedpriority investments. Given existing pressures for increased expenditure on the wage bill and on goods and services, this principle appears to be the most difficult to attain(and maintain). In 2006 and, more tangibly, in 2007, the ratio of recurrent expenditure to GDP has increased, and it will do so again in 2008. As a result, with more binding budget constraints for recurrent expenditure, Government will have to raise the effectiveness and efficiency of related spending, which should help to achieve the delicate balance between increased demands on the public sector (EU integrationand decentralization)and graduallytighter budgetsfor recurrent expenditure. 6. If adopted, such an approachwould allow fiscal policy to play its double role, by combining (moderately) pro-cyclical elements (within well-defined overall constraints) with efforts to overcome existing bottlenecks in public infrastructure. Conceptualizing a multi-year capital budget should facilitate the provision of adequate financing for-and increase the overall quality of-realized public investments.Taken together, these principles combine features of short-term budgetary flexibility (by allowing for overall fiscal deficits during economic downturns) with medium-termfiscal discipline (exemplifiedby the absenceof any significant increases in the debt-to-GDPratio). A correspondingfiscal framework comprising all three elements should thus result in the gradual decline of sovereign risk premiaand an improvement in the grades conferredto Montenegro by internationalcredit rating agencies, loweringthe budget's debt-serviceobligations. 7. The main risks come from insufficient private-sector participation in the public investment program and continuedwage pressures. Public investmentplans exceed the state's capacity to finance them by a considerably margin, necessitating Government to (i)explore ways to access private-sector capital (privatization, public-private partnerships, and concession arrangements); (ii) lengthen the projects' implementationperiods; and (iii) consider, as necessary, a downsizing in the scale and scope of the public investment projects. As experiences elsewhere have shown, hastily negotiated PPPs can include larger-than-foreseencontingent liabilities and narrow the remaining fiscal space. At the same time, the large wage increases granted to employees in the private sector has increased the competition between the private and public sectors for available talent, increasing the need to accelerate the process towards public sector wage decompression. Across-the-boardwage increases, similar to those adopted in late 2007, need to be avoided, and a difficult challenge an electoralyear. Public Investment Priorities 8. I n the energy sector, major investmentsare required to ensure both a sufficient availability of reasonably priced energy and a sustainable financial position of the power utility. Reflecting decades of negligence, the recently adopted energy strategy foresees investments of about 1.8 billion (more than 70 percent of 2007 GDP) until 2025 are very high. But the status quo is not an option either. Since 2002, the power utility (EPCG) has reported annual losses of about 1 percent of GDP. New investments have been very limited and its assets have deteriorated due to a lack of maintenance and V replacements. To improve its physical and financial conditions, EPCG is launching a major investment program, while seeking to address its fragile financial position. Both objectives are interlinked, as an improvement in EPCG's financial situation can only be achieved ifthe power utility is able to (i) maintain electricity production from local generation plants; (ii) improve its collections; and (iii) reduce its losses. Increasing energy-generation capacities presuppose the diversification of energy sources and active private-sector participation.To this end, Government has adopted a long-termenergy-sector development strategy, specifyingnew investments, with private-sectorparticipation, in generation capacity, includinga second thermal power plant, new hydro power plants, and the development of wind and solar power plants. Among various financing options, and given existing investors' interest, Governmentmight want to consider the full privatization of the power utility (also in light of competing public investment priorities elsewhere) as an alternative to the potential downsizing of investment projects and/or the lengtheninginthe implementationperiods, which might otherwisebe required. 9. For the transport sector, a detailed medium-term budgetary program should be developed as planning tool for prioritizing and sequencingpublic investments,placingthese within pre-specified fiscal constraints, while developing a set of criteria, carefully weighing costs and benefits, according to which decisions on the identification of projects are made. Sound feasibility studies are an essential tool, while appropriate project designs, which integrate measures to increase safety features and decrease maintenance requirements, can reduce future rehabilitation and/or safety improvement works. To the extent possible, carefully negotiated public-private partnerships (PPPs) can play an important role in realizing the investments, particularly for the highway project linking the port of Bar with Belgrade and the European Corridor 10. Ifthe private sector considers these projects as not being economically viable and private-sector co-financing is not forthcoming, Government will have to consider alternatives, includingthe phasing or scalingback ofthese projects.Internationalexperience shows that the structuring and procurementof complex PPP projects require time and, typically, a significant participationfrom the public sector to make the projects financially and economically viable. Given the difficult terrain and Montenegro's small market size, this is likely to prove a particularly binding constraint in the related contract negotiations.To realize the various transport-sectorPPPs, Montenegro needs a concession law that draws from best internationalpractice. 10. The road and railway sectors have long been underfunded, resulting in insufficient backlog, routine, and periodic maintenanceand delays in implementing some priority constructions.For the road sector, this has detrimentally affected safety, resulting in accident and fatality rates considerably higher than most countries in the region, with high social and economic costs. Public funds are roughly adequate to ensure proper routine and periodic maintenance, leavingunfundedboth backlogmaintenance and plans for the construction of new highways. Apart from efforts to increase the efficiency in the provision of maintenance services, possibly by means of outsourcing maintenance services, Government will, in all likelihood, be required to increase budgetary allocations and/or delay the implementation schedule for capitalprojects. Implications for the Wage Bill 1 1 . To create the needed fiscal space for these public investments, it is critical that the wage bill-the single-largest component in the current budget-be curtailed as a share of general government spending. Current levels are very high, even by regional standards. At 11.8 percent of GDP in 2006, the wage bill exceeded levels observed in neighboring countries and most o f the new EU member states. However, Government is exposed to increasing pressures to raise salaries in the public sector, which are partly motivated by the objective to remain competitive with the private sector. As a result, the wage bill is continuing to increase-with the 2008 ratio likely to exceed the outcome of 12.7 percent of GDP in 2007, for principally two reasons: vi 0 Large across-the-board wage increases have been granted in late 2007. Partly in reaction to increasing(food and electricity) prices, partly to catch up with wage developments in the private sector, Government agreed to a 30-percent increase in public sector wages. The effects of this decision-together with a 10-percent basic salary increase-will only become apparent in 2008 and subsequent years. To compound matters, the wage negotiation for civil servants in Montenegro itself is highly fragmented, allowing various labor unions to negotiate salary increases outside the control of the Finance Ministry and regular budget preparation processes. 0 Additional public-sector recruitment for reasons of EUintegration and decentralization has not been compensated with a corresponding decrease in staff or administrative structures elsewhere, resulting in an overly complex government organization. While Government effectiveness in Montenegro is still lower than among Eastern European and Baltic countries, it is improvingat considerably faster rates, thereby giving encouraging signs that determined efforts can and do pay off. 12. The authorities have already taken important steps towards reforming the public administration by adopting the Law on the Civil Service and implementing relevant regulations, including on those defining the civil-service salary system. A set of further policy measures will have to be implemented to (i)increase effectiveness and professionalismof the public administrationin key areas critical for achievingthe EU integrationobjective; (ii)prevent a "brain drain" towards the private sector amongthe high-skilled; and (iii)containthe overall expenses for public-sectoremployees to a levelthat is consistentwith the realizationof the Government's broader fiscal-policypriorities. 13. To achieve these objectives, Government should initiate a pay and grading reform. The current pay system-based largely on seniority-will need to be replaced by system that links remuneration to performance. The complex collective bargaining process needs to be streamlined. It should start earlier each year and be concluded before the regular budget preparation process. Over a more medium-term horizon, Government needs to reduce public employment in selected areas. Staff reduction could be achieved through a combination of attrition with a partial and selective hiring freeze. Similarly, there is scope for rationalizing the structure of government operations, which would presuppose a comprehensive functional review of the size, functions, and staffing of all government organizations.Government will need to develop policy criteriato facilitate decision-makingon whether a given function should be undertaken by central government or be dissolved, devolved to local government, or privatized. Non-civil servant positions in non-core functions could be transferred, by public tender, to the private sector. The main source of inherent cast savings would come from the increasedefficiency, with which the privatesector can performthese tasks. vii 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 deJined Europeanperspective representedfactors that allowed-once political uncertainties had been removed- for a surge of pent-up investment,fueling domestic demand and economic growth, at rates muchfaster 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 deJicit. These trends explain the unforeseen tax-revenue abundance, especially since Montenegro 's "regionally competitive" tax regime relies on trade as a primary source of Jiscal 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 fiaming 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 dificult) 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 toplay a key role. A. MACROECONOMICMANIFESTATION 1.1. In 2007, Montenegro was one of the world's fastest growing non-oil economies (see Figure 1.l)-a development that extended well into the first half o f 2008. Fueled by large inflows o f foreign capital, the country was able to build on an economic growth momentum that had begun to take hold in late 2005. The economic dynamism resulted in buoyant fiscal revenues and-with effective control over public expenditures in 20072-a very substantial overall surplus o f 7.1 percent o f GDP. However, unless similar spending discipline is maintained, future budgets risk being strained by revenue volatility, increased pressures on recurrent spending, and an insufficient ability to prioritize investments. 1.2. The strength of the post-independence recovery in 2007 exceeded all (published) projection^.^ This outcome reflected increased investors' confidence4 and the belief that the country was ' Prepared by Jan-Peter Olters (ECCME). As will be discussed below, some measures taken in 2007 and included in the supplementary budget (such as the across-the-board increase in public sector salaries) affected mostly the 2008 budget and had thus only relatively minor effects on the overall fiscal outturn in 2007. At end-2006, the consensus forecast for real growth in 2007 was about 6.0 percent, underpinning the tax-revenue projections in the 2007 budget; see also IMF (2006). According to current data, real GDP has grown by an estimated 10-12 percent in 2007. This document uses the preliminary-and very cautionary-Ministry of Finance estimate of 10.3 percent real growth in 2007. Montenegro's Statistical Office, MONSTAT, is expected to publish 2007 GDP estimates and growth rates in autumn 2008. In its 2008 Doing Business ranking, the World Bank Group ranked Montenegro 81st out of atotal of 178 countries, ahead of Serbia, Croatia, Greece, Bosnia-Herzegovina, and Albania. In the "protecting investors" sub-category, 1 on the right track-en route to becoming a full member of the European Union (EU) in the foreseeable future. The change in outlook followed propitious political factors, especially those surrounding the successful conclusion of state-buildingchallenges. Montenegro reaped the benefits from having laid the necessary economic foundations during the pre-independence years, during which period important structuralreformswere implementedand an ambitious privatizationagendapursued. 1.3. The economic boom was triggered by the injection of very considerable doses of liquidity into the Montenegrin economy-foreign direct investment (FDI) and credits to the economy; see Table 1.1. Table 1.1: Montenegro: Demand Stimuli, 2003-08 2003 2004 2005 2006 2007 2008-SI prel est (In millions ofeuro) Demandstimuli 106 1 128 6 4687 1,0903 2,3848 907.0 Gross FDI 43 8 52 7 392 7 644 3 1,007 7 465.8 Ofwhich real estate 5 3 I O 9 70 3 337 9 514 4 172.5 Increasein private-sectorcredits 62 3 75 9 76 0 446 0 1,377 1 441.3 Increasein external borrowing by banks 22 0 I 8 3 I 9 8 84 4 356 7 201.8 Increasein banks' domestic liabilities 40 4 57 6 56 2 361 6 1,0204 239.4 Gross domestic product 1,510 1 1,669 8 1,815 0 2,148 9 2,540 0 2.816.9 (In percent of annualizedGDP, unless otherwise indicated) Demandstimuli 7 0 7 7 25 8 50 7 93 9 64 4 Gross FDI 2 9 3 2 21 6 30 0 39 7 33 I Ofwhich real estate 0 4 0 7 3 9 15 7 20 3 12 2 Increase in private-sectorcredits 4 1 4 5 4 2 20 8 54 2 31 3 Increase in external borrowing by banks 1 5 I1 1 1 3 9 14 0 I 4 3 Increase in banks' domestic liabilities 2 7 3 5 3 1 I 6 8 40 2 1 7 0 RealGDP growth, year-on-year. in percent 2 5 4 4 4 2 8 6 I O 3 8.0 Sources: CBCG;Monstat;Ministry of Finance;and World Bank staff estimates. (i) Gross FDI represented 40 percent of GDP in 2007. The high-potential tourism sector- together with an open, low-tax, pro-business environment-attracted large inflows of FDI, with payments originating, in roughly equal shares, from the EU-15 member states, mini states and off-shore centers, countriesof the former Soviet Union, and others (Table 1.2). Apart from actual investments into an updated, modern hotel infrastructure, the purchase of real estate alone represented more than one-half of all investments.Already in 2006, no other country in Europe and Central Asia (ECA) managedto attract more per capita FDI than Montenegro (Figure 1.2)- prior to net per capita FDI having increased further by 14.7 percent, from 783 to 899 in 2007. Following strategic privatizations during pre-independence years (banks, telecommunications, Montenegro fared particularly well, ranking 19th.However, in the 2009 survey, Montenegrc+while staying ahead of its regionalcompetitors, except Albania-slipped to 90th rank (out of a total of 181 countries),largely on account of a relatively slower progress in addressingobstaclessurroundingconstructionpermits and registeringproperty.A new World Bank project, currently in the final stages of preparation,seeks to address corresponding obstacles and help to modernizereal-estateadministration and improvethe planningandpermittingsystem. 2 and heavy indu~try),~the uncontroversialinternationalrecognitionof independenceallowedpent- up investments to be realized.Thus, by 2007, nominal (euro-denominated) FDI stood at a level 2% times that of 2005-and considerably morethan 200 times that of 2001 (Figure 1.3). Table 1.2: Montenegro: Foreign Direct Investments,2001-07 2001 2002 2003 2004 2005 2006 (In percent of GDP) Foreign direct investments (net) ... ... 2.6 3.0 21.0 21.7 Outflow of investments ... , . . 0.3 0.1 0.7 8.3 Foreigndirect investments (gross) 0.4 5.6 2.9 3.2 21.6 30.0 (In millions of euro) Foreign direct investments (net) ... , . . 38.7 50.6 380.9 466.7 Outflow of investments .,. . . . 5.1 2.1 11.8 177.6 Foreign direct investments (gross) 4.7 76.4 43.8 52.7 392.7 644.3 1 Gross FDI by country groups (origin of transfers of funds 4.1 76.4 43.8 52.7 392.7 644.3 1 EU-I5 memberstates, excl dependencies I.2 69.5 16.4 11.7 140.0 181.7 Mini states and off-shorecenters' 0.0 I.3 9.7 10.9 20.7 128.0 Countries of the former Soviet Union 0.8 0.0 0.4 4.7 16.6 127.0 Countries in SoutheasternEurope2 1.5 4.3 15.2 17.9 36.2 50.4 Other countries and regions 1.1 1.4 2.I 7.5 179.2 157.3 By sector 4.7 76.4 43.8 52.7 392.7 644.3 1 In producingsectors -0.4 3.4 2.2 2.3 68.6 ... In service sectors 3.4 69.1 24.2 37.7 193.7 ... In financial organizations 1.7 3.8 12.1 1.8 60.1 ... For companiesand banks , . . ... ... 252.1 For shares in domestic companies ... ... ... 6.1 For domestically-owned real estate abroad ... ... ... ,.. ... 1.2 For stocks of publicly traded enterprises . . . ... ... , . . , . . 45.1 For domestically-owned assets abroad , . . ... ... , . . , . . 2.0 For real estate 0.0 0.0 5.3 10.9 70.3 337.9 ' Andorra. Bahamas. Bahrein, Barbados, Belize, Bermuda. British Virgin Islands, Cayman Islands, Cyprus, Gibraltar, Hong Kong, Kiribati, Kuwait, Lesotho. Liechtenstein, Macao, Malta, Marshall Islands, Mauritius, Monaco, Panama. Reunion, Saint Vincent and the Grenadines. SsLo Tome and Principe, Singapore. Surinam. Switzerland, Turks and Caicos Islands, United Arab Emirates. US Virgin Islands, Swaziland. and the Vatikan. ' Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Romania, Serbia. Slovenia, and Turkey. Source; CBCG: and World Bank staff estimates In the National Programfor Integration (NPI), the Government of Montenegro (2008a) states that more than 85 percentofthe state-ownedcapitalhas beensuccessfully privatizedso far. 3 d I Figure 1.3: Montenegro: Gross Foreign Direct Investment, 2002-07 45 T 90 40 \ 80 Real estate sales and privatizations 35 70 30 60 - ga e B 25 50 32 0 40 32 -v Real estate sales 30 ' (right-hand scale) 20 I O 0 0 2002 2003 2004 2005 2006 2007 Sources: CBCG; Ministry of Finance. Figure 1.4: Montenegro: Range of Weighted Average Lending Rates, September 2005-June 2008 14 Lendingrates 12 - . I O + 8 e, C - 6 Inflation rates 4 2 0 a 1 1 I 3 5 7 9 1 1 1 3 5 7 9 11 1 3 5 2005 2006 2007 2008 Sources; CBCG; Monstat; and World Bank staff estimates. 6 (ii) Domestic credit increased by more than 50 percentage points of GDP in 2007, private-sector credit by almost 49 percentagepoints; see Table 1.3. Several factors-including (i)thetransfer of bank ownership to the private sector; (ii)the large share of foreign-owned banks in Montenegro's financial sector; and (iii)favorable conditions on the international credit markets-permitted domestic banks to compete and lend aggressively, leading to a steady decline in (nominal) interest rates (Figures 1.4 and 1.5). The wealth effect stemming from the booming stock exchange (until mid-2007) and the real-estate market resulted in the doubling of deposits, from 0.9 billion at end-2006 to 1.8 billion a year later. With ample liquidity in international markets, foreign (mother) banks supported the domestic banks' decision to push lending to the economy. Thus, during the period between end-2006 and end-2007, the loan-deposit ratio increased from 87 percent to 122 percent. This implies that, in 2007, almost one-quarter o f the increase in credits to the economy was financed by bank credits from abroad-this alone represents a demand stimulus equivalent to 14 percent of GDP. Table 1.3: Montenegro: Credits, Deposits, and External Bank Debt, 2003-08 2003 2004 2005 2006 2007 2008-S1 (In percent of GDP) Stock of domestic credit 15.3 19.1 25.1 48.8 99.3 104.6 Stock of private-sector credit' 10.9 14.4 17.4 35.5 84.2 91.6 Deposits in bankingsector 11.7 13.0 22.0 40.9 69.0 65.2 Deposits by private sector' 3.5 3.3 5.9 13.1 30.3 31.9 Externalindebtednessby banks 2.2 3.1 4.0 7.3 20.2 25.4 Increasein domestic credit' 6.1 5.3 7.5 27.6 58.0 30.2 Increase in private-sector credit'I2 4.1 4.5 4.2 20.8 54.2 31.3 Increase in deposits in bankingsector' 2.0 2.4 10.1 22.2 34.4 5.9 Increase in depositsby private sector"' 1.1 0.1 2.9 8.1 19.2 9.I Increasein external indebtednessby banks' 1.5 1.1 1.1 3.9 14.0 14.3 (In millions of euro) Stock of domestic credit 23 1.7 319.4 454.7 1,048.7 2,521.9 2,947.2 Stock of private-sector credit' 164.7 240.6 316.6 762.6 2,139.7 2,581.O Deposits in bankingsector 176.6 217.3 400.2 878.3 1,752.2 1,835.2 Deposits by privatesector' 52.1 54.6 107.9 282.1 769.8 898.1 External indebtednessby banks 34.0 52.3 72.1 156.5 513.2 715.0 Increasein domestic credit 92.5 87.7 135.3 594.0 1,473.2 425.3 Increase in private-sector credit' 62.3 75.9 76.0 446.0 1,377.1 441.3 Increase in deposits in bankingsector 30.3 40.6 182.9 478.1 873.9 83.0 Increase in depositsby private sector' 16.5 2.4 53.3 174.1 487.8 128.3 Increase in external indebtednessby banks 22.0 18.3 19.8 84.4 356.7 201.8 (In percent) Increasein domestic credit' 66.4 37.9 42.3 130.6 140.5 33.7 Increase in private-sector credit',' 60.9 46.1 31.6 140.9 180.6 41.2 Stock of domestic credit, in percent of deposits 131.2 147.0 113.6 119.4 143.9 160.6 ' Stock of credit to the economy, in pct. of deposits 93.2 110.7 79.1 86.8 122.1 140.6 "Other non-financialcorporations" and "other resident sectors". 2 For 20084 1, in percent of annualized GDP or twice the percentageincrease for end-December to end-June. Sources; CBCG; and World Bank staff estimates. 7 Figure 1.5: Montenegro: Range of Real Weighted Average Lending Rates, September 2005-June 2008 12 3 Credit to the economy (right-handscale) 1 I O r highest Real lendingrates 8 I / . I 6 e 0 i 4 n n l l l I' / I e C 2 0 & 9 1 1 1 3 5 7 9 II 1 3 5 7 9 1 )05 2006 2007 2008 -2 -4 Source: Central Bank o f Montenegro; and World Bank staff estimates. 1.4. The economic boom has allowed basic social and income indicators to improve (Table 1.4). In particular, the number of employed has increased, representing about one-quarter of the population at end-2007, while the unemployment rate has fallen considerably, from 23 percent at end-2004 to 12 percent in late 2007. Average wages have grown by 16 and 32 percent in 2006 and 2007, respectively. While recorded poverty rates appear to have stagnated between 2005 and 2006 (there are no data yet for 2007), a recent World Bank (2008~)study has shown that the depth and severity of poverty has decreased, a presage of the potential of a more substantial decline of poverty rates in the next few years. According to the same study, inequalities in consumption and income have also declineda6 Table 1.4: Montenegro: Selected SocialIndicators; 2004-08 2004 2005 2006 2007 2008-SI est. Average wages (gross), in euro* Annual average 302.8 326.5 434.2 495.8 589.8 End of period 344.8 387.8 471.0 554.0 623-0 Average wages (net), in euro* Annual average 195.4 213.2 283.0 336.8 403.0 Endof period 226.3 253.7 307.0 376.0 425.0 Number of employed* 142,438 145,261 150,746 159,223 170,146 Number of unemployedt 58,950 48,825 38,876 31,469 29,088 Poverty rate, in percent Unemployment rate, in ercent+ P 22.4 18.5 14.7 11.9 11.0 .., 11.3 11.3 ... ... Average consumption of the poor as percent of average consumption ... 42.8 44.8 ... ... Gini coefficient' ... 0.259 0.243 ... . . # Sources: Monstat*; Employment Agency (ZZZ)+and World Bank (2008~)'. 6For a lack of data, Montenegro was not included in the UNDP's Human Development Index 2007108. 8 B. INHERENT RISKS 1.5. During the immediate post-independence period, Montenegro's economy has exhibited above-potentialgrowth trends. All the indicatorsof an impendingslowdown of the creditRD1-financed boom are present-widening current-account deficits, tightening labor markets, increasing wage pressures, and accelerating inflation rates. These developments are likely to be amplified by the concomitant deterioration in the international economic environment (Box 1.1). The sub-prime crisis, which originated in the United States, has led to a credit crunch on international financial markets. In addition, the increasingenergy and food prices risk undoing the initial success in improving the income and wealth distribution. 1.6. Most critically, however, forecasts for asset prices point downwards, both for stocks and real estate. Thus, removing the wealth affect from rising asset prices and projecting a considerable decrease in external capital inflows imply that, for both domestic and external reasons, economic activitieswill be less buoyant in the next few years than they had been during2006-07. (i) Stock-market indices in mid-2008 are less than one-half of what they had been at the peak of the cycle during mid-2007. Especially during the first six months of 2007, the two stock exchanges demonstrated an exceptional escalation in prices-far in excess of more established bourses (Figure 1.6). The wealth effect from the sale of (coastal) real estate (as well as bank credits) had fueled the stock-market boom at that time. Partly caused by a shift towards investments in physicalassets (in particular, houses and apartments in Podgoricaand elsewhere), funds were withdrawn from the stock markets, contributingto the decline of morethan 50 percent in stock-marketpricesbetweenmid-2007and June 2008. Figure 1.6: Montenegro: Stock ExchangeIndices: March2003-June 2008 1,200 , NEX PIF I\ (NEX Stock Exchange) g" l.000t i* MOSTE I $ (Montenegro 1 I 0 h Stock Exchange) 2 800i II !J& W NEX 20 (NEX Stock Exchange) 600 vi 0 0 N, 4X 400 C I 200 0 Source; CBCG; and World Bank staff estimates. 9 (ii) Real-estate prices appear to have reachedtheir peak, with the current price level permitting further increases-if at all-only in very few locations along the coast and, possibly, in the capital.' During the last two years, Montenegro found itself in the midst of a real-estate boom, primarily driven by Russian buyers. Real-estateagents reported price increases at par with and, in late 2007, exceeding those on the stock exchanges (Table 1,5). During 2006-07, foreign investors bought more than 850 million worth of real estate (an average 18 percent of GDP), notwithstanding the fact that not all obstacles surrounding land titles for previously expropriated lots had been fully resolved. The wealth effect from the real-estate sales led (i)to an inflow into (and, as of mid-2007, an outflow from) the two stock exchanges; (ii)a construction boom in Podgorica and elsewhere; and (iii)increased imports and a widening of the already large current- account deficit. The boom led to a situation in which-with an estimated average price of 1,738 per square meter-the prices for apartments and houses in Podgorica currently exceed those in Berlin or Beijing (Figure 1.7). There is not much space for further increases, and available indicators point to-possibly considerable-price corrections in Montenegrinreal estate. (iii) Main elements of FDI will wane. In particular, purchases of coastal real estate by non-residents represent more than one-half of total FDI in 2006 and 2007. With a coastline of 293 kilometers, the supply o f beachfront property is-per deJnitionem-finite,8 (iv) Domestic banks will not be able to lend to the private sector as aggressively as during the period 2006-07. Credit to the economy had grown at unprecedented rates and, in 2007, considerably faster than deposits. As indicated in Figure 1.8, this implied increased foreign borrowing by domestic banks abroad, often from their mother banks. Because o f the financial institutions' rapidly increasing exposure to external credits, Standard & Poor's rated the banking sector the riskiest in the region in August 2008. In its banking industry country risk assessment (BICRA), the rating agency included Montenegro in the so-called "Group 9" of countries with a "high level" of economic and credit risk.' This decision followed, for similar reasons, the adoption o f pre-emptive measures by the Central Bank of Montenegro (CBCG) more than half a year early. It implemented a set of measures aimed at strengthening prudential ratios reflected the fact that credits had been extended without commercial banks having had access to any central credit registry (which became operational in January 2008). In response to the inherent risks to portfolio quality and concerns about macroeconomic stability, the CBCG tightened definitions of prudential indicators" and, in so doing, helped to decelerate private-sector credit growth rates in 2008 (with an objective of having growth rates decelerate from more than 180 percent to about 7 See, e.g., Fabris and Kalezic (2008). They report a square meter price of 1,738.27 for Podgorica, 3,232.37 for Budva, 2,614.66 for HercegNovi, and2,145.60 for Tivat. 8 Principally, a similar argument could be made for privatization receipts-assuming that investors, without the available offers, would not have realized "green field" investments instead. The process of privatizing formerly state-owned enterprises and selling remaining Government shares in publicly (co-)owned enterprises is winding down. "Green field" investments, which will have to give the growth impetus in the medium term, have (thus far) remained disappointing;see also IMF (2008:16): "green field investment, which is instrumentalfor expanding the productivebase, accounted for a meager 10 percent oftotal FDI." This risk rating implies that, against the backdrop of the international financial crisis, liquidity available to Montenegrin banks might dry up faster and be unavailable for longer periods than currently expected. 10In late 2007, the CBCG tightened definitions of prudential indicators. In particular, it tightened the definition of minimumcriteriaand the procedures for the classificationof assets and off-balancesheet items (which expose banks to credit risks) and broadened the base for reserve requirements by including all public-sector sight deposits (previously,only those public-sectordeposits with a maturity of up to one year were included in the base for reserve requirements). The central bank defined solvency ratios as function of annual credit-growth rates, while setting credit-growthceilings of 30-60 percent relative to the stock of outstanding credits, thus grantinghigher growthrates to banks with a smaller loan portfolio. Twelve-monthgrowth rates thus decelerated from a peak o f 202 percent in October 2007 to 181 percent in December2007 and 98 percent in May 2008. 10 40 percent). If as successful as Figure 1.9 seems to indicate, the correspondingdemand stimulus will be considerablyless pronounced. Table 1.5: Coastal Montenegro:Average Percent Increasesin the Priceper Square Meter, 2005-07 Apartments Houses Plots Business premises 2005 2006 2007 2005 2006 2007 2005 2006 2007 2005 2006 2007 Average 53 91 80 39 101 133 109 246 64 46 81 107 UlcinjiLilqin 17 57 127 18 60 88 225 115 114 33 67 113 Bar 50 106 62 29 89 106 114 407 45 29 94 129 Petrovac 39 68 55 31 100 165 100 100 120 78 41 122 BeEiCi 43 60 119 29 91 138 88 233 50 41 88 100 Budva 47 82 75 41 133 79 106 243 -8 50 56 43 Tivat 25 93 124 29 118 108 83 218 100 44 52 186 Kotor 41 111 88 50 150 167 133 171 137 59 74 113 HercegNovi 75 162 64 50 133 114 67 400 10 41 171 85 Source; CEED Consulting (2007) Figure 1.7: ApartmentPricesPer SquareMeter in City Center,2007/08 9.000 8.000 Underlying exchange rate el =US$I 5s 7,000 -E 6.000 5.000 5 4.000 5 W 3,000 ---------------- Range provided hy CEED fir Pidgurrca ("i~erycenter o/town'1 2,000 ----- 1,000 0 Sources: Global Property Guide, 2008, "Most Expensive Cities in 2008"; and, for Podgorica, CBCG; and CEED Consulting (2007). 11 Box 1.1: HousingPrices, Credit Crunch, and the End to Economic Booms A credit-driven economic boom made Iceland the first victim of the global credit crunch. The island's narrow productionbase implies a high import propensity.The strong appreciation of the Icelandickronaduring2004-05, creatinga seizeablewealth effect, induced Icelandersto consume more, leadingto a very large current-account deficit (26 percent of GDP in 2006). The overall fiscal balanceremainedin surplus (6 percent of GDP in 2006). To finance the current-accountdeficit, the country's big banks borrowedinternationally, stretching themselvesbeyond their domestic depositor base. The demandpressuresledto increasinginflation, which resulted in interest ratesto be raised, leadingto a further strengtheningofthe currency. The boomburst with the globalcredit crunch. Triggeredby the U.S."sub-prime" crisis, Europeanbanks ceasedto lendto their Icelandiccounterparts. Inan effort to avert a full- blown crisis, the central bank secured swap agreements with the central banks of Denmark, Norway, and Sweden, which permittedit to exchangeIcelandickronur into euro up to a limit of500 million each. To bolster central bank reserves,parliament authorized government to borrow up to about4 billion. Falling U.S. housing prices triggered the "sub- prime" mortgage crisis, causing liquidity Figure 1.8: Real Growth, 2004-07 and 2008-41 shortages worldwide. Fueled by gains from an I 2 , earlier stock-market boom and readily available, low-interest mortgages, many lower-imiddle- income Americans became homeowners,counting on the ability to refinance existing mortgages against higher house-value estimates.The cooling of the real-estate market led to increasing default rates, especially on higher-risk mortgages (the so- called sub-prime market). More than 100 sub- prime mortgage lenders failed. Sub-prime debts had been included in various investment vehicles and traded internationally. The International Monetary Fund (IMF, 2008a) estimated that global losses from the crisis exceeded600 billion; and there is no end in sight. The 100 biggest banks alone lost 240 billion (Onaran, 2008). Many banks and mortgage lenders had to be bailed out. Even unaffectedbanks reined intheir lending, leadingto rising interest rates and widespread difficulty in maintainingcredit lines, affectingeven companies otherwiseentirely unrelatedto the crisis. Rapid rates of growth in real-estate prices tended to accompany the booms in the fastest growing Eastern European economies-together with bank credits from abroad. Many of the transition economies in Europe are thus being regarded as vulnerable to abrupt contractions. During previous years, countries as heterogeneous as the Baltic republics or Bulgaria(as much as Icelandand Ireland)have benefited from easy access to credit, low (or even negative) interest rates, and from the presence of foreign banks, meaning they could borrow from their respective mother banks (Edgeworth, 2008). With high rates of investment and consumer spending, these economies experienced prolonged periods of above-trendgrowth, accompaniedby tightening labor markets. Widespread wage and price pressures, asset bubbles (especially house prices), and the widening of current-account deficits have left these economies fragile and vulnerable to the effects from the current internationalcrisis. Academics have long stressed the pro-cyclical nature of private-sector credit. The "small shocks, large cycles" story first formalized by Bemanke et al. (1996) implied that economic downturns induced banks to engage in a "flight to quality". Relatively high-risk borrowers, including innovative SMEs, would bear the brunt of the contraction in bank lending. With fewer credits leading to lower rates of investment, Bernanke et al. (1996) demonstrated that high ratios of private-sector credit aggravated the effects from the credit cycle on the real economy. Braun and Larrain (2005) showed that (i)credit-dependent sectors were more sensitive to economy-wide recessions; and (ii)the financial mechanism was "asymmetric over the cycle, stronger during downturns than in booms, and especially strong when recessionsare accompaniedby credit crunches." The combination of adverse external shocks and the natural end to the economic expansion foreshadow a worsening of the financial conditions and increased vulnerability. As argued by Edgeworth (2008), in those countries where the credit boom had been biggest-viz., Estonia, Latvia, and Iceland-the contractionthus far has proven especially sharp. Compared to these countries, Montenegro's recent boom was considerably more pronounced, as exemplifiedby unparalleled rates of private-sector credit growth and a much larger current account deficit. 12 Figure 1.9: Montenegro:Depositsand Credits,December 20044une 2008 3.0 III i o.6 2.5 - 0.5 2.o 1.o 0.5 - 0.1 0.0 - 0.0 2005 2006 I 2007 Source; CBCG; and World Bank staff estimates. Figure1.10: Montenegro:Private-SectorCredit Growth,December 2004-June 2008 220 1 3.0 200 Private-sector credit growth (year-on-year) 180 - 2.5 (left-hand scale) y1 160 / l i ? 140 .r - 2.0 Eo $ 120 -358' I - 1.5 5 % 80 a5 - 1.0 60 1 ; 1 1 ' 1 1~ 1 I 40 Credit to the private sector - 0.5 20 1 (right-hand scale) I 1 1 ~ 0 + 0.0 I 2 I 2 3 4 5 6 7 8 9 1 0 1 1 I 2 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 2 3 4 5 6 2004 2005 2006 2007 2008 13 Box 1.2: Growth Engine Tourism FDI inflows reflect expectations that tourism demand will continue to increase at rates comparable to those seen in previous years. According to Government of Montenegro (2008~)figures, the number of foreign tourists increased by more than 45 percent in both 2005 and 2006 and by almost 55 percent in 2007, while tourists have tended to stay longer than in preceding years. The World Travel and Tourism Council (2008) has remained very optimistic about Montenegro's potential,expectingthe tourist sector to grow by 17.0 percent in 2008 and an average 5.6 percent during 2009-2018. The buoyancy in the sales of (coastal) real estate, leadingto considerable follow-up investments in refurbishing existing-or constructing new-hotels, apartments, and other tourist facilities, reflects this outlook. However, tourism demand tends to be unpredictable, and there are some weaknesses in the supply of Montenegro's tourism product. The World Economic Forum (2008a), in its 130-country study on tourism and travel competitiveness, highlighted two areas of particular concern that could render aforementioned tourism demand projectionsas overly optimist, viz., (i) environmental sustainability(where Montenegro ranked 105th); and (ii) price competitiveness (129th). Montenegro has traditionally attracted tourists that enjoyed its splendid nature, focusing its internationally broadcast advertisingstrategy on the Wild Beauty aspect of tourism supply. However, once the wilderness disappears (for instance, as a result of uncontrolled development), including those attractions advertised in official tourist brochures, tourists might reconsider their choice of destination-even more so if the relationbetweenprice and service is skewed andtourism supply uncompetitive.As tourism-relatedFDIis afunction o f existing supply constraints (as discussed above) and projectedtourism demand, a weaker-than-forecast tourism season could quickly translate into less exuberant expectations and, consequently, an ebbing stream of related foreign capital inflows. Economic policy decisions-with respect to macroeconomic management, the implementationof its tourism development strategy, and the uniform enforcement of the recently adopted spatial plan-will haveto be made with this in mind. Table 1.6: South Eastern Europe: Tourism and Travel Competiveness,2008 (Country rank of altogether 130 countries) Western Balkans Regional comparators MNE AL BiH MK SRB BG HR GR I SLO TR Overall index 59 92 105 83 78 43 34 22 28 36 54 Regulatory framework 53 81 98 93 73 50 39 17 41 42 56 Policy rules and regulations 37 104 109 75 59 85 66 61 57 87 43 Environmentalsustainability 105 93 113 84 128 73 41 40 39 17 90 Safety and security 53 71 57 60 76 90 41 31 81 20 79 Healthand hygiene 52 59 55 68 46 12 28 16 19 36 62 Prioritizationof travel and tourism 67 104 124 128 114 65 51 1 46 84 45 Businessenvironment and infrastructure 68 105 91 80 72 52 38 30 24 33 57 Air transport 54 112 124 113 92 101 66 20 26 70 44 Ground transport 71 116 115 79 86 77 54 46 40 23 63 Tourism infrastructure 31 86 59 61 52 22 10 9 4 20 50 ICT infrastructure 63 86 62 72 57 44 37 39 25 26 55 Price competitiveness 129 90 107 72 82 69 98 120 124 102 103 Human, cultural, and natural resources 45 71 117 81 68 31 32 18 15 61 44 Human resources 76 58 106 71 45 59 50 43 39 35 73 Affinity for travel and tourism 1 6 93 75 98 16 7 39 67 53 38 Naturalresources 69 130 120 85 112 59 68 75 60 76 79 Culturalresources 66 75 70 57 52 29 37 16 8 54 28 Source: World Economic Forum (2008a). 14 (v) The 2007 tourist season had been exceptional, partly because of the "newness" of the destination and a number of internationally significant cultural events. However, the materialization of public infrastructure bottlenecks during periods of peak demand, especially relatedto the provision of water and electricity, uncontrolled construction, and largely unresolved challenges of solid and liquid waste disposalmight deter (higher end) tourists from returning. As indicated in Box 1.2, the Montenegrintourism product is attractive only when compared to other destinations in the Western Balkans, but it is not yet competitive with more established tourist markets in the region. There are serious concerns regarding price competitiveness and environmental sustainability of Montenegro's tourist sector, foreshadowing a slowdown in growth from some key countries of origin." Preliminarydata for the 2008 summer season appear to corroboratethis. 1.7. The size of the external capital inflow, relative to GDP,was so substantialthat the economy gave clear indications of its difficulty in absorbing the additional demand. For tradable goods, the consequence was higher importsand a resultantwidening of the current-accountdeficit. For non-tradable goods and services, the additional, unmet demand let to higher pricesand acceleratinginflation rates. (i) The current-account deficit increased from 0.5 billion in 2006 (25 percent of GDP) to 1.0 billion in 2007 (40 percent). This ratio is higher than in any other country in the ECA region, with only a few tourist-dependent island economies having similar levels of current-account deficits; see Figure 1 In 2007, the current-account deficit (1,007.6 million) was fully financed by FDI (1,007.7 million), as was the case in 2006 (531.2 million vs. 644.3 million). A sudden-exogenously induced-decrease in foreign-capital inflows would lead to a corresponding decline in aggregate demand and, subsequently, a reduction in imports. Without the risk of an (expected) devaluation(as is the case in a standard fixed exchange-rate regime), the adjustment will be restrictedto the current account and spilloversto the fiscal sector (see below). (ii) Twelve-month inflation rates increased from 2 percent at end-2006 to 11.4 percent in June 2008. For non-tradable goods, excess demand resulted in price and wage pressures. Price increases affected not only energy and food prices (which have increased on a global scale) but also those for services in non-tradable sectors (representingthe market's reactingto developing supply bottlenecks). Similarly, rising wages for public-sector employees and, especially, skilled labor in the private sector foreshadow a considerable tighteningof the labor market and hrther- endogenous-price pressures in subsequent periods. " late2007, a In large, Western European tour operator removedMontenegroas a tourist destinationfrom its 2008 catalogue-reportedly for reasonsof excessive hotel prices, frequent tourist complaints about overcrowdedbeaches, incessantnocturnalnightclub noise, and other inconveniences. ''Preliminary first-quarter 2008 data by the CBCG show that the current-accountdeficit widened further to an estimated67 percent of GDP. This widening occurs against increaseddebt financing of the current-accountdeficit and the fact that, from November 2007, CBCG reserves-which had increasedby more than 200 percent since independence-started to decline, by 6 percent between November 2007 and June 2008. At end-2007, reserves coveredabout 7% monthsof importsofgoods andservices. 15 I -1 - z 0 m 0 0 N 0 0 0 0 -Y 0 0 p;' 3 s P C. FISCALPOLICIES 1.8. Given its 1999 euroization decision, Montenegro's only policy instrument of macroeconomic managementis fiscal policy (Box 1.3). As such, fiscal policy has to play a double function in ensuring continued macroeconomic stability and advancing and socio-economic development, both of which objectives-pulling in different directions-place considerable demands on policymakers. (0 Macroeconomic stabilization. Given Montenegro's increasing vulnerability to external factorsI3 and inherent characteristics of pro-~yclicality'~,fiscal policies need to be designed with a view to counterbalancing these effects if a boom-bust cycle is to be avoided. During 2006-07, Government was broadly successful, having posted sizeable overall fiscal surpluses. (ii) Socio-economic development. The Government is conscious of the weaknesses in public infrastructure, placing an undue burden on private-sector activities. It has thus devised an ambitious public investment program to address these challenges. As a result, sufficient fiscal space needs to be created in future budgets to ensure that these large-scale public investments, even if co-financed by the private sector, will be realized so as to be able to contribute to the increase in the productivity o f the private sector's invested capital and employed 1ab0r.I~To do this, Government needs to strictly control recurrent spending-and especially the wage bill, where there are considerable pressures to increase both staffing and wage rates. 1.9. The twin objectives of containing recurrent spending and implementing the integration- inspiredinstitutionalreform agenda can only be achieved by further increasingthe efficiency of the public administration. Without the ability to increase recurrent spending in real terms, a particular emphasis needs to be placed on accelerating the process of institutional modernization and implementing reforms that aim at ensuring increased efficiency at a given level of public spending. This is particularly relevant for the wage bill-given (i)additional demandsonthepublicsectorfor Europeanintegration and decentralization purposes, which require further recruitment in certain areas of public administration; (ii) accelerating prices for food and fuel, which have already resulted in mounting political pressure for 13 These vulnerabilities are particularly pronounced given the backdrop of large, but unsustainable elements of foreign direct investment and external private debt. l4 The import-relianttax regime, as discussed below, amplifies the pro-cyclicality in tax revenues, while the role of the real-estate market as source of external capital and the relative importance of credit to finance the private sector's investment and consumption add risks to large fluctuations in economic activities over the course of a businesscycle. l5Montenegro does not have a development strategy per se, which would help in defining criteria according to which Government could prioritize capital spendingpriorities. Sectoral strategies, to the degree that they have been developed, have yet to be comprised in a single strategy, including respective spending and financing profiles, and represented in a medium-term expenditure framework that would form the critical input into the annual budget preparation process. However, Government defined its overarching policy objective-wentual EU membership- and the necessary steps towards achieving that goal have, however, been devised by ministerial staff, debated in public, and approved by Government duringthe first halfof 2008. With its National Programfor Integration (NPI), the Government of Montenegro (2008a) seeks to define its strategic development objectives, including relevant policies, reforms, and measures required to accomplish these objectives. The NPI, includingthe timeline for reform implementation, has been presented as a detailed plan of activities necessary "to enable Montenegro to become ready to assume its commitments emanating from the EU membershipby the end of2012." With this document, the Government established a detailed agenda for the harmonization of Montenegrin legislation with EU standards. In addition, to support private-sector activities, the Government is taking the necessary steps to prepare large-scale public investments, including in the critical areas of energy and transport. 17 further across-the-board wage increases; and (iii)increased wage competition from the private sector, particularly for the highly skilled staff. As difficult as this challenge is, there is no alternative: not being able to contain the wage bill would, in the given context, jeopardize the Government's broader policy objectives, preventthe realization of the ambitious public investmentprogram, and create additional risks to macroeconomic stability. Box 1.3: The ReformAgenda: Economic Constraints and Political Objectives In the late 1990s, the Government combined measures of post-war economic recovery with those of creating an economic space separate from Serbia's. Economic stabilization and development objectives became a function of the unambiguously pro-European foreign-policy anchor, as manifested in the unilateral euroizationdecision in 1999.Confronted with the needto asphyxiate hyperinflationarypressuresprevailingin FR Yugoslavia's economy, placed under UN sanctions, the Government of Montenegro regularized the de facto dollarization and, independently from decisions taken in Belgrade, established its own central bank, adopted the Deutsche Mark (replacedby the euro in 2002) as legaltender, thereby re-establishingprice stability.* This step cemented earlier moves intended to insulate Montenegro's economy from the post-conflict instability in Serbia. Montenegro lowered customs tariffs, adopted a separate state budget, lifted visa requirements for foreign nationals (thereby provoking Serbia to establish border controls inside the state union), implemented an ambitious privatization agenda, introduced the value-added tax (VAT), and introduced a medium-term economic reform program. The undefined political status, however, prevented Montenegro from reaping the full benefits of this agenda, which in itself became an argument for the Government to push for political independence.Inthe pre-referendumpublic debate, it portrayed the state union's (political) constraints as principalhindrancetowards achievingMontenegro's Europeanintegrationobjectives. An economy burdened by sanctionsand constrained by decades of neglect of public infrastructure urgently requires large-scale investments from abroad. Tax policy became a central element in a strategy aimed at attractingforeign capital.Montenegro thus beganto engage in-what German-speaking economists refer to as- Standortwettbewerb, that is, the competition with neighboring countries over international capital, know-how, skills, and technology. The Government placed considerable emphasis on improving the overall business climate and, for that reason, engaged in regionaltax competition. * See, for instance, Fabris et al. (2004). The decision on, and the steps towards, unilateral euroization were taken without involvingthe IMF. Tax Policy: Providing a Pro-Business Environment 1.10. Like many other countries in Eastern Europe, Montenegro has been aggressively reducing its direct tax rates; see Table 1.6. In late 2006, the Government adopted a uniform 9 percent rate on corporate income (the lowest rate in Eastern Europe), effective as of mid-2007, and is planning to gradually reduce the personal income-tax rate from currently 15 percent to 9 percent by 2010. It eliminated capital gains taxationi6and kept social contributions at a minimum. As recent developments have shown, this decision has been very beneficial in terms of enhancing the relative attractiveness of Montenegro as site for (foreign) direct investments (and the Government's ability to strengthen tax administration). 1.1 1. At the same time, however, the flat tax has removed automatic stabilizers, making Montenegro's tax regime pro-cyclical. The low tax rates have made the budget more susceptible to external demand shocks and increased its reliance on imports as a source for fiscal revenues, which will amplify the variability of fiscal revenues over time. This point has a particular relevance in light of the 16 Any tax obligations from capital gains are waived if corresponding amounts are reinvested within a year. Otherwise, capitalgains are subject to the standard 9 percent corporate income tax. 18 underlying factors that have fueled the currently dynamic rates of economic growth. Two of these, in particular, are unsustainable and will wane over the medium-term horizon-viz. FDI in real estate (20 percent of GDP in 2007) and foreign borrowing by domestic banks (14 percent). Table 1.7: Montenegroand Neighboring Countries: Principal Tax Rates, 2008 Tax rate Tax base ALE BiH BUL CRO MKD SRB Corporatetax 9 0 Flat tax on corporateprofits; no separate 10.0 10.0 10.0 20.0 10.0 treatmentof capital gains; reinvested capital gains excluded from tax base. Withholding tax I 5 0 5 percent on interest income; 15 percenton 10.0 10.0 10.0 15.0 10.0 divident payments.royalties. capital gains, and rent from real-estateleasedto non-residents Personal income tax 15 0 As of 2007, progressive incometax replaced 10.0 depends on I O 0 4 brackets I O 0 by flat tax, In 2009, rates of 12percentare entltylcaniOn 15 - 45 foreseen and of 9 percent in 2010. Social sec conbibunons (employer: I S 0 Mandatory social insurance.gross personal 21 7 Fed 100 =21 17.2 0.0 Pension. health, unemployment income is base for calculation of conaibuhons. RS 420 Social sec conmbutions (employee I9 0 In 2007, employer pays 16.I percent and I12 Fed 28 0 = 13 0.0 II3 Pension. health. unemployment employee 20 percent In 2009, ratesare , RS 0 0 foreseento be lowered to 14.5 and 17 5 percent, and in 2010, to I 3 5 and 16 5 percent, respectively Value-addedtax 17 0 17 percent is the general VAT rate. 7 percent 20 0 I 7 0 20 0 (7 0) on social necessities. daily publications. computer equipment.marina services. exemption for exports and relatedservices, banking services, rental for and relatedservices, banking services, rental for I 10.0 vaned flats and builidngs for residential purposes, insurance renting of agncultural. forest. and construction land Source; Ministry of Finance; PriceWaterhouseCoopers(2008); and World Bank staff estimates. 1.12. During 2003-07, imports have increased in line with the unsustainableelements of capital inflows. As shown in Figure 1.I1, the regression slope implies that an exogenous change in the non- sustainable elements of external capital inflows" leads to a correspondingchange in imports. These, in turn, have a strong correlation with tax receipts-and, in particular, with those derived from the value- added tax. According to Figure 1.12, for every 100 million change in imports, there will be a 18.9 million effect on total tax revenues, which would imply that the 871 million in temporarily available external demandstimuli (TEDSFreal-estate sales and externalbank credits+orrespond to 165 million in, or 21 percent of, total tax revenues. These strongcorrelations help to explain the under projectionsof fiscal revenues for both the initial 2006 and 2007 budgets but, simultaneously, frame the risks of any medium-term fiscal strategy. In an adverse situation, Montenegro will encounter immense difficulty in rebalancingthe sources of its tax base, not least because the region as a whole is engaged in aggressive tax competition, limiting tax-policy options in instances of unanticipated fiscal shortfalls." Montenegro has gone further in the regional race to the bottom, implying that there could be a modest space for tax- policy adjustments, if needed-in particular, if it succeeds in improving the business climate by implementing crucial public infrastructure investments and strengtheningpublic administration, thereby removingthe necessityto engage in Standortwettbewerbover the lowesttax rates alone. Both real-estate purchases by non-residents and external bank credits are henceforth subsumed under the term "temporarily available external demand stimuli" (TEDS). 18 Current developments point to the opposite direction, as Montenegro's tax regime is to be made even more "competitive". The Government seeks to lower the rates for personal income taxes and social-securitycontributions (see Table 1.6)- 19 Figure 1.12: Montenegro: Temporarily Available External Demand Stimuli and Imports, 2003-07 IMg= 46 0 + 1 I53 TLDS R' =0 945 0 6 12 18 24 30 36 Temporarilyavailableexternal demand stimuli (TEDS), in percent of GDP Sources: CGCG, Monstat; and World Bank staff estimates. Figure 1.13: Montenegro: Imports and Tax Receipts, 2003-07 32 0 TTR =I 3 87 + 0 189 IMg R2=0898 40 48 56 64 72 80 88 Imports of goods (Uvl'), in percent of GDP Sources: Ministry of Finance; CGCG, Monstat; and World Bank staff estimates. 20 Expenditure Policy: IncreasingFactor Productivity 1.13. The principal economic policy challenge has consisted of raising total factor productivity (TFP). This places the relative weights of the wage bill and of capital expenditures at the center of the fiscal-policy debate. Relativeto other countries in the region, Montenegroshows higher shares for either category, both in terms of total expenditureand as a share of GDP (Table 1.7), implying tight budgets for maintenance. A policy geared towards increasing TFP needs to ensure that the rates of return on public infrastructure and social investments be increased, with a view to (i)crowding in private-sector investments in boththe tourist and non-tourist sector^;'^ and (ii)preparingthe economy to absorb a larger share of aggregate demand. In response, the Government has attempted to control expenditures on the wage bill, which increased by an average 11.6 percent in nominalterms during 2004-07 (Table lug),less than nominal GDP (14.0 percent). As a result, related expenditures declined both as a share of total expenditures, from 36.2 percent in 2004 to 27.9 percent in 2007, and in percent of GDP, from 14.5 percent in 2004 to 12.7 in 2007 (Table l.9).20Combining all budgetary expenditures directly benefiting individuals (that is, the wage bill, social-securitycontributions, and transfers to individuals), the relative share has declined from 72.2 percent of total expenditures in 2004 to 55.6 percent in 2007. This has left additional fiscal space for maintenanceand, in particular, public investments. Table 1.8: RegionalComparisonof Budget Structures, 2007 As share of total expenditures As share of GDP wage bill investments wage bill investments Montenegro 27.9 16.3 12.7 7.4 Weightedregionalaverage' 21.0 12.5 7.0 3.7 Unweightedregionalaverage 21.7 11.6 7.6 3.9 Albania 20.7 19.9 6.1 5.9 BosniaandHerzegovina 24.2 6.2 12.2 3.1 Bulgaria 16.6 16.1 6.2 5.9 Croatia 23.5 9.9 4.1 1.7 Estonia 17.9 10.1 6.4 3.6 Lithuania 29.1 9.6 9.9 3.2 Macedonia,FYR 20.5 11.9 7.0 4.1 Romania 18.8 10.5 6.3 3.6 Serbia 23.8 9.9 10.1 4.2 IWeightedby 2007 GDP(WE0 Database. April 2008). Sourc&; MoitenegrinMinistry of Finance;IMF(latest staff reports); and World Bank staff estimates. 1.14. Capital expenditures represent a steadily growing share of total expenditures, increasing from 4.6 percent in 2004 to 16.3 percent in 2007, while remaining insufficient for purposes of realizing the Government's ambitious public investmentplans. As a share of GDP, this represents an increase from 1.8 percent in 2004 to 7.4 percent in 2007. At the same time, the Governmenttook steps to strengthen public investments and finance these with proper resources. This reorientation in post-independence expenditure policies, made possible by abundant tax revenues and political efforts to control the (still large) wage bill, frames current fiscal-policy challenges. The comparison to countries in the region supports this view, as capital expenditures have risento a level that is favorableto that of other countries, 19 In mid-2007, the Government decided not to request program support from the IMF, largely because key representativesfelt that it would placeundueupper limitson public investments. 20 With a 30-percent increase in salaries granted late 2007, some of these gains will, however, be undone, partly reflectingtighteninglabor marketsandthe increasingcompetitionwiththe private sector. 21 while the wage bill-with the 28-percent ratio to total expenditures partly reflecting the small size of the country-remains several percentage pointsof total expenditures higherthan in neighboringcountries. 1,15. These trend shifts in expenditure support the Government's objective in preparing large- scale (public) infrastructure investments over the medium. They also reflect efforts to implement policiesconsistent with the recommendations containedin the previousPEIR (World Bank, 2006). In line with this report,the following measureswere implementedduring2007: (0 Reduce the cost of public employment, while modernizingpublic administration. As discussed in Chapter IV, Montenegro has been taking measures aimed at facing the double challenge of controlling the wage bill (also in light of rapid wage increases in the private sector), while strengtheningpublic administration in areas requiredfor structuralreforms, the realizationof the European integration objective, decentralization, and the modernization in health and education , as well as the administration of the pension and unemploymentfunds. Between 2002 and 2006, there has beena steady trend decrease in public-sectoremployment,which declinedby 12 percent during this quinquennium-from 48,67 1 to 42,873. However, the modernization objective resulted in an increase in public-sector employment in 2007, to 44,015, but mainly in areas crucial for the EU integration process, the judiciary (+343), for specialized agencies, the health, pension, and unemployment funds (+218), and for teachers and other education-sector staff (+132). Staff increases by local self-government(+459) accounted for 40 percent of the total rise, while representingonly about 10 percent of public-sectoremployment.Corrective measures took place in other areas: public-sectoremploymentwithin uniformed services, for instance, fell by 40 percent from 14,638 in 2002 to 8,676 in 2007. As such, public-sector employment fell from around 17%percent of the total labor force duringthe pre-independenceyears to about an average 16% percent in the post-independence years, with a declining trend. The wage bill, which averagedmore than 12 percent of GDP during 2003-05, has beenon a decliningtrend since 2004, representingabout 10.5 percent of GDP in 2007. (ii) Reform publicfinancial management andprocurement. In early 2008, the Governmentrequested a "Public Expenditure and FinancialAccountability" assessmentto frame further reforms in this area (World Bank, 2008d), having created the legal base (especially the organic budget law) and necessary public institutions (e.g., the State Audit Institution, the Directorate for Public Procurement, and the Commission for Supervising the Process of Public Procurement). Montenegro has made good progress towards implementinga program budget; this process is to be concluded with the 2009 state budget. (iii) Improve institutional capacity for public investment planning. While there is no comprehensive socio-economicdevelopment strategy in the classic sense of Poverty-ReductionStrategy Papers, with poverty assessments and a definition of overarching policy priorities, Government's recent publicationof a number of strategic documents, includingthose of a cross-sectoral nature (Table I . l O ) ,highlights its recognition that a full consistency in its policy framework needs to be assured, not least to guide the Government's progress towards achieving the country's principal politico-economic integration and socio-economic development objectives. The spatial plan outlines the geographic priorities and constraints, balancing goals of economic development and environmental protection, in itself a crucial input to Montenegro's longer-term sustainable development objectives. In several key sectors-particularly in energy-sectoral strategies have been developed that define expenditure need and the challenge to integrate capital expenditures with strategic partnerships with private enterprises(including in the transportand energy sectors). Especially in light of existing capacity constraints, Government officials view these longer-term documents increasingly as helpful internal monitoring devices that help them to achieve a consistent policy mix. 22 Table 1.9: Montenegro:ConsolidatedGeneralGovernment FiscalOperations,2003-07 (in millions of euro) 2003 2004 2005 2006 2007 Total revenues and grants 614 8 662 4 727 0 981 5 1,341 7 Total revenues 599 3 655 3 724 2 980 3 1,340 0 Current revenues 593 3 648 9 718 8 965 1 1,317 2 Taxes 344 2 378 3 439 2 554 5 782 9 Personal income tax 85 3 79 7 85 I 93 0 108 I Corporate income tax 13 4 I 6 5 21 3 12 7 39 I Taxes on property 6 3 3 8 5 0 24 9 40 2 Value added tax I37 2 158 I 193 4 273 2 393 2 Excises 58 2 61 5 65 6 72 4 94 5 Taxes on international trade 39 3 36 7 41 1 56 8 68 5 Local government taxes 4 4 20 5 24 0 17 I 32 6 Other taxes 0 0 1 6 3 7 4 5 6 7 Social security contributions I75 0 195 3 201 4 255 2 306 8 Contributions for pension. disability insurance 105 9 1159 1183 138 2 173 5 Contributions for health insurance 65 5 75 2 75 4 1106 125 5 Contributions for unemployment insurance 3 7 4 1 7 7 6 1 7 5 Other contributions 0 0 0 0 0 0 0 3 0 4 Nontax revenues 74 2 75 4 78 2 155 5 227 5 Duties 107 14 3 I 7 0 29 3 33 8 Administrative duties 2 7 5 7 6 6 9 3 II 6 Court duties 2 0 2 3 1 6 6 0 8 7 Residential duty 1 5 0 9 0 3 1 5 0 8 Local communal duties 3 6 4 2 7 3 10 6 9 3 Other duties 0 9 1 2 1 3 1 9 3 5 Fees 32 6 23 0 34 6 58 0 I22 7 Fees for use o f goods o f common interest I 6 6 3 9 8 9 3 8 6 9 Fees for use o f natural resources 0 0 0 0 0 0 3 5 3 7 Ecological fees 0 0 0 0 0 0 1 9 2 2 Fee for organizing games of chance 0 0 0 0 0 0 3 4 4 4 Fee for usage of construction land 14 3 I 6 6 12 3 8 0 15 7 Compensation for maintenance of local roads 1 4 1 6 12 7 3 2 4 8 Road fees 0 0 0 0 0 0 5 4 6 5 Other fees 0 3 0 9 0 7 28 9 78 5 Other revenues 30 9 38 1 26 6 68 2 71 0 Fines and seized property gains 0 1 0 2 0 2 7 9 1 1 7 Revenues from o w n activities o f government bodies 7 3 I 5 2 I I 9 32 0 23 0 Revenues from capital 0 1 3 1 4 1 8 2 18 7 Other revenues 23 4 19 6 I O 5 20 I 176 Receipts from repayment o f loans (from previous year) 6 0 6 4 5 4 15 I 22 8 Grants 15 5 7 1 2 9 1 2 1 7 Total expenditures and net lending 667 0 688 3 759 7 9170 1,161 0 Total expenditures 638 7 668 9 743 0 899 4 1,151 4 Current expenditures 317 2 365 I 372 3 445 4 565 3 Wage bill 2104 242 2 243 8 254 4 321 5 Gross salanes I90 4 219 8 226 4 234 5 287 8 Net salaries IO9 0 125 7 140 7 134 9 166 I Personal income tax 25 2 27 3 24 7 27 4 30 3 Social-security contributions 52 8 63 3 57 0 67 9 87 0 Contributions charged to employee 26 4 31 7 28 5 35 2 45 2 Contributions charged t o employer 26 4 31 7 28 5 32 7 41 8 Municipal surtax 3 5 3 5 4 1 4 3 4 4 Other personal income 20 0 22 4 174 19 8 33 7 Goods. services. and maintenance 56 5 71 9 87 5 152 3 188 6 Goods and services 56 5 71 9 87 5 I27 2 158 5 Current maintenance 0 0 0 0 0 0 25 I 30 1 Interest payments I 4 7 25 8 21 7 23 9 27 9 Rent 1 9 1 8 2 0 3 1 5 6 Subsidies t o enterpnses 23 2 13 7 I 2 7 6 6 13 9 Other outflows 10 5 9 7 4 7 5 1 7 8 Social secunty transfers 212 2 231 4 239 9 260 I 298 8 Of which pension and disability insurance rights 131 5 144 7 I47 4 I99 4 228 4 Other transfers 60 4 25 3 29 6 64 9 81 2 Transfers t o public institutions 12 4 I 3 2 12 3 29 2 38 5 Transfers t o N G O s 1 8 2 6 0 0 6 8 10 5 Transfers to individuals 14 6 9 6 I 7 3 22 1 19 5 Transfers t o public enterprises . 0 0 0 0 0 0 6 8 12 7 Transfers to Union budget 31 5 Capital expenditures 40 5 30 5 84 2 97 1 187 3 Reserves 8 4 16 7 17 1 32 1 19 0 Net lending 28 3 I 9 4 16 8 I 7 6 9 6 Loans and credits I 6 9 8 8 10 6 16 5 9 6 Repayment of guarantees 1 1 5 10 6 6 2 1 1 0 1 O\erall balance -52 2 -25 9 -32 7 64 5 180 7 Financing 52 2 25 9 32 7 -64 5 -1807 Sources Ministry of Finance. and World Bank staff estimates 23 Table 1.10: Montenegro:ConsolidatedGeneralGovernmentFiscalOperations,2003-07 (in percent of GDP) 2003 2004 2005 2006 2007 Total revenues and grants 40 7 39 7 40 1 45 7 52 8 Total revenues 39 7 39 2 39 9 45 6 52 8 Current revenues 39 3 38 9 39 6 44 9 51 9 Taxes 22 8 22 7 24 2 25 8 30 8 Personal income tax 5 7 4 8 4 7 4 3 4 3 Corporate income tax 0 9 I O 1 2 0 6 1 5 Taxes on property 0 4 0 2 0 3 1 2 1 6 Value added tax 9 1 9 5 I O 7 12 7 15 5 Excises 3 9 3 7 3 6 3 4 3 7 Taxes on international trade 2 6 2 2 2 3 2 6 2 7 Local government taxes 0 3 1 2 1 3 0 8 1 3 Other taxes 0 0 0 1 0 2 0 2 0 3 Social secunty contributions 1 1 6 II7 I 1 I 1 1 9 12 1 Contributions for pension, disability insurance 7 0 6 9 6 5 6 4 6 8 Contnbutions for health insurance 4 3 4 5 4 2 5 1 4 9 Contnbutions for unemployment insurance 0 2 0 2 0 4 0 3 0 3 Other contributions 0 0 0 0 0 0 0 0 0 0 Nontax revenues 4 9 4 5 4 3 7 2 9 0 Duties 0 7 0 9 0 9 1 4 1 3 Administrative duties 0 2 0 3 0 4 0 4 0 5 Court duties 0 1 0 1 0 1 0 3 0 3 Residential duty 0 1 0 1 0 0 0 1 0 0 Local communal duties 0 2 0 2 0 4 0 5 0 4 Other duties 0 1 0 1 0 1 0 1 0 1 Fees 2 2 1 4 I 9 2 7 4 8 Fees for use of goods of common interest I 1 0 2 0 5 0 2 0 3 Fees for use o f natural resources 0 0 0 0 0 0 0 2 0 1 Ecolopcal fees 0 0 0 0 0 0 0 1 0 1 Fee for organizing games o f chance 0 0 0 0 0 0 0 2 0 2 Fee for usage o f constmction land 0 9 1 0 0 7 0 4 0 6 Compensation for maintenance o f local roads 0 1 0 1 0 7 0 1 0 2 Road fees 0 0 0 0 0 0 0 3 0 3 Other fees 0 0 0 1 0 0 1 3 3 1 Other revenues 2 0 2 3 1 5 3 2 2 8 Fines and seized property gains 0 0 0 0 0 0 0 4 0 5 Revenues from own activities o f government bodir 0 5 0 9 0 7 1 5 0 9 Revenues from capital 0 0 0 2 0 2 0 4 0 7 Other revenues 1 6 1 2 0 6 0 9 0 7 Receipts from repayment of loans (from previous year) 0 4 0 4 0 3 0 7 0 9 Grants 1 0 0 4 0 2 0 1 0 1 Total expenditures and net lending 44 2 41 2 41 9 42 7 45 7 Total expenditures 42 3 40 1 40 9 41 9 45 3 Current expenditures 21 0 21 9 20 5 20 7 22 3 Wage bill 13 9 14 5 13 4 11 8 12 7 Gross salanes 12 6 13 2 12 5 I O 9 11 3 Net salanes 7 2 7 5 7 8 6 3 6 5 Personal income tax 1 7 1 6 1 4 1 3 1 2 Social-security Contnbutions 3 5 3 8 3 1 3 2 3 4 Conmbutions charged to employee 1 7 1 9 1 6 1 6 1 8 Contributions charged to employer 1 7 1 9 1 6 1 5 1 6 Municipal surtax 0 2 0 2 0 2 0 2 0 2 Other personal income 1 3 1 3 1 0 0 9 1 3 Goods, services, and maintenance 3 7 4 3 4 8 7 1 7 4 Goods and services 3 7 4 3 4 8 5 9 6 2 Current maintenance 0 0 0 0 0 0 I 2 I 2 Interest payments 1 0 1.5 1 2 I 1 I 1 Rent 0 1 0 1 0 1 0 1 0 2 Subsidies to enterprises 1 5 0 8 0 7 0 3 0 5 Other outflows 0 7 0 6 0 3 0 2 0 3 Social security transfers 14 I 13 9 I 3 2 12 I II8 Ofw hirh pension and disability insurance rights 8 7 8 7 8 1 9 3 9 0 Other transfers 4 0 1 5 1 6 3 0 3 2 Transfers to public institutions 0 8 0 8 0 7 1 4 1 5 Transfers to NGOs 0 1 0 2 0 0 0 3 0 4 Transfers to individuals I O 0 6 1 0 1 0 0 8 Transfers to public enterpnses 0 0 0 0 0 0 0 3 0 5 Transfers to Union budget 2 1 Capital expenditures 2 7 1 8 4 6 4 5 7 4 Reserves 0 6 I O 0 9 1 5 0 7 Net lending 1 9 1 2 0 9 0 8 0 4 Loans and credits 1 1 0 5 0 6 0 8 0 4 Repayment of guarantees 0 8 0 6 0 3 0 0 0 0 Overall balance -3 5 -1 6 -1 8 3 0 7 1 Financing 3 5 1 6 1 8 -3 0 -7 1 Sotircrs Mnistry of Finance. and World Bank staff estimates 24 Table 1.11: Montenegro: Strategies Adopted Since PEIR 1,2007-08 "National Programme for the Integrationof Apr 2008 Montenegrointothe EuropeanUnionfor the Governmentof Montenegro Period2008-20 12" Mar 2008 "Spatial Planof MontenegroUntil2020" Governmentof Montenegro "National ForestandForestLand Ministryof Agriculture, Forestry,and Mar 2008 Administration Policy" Water Management "Energy DevelopmentStrategy of Dec 2007 Montenegroby 2025: White Book" Ministryof EconomicDevelopment "Montenegro Economic and Fiscal Nov 2007 Programme2007-20 10" Ministryof Finance Source: Governmentof Montenegro. (iv) Monitor and control Jiscal risks beyond the national budget. During the previous year, the Montenegrin authorities have taken a number of steps containing fiscal risks, including by (a) integrating all extra-budgetary funds into the state budget and regulatory agencies and public enterprises into an appendix; (b) using60 million (2.4 percent of GDP) in unforeseen revenues to prepay external debt owed to the World Bank; (c) integrate130 million in disputed pension obligations into the fiscal program; and (d) limiting by law annual restitution payments from the budget to one-halfof a percent of GDP. In early 2008, against the backdropof continuously large fiscal surpluses, the Government offered holders of treasury bonds with a maturity to 2016 and 2017 to redeemthose prematurely. D. LOOKING FORWARD: CHALLENGESOF MANAGING BOOM THE 1.16. F r o m a macroeconomic point o f view, Montenegrin policymakers face several critical challenges that necessitate a holistic approach to the design o f fiscal policies in the medium term. Four developments, in particular,place constraintson any medium-termexpenditureframework. (i) Montenegro is not immune to the effects from the international financial crisis, foreshadowinga trend reversalinbanks' external indebtedness. (ii) Wealth effects from the stock and real-estate markets will dissipate and cease to fuel growth. With some lags, this shouldtranslateinto a trend reversalin imports as well. (iii) With a procyclical tax system, the possible decrease in imports will detrimentally affect tax revenues, largely because of the impact on the value-added tax. Aggressive regional tax competition limits the use of tax-policy instruments. (iv) Budgetary resources are insufficient to finance large-scale public infrastructure investments, necessitating close cooperation with the private sector and strict control over recurrentexpenditure. 25 Box 1.4: StrongStrategic Policy Anchors EU membership is a national consensus project and, as such, the overarching focal point of economic policy-making. The implementationof related reforms represents the country's first major policy challenge that does not cause a rift in the electorate and among the 16 political parties in the 81-member parliament (as has been the case with both the struggletowards statehood and the processtowards adoptingthe Constitution). The opposition is supportive and, if anything, apprehensive of the apparent lack of political commitment by Government to implementthe correspondingreforms in atimely manner. Delays in submitting the application for membership is a case in point. During the 2006 campaign for independence, statehood was represented as an integral component of a strategy aimed at accelerating EU integration. In the run-up to this watershed event, gradual steps had been taken in this direction for about a decade. Montenegro had sought to solve the post-war economic crisis by progressively increasingthe degree of economic (and, where possible, political) sovereignty. Even before the referendum on independence on May 21, 2008, Montenegro had largely acted as if it already were an independent state. Supported by 55% percent of the electorate, the country took the final step towards the final dissolution of the loose state union between Serbia and Montenegro, securing full international recognition (including by Serbia). The adoption of the Constitution in late 2007 formally concludedthe process of state- building, the irreversibility of which was confirmed by the results of the presidential elections in early April 2008. Montenegro seeks EUcandidate status as quickly as possible. Beyondthe political goal of EUmembership, the restrictivenessof Montenegro's internal market necessitates market-openingpolicies, and this gives the regional and EU integrationagenda a particular significance. As a result, an open trade regime, including low external tariffs, have complemented Montenegro's EU integrationagenda, the implementationof which is to secure the development of profitable niche markets, increased factor productivity, risk diversification, and improved income predictability. In politico-economic terms, Montenegro has lived up to its pre-independence promise and managed to accelerate the approximationprocess and to secure itself a pole position among the countries in Southeastern Europe. In late 2007, Montenegro signed and ratified the Stability and Association Agreement (SAA) with the EU, joining Albania, Croatia, and Macedoniaas the fourth SoutheasternEuropean country to have successfully concludedthe Stability and Association process (SAP). On various occasions, the Government has re-emphasizedits commitment to implementquickly all obligations spelt out in the SAA and InterimAgreement, while seekingto assurethe EU candidate status as soon as possible. Montenegro has prepared a special program for the implementation of reforms required under the SAA. To accelerate the implementation of various obligations spelt out in the SAA, and to harmonize Montenegro's legal framework with the EU's acquis communautaire, the Government has sought to engage its citizens in a public debate on this "national consensus" project. It compressedthe related reform agenda in a comprehensive 2008-1 2 National Program for Integration (NPI),+ which aims at (i) defining developmental and strategic objectives, together with corresponding policies, reforms, and measures; (ii)developing a detailed agenda for the legislation approximation and institutional capacity-building challenges; and (iii) defining the requiredresources for the successful implementationof the NPI reform agenda. Montenegroseeks to use the SAA implementationand the NPI as motivating argument to submit the formal applicationfor EU membershipduringthe French EU Presidencyin 2008-S2. * In mid-April 2008, following three years of negotiations, Montenegro and EU signed bilateral agreement on trade tariffs and the reciprocal opening of the services markets accession, thereby opening the doors for Montenegro's membership in the World Trade Organization. This agreement was widely seen as important support to economic and trade reforms and to meeting the Copenhagen economic criteria. t Every candidate country for EU membership has to prepare national plan for the adoption of acquis communautaire. The Government of Montenegro decided to combine the program for S A A implementation with the plan of adoption to the acquis communautaire in one single document. 26 1.17. Montenegro shows all the signs of above-trend growth. Following the country's decision to euroize, policymakers have to rely on fiscal policies as the one instrument that can help them to avoid a full-blown boom-bust cycle, A number of factors facilitate this otherwise difficult task, including (i) Government's commitment to overall fiscal surpluses (Government of Montenegro, 2008b); (ii) the continued reduction in the public debt-to-GDP ratio; (iii) a largely foreign-owned and fully private banking system; (iv) the relatively high share of credits extended to enterprises (rather than households); (v) increased central bank attention to the risk of excessive private-sectorgrowth rates; (vi) rising CBCG reserves; and (vii) a considerable number of privatizations (Table 1.11) and large-scale development concessions(including those along the southern shoreline). Table 1.12: Montenegro. Majority State-Owned Enterprises, April 2008 Nominal value State share Value of state share (in millions of euro) (in percent) (in millions of euro) State owned companies 1,691.0 63.8 1,078.1 Electroprivreda CG NikSiC Power utility 907.0 67.0 607.7 ieljeznice Crne Gore Railways 3 19.5 65.0 207.7 Jadransko brodogradiliste Bijela Shipyard 31.6 62.0 19.6 PIantate Vineyard 68.7 54.0 37.1 Luka Bar Harbor 134.0 54.0 72.3 Duvanski kombinat Podgorica Tobacco 19.8 51.1 10.1 Institut Dr Simo MiloSeviC Rehabilitation clinic 59.2 56.0 33.2 HTP Budvanska rivijera Tourism 69.6 58.7 40.9 HTP Ulcinjska rivijera Tourism 81.5 60.7 49.5 Source: Government of Montenegro (2008a). 1,18. External shocks coincidingwith a maturing boom could lead to a rapid deterioration in the overall economic outlook.The mainrisks include (i)spilloversfrom the internationalfinancial crisis and an end to inter-bank credits to financial institutions in Montenegro; (ii)an abrupt reorientationof foreign capital flows to investment destinations other than Montenegro; (iii) a weaker-than-expected tourist seasons, affecting expectations and confidence into the profitability of the Montenegrinmarket; and (iv) a faster-than-projected deterioration in international competitiveness. These factors would remove key sources of growth. 1.19. Fiscal policies play a key role in managing the economic cycle. As will be discussed in the subsequent chapters, the recompositionof public expenditure towards high-impact capital expenditure is critical to crowd in privatecapital and increasetotal factor productivity. It is thus crucially importantto (i) maintain a macroeconomic equilibrium and financial stability; (ii) sustain the momentum towards European integration, including with the timely adoption and careful implementation of required structural reforms; and (iii)provide the private sector with an overall environment, including public infrastructurethat remains conducive to continuouslyhigh rates of foreign direct investment. 1.20. High overall fiscal surpluses are deceptive. Given the unusual importance of unsustainable growth stimuli, decisions on (re)current expenditure need to be made relative to revenues that can be maintained even after these special factors have dissipated. This necessitates a strict focus on the structural balance between "permanent" tax revenues (not dependent on temporary factors) and current expenditures-cum-maintenance investments. As will be shown in Chapter 11, the Finance Ministry's 27 advocated strategy of limiting current expenditure to the projected rates of inflation and public investments to nominal GDP growth is clearly a step in the right direction-an important step towards adhering to the advice given by Solow (1974) to those policymakersunlucky enough to be in charge of managing economies abundantly endowed with natural resources: "Someone ...must always be taking the long view. They [sic] must somehow notice in advance that the resource economy is moving along a path that is bound to end in disequilibrium of some extreme kind. Ifthey do notice it, and take defensive actions, they will help steer the economy from the wrong path toward the right one." 1.21. The analysis contained in this second volume of the Public Expenditure and Institutional Review (PEIR-2) aims at contributingto the ongoing debate on a consistent medium-term policy framework. The PEIR-2 will orient its analysis towards the overarching policy objectives of (i) maintaining a sustainable fiscal policy stance; (ii) enhancing the strategic resource allocation of public funds, with a view to improving the overall business climate and total factor productivity; and (iii) developing operational criteria needed to improve the budgetary composition and fiscal prioritization for a given level of public expenditure. Implicit in these objectives are attempts to avoid a strongly pro- cyclical policy stance. Experienceelsewhere has shown that boom-bust cycles impose disproportionate costs to the already most disadvantaged segments of society2' in instances, in which the boom busts, reverting any progress already made in socio-economic development. Recent contributions in political economy view strongly pro-cyclical fiscal-policy stances as reflecting substantial and unresolved deficienciesin governance.22 2 'Boom-and-bust cycles tend to imply an abrupt, often haphazard tightening in fiscal policy, with the result that income and wealth inequalities widen, thereby reversingany momentum towards increasing living standards; see, '*See for instance, Jensen and Rutherford(2002) and Baldacci,de Mello, and lnchauste (2006). Alesina and Tabellini (2005). The authors test a political economy model, finding that pro-cyclicality phenomenon by arguing that voters do not trust corrupt Government with resources and, therefore, demand-when the economy is hit by positive shocks-tax cuts, increases in productiveGovernment spending, or transfers because they fear that, otherwise, available resources would be "wasted" in rents. 28 2. FISCAL CONSTRAINTS AND GOLDEN RULES23 This chapter describes how broadprinciples underlying the design offiscal 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 offlexibility 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 thefiscal criteria in the Growth and Stability Pact are binding. Second, tax revenues net of those derived ?om temporary factors need to be able to finance current expenditure (implying that Government can only borrow tofinance investments). This "modfied 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 (0 a buffer for abrupt economic downturns; and (ii) an increasingly largerfiscal spacefor 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; (io a clearly defined fiscal space for public investments; and (iig and fiscal incentives for the acceleration of institutional reforms aimed at increasing the effectiveness of public administration. Thefiscal discipline inherent in this approach should result in the gradual decline in sovereign riskpremia and an eventual upgrading of Montenegro 's grades by international credit rating agencies. A. INTRODUCTION 2.1. Future economic developments cannot be forecast as a simple linear extension of current trends. As argued in Chapter I,key factors that have underpinned Montenegro's impressive post- independencegrowth-and, with it, its currentfiscal-revenueabundance-will dissipate over the medium term, particularly (i) the sales of (coastal) real estate; and (ii) external borrowing by commercial banks.24 Largely because these two factors hinge on a number of exogenous developments closely tied to, and affected by, the financial crisis currently unfolding in international capital markets, it is extremely difficult to forecast the timing and abruptness of their eventual disappearance. The effects on the Montenegrin economy, however, can be expected to be considerable. In 2007, these two factors represented an injection of liquidity to the economy of about 34 percent of GDP, following an already extraordinaryyear with capital inflows equivalentto 20 percent of GDP in 2006. This chapter will look at the fiscal implications of two alternative scenarios around a base-caseprojection-an optimistic scenario with a gradual adjustment in temporarily availableexternaldemand stimuli (TEDS) and a pessimistic one with an abrupt end to these externalcapital inflows. 2.2. Montenegro is not alone in having to manage large-but only temporary-streams of revenue. Whether for reasons of (i)creating pre-electoralbooms, as suggested by models in the tradition of Nordhaus' (1975) political business cycle; (ii) strategic debt accumulation (Persson and Svensson, 23Preparedby Jan-Peter Olters (ECCME). 24These two factors will be subsumedunder the term "temporarily available external demand stimuli" (TEDS). 29 1989); and/or (iii)mollifying voters' suspicions regarding underlying government motives (Alesina and Tabellini, 2005),25policymakers are faced with numerous (short-term) incentives to spend more duringan upswing than they will be able to maintain during downturns. Depending on the existing level of public indebtedness and the country's international creditworthiness,26 the inherent cyclicality in economic development is frequently amplified by the risk aversion in capital markets. While in good times, many countries (including their financial sectors) find it relatively easy to borrow externally, in bad times, when credits would be needed most, they can do so at only prohibitively high interest rates or not at all (Gavin and Perotti, 1997). The Iceland example discussed in Box 1.1 i s a case in point. Any such situation tends to result in a situation that requires policymakers to agree on ad hoc spending cuts, typically at the expense of those items that have the highest impact on socio-economic de~elopment.~'Such a response would delay the achievement of the Government of Montenegro's (2008a) underlying policy objectives, as these fiscal contractions preclude the (timely) implementation o f the highest-priority public investment plans. Economic history is littered with such examples (see, e.g., Jensen and Rutherford, 2002, and Baldacci et al., 2006). 2.3. At this point in Montenegro's economic cycle, the principal fiscal-policy challenge consists of ensuring that future budgets will provide sufficient budgetary space for public investments.As discussed in Chapter I,large capital inflows and essentially proportional increases in imports (Figure 1.1 1) have permitted Government to collect tax revenues at levels far above budgetary projections.28 Looking forward, it is crucial to ensurethat recurrent ("permanent") spending obligations are not financed by temporary sources of income. Figure 2.1 summarizes the corresponding threat to macroeconomic stability and fiscal sustainability. It represents recent fiscal developments-in a stylized manner-to the left o f the vertical line. To its right, it outlines the inherent risks stemming from the temporary nature of the current boom. The Ministry of Finance recognized this explicitly on several occasions and considered implications in its internal macroeconomic simulation^,^^ concurring that a forward-looking fiscal strategy 25A recent survey of political economymodels can be found in Olters (2004). 26For internationalcapital market, Montenegro's sovereign credit risk is not yet investment grade, thus increasing the risk andor cost of borrowing in an economic downturn. At the moment, Standard & Poor's has rated Montenegro stable at a high non-investment grade (BB+ on its long-termand B on its short-term debt), emphasizing the inherent risks stemming from external imbalances caused by rapid credit growth and rising incomes, while noting strong growth, the government's budgetary surplus, political stability, and good prospects for EU accession. Moody's assigned a Baal country ceiling for long-term foreign currency debt (low investment grade) and a Ba2 issuer rating for the foreign currency debt obligations by government (high speculative grade). The agency had warned Montenegro that its economy had to remain sufficiently flexible to cope with any change in investors' sentiment that could lead to an outflow of capital, adding that such an event would force a real adjustment in the economy that could be severe. Over the longer-term, Moody's argued that structural reform would be critical for improvingproductivity and raising incomestowards the Europeanaverage. 27Many budgetary items-such as the wage bill or interest payments-are pre-committedand cannot be cut quickly. This implies that, in such instances, capitalexpenditures and social benefits are the first items to be adjusted, at great cost to a country's socio-economic development potential. 28In 2007, realized tax revenues exceeded the initial budget by more than 30 percent, which Government succeeded in translating into considerable overall fiscal surpluses-despite adoption of a supplementary budget in late 2007 that increasedcurrent spendingby 2 percentagepointsof GDP. 29For instance, in his opening Speech for a seminar on Strategic Planning and Medium-Term Budget Framework on April 23, 2008, Finance Minister LukSiC (2008) stressed that, "the boom that occurs when foreign capital first arrives is temporary in nature and this period must be usedto put the economy, and the government's finances, on a solid medium-term footing. High wage increases could undermine the medium-term competitiveness of the economy and the temporary surplus in the budget must not lead to high and unsustainable levels of government expenditure." On the same occasion, O'Callaghan (2008) presented a macroeconomic model that quantified (i)the temporary nature of FDI; (ii)the close correspondence between FDI and imports; and (iii) the resultant temporary 30 needs to take into account the pro-cyclical nature of the underlying tax regime and the degree to which external demand stimuli are sustainable (Figure 2.2). Figure2.1: InherentRisks to Long-TermFiscalDynamics Total tax raenues Budgetarq expznditure alongside establishedexpenditurepath (andwithout further commitments) Budgetq evpendmie path with long-term vision and without needfor abrupt adjustments I 1I ____ _____-_____ _________ Figure2.2: Montenegro:Stylized (First-Round) Pass-Through of ForeignCapital Inflow Exogenour strmuir Foreign capital inflows likely to continue L'nsustainableexternal demundstimuli (EDS) Foreigncapital surge in VAT revenues. Similarly, in Government of Montenegro (2008b), it was arguedthat the main potential risk Montenegro was exposed to the sudden decrease o f economic growth due to its great dependency to fluctuations within several economic sectors. 31 2.4. This chapter seeks to frame a sustainable, forward-looking fiscal strategy. Such a fiscal- policy approach needs to (i)maintainmacroeconomicstability; (ii)increase total factor productivity and advance socio-economic development; and (iii) be sufficiently flexible to react to potentially large external shocks. Section B will thus estimate the impact of temporary factors on tax revenues. SectionC looks at options to devise a sustainable strategy, weighing the inherent advantages and disadvantages of possiblefiscal benchmarks underlyingsuch a framework. Section D concludes, while placingChapters 111 and IV into the contextof a medium-termfiscal strategy. B. STRUCTURALTAXREVENUES 2.5. Fiscal policies are currently being described by a combination of large overall fiscal surpluses and modest structural deficits. Analogous to Figure 2.1, the structural balance captures the difference between budgetary revenues net of tax receipts derived from temporary factors (in this case, the TEDS) and total expenditures. Applying this definition, Montenegro has maintained a moderate structural deficit, averaging about 2.2 percent of GDP during 2003-07. In 2007, this deficit was even lower, at about 0.8 percent of GDP. As summarized in Table 2.1, tax revenues from TEDS-financed imports represented about 26 percent of total tax revenues (or 8 percent of GDP). This implies that the Ministry of Finance would have had to absorb a tax revenue shortfall of about 200 million ifthe TEDS had not materializedin 2007.30 2.6. A more relevant indicator is the current structural balance, for which Government could post a modest surplus during both boom years (Table 2.1). The structural balance rule removes cyclical effects-tax revenues from TEDS-financed imports-from government revenue, while the current balance expresses expenditures net of investments.In assessing the fiscal stance of an economy benefitingfrom temporary streams of reven~e,~'it is crucial to see that these transient sources of finance do not translate into permanent spending obligations, which cannot be maintained on the downward- sloping portion of the business cycle. The current structural balance (the difference between budgetary revenues net of temporary tax receipts and total expenditures net of public investments) is such a measure. Montenegro has been able, on average, to pay its current obligations with structural fiscal revenues. During 2006-07, the Finance Ministry could post an average current structural surplus of 4.8 percent of GDP, considerablyimprovedfrom the average 0.1-percent surplus posted during 2003-05. 30This result has beencalculated on the basis of estimates summarizedin Figure2.3, with an estimatedslope for the trend line of0.231. 31For this reason, privatization revenuesare typically recorded below the line. 32 Table 2.1: Montenegro: Structural Fiscal Balance,2003-07 (in millions of euro; unless otherwiseindicated) 2003 2004 2005 2006 2007 Overall fiscal balance -52.2 -25.9 -32.7 64.5 180.7 Inpercent of GDP -3.5 -1.6 -1.8 3.0 7.1 Unsustainable external demand stimuli (EDS) 27.3 29.2 90.2 422.3 871.1 Real estate sales 5.3 10.9 70.3 337.9 514.4 External bank credits 22.0 18.3 19.8 84.4 356.7 Related tax revenues 6.3 6.7 20.8 97.5 201.o Structural fiscal balance -58.5 -32.7 -53.5 -33.0 -20.4 In percent of GDP -3.9 -2.0 -2.9 -1.5 -0.8 Capital expenditures 40.5 30.5 84.2 97.1 187.3 In percent of GDP 2.7 1.8 4.6 4.5 7.4 Current structural balance -18.0 -2.2 30.6 64.1 166.9 In percent of GDP -1.2 -0.1 1.7 3.0 6.6 Source: Montenegrin authorities; and World Bank staff estimations. Figure 2.3: Montenegro: Non-SustainableExternalDemand Stimuli and Tax Receipts,2003-07 TTR = 22 4 + 0 231 TEDS Rz=0956 VAT = 8 0 + 0 226 TEDS R2=0910 0 6 12 18 24 30 36 Temporarilyavailable externaldemandstimuli (TEDS), in percent of GDP 33 C. MEDIUM-TERMFISCAL PROGRAMMING 2.7. Looking forward, policymakers would benefit from clear benchmarks against which to judge the implementation of fiscal policy. A Government's definition of, and its political commitment to, such a "fiscal anchor" would allow policymakersto (i) strengthen fiscal credibility; (ii) help to reduce sovereign risk premiaby improvingthe country's standing vis-a-vis internationalcredit agencies; and (iii) lengthen investors' confidence and time horizons. By devising a long-termapproach to fiscal discipline, Government would permit parliamentarians, the public, and potential investors to measure fiscal-policy implementation, distinguish sound and forward-looking fiscal policies from short-sightedones designed to address only immediate demands, and assess the degree of fiscal consolidationthat would be required for development and sustainabilityreasons. 2.8. A sustainablefiscal-policy approach in a small, open economy with a few dominant sectors susceptible to exogenous shocks requires a less pro-cyclical and a somewhat more flexible policy rule than a simple balanced-budget requirement. The high degree of pro-cyclicality inherent in Montenegro's tax regime and the large public investmentprogram suggest designing fiscal policies over the course of an entire economic cycle, with a view to maintaining an average overall surplus, while targeting growth rates of current expenditure. The three guidelines summarized below represent one possibility of such a policy anchor that would help to ensure a sufficient degree of fiscal discipline, preclude a strongly pro-cyclical fiscal-policy stance, and ensure sufficient fiscal space for large-scale public investment projects. (i) Fiscal policy stays within the criteria dejhed in the Stability and Growth Pact (SGP). Two key policy decisions-the unilateral euroization in 2000 and the ratification of the SAA in 2007- define the Montenegro's broader fiscal framework. As it seeks to join the EU and eventually formalize the use of the euro, Montenegro will have to shadow the obligations spelt out in the Stability and Growth Pact (SGP). This agreement on the conduct of fiscal policy, adopted in 1997, outlined policy principles considered essential to maintain the Economic and Monetary Union. SGP signatories sought to ensure that fiscal discipline would be maintainedand enforced by all member states that have adoptingthe euro, defining as policy objective a balanced budget over the span of a business cycle. Montenegro's particular position vis-a-vis EU institutions define the implicitly bindingnature of the fiscal criteria, which limit (i) the overall annual budget deficit of general government to 3 percent of GDP; and (ii)public debt to 60 percent of GDP (or approaching that value).32 (ii) The current structural balance remains in surplus. This "modified golden rule" specifies that borrowing cannot exceed capital expenditure. As such, this fiscal-policy principle could be thought of as a "permanent" anchor. (iii) The ratio of recurrent expenditure to GDP declines gradually. The simulations derived for illustrative purposes are based on the assumption that recurrent spending is kept constant in real terms-with a view to creatingthe fiscal space necessary for the implementationof the ambitious 32 Given Montenegro's end-2007 debt-to-GDPratio o f about one-half the SGP limit, committing to the deficit criterion implies that-under moderately pessimistic assumptions of nominal growth rates and budget deficits-the debt-to-GDPratio should not increasebeyondthe current level. For example, Montenegrocould theoretically have a 3(2)-percent budget deficit every single year and keep the debt-to-GDPratio constant, provided that nominal GDP grew at annual rates slightly higher than 11 (7) percent. Since 2004, fiscal policies have remained consistently within SGP limits. In a worst-case scenario, with the aforementioned unsustainable external capital inflows dissipatingabruptly, Governmentwill have to curtail public investmentsas well to stay within the limits spelt out in the SGP. 34 public investment program. Following its implementation, this rule can be relaxed to avoid a situation, in which the state becomes"too small." 2.9. The adoption of appropriate fiscal benchmarks-together with measures to access private-sector capital-could contribute to the development of a consistent policy framework over the businesscycle. As argued in Box 2.1, public-privatepartnerships (PPPs) can form a critical element in a strategy aimed at fostering economic diversification and growth, by helpingGovernment to accelerate the implementationof important public investments beyondthe capacity of state budgets. However, as seen elsewhere, PPPs are not a panacea and-if ill-designed-contain large and uncontrollable contingent liabilities. Still, these arrangements could nicely complement a possible decision on the use of explicit fiscal rules (Box 2.2), adopted with a view to reducing Government's ability to pursue excessively discretionary fiscal policies and protecting (and improving) the country's internationalcreditworthiness. 2.10. Current expenditures should not exceed a level that can be financed with sustainable budgetary resources. Analogous to the way the privatization receipts are recorded"below the line", commitments on recurrent spending obligations must not exceed revenues that can be permanently expected. A fiscal-policy anchor of this type would be particularly binding during boom periods as it aims at precludingthe need for sharp adjustments in expenditures during less favorableperiodswhile, more generally, enshrining the principle that any government borrowing can only occur to finance investments. In that, it is related to the "Golden Rule" discussed in Box 2.1. Inversely, such an approach would not be inconsistent with overall fiscal deficits during periods of relative stagnation, thereby ensuring that Government can continue to implement (multi-annual) public investment projects over the course of a business cycle. This is a critical condition for reasons of macroeconomic management(allowing government spending to be counter-cyclical) and socio-economicdevelopment (given that capitalexpenditures tend to be the spending itemswith the highest impacton future growth potentials). Especially given the size of the public investments, Government has to ensure a surplus over the course of an economic cycle. 2.1 1. The ambitious plans for the large-scale public investments can only be realized if sufficient fiscal space is ensured. This section will thus discuss a central projection with two surrounding policy scenarios-a pessimistic outlook (the TEDS come to an abrupt and complete end in 2009) and an optimistic one (with a gradual waning of these factors). In all likelihood, the realized decelerationin these two sources of capital inflows will be somewhere between these two scenarios. For the purpose of the policy simulations, the following assumptions have been made, includingthose on underlyingfiscal rules for budgetingof currentand capitalexpenditures. (i) Real-estate sales to foreigners. As argued above, much property along the 293-kilometer coastline has already been sold. Many factors-both exogenous and those under the control of Government (public infrastructure,control of illegal construction, and property registration)- will affect this market, complicating the task of accurate forecasts. Under the optimistic scenario, it will be assumed that Montenegro will be able to maintain real-estate sales at the nominal level realized in 2007 (514.4 million). As summarized in Table 2.3a, as a share of GDP, this implies a gradual reductionfrom 16.9 percent in 2008 to 10.2 percent in 2012. In the pessimistic scenario, real-estate sales in 2008 will be no more than 300million, and there will be no further real-estate sales to foreignersduring 2009-12 (Table 2.3b). The base-casescenario just lies between these two assumptions(Table 2.2). (ii) External bank borrowing. Here as well, a number of factors affect the ultimate path of external bank borrowing by domestic banks. These include changes to domestic credit demand, deposit growth, and central bank policy as well as the ultimate consequences from the international 35 credit crunch on Montenegro's economy. While there are-as discussed above-already some indicationsas to the decelerationin deposit and private-sectorcredit growth, it can be expected that effects will become more visible during the second half of 2008 and during the following years. In the optimistic scenario, it will thus be assumed that banks increase their stock of debt vis-a-vis foreign banks by altogether300 million (this impliesthat the increase in external bank borrowing by banks during the second semester of 2008 will be one-half of the increase seen during the first six months). In subsequent years, the nominal increase in external borrowing is assumedto be one- half of that in the respective previous year. In the pessimistic scenario, there will not be any external borrowing by the commercial banks after September 2008, implying an estimated amount of additional external bank debt of 220 million in 2008 and zero thereafter. As before, the base- case scenario assumes a path of external bank borrowing between these two extremes. Figure 2.4 summarizes the combinedeffects of the TEDS disappearance. (iii) Recurrent expenditures.As discussed above, a number of factors (public sector wage increases, pensionarrears, and restitutionclaims) have led to an increase in current expenditurein 2008. For 2009-1 2, current expenditurewill be held constant in real terms, thus implying a gradual decrease in the share of current expenditureto GDP. Whether or not Government-if it decided to adhere to such a rule-would be able to succeed in limiting current spending increases to expected inflation hinges, to a large extent, on the ability to containthe wage bill (Chapter IV). (iv) Capital spending. Chapter 111 refers to some of the public-investment projects foreseen in the energy and transport sectors alone. At this stage, it is unclearto which degree the private sector, by means of PPP arrangements, will be able to co-financethese investments. Still, it is clear that, in order to realize these investments, Government requires increasingbudgetary space for these (and other) investments. The fiscal simulations, based on the expectationof realizedcapitalexpenditures of around 7 percent of GDP in 2008, program capital expendituresto increase by an annual 0.25 percentage points of GDP during the forecast period 2009-12. The trend increase in the implicit floor on capital expenditures, expressed as a share of GDP, together with the concomitant compression of recurrent expenditures, is consistent with the medium-termfiscal programoutlined in Governmentof Montenegro(2008b).33 The implicationsof such a policy approach are summarizedin Tables 2.2-2.3 and Figures 2.5-2.7. Except for situations, in which TEDS-in their entirety-disappear abruptly, these simple guidelines allow for the design of a fiscal policy program that would ensure flexibility, sustainability, and a certain degree of counter-cyclicality. Simulationsfor the base-case scenario show that, for a four-year transition period, there would be a modest overall deficit. These results emphasize the importance of including precautionarymotives into the design of a medium-termfiscal programand of formalizing mechanismsto control recurrent spending. The illustrative fiscal rules, as specified in this document, are insufficiently stringent to ensure the adherence (without further adjustment) to the fiscal SGP criterion in instances, in which the deteriorationin the external environment results in the drying up of both external bank credits and real-estate sales to non-residents.The intensitywith which the internationalfinancial crisis will affect the Montenegrin economy remains unclear, but the potential of very strong, adverse shocks necessitates the inclusion of fiscal "buffers" in recurrent spending, capital expenditure, and/or tax policy to avert a breach of the fiscal SGP criterion, which would jeopardize the chances of reaching a formalization agreement with the EU on Montenegro's monetary arrangement, increasinguncertainty and dampening investors' confidence. 33 Due to differences in underlying assumptions and classifications, the macro economic framework and fiscal programmingcannot be directly compared.However, the fiscal program outlined in this chapter is consistent with the broadoutline of fiscal policiesover the mediumterm. 36 Figure 2.4: Montenegro: The Size of TEDS, 2006-12 35 30 25 20 15 10 5 0 2006 2007 2008 2009 2010 201I 2012 Figure 2.5: Montenegro: The Impact of TEDS on Taxes and Fiscal Balances, 2006-12 I 35 Ln percent of GDP 30 Gradual TEDS disappearance 25 --\- Tax revenues 20 15 I O Overall fiscal balanc 5 Gradual TEDS dlsappearance --_" " _-*-* '" ~ 0 -5 -10 37 Box 2.1: Benefits and Risks of Public-PrivatePartnerships Public-private partnerships (PPPs) are potentially very important tools for governments to improve, in a substantial manner, (previously neglected) public infrastructure, crowd in private-sector investments, and accelerate the rate of socio-economic development. Currently, public investment plans in Montenegro exceed the actual size of the capital budget by very large margins. Therefore, to implement the foreseen investments for the Bar-Boljare motorway en route to Belgrade, at a cost of about 79 percent of 2007 GDP, the Adriatic-Ionian highway (30 percent of 2007 GDP), and the electricity sector (70 of 2007 GDP), Government relies on the active participationof the privatesector. The two most frequently used PPPs are the following: (i) Standard "build-operate-transfer (BOT)" PPPs. These types of PPPs are currently sought, eg., for the road transport sector. They promise large efficiency gains from the involvement o f the private sector. At the same time, these BOT PPPs-if not carefully negotiated-entail significant risks of "hidden" costs and contingent liabilities. (ii) Concessions. These are considered by Government (once the Concession Law has been approved by Parliament) for the operation of complementary transport projects, including the port of Bar, the railway, and the airports. These types of contracts encourage private-sector management, while ensuring that the infrastructure remains in public hands. Under standard PPP arrangements, the private sector-taking on standard risks of doing business-finances, constructs, and maintains the infrastructure as well as offers, for a pre-specified amount of time, the corresponding services. A PPP contract providesthe private company with economic incentives to seek efficiency gains in the design, construction, and operation of a particular asset. A critical determinant in the final assessment of the desirability of a given PPP arrangement is the negotiated distribution of risks between the government and the private sector. For road-transport PPPs, for instance, explicit contingent liabilities might contain stipulations regarding guaranteed minimum traffic volumes, thereby transferring typical business risks back to government. However, governments should typically bear any "political" risk for developmentsthat are under their direct control. Managing fiscal risks of PPPs requires strong institutions, a sound legal framework, and overall political commitment, including the development o f (i) effective planning mechanisms for public investments so as to ensure that the highest-quality projects are prioritized; (ii)required institutional capacity to manage PPPs; (iii) sufficiently robust accounting and reportingsystems to accurately reflect all PPP-relatedfiscal implications;and (iv) a strong legal framework enshriningprocedures for the management of fiscal risks. It is well documentedthat PPPs tend to fail in countries with weak governance and widespread corruption, in countries with an insufficient degree of political commitment to reject pressures to undertake those PPPs that have adverse fiscal implications ("white elephants"). Experience has shown that highway PPPs are often based on overly optimistic assumptions; see Queiroz (2005). Three reasons are typically mentioned for this outcome. First, preliminary calculations are based on incorrectassumptions andor poor data. This applies, e.g., to the price elasticity of traffic to tolls. Second, too much "political capital" has been invested in a particular project to be able to reverse the decision to construct or to lengthen the implementation phase (which would, e.g., allow for the adherence of sound bidding practices). And third, motorway PPPs tend to be more vulnerable to changes in the political, financial, or economic environment than was initially assumed. 38 Box 2.2: Can Fiscal Rules Help to Realize Ambitious Public Investment Plans? As a small, open economy that is dependent on tourism and metal production, Montenegro is susceptible to large (external) shocks and abrupt changes to the overall economic environment. It counts on the revenue streams from the current FDI-/credit-financedboom to start to lay the foundation for economic diversification and increased factor productivity, with plans for large-scale public investment projects in transport and energy. Government will have to rely on proper budgetary resources and-to the extent possible-private-sector co- financing. The sheer size of these projects risks the unavailability of sufficient public funds during realization periods, delaying implementation, inherent rates of return, and-ultimately-the country's socio-economic development potential. As financial commitments for these large-scale public investment projects span over business and electoral cycles, Government might want to consider following the example of other countries that have experimented with explicit fiscal rule, with a view to ensuring that sufficient public funds are available in future budgetsto continueto finance these investmentsas currently foreseen. Fiscal rules are generally understood as "a permanent constraint on fiscal policy, typically defined in terms of Table 2.2: International Comparison of Fiscal Rules an indicator of overall fiscal performance (Kopits and Rules on Imposed on which govement Deficit Debt Expsnditurc General Central h o d Symansky, 1998), introduced to (i)signal commitment to fiscal discipline; (ii) contain policy discretion; and (iii) EN0 ZOnc 8 M Y d BMUd ucaty Finland prevent pro-cyclical fiscal policies(and, in so doing, avoid muluwar multivear agreement muIu\ear lW the negative consequences of full-blown boom-bust France annual IW German, BMYal COnSlltuUOn cycles).Hallerbergand Wolff (2006) show that fiscal rules Nelherlandr multi\ear agreement Slo,en,a multnear agreement tend to be perceivedby capital markets as improving long- annual law term fiscal perspectives, thus leading to a reduction in Spain O\CTC\EIC law BMUP. 18% sovereign risk premia and lower interest rates. Economic Australia o \ ~ r q o l e o\ercvclc IBU history is littered with examples in which a number of Brazil a"""Dl IBW Denmark multiyear agreement factors-typically grounded in political economy Estonia multqear agreement aMYd I&+ considerations-created sufficient incentives for electoral Lllhuanla a M U d law Iaa Nsa Zealand orerc)cle IS\) cycles (Nordhaus, 1975), excessively pro-cyclical fiscal Poland a M Y . 4 constmuon law policies (especially during upturns), and large, persistent Slovak BM".I Swcdcn o ~ o r c ) c l ~ agreement deficits over the economic cycle. SwitLcrland over oycle constimuon UK over cycle over EYElC law Sourcrr Debw. Epswn. and Spansky (2000, and World Bank rtrN and/or public expenditures. For reasons of.transparency and monitorability (and therefore as a strong, fonvard- Fiscal rules tend to cover budget deficits,. public debt, I looking signal to capital markets), budget-deficit andor public-debt ceilings are the most frequently used rules. Germany's Basic Law, approved in 1949, stipulates that borrowingmust not exceedbudgeted investments (unlessto avert an overall economic disequilibrium). In 2000, the United Kingdom introduced its influential "Golden Rule" that also restricted borrowingfor reasons other than investments, implying that current budgets must be balanced in any given fiscal year and, over the span of an economic cycle, be brought into surplus. The fiscal condition in the Stability and Growth Pact "Maastricht Treaty") requires member countries in, and candidates to, the euro zone to adhere to the objective of sound budgetary positions by keeping the budget "close to balance or in surplus". The Treaty allows the countries to deal with normal cyclical fluctuations by defining a government deficit ceiling of 3 percent of GDP, while specifying sanctions for euro zone countries unwilling to comply with these stipulations. The requirement for current surpluses during boom periods has also macroeconomic advantages in that it helps to counter pressures for interest rates to increase,thus avoidingthe unnecessary crowding-out of private investments. On the whole, empirical studies have shown that rules have improved the conduct of fiscal policies over the course of an economic cycle. Responding to the economic legacies of the 1970s and 1980s, policymakers in the 1990s have largely acknowledgedthe socio-economic costs inherent in rising levels of public debt and excessively pro-cyclical fiscal policies. For reasons not too dissimilar from those justifying independent central banks, many countries have thus introduced some form of fiscal rules, often accompanied with efforts to strengthen their multi- annual expenditure frameworks; see also Kumar and Ter-Minassian (2007). Debrun et al. (2008) provide evidence that suggests a causality running from rules to fiscal behavior.They find that rules specifically designedto prevent conflicts with the stabilizationfunction of fiscal policy are indeed associatedwith less pro-cyclical policies.As such, fiscal rules outweighinherentrisks and (political) costs. 39 Box 2.3: Designing a Successful Fiscal Framework in Montenegro Fiscal policy frameworks differ widely across countries, partly reflecting differences in the economic structure, public institutions charged with economic management, and overall policy objectives. In providing a preliminary assessment of the underlying strength of the EU's Stability and Growth Pact, Annett and Jaeger (2004) find that it "combines discipline and flexibility by requiringcountriesto reach fiscal positions `close to balance or in surplus' (a reference to the underlyingor structural fiscal position) and keep actual deficits below 3 percent of GDP, except in the case of unusually large shocks." For them, the litmus test for any successful fiscal framework consists of two criteria, viz., whether a policy framework is (i) capable of ensuring medium-termfiscal discipline; and (ii)flexible enough to help to smooth short-term business cycle fluctuations. The graph above summarizes the interrelation I between both policy objectives The fiscal guidelinesdiscussed in this chapter are consistent with both objectives. The assumptionthat increases in recurrent spending-quivalent to about 85 percent of all government expenditure in 2007-is limitedto expected inflation helps to define a medium-termpath that allows for an increased envelope for cauital Table 2.3: Design of Fiscal Frameworks expenditure and/or a gradual improvemen; in Medium-termfiscal discipline fiscal imbalances, should these occur in hture Q$ .;.."1 budgets. In addition, the Government's 0o$ Q" Yes No commitment to maintaining a current structural balance ensures that any borrowing will be Ideal fiscal framework Counter-cyclical, but restricted to financing (high-impact) public anchorlessfiscal framework investments. At the same time, these rules permit a considerable degree of flexibility in that they r= allow overall fiscal deficits to occur in years with Overly rigid, pro-procyclical Poor fiscal framework, particularly negative external shocks. This way, fiscal framework policy drift z 6 No there is increased budgetary security for the r/l purpose of implementing multi-annual public . . Source Annett anc aeger (2004) investment projects, whileproviding a fiscai (credit-financed)stimulus only in the case of unusually large shocks The fiscal guidelinesdiscussed in this chapter are consistent with both objectives. The assumptionthat increases in recurrent spending-equivalent to about 85 percent of all government expenditure in 20074s limited to expected inflation helps to define a medium-termpath that allows for an increased envelope for capital expenditure and/or a gradual improvement in fiscal imbalances, should these occur in future budgets. In addition, the Government's commitment to maintaining a current structural balance ensures that any borrowing will be restrictedto financing (high-impact) public investments. At the same time, these rules permit a considerable degree of flexibility in that they allow overall fiscal deficits to occur in years with particularly negative external shocks. This way, there is increased budgetary security for the purpose of implementing multi-annual public investment projects, while providinga fiscal (credit-financed)stimulus only in the case of unusuallylarge shocks. The proposed principles, apart from those relating to the SGP, avoid the need of defining fiscal-policy objectives as a share of GDP. Montenegro's statistical institute is currently undergoing comprehensive reforms aimed at improving its GDP estimates. Any objective of spending, deficit, or debt that is expressed as a percentage of GDP would "politicize" the reform process, while reducingthe implicit strength o fthe fiscal-policy anchor. Other possible definitionsof fiscal rules tilt the balance of inherent costs and benefits towards the former. Given the large degree of pro-cyclicality that is already inherent in Montenegro's tax system, annual deficit targets would amplify the fluctuations in economic activity and fiscal revenue. With the statisticalinformation still weak, and their regular availability not (yet) assured, defining similar targets over an entire economic cycle-as done in a number of countries-is impracticalas a policy tool and subject to dispute.A fiscal rule that allows for a modest increase in the real recurrent-expenditure envelope is a political decision, limitingGovernment's ability to implement the envisaged public investment projects. 40 Figure2.6: Montenegro: The Impact of TEDS and the Budget Structure, 2006-12 50 In percent of GDP Abrupt TEDS disappearance 45 With adjustment _ _ 40 -^I1.. --..* -" to meet fiscal SGP criterion in pessimistic Scenario Gradual TEDS disappearance 35 30 25 1 Current expenditure 1 I OJ I I 1 Capital expenditure With adjustment to meet fiscal SGP crltenon in peSSimiStiC 0 I 2006 2007 2008 2009 2010 2011 2012 Figure2.7: Montenegro: The Impact of TEDS and Relative Budget Structure, 2006-12 22 :spital expenditure in percent of total budgetalyexpenditure Gradual TEDS disappearance 20 18 16 14 12 / / / ipt TEDS disappearance, with adjustmentto fiscal SGP criterion I O 2006 2007 2008 2009 2010 2011 2012 41 Table 2.4: Montenegro:Base Case Macro Framework With Semi-AbruDt End to TEDS,200612 (in percent of GDP; unless otherwise indicated) 2006 2007 2008 2009 2010 2011 2012 Prel Projections Real sector Gross domestic product 1000 100 0 1000 1000 1000 1000 1000 Pnvate sector consumption and investment 87 7 97 0 88 6 73 7 70 8 70 8 71 2 Government 42 7 45 7 47 4 45 7 44 3 43 0 41 8 Exports 49 6 51 3 45 0 47 0 49 0 49 0 49 0 Imports 80 0 93 9 81 0 66 4 64 1 62 8 62 0 Monetary sector Net foreign assets -I4 -18 0 -22 3 -21 4 -20 0 -184 -16 9 Claims I 3 2 13 5 I 3 4 I 3 4 I 3 4 I 3 4 I 3 4 Liabilities I 4 7 31 5 35 7 34 8 33 4 31 8 30 3 I Loans by domestic banks 7 3 20 2 25 7 24 8 23 4 21 8 20 3 Of which: change in external indebtedness 3.9 14.0 8.6 2.2 0.5 0.21 Other 1 4 I 1 2 100 1.o 100 I O 0 10 0 100 Net domestic assets 42 3 87 0 1109 105 4 99 I 92 9 86 7 Domestic credit 48 8 99 3 1109 105 4 99 I 92 9 86 7 Net claims on central bank 10 8 13 5 I 3 4 13 4 134 I 3 4 134 Net claims on central government -1 7 -2 8 0 0 0 0 0 0 0 0 0 0 Net claims on other sectors 39 7 88 6 97 5 92 0 85 7 79 5 73 3 01which credit totheeconomy 35 5 84 2 92 7 87 5 81 5 75 6 69 7 Other items (net) 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Broad money 40 9 69 I 88 6 84 0 79 2 74 5 69 8 Deposits 40 7 68 6 88 2 83 6 78 8 74 1 69 4 Other 0 2 0 4 0 4 0 4 0 4 0 4 0 4 External sector Current account -24 7 -39 7 -32 0 -15 4 -11 I -9 8 -9 0 Trade balance -30 4 -42 7 -36 0 -194 -15 1 -13 8 -13 0 Exports of goods and services 49 6 51 3 45 0 47 0 49 0 49 0 49 0 Imports of goods and services 80 0 93 9 81 0 66 4 64 1 62 8 62 0 Imports of goods 69 7 84 7 71 5 56 8 54 4 53 0 52 1 Structural imports 47 1 45 2 46 0 46 0 46 0 46 0 46 0 EDSlfinanced 22 6 39 5 25 5 10 8 8 4 7 0 6 1 Imports of services I O 3 9 2 9 5 9 6 9 7 9 8 9 9 Income (net) 1 4 0 7 I O I O 1 0 I O I O Transfers (net) 4 2 2 3 3 0 3 0 3 0 3 0 3 0 Capital and financial account 28 6 34 6 32 3 I 1 8 9 0 8 4 8 0 Foreign direct investments (net) 21 7 20 7 I 4 0 7 7 6 8 6 1 5 6 I Foreign direct investments (gross) 30 0 39 7 33 0 26 7 25 8 25 I 24 6 Purchases o f real estate by foreigners 15.7 20.3 13.5 7.1 6.3 5.6 5.1 Other FDI 143 194 I 9 5 I 9 5 I 9 5 I 9 5 19 5 Outflow of investments 8 3 I 9 0 I 9 0 I 9 0 190 I 9 0 190 Portfolio and other investments 6 9 13 9 183 4 1 2 2 2 3 2 4 Net errors and omissions -0 5 21 9 0 0 0 0 0 0 0 0 0 0 Financing (changein net foreign assets) 3 4 I6 8 -0 3 3 6 2 1 1 4 10 Fiscal sector Budgetary revenues 45 7 52 8 46 0 43 I 42 6 42 3 42 I Tax revenue 25 8 30 8 27 5 24 6 24 1 23 8 23 6 Structural 25 8 30 8 22 4 22 4 22 4 22 4 22 4 Irmporal (from hDS-frnanced rmporrr) 6 2 / / Ix 5 1 2 2 I 7 I 4 1 2 Other budgetary revenues 199 22 0 18 5 18 5 18 5 I 8 5 18 5 Total expenditures and net lending 42 7 45 7 47 4 45 7 44 3 43 0 41 8 Current expenditures, transfers, and other expendinire 38 2 38 3 39 9 38 0 36 3 34 7 33 3 Wage bill 1 1 8 12 7 I 3 9 13 2 12 6 12 I 11 6 Other current expenditure 26 3 25 7 26 0 24 7 23 6 22 6 21 7 Capital expenditures 4 5 7 4 7 5 7 8 8 0 8 3 8 5 O\erall balance (2 -3) 3 0 7 1 -1 4 -2 6 -1 7 -0 7 0 3 Current structural balance(2 0) 1 3 3 7 I O 2 9 4 6 6 2 7 6 Fiscal adjustment need 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Memorandum items. in millions of euro, unless otherwise specified Real GDP growth rate, in percent 8 6 10 3 7 7 5 1 4 7 4 4 4 3 GDP deflator. in percent 9 0 7 2 100 8 0 6 0 5 0 4 0 Nominal GDP 2.1489 2,540 0 3,009 2 3,415 4 3,7892 4,154 5 4,504 7 Change in net foreign assets -73 0 -426 I 9 5 -123 5 -79 3 -56 9 -45 4 Stock of net foreign assets -30 8 -456 9 -447 4 -5709 -6503 -707 2 -752 6 Stock o f private-sector credit 762 6 2,165 0 2,789 1 2,989 1 3,089 I 3,139 I 3,139 I Annual change in private-sector credit 446 0 1,402 3 624 1 200 0 1000 50 0 0 0 Stock of external loans by banks(eop) I56 5 513 2 773 2 848 2 885 7 904 5 913 9 Annual change in external borrowing 84.4 356.7 260.0 75.0 37.5 18.8 9.4 Wage bill 254 4 321 5 4180 451 4 478 5 502 4 522 5 Other current expenditure 565 6 652 3 782 5 845 1 895 8 940 6 978 2 Capital expenditure 97 1 187 3 225 7 264 7 303 1 342 7 382 9 Sources Ministry of Finance, CBCG, Monstat, IMF, and World Bank staff estimatesand projections 42 Table 2.4a: Montenegro: Macro FrameworkWith a Gradual End to TEDS, 2006-12 (in percent of GDP; unlessotherwisespecified) 2006 2007 2008 2009 2010 201 I 2012 Prel Projections Real sector GTOSS domestic product 100 0 100 0 1000 100 0 100 0 100 0 100 0 Pnvate sector consumption and investment 87 7 97 0 94 3 85 3 80 5 79 5 79 2 Government 42 7 45 7 47 0 44 7 42 8 41 2 39 8 Exports 49 6 51 3 45 0 47 0 49 0 49 0 49 0 lmports 80 0 93 9 86 4 77 0 72 4 69 7 68 0 Monetary sector Net foreign assets -1 4 -18 0 -23 4 -23 6 -22 I -20 2 -18 3 Claims I3 2 13 5 I 3 4 I 3 4 I 3 4 I 3 4 I 3 4 Liabilities 14 7 31 5 36 8 37 0 35 5 33 6 31 7 Loans by domestic banks 7 3 20 2 26 8 27 0 25 5 23 6 21 7 Of which: change in external indebtedness 3.9 14.0 9.9 4.2 1.8 0.8 0.41 Other ~. 7 4 I.~2 1 - 10 0 ... I.~0 O I.. 0 O . . ~ . 10 0 .~ 10 0 ~ ~ Net domestic assets 42 3 87 0 1100 101.5 93 3 85 7 78 7 Domestic credit 48 8 99 3 1100 101 5 93 3 85 7 78 7 Net claims on central bank 10 8 13 5 1 3 4 13 4 13 4 13 4 13 4 Net claims on central government -I7 -2 8 0 0 0 0 0 0 0 0 0 0 Net claims on other sectors 39 7 88 6 96 6 88 I 79 9 72 3 65 3 Ofwhich credit to the economy 35 5 84 2 91 9 83 8 75 9 68 8 62 I Other items (net) 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Broad money 40 9 69 I 86 6 77 9 71 2 65 6 60 5 Deposits 40 7 68 6 86 2 77 5 70 8 65 2 60 I Other 0 2 0 4 0 4 0 4 0 4 0 4 0 4 External sector Current account -24 7 -39 7 -37 4 -26 0 -194 -16 7 -1s 0 Trade balance -30 4 -42 7 -41 4 -30 0 -23 4 -20 7 -190 Exports of goods and services 49 6 51 3 45 0 47 0 49 0 49 0 49 0 Imports o f goods and services 80 0 93 9 86 4 77 0 72 4 69 7 68 0 Imports of goods 69 7 84 7 76 9 67 4 62 7 59 9 58 I Structural imports 47 I 45 2 46 0 46 0 46 0 46 0 46 0 I.DS-finunced 22 6 39 5 30 9 21 4 16 7 13 9 12 I Imports o f services 103 9 2 9 5 9 6 9 7 9 8 9 9 Income (net) 1 4 0 7 10 1 0 1 0 1 0 10 Transfers (net) 4 2 2 3 3 0 3 0 3 0 3 0 3 0 Capital and financial account 28 6 34 6 35 7 1 9 0 I 5 3 14 I 13 1 Foreign direct investments (net) 21 7 20 7 174 14 9 13 1 I 1 8 I O 7 1 Foreign direct investments (gross) 30 0 39 7 36 4 33 9 32 I 30 8 29 7 Purchases o f real estate by foreigners 15.7 20.3 16.9 14.4 12.6 11.3 10.2 Other FDI 14 3 19 4 I 9 5 I 9 5 I 9 5 I 9 5 I 9 5 Outflow o f investments 8 3 19 0 19 0 19 0 19 0 I 9 0 19 0 Portfolio and other investments 6 9 13 9 18 3 4 1 2 2 2 3 2 4 Net errors and omissions -0 5 21 9 0 0 0 0 0 0 0 0 0 0 Financing (change in net foreign assets) 3 4 16 8 1 6 7 0 4 0 2 6 2 0 Fiscal sector Budgetary revenues 45 7 52 8 47 I 45 2 44 2 43 7 43 3 Tax revenue 25 8 30 8 28 6 26 7 25 7 25 2 24 8 Structural 25 8 30 8 22 4 22 4 22 4 22 4 22 4 Temporal from EDS-flnanced rmporrs) 6 2 I O 8 6 2 4 3 3 3 2 8 2 4 Other budgetary revenues I 9 9 22 0 I 8 5 I 8 5 18 5 18 5 18 5 Total expenditures and net lending 42 7 45 7 47 0 44 7 42 8 41 2 39 8 Current expenditures. transfers, and other expeliditure 38 2 38 3 39 5 37 0 34 8 33 0 31 3 Wage bill II8 12 7 13 8 12 9 12 I I!5 10 9 Other current expenditure 26 3 25 7 25 8 24 I 22 7 21 5 20 4 Capital expenditures 4 5 7 4 7 5 7 8 8 0 8 3 8 5 Overall balance (2-3) 3 0 7 1 0 1 0 5 1 4 2 5 3 5 Current structural balance (2 0) I 3 3 7 1 4 3 9 6 1 7 9 9 6 Fiscal adjustment need 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Memorandum items. in millions o f euro. unless othenvise specified Real GDP growth rate, in percent 8 6 I O 3 8 7 7 0 6 1 5 6 5 3 GDP deflator. in percent 9 0 7 2 10 0 9 8 7 5 6 2 5 1 Nominal GDP 2 1489 2,540 0 3.0362 3 5669 4 067 4 4 564 5 5 052 4 Change in net foreign assets -73 0 -426 I -496 -2503 -164 0 -120 8 -99 3 Stock of net foreign assets -30 8 -456 9 -506 5 -756 8 -920 8 - 1 041 7 -1,1409 Stock o f pnvate-sector credit 762 6 2.165 0 2,789 I 2.989 I 3,089 I 3,139 I 3,139 I Annual change i n pnvate-sector credit 446 0 1.402 3 624 I 200 0 1000 50 0 0 0 Stock of external loans by banks (eop) I56 5 513 2 813 2 963 3 1.038 3 1.075 8 1.094 5 Annual change in external borrowing 84.4 356.7 300.0 150.0 75.0 37.5 18.8 Wage bill 254 4 321 5 4180 459 I 493 3 524 2 550 9 Other current expenditure 565 6 652 3 782 5 859 5 923 7 981 4 1,031 5 Capital expenditure 97 I 187 3 227 7 276 4 325 4 376 6 429 5 Sources Ministry of Finance. CBCG, Monstat; IMF, and World Bank staff estimates and projections. 43 Table 2.4b: Montenegro: Macro Framework With an Abrupt End to TEDS,2006-12 (in percent of GDP; unless otherwise indicated) 2006 2007 2008 2009 2010 2011 2012 Prel Projections Real sector Gross domestic product 1000 1000 IO00 1000 1000 100 0 1000 Private sector consumption and inbestment 87 7 97 0 82 8 61 8 60 9 61 9 62 9 Government 42 1 45 7 47 8 46 8 45 8 44 9 44 0 Exports 49 6 51 3 45 0 47 0 49 0 49 0 49 0 Imports 80 0 93 9 75 6 55 6 55 7 55 8 55 9 Monetary sector Net foreign assets -1 4 -18 0 -23 9 -21 5 -197 -18 2 -16 9 Claims I 3 2 13 5 I 3 4 13 4 134 I 3 4 I 3 4 Liabilities I 4 7 31 5 37 3 34 9 33 1 31 6 30 3 Loans by domestic banks 7 3 20 2 27 3 24 9 23 1 21 6 20 3 Of whrrh. change in external indebtedness 3.9 14.0 7.4 0.0 0.0 0.0 0.0 Other 7 4 1 1 2 100 10 0 I O 0 10 0 10 0 Net domestic assets 42 3 87 0 Ill8 IO9 6 105 6 100 9 95 8 Domestic credit 48 8 99 3 1 1 1 8 IO9 6 105 6 100 9 95 8 Net claims on central bank 10 8 13 5 13 4 13 4 134 I 3 4 134 Net claims on central government - 1 7 -2 8 0 0 0 0 0 0 0 0 0 0 Net claims on other sectors 39 7 88 6 98 4 96 2 92 2 87 5 82 4 Of which credit to the economy 35 5 84 2 93 5 91 5 87 6 83 2 78 3 Other items (net) 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Broad money 40 9 69 I 87 9 88 1 85 9 82 7 78 9 Deposits 40 7 68 6 87 5 87 7 85 5 82 3 78 5 Other 0 2 0 4 0 4 0 4 0 4 0 4 0 4 External sector Current account -24 7 -39 7 -26 6 -4 6 -2 7 -2 8 -2 9 Trade balance -30 4 -42 7 -30 6 -8 6 -6 7 -6 8 -6 9 Exports o f goods and S ~ N ~ C ~ S 49 6 51 3 45 0 47 0 49 0 49 0 49 0 Imports o f goods and services 80 0 93 9 75 6 55 6 55 7 55 8 55 9 h p o r t s o f goods 69 7 84 7 66 1 46 0 46 0 46 0 46 0 Structural imports 47 1 45 2 46 0 46 0 46 0 46 0 46 0 E/X-/inanced 22 6 39 5 20 I 0 0 0 0 1/11 n o h p o r t s o f sewices I O 3 9 2 9 5 9 6 9 1 9 8 9 9 Income (net) 1 4 0 7 10 I O I O I O 1 0 Transfers (net) 4 2 2 3 3 0 3 0 3 0 3 0 3 0 Capital and financial account 28 6 34 6 28 9 4 6 2 1 2 8 2 9 Foreim direct investments (net) 21 7 20 7 106 0 5 0 5 0 5 0 5 I Foreign direct investments (gross) 30 0 39 7 29 6 I 9 5 195 I 9 5 19 5 Purchases of real estate by foreigners 15.7 20.3 10.1 0.0 0.01 Other F D I 14 3 I 9 4 I 9 5 I 9 5 I0.0 9 5 I 0.0 9 5 19 5 Outflow o f investments 8 3 I 9 0 190 I 9 0 190 I 9 0 190 Portfolio and other investments 6 9 13 9 183 4 1 2 2 2 3 2 4 Net errors and omissions -0 5 21 9 0 0 0 0 0 0 0 0 0 0 Financing (change in net foreign assets) 3 4 16 8 -2 3 0 0 0 0 0 0 0 0 Fiscal sector Budgetary revenues, including grants 45 7 52 8 44 9 40 9 40 9 40 9 40 9 Tax revenue 25 8 30 8 26 4 22 4 22 4 22 4 22 4 Structural 25 8 30 8 22 4 22 4 22 4 22 4 22 4 Temporal (from hDS-frnancrd rmporrcj 6 2 10 8 4 D 0 0 0 0 (1 0 0 0 Other budgetary revenues 19 9 22 0 I 8 5 18 5 I 8 5 18 5 I 8 5 Total expenditures and net lending 42 7 45 7 47 8 46 8 45 8 44 9 44 0 Current expenditures, transfers and other expenditure 38 2 38 3 40 3 39 0 37 8 36 6 35 5 Wage bill 1 1 8 I2 7 I 4 0 13 6 I 3 2 12 8 124 Other current expenditure 26 3 25 7 26 2 25 4 24 6 23 9 23 1 Capital expenditures 4 5 1 4 7 5 7 8 8 0 8 3 8 5 Overall balance (> -3) 3 0 7 1 -2 8 -5 9 -4 9 -4 0 -3 1 Current structural balance (5 0) 1 3 3 7 0 6 1 9 3 1 4 3 5 4 Fiscal adjustment need 0 0 0 0 0 0 2 9 1 9 I O 0 1 Memorandum items, in millions o f euro, unless otherwise specified Real GDP growth rate, in percent 8 6 10 3 6 7 3 2 3 2 3 2 3 2 GDP deflator, in percent 9 0 7 2 100 6 2 4 5 3 7 2 9 Nominal GDP 2,148 9 2,540 0 2.982 3 3,267 3 3,524 5 3,773 6 4,007 0 Change in net foreign assets -73 0 -426 1 68 3 0 0 0 0 0 0 0 0 Stock o f net foreign assets -30 8 -456 9 -388 6 -388 6 -3886 -388 6 -388 6 Stock of private-sector credit 762 6 2.165 0 2.789 1 2,989 1 3,089 1 3,139 1 3,139 1 Annual change in private-sector credit 446 0 1,402 3 624 1 200 0 1000 50 0 0 0 Stock of external loans by banks (eop) I56 5 513 2 813 2 813 2 813 2 813 2 813 2 Annual change in external borrowing 84.4 356.7 220.0 0.0 0.0 0.0 0.0 Wage bill 254 4 321 5 4180 443 7 463 8 481 2 495 1 Other current expenditure 565 6 652 3 782 5 830 7 868 3 900 9 926 9 Capital expenditure 97 1 187 3 223 7 253 2 282 0 311 3 340 6 Siwrca~ Ministry of Finance. CBCG Monstat, IMF. and World Bank staffestimates and projections 44 2.12. The three scenarios differ in the assumed inflow of capital from abroad. The sum of the changes to the external indebtedness by banks and purchases of real-estate by foreigners represent additional liquidity that lead to increased imports, with coefficients used as estimated by the regressions summarized above. These, in turn, affect not only fiscal revenues but also the development of the real economy. Given Montenegro's high import elasticity of demand, with imports of goods representing close to 100 percent of GDP, the overall impact on domestic economic activities, bothup and down, from changes to external capital inflows is somewhat lower than in countries with lower elasticities (as, for instance, in Estonia, where imports of goods represent about 70 percentof GDP). 2.13. For reasons of political economy, the most difficult challenge consists of containingcurrent expenditures. With the additional demands placed on the budget, there are indications that, in 2008, Montenegro will post a (modest) current structural deficit. Increasing demands are placed on public administration, and wage increases in the private sector outpace that to what Government is able to commit (unless the overall size of the public administration is reduced). There are plans to decrease tax rates even further (for instance, on personal-incometaxes and social-security contributions), thereby placingeven tighter constraints on the fiscal envelope for recurrentspending. In addition, with legislative elections foreseen during the second half of 2009, there always exist incentivesfor policymakersto relax budgetary constraints. IfMontenegro wants to realize its priority objectives, it cannot affordto do so. D. CONCLUDING REMARKS 2.14. Montenegro has developed an ambitious plan aimed at modernizing public infrastructure. The costs for the planned investments in the electricity and transport sectors alone exceed current GDP at quite a substantial margin. It will take years and several budgets to implement these investments and, even if PPPs can finance substantial portions, Government contributionswill remainvery large. To allow for effective planning and timely realization, it is crucial that the fiscal space for these (and other) investments be secured, including through their explicit representation in a medium-term budgetary program.The fiscal framework as presentedhere allows for gradually increasingcapital expenditures as a share of GDP. 2.15. The large reliance on imports as a source for fiscal revenues results in a pro-cyclical bias of the tax regime. The clear definition of a capital budget as described above ensures a certain extent of counter-cyclicalityin expenses-in the sense that, in years with low capital inflows and reduced imports, the overall balance will be permitted to be in deficit. The commitment to a current structural balance ensures that any net borrowingis done only for the purposeof (high-impact) investments. 2.16. Precluding any further increase in real recurrent spending ensures that any overall fiscal deficit for years with adverse economic shocks will be temporary, as the share of recurrent spending to GDP will gradually decline. Such an expenditure envelope can usefully frame reform efforts, including those for human resource management in the public administration, and should help Government to implement reforms aimed at makingthe public sector more effective. 2.17. Effects on the Montenegrin economy from the dramatically deteriorating international environment remain unclear, but they increase the importance of adding precautionary motives into the design of a medium-term fiscal program. Simulations have shown that an abrupt disappearance of all temporarily available external demand stimuli would result in the breaching of the fiscal SGP criterion of an overall fiscal deficit by general government o f less than 3 percent of GDP for several years in a row, requiringa correspondingadjustment of the capital budget.Without tight control over recurrentspending, without efforts to access private-sectorcapital to financingthe public investment projects, and without a strong emphasis to ensure a high effectiveness of all public expenditure, 45 Montenegro will not be able to successfully implement its ambitious reform and modernizationagenda. Also domestically, increasingeconomic imbalances, as signified by increasinginflation rates and current- account deficits, require Montenegro to use its one remaining instrument of macroeconomic management-fiscal policy-for this purpose. During recent years, Government has pursued a moderately counter-cyclical fiscal policy, having accumulated sizeable overall fiscal surpluses. During the boom years, however, pressures for additional spending have increased, as exemplifiedby the changes to recurrent spending limits in the supplementary budgets 2007 and 2008. Montenegro will not be able to do this any longer. 46 3. PUBLIC INVESTMENTS Following the transition towards afunctioning market economy, the demands on public infiastructure- 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 thepeak 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 infiastructure 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 identijied 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 thefiscal space, necessitating intensijied efforts to (i) attract prioritized; and (iii) assess available options- -ifneed be-to downsize or delay public investments. private-sector eo-financing; (ii) devise criteria according to which capital expenditures could be A. THEENERGY SECTOR34 3.1 Major investments need to be financed to ensure (i)an adequate availability of reasonably priced energy to a rapidly growing economy; and (ii)a sustainable financial position of the power utility. Montenegro's energy infrastructure has been severely neglected for more than a decade o f under- investment and deferred maintenance. The status quo is not an option, and-to be able to finance the required investments-ciovernment needs to strengthen the fiscal elements o f the sector strategy, combining (i)improved financial management by the Electrical Company o f Montenegro (EPCG); (ii)the implementation o f complementing structural reforms; (iii)the careful costing and prioritization o f all proposed investment projects, which might a corresponding adjustment to the energy strategy; (iv) the development o f public-private partnerships, where possible; and (v) the re-opening a debate within Government on the possible private-sector participation in EPCG beyond the 45 percent currently foreseen. 3.2 Notwithstanding considerable progress made in recent years to enhance the financial viability of the power utility;* the sector continues to generate significant quasi-fiscal deficits. With recent reforms, the EPCG does no longer present a direct burden on the budget, except for very limited resources required to finance a minimal social-safety net for the most vulnerable consumers that are worst affected by the tariff increases. However, the sector continues to generate significant quasi-fiscal deficits, 34Preparedby Husam Beides (ECSSD) and Richard Wong (ECSSD). 35Montenegro finds itself in the midst of a comprehensivereform process of the electricity sector, as many obstacles to an efficient and sufficient production of electricity have been tackled on partially. In particular, there remain issues of cross-subsidization among various categories of users, periodic blackouts and their impact on economic activities particularly in the high-potential tourism sector, social issues related to tariff increases, or the extent of technical and non-technical losses, billings and collections. 47 as EPCG's current revenues do not cover its needs, neither for normal and backlog maintenance nor for new generation, transmission, and distribution capacities that would be required to meet growing-and spatially shifting-power demand. Without the implementation o f both urgently required investments and complementing reforms, the sector would have to rely increasingly on power imports. Given the already tight and volatile regional market, this would complicate EPCG's cash-flow management further and increase the risks for higher deficits and a resultant widening o f the external current-account deficit. 3.3 Facedwith the poor financial performance of the power utility, Government has initiated a reform process in the energy sector. EPCG's inability to rehabilitate and upgrade its generation and transmission facilities followed poor operational and financial performance. This development was amplified by administrative tariffs that were-for social-policy reasons-set at levels below cost recovery. 36Against this background, Government initiated a reform process for the energy sector during previous years that aimed at (i) restructuring EPCG; (ii) supporting the privatization and commercialization o f the aluminum smelter KAP (consuming about one-third o f the electricity demanded in Montenegro); and (iii)requiring KAP to gradually import, on its own account and at international -\ market prices, increasing portions o f the electricity it -~ consumes from the regional market. This has relieved , I EPCG from some o f its supply obligations to KAP, I contributing to the gradual improvement o f EPCG's financial performance. 1\ 3.4 The energy strategy identified necessary 1 investments of about 1.8 billion up until 202537-that About (.I5 billion is, an annual average o f about 106 million. With the 1 energy-sector reform, Government sought to address ~ broader institutional constraints as well. It signed and ratified the Energy Community o f South East Europe i for coiwrwtion at new powtr fHCliltiES I \, ~ Treaty and created the Energy Regulatory Agency. It i <.\ -----./- / approved a new tariff methodology, which established in June 2007 a new unbundled transmission tariff and a new retail tariff. Also in 2007, Government adopted the Ministry o f Economic Development's (2007) Energy Development Strategy, which calls for a total o f 1.8 billion o f investments" in (i)the rehabilitation and expansion o f existing energy infrastructure (0.3 billion); and (ii)the construction o f new power-generation capacities (1.5 billion). These investments are needed to meet growing energy demand and improve the security o f electricity supply. 36 Social-policy considerations, a prerogative of Government, should not directly impact the discussion on the structure of electricity tariffs. The social implications of tariff increases, however, represent an additional challenge to Government. Any increases in the tariffs for households should therefore take into account their impact on the poorest consumers. The existing social safety net supported by the Ministry of Health, Labor, and Social Welfare provides targeted subsidies for vulnerable electricity consumers, which need to be continuously re-evaluated to ensure the accurate coverage of low-income consumers. These programs represent an important element of the Government support to the electricity-sector reforms, ensuringensure their socio-political sustainability. 37An even larger figure of 3.6 billion was mentioned in the context of an international energy conference "Energy Development in Montenegro: Future, Opportunities, and Challenges" in KolaSin during July 10-1 3, 2008, which had invited, inter alia, potential private-sector investors in this sector. The additional energy-sector investments are those offered to the private sector to be implemented on the basis of individual calculations of economic profitability. 38The related1.816 billion in investments foreseen for the period 2007-25 investments include (i)166 million in the rehabilitation of existing generation plants; (ii)960 million in new power plants; (iii)El99 million in power transmissionnetwork; and (iv) 491 million in power distribution networks. The latter two categories of investments include expendituresfor rehabilitation and new construction. 48 3.5 Investmentneeds in the electricitysector exceed the financial resourcesof Governmentand the power utility. This section will therefore seek to (i) provide a review of EPCG's financial performance, including medium-termforecasts; (ii)examine the link between EPCG's financial situation and its ability to invest in the infrastructure, which is needed to provide a sustained, reliable, and profitable supply of electricity in Montenegro; and (iii)derive policy recommendations for future restructuringand reform.The focus of this section will be on the electricity sub-sector, for reasonsfor this being the most critical area to the development of a policy mix aimed at ensuring dynamic rates of sustainable growth and the only area, in which the energy sector requireslarge-scalepublic expenditures. FinancialPerformanceof the PowerUtility 3.6 Reform steps are being implemented to improve EPCG's financial performance. During 2007-1 1, EPCG's investment plan projects capital expenditures of 334 million aimed at rehabilitating and expanding existing generation, transmission and distribution systems.39These investments will be necessary during the coming four years to improve EPCG's operational performance and expand its generation capacity. For the purpose of this document, the team reviewed the power utility's financial ability to carry out these investments.This financial review is intended to provide an overview of the compan 's financial prospect and its ability to finance critical investments. Table 3.1 provides the review4 of EPCG's past and expected future financial performance. ? 3.7 As part of the reform process, EPCG completedthe financial and accounting unbundlingof its functionalunits. Governmentis now in the process of legally unbundlingEPCG's functional units. It is expected to start this process with the legal unbundling (and full operational separation) of EPCG's transmissionunit. Governmentis conscious of the fact that further reform steps are neededto (i)complete the full unbundling of EPCG; (ii) continue the process of tariff reforms; and (iii) establish a policy for private-sectorparticipationin the energy sector-a necessarypreconditionfor the financingthe long-term investment needs in the energy sector. 3.8 With the successful implementation of the reform and investment program, and on the basis of the current KAP agreement, EPCG is not expected to have any further operational losses after 2008, which it had incurredat least since 2001. These losses stemmed from the long-termstructural power deficit, production capacity constraints, and low tariff pricing (especially to U P ) . A series of operational and strategic changes to EPCG are currently being undertaken to improve the utility's financial performance: (i) The subsidy to the aluminum smelter will be phased out. After U P ' Sprivatization in 2006, KAP and EPCG signed a multi-year power-purchase agreement (PPA), which provides for a phased tariff increase for electricity supplied by EPCG to the smelter. According to the PPA, EPCG is responsible for supplyingKAP with two-thirds of its electricity needs in 2007 and 2008 (at an electricity price that is indexedto the aluminum market price) and one-halfof its electricity needs between 2009 and November 2010 (at an electricity price indexedto boththe marketprices of aluminum and electricity). After November 2010, KAP is expected to import all needed electricity directly. In 2007, the price of electricity supplied to KAP was about 39 per MWh, compared to 20 per MWh in 2006. Together with KAP's improved payment discipline, the gradual reductionof EPCG's obligationto supply electricity to KAP has begunto show a positive 39 EPCG 2007-1 1 investments include 138 million in generation investments, 85 million` in transmission investments,108 million in distribution investments, and3.6 million in supply investments. 40 EPCG financial review was based on a draft financial model prepared by EPCG and on other sources of informationobtained from EPCG and discussions with EPCG staff. 49 impact on EPCG's financial performance in 2007. The effects will become more apparent in subsequentyears. Table 3.1: Montenegro: EPCG Operational and Financial Performance Indicators, 200611 2006 2007 2008 2009 2010 201 1 Operational indicators Installed capacity 868 868 883 883 883 883 Generation, excl imports, GWh 2,818 2,520 2,903 2,903 2,903 2,903 Imports (PIVA swap), GWh 1,204 1,076 1.076 1,076 1,076 1,076 Imports (others), GWh 1.728 1,966 1,436 1,494 1,546 1,936 EPCG 1,022 1,235 705 462 438 0 KAP 706 73 1 73 I 1,032 1,108 1,936 Exports (PIVA swap), GWh 991 762 762 762 762 762 Exports (others), GWh 75 0 0 0 0 336 Gross consumption, GWh 4,684 4,800 4,653 4,711 4,763 4,8 17 Direct consumer consumption, GWh 2,142 2,153 2,163 2,170 2, I 7 0 2,171 35k V and below consumption, GWh 2,386 2,464 2,320 2,371 2,423 2,476 35k V and below net consumption, GWh 1,693 1,930 1,879 1,992 2,084 2,179 Distribution losses, GWh 693 534 44 1 379 339 297 Transmission losses, GWh 156 183 170 170 170 170 Distribution losses, percent 29 22 19 16 14 12 Transmission losses, percent 3 4 4 4 4 4 Distribution and transmission losses, percent 18 15 13 12 1 1 I O Financial indicators Operating revenue, millions o f euro 193 24 243 00 243.50 242.50 247.99 252 I O Expenditure, millions o f euro 225 13 254 56 255.62 225.32 223.07 187 23 EBIT, millions of euro -31 88 - 1 1 56 -12.12 17.18 24.92 64 87 Collections, percent o f sales 95 93 95 96 97 98 Self-financingratio II 34 33 78 1 I 3 183 Net funds. generated internally, millions o f euro 4 87 24 20 24.71 55.98 65.42 106 68 Average 3-year Capex millions o f euro 43 79 71 34 75.20 71.77 57.78 58 38 Source EPCG, and World Bank staff estimatesand projections (ii) Collections rates will continue to improve and distribution losses decline. During 2006-07, EPCG's distribution losses remained in the range of 20-30 percent, with negative impacts on EPCG's financial position, while the power utility as able to improve its collection ratio to an average 94 percent for both post-independenceyears. The latter outcome was party the result of completing a pilot metering program introduced to reduce network losses. The power utility intends to scale up this project, planning to install another 50,000 meters in areas with high network losses. EPCGhas set targets for improving its collection ratio from 93 percent in 2007 to 98 percent in 2011, while reducing its losses concomitantly from 22 to 12 percent. To succeed with its ambitious but achievable targets, EPCG needs to implement its 2007-1 0 metering replacement and network rehabilitationproject, at an expected cost of altogether 110million. (iii) EPCGwill haveto investinnewgenerationfacilities.Formanyyears, Montenegrohashada power-productiondeficit, mainly because it could not put into operationnew generation facilities. The last such plant was integrated into its grid in 1982. Since then, industrial consumption- specifically for the aluminumand steel plants-and householdconsumptionhave increasedthree- fold. Given increasing supply constraints, this persistent electricity deficit has resulted in increasing imports. With the rehabilitation of the Pljevlja thermo power plant expected to be completed in 2008, an increase in overall production can be expected, implying that total electricity imports should be lower than those in 2007. This reduction in the level of imports can only be achieved if EPCG implementsits planned90 million investmentin the rehabilitationand expansion of the Perucica and Piva hydro power plants, while providing 46 million for additionalimprovementsin Pljevlja. 50 EPCG restructuring has to continue. In December 2006, EPCG's outstandingdebt outstanding stood at 1 14 million. In 2007, Government was able to restructure 92 million of EPCG debt with both London and Paris Club creditors.Governmentconvertedremainingdebt into additional equity holdings, with the resultthat its shares increased from 67 to 70 percent. The debt reduction has reduced interestcosts. However, the debt deals did not cover the 22 million debt to Russia, the European Investment Bank (EIB), or the International Bank for Reconstruction and Development(IBRD). EPCG's business plan for the period 2007-1 1 foresees decreased external borrowing, excludingthe possibility of new external debt, to be taken of for capital expenditures, as of 2010. EPCG staff will need to be cut. It is foreseen that EPCG will reduce staff by 170employees (or about 5 percent of its current workforce), increasing its ability to control personnel costs. Over the 5-year span 2007-1 1, this objective is to be achieved mainly though plannedretirementsin its generation and distribution units. This reduction would result in the reduction of annual labor costs by about 0.2 million (net). During the process of restructuring, EPCG needs to define a strategy outlining labor restructuring and skills divestiture to ensure continued (if not increased) operationalefficiency. Further tariff reforms are critical to improve the power utility's financial health-apart from the objective of eliminating high cross subsidies that exist among different consumer groups. Once KAP will be responsible for importing its own electricity, EPCG should be in a positionto ensure full cost recovery from all sales of electricity, including the steel plant and the railways. High cross-subsidies exists between other consumers connected to the distribution network (Table 3.2), which includes the level of tariffs for regulated consumers after the regulator's latest tariff revision in July 2008. At the same voltage level, tariffs to households can be a fraction of those for some categories of commercial consumers and small enterprises. To some extent, the July 2008 tariff changes have rectified the situation, but the tariff structure continues to affect the business climate detrimentally. The high cross subsidy between commercialand private EPCGclients does not accuratelyreflect the underlyingcost of supplying these consumers. A tariff path needs to be established that eliminates cross subsidies among consumer groups. This could be achieved over a three- to five- year horizon. Table 3.2: Montenegro: Electricity Tariffs, 2007-08 Category Customer Average tariff (in 6IMWh) Percentage until June 30. 2008 as ofJuly I.2008 increase I KAP' 29.70 33.70 13.5 2 Steel factory 56.80 56.80 0.0 3 Railways 64.40 64.40 0.0 4 35kV 63.40 63.40 0.0 5 1OkV 77.20 77.20 0.0 6 Households-two tariff (IOpm-6am lower tariff, from 6am to lOpmhigher tariff) 66.50 76.60 15.2 7 Households-singletariff (same tariff throughout the day, therefore priced 86.20 91.90 6.6 8 Idegree(customerscanestimateselfpeakpower) 164.50 152.20 -7.5 9 IIdegree(nomaximumpeakprovided) 189.70 175.50 -7.5 I O Public lights. 137.98 137.98 0.0 , . . Households, weighted average betweencategories6 and 7 69.30 78.70 13.6 . . . All consumers, weighted average 65.70 71.10 8.2 Sources. Energy regulator; and World Bank staff estimates 'Pnce according to the KAP-EPCGsupply agreement In addition. KAP imports about 113 of its elecmclty needs from the regional power market at market pncer 51 3.9 According to the financial analysis, an improvement in EPCG's position can be expected. Based on the assumptions and calculations made by EPCG (especially those relatedto the improvement in collections, the reduction in network losses, and the expected levels of electricity imports), the company's financial positionand operatingperformance should start to improve(Figure 3.1). 3.10 Imports and collection ratios remain risk factors. Figure 3.1 summarizes the results of a sensitivity analysis, which shows that EPCG's financial performance will remain fragile if (i) current forecasts regarding electricity imports are exceeded (one possible reason could be that local generators will not meet their targets for electricity generation); and/or (ii)EPCG proves unable to achieve targets for the improvement in collection ratios and the reduction of network losses. This finding increases the urgency with which EPCG needs to implement its investments plan for 2007-1 1 and continue to improve its operationalperformance. Figure3.1: Montenegro: EPCG's Net Operating Income, 2006-11 80 / EPCG`sfinancial performancebasedon plannedimports and improvements in collection and losses 60 40 Sensitivityin collectioncaseand 'L 2 Targetslossesarefornotimprovementsachieved e2 20 - `i. -0 vi -g o C 2010 201 I -20 -40 Sensitivity case I Targets for imports are not met and additional 300 GWh will be needed yearly -60 Implied Assumptionof InfrastructureImprovements 3.1 1 EPCG's developmentand investmentplans amount to a 334 million over the period 2007- 11. The revitalization and modernization of equipment and plants for transmission, generation, and distribution are a prerequisite for improvements in both the production capabilities of local generation plants and the performance of the transmission and distribution networks. Without these investments, EPCG will not be able to meet its targets for electricity supply and network performance.Government and EPCG management place strategic importance to these improvements, motivatingthe development of a five-year development and investment plan(Table 3.3). 52 Table 3.3: Montenegro:EPCG InvestmentPlan, 2007-1 1 2007 2008 2009 2010 2011 Total (In millions of euro; unless otherwise indicated) Total 71 3 89 3 65 0 61 1 47 3 334 0 Generation 26 6 37 7 27 2 27 8 I8 4 137 6 Transmission 21 3 26 4 15 8 12 6 8 3 84 5 Distribution (35kV) I 4 2 I 4 9 13 5 12 1 12 1 66 9 Distribution (1 0 and 0 4kV) 8 3 8 3 8 3 8 3 8 2 41 3 Supply 0 9 2 0 0 2 0 2 0 2 3 6 Base-case assumptions Self-financingratio, in percent 34 33 78 113 183 ... Available own funds 24.3 29.3 50.7 69.1 86.4 ... External funding 47.0 59.9 14.3 0.0 0.0 ... Sources: EPCG;and World Bank estimates and projections. 3.12 The full financing of these investments is not yet secured. Of the 334 million in foreseen investments, outside funding of 92 million was identified and has been negotiatedin 2007 with bilateral (Norway, France, and Germany) and multilateral (EIB and IBRD) development partners. Additional borrowingof 34 million is expectedto meet the investment~chedule.~'As EPCG's financial situation is expected to improve in 2009, accordingto the assumptions underlying the base-casescenario, additional financingfrom EPCG's own resourcescan be expected to become available.However, if EPCG does not meet the targets of network improvementand import levels, significant additional external borrowingwill be necessary, which would represent a fiscal burden and, within the constraintsof the fiscal rules, crowd out other needed expenditure. Alternatively, additional capital can be raised by privatizing a share of EPCG that exceeds the currently foreseen limit of 45 percent; there are no economic efficiency reasons that would precludea full privatizationofthe power utility. Summary and Conclusions 3.13 Energy-sector investments are needed to protect Montenegro's growth potential. Rapid growth rates in economic activities, includingthe development of a high-endtourism industry, imply high and consistent growth rates in energy demand. With regional supply beinglimited and the current-account deficit already very high, energy-sector investments into the construction of new power generation facilities represent an importantpillar of Montenegro's socio-economicdevelopment strategy, which aims at ensuring the sufficient availability of reasonably priced energy. The energy strategy (Ministry of Economic Development, 2007) has outlined measures to achieve this, at costs equivalent to about 70 percent of 2007 GDP. 3.14 EPCG's poor financial performance in the past led to the negligence in energy infrastructure-necessitating an improvement of the former to address the legacy of the latter. Since 2002, EPCG has reportedannual losses of about 1 percent of GDP. Subsequently, new investments were very limited, and EPCG's assets have deteriorateddue to a lack of maintenance and replacements. To improve its physical and financial conditions, EPCG has launcheda major reform program aimed at addressing its fragile financial position. To this end, the power utility is embarking on operational improvements, such as meter installations and loss-reduction programs, while introducing measures to 41The relatively small size of the remainingfinancing gap brings EPCG--on the assumption that it can successfully implementits reform and investmentprogram-within the range of beingable to borrow, akin to the situationof the Port o f Bar and the Airport of Montenegro (see below) on its own account and without fiscal implications for the state budget. 53 improve staff productivity. A strong earnings increase is expected from these actions. However, the improvement in EPCG's financial situation will only be achieved if the power utility is able to (i) maintain electricity production from local generation plants; (ii)improve its collections; and (iii)reduce its losses in line with its targets for 2008-1 1. As a result, there is a close interrelationbetweenoperational improvements and the realization of planned investment projects, particularly those aimed at rehabilitating and expanding existing generation plants. Together with complementary distribution networkprojects,their implementationshouldsuffice to place EPCG in a financially self-reliantposition. 3.15 I n parallel, EPCG's corporate structure will have to be adjusted. Improvements in EPCG's financial performance will require changes from the traditional form of governance-away from a vertically integrated, state-owned utility towards a commercially oriented company with an unbundled corporate governance structure. This process has started with the functional unbundling of EPCG into transmission, distribution, and generation units. Further steps need to be taken to finalize the utility's legal unbundling. Government strives towards a complete legal unbundlingof EPCG's transmission and market operations into ajoint stock company (JSC) by end-2008. The generation, supply, and distribution units will become legally separate JSCs by end-2009.Concomitantly, EPCG needs to develop a strategy for labor restructuringand skills allocation, and divesture to ensure the operational efficiency of the new companies. 3.16 A partial success in implementing complementary structural reforms will delay the improvement in EPCG's financial situation and might ultimately require the power utility's full privatization. In the coming 12-1 8 months, efforts must be focused on improving EPCG's operational and financial performance, while finalizing the legalunbundlingof EPCGactivities.Progress inthese two areas will provide the Government with more favorable conditions for attracting private-sector participation in EPCG. If these targets are achieved, resulting in improved earnings, private-investor interestin EPCGwill, in all likelihood, be higher-as will be the receiptsfrom any (partial) sale. 3.17 Increasing energy generation capacities presuppose the diversification of energy sources and active private-sector participation. Following the adoption by Government of the long-term energy-sector development strategy in 2007, a total of 1.5 billion will need to be investeduntil 2025 in new generation capacities (other than existing plants). Investments include the development of wind, small hydro, and solar power plants, as well as the Pljevlja 2 thermal power plant and the constructionof new, larger hydro power plants.Over the 17-yeartime horizon, this averages about 88 million annually, in current prices. Together with 0.3 billion investments required for the rehabilitationand expansion of existing energy infrastructure during 2008-1 1, this would add another average 67 million to energy- sector investments.These amounts can be lowered by extendingthe implementationhorizon, downsizing the investment plans, andor increasing private-sector participation in the energy sector. The trade-off among various sectors will require Government to decide on the cross-sectoral prioritization of conflicting public investment projects, which could be facilitated by a reassessment of the inherent economic benefitsand costs of keepingEPCGmajority state-owned. B. THETRANSPORT SECTOR4* 3.18 Montenegro has ambitiousplans to ensure the integration of the Montenegrin road network with those of neighboringcountries. In particular, two major highway corridors are foreseen-viz., Bar-Boljare highway (en route to Belgrade, Serbia, and the pan-EuropeanCorridor lo), and the Adriatic- the Ionian highway through Montenegro-as well as several other road projects considered to be of strategic importance.The planned investment for the two main highways is a central component of the transport 42Preparedby R. MartinHumphreys,Vickram Cuttaree, and StephenMuzira(all ECSSD). 54 strategy, with expected costs of at least 2.8 billion (109 percent of 2007 GDP). The scale of these projects underlines the importance, if they are to go forward, that the design and implementation schedules are fully reflective of both current and projected demand and the fiscal envelope available to Government. The sheer scale of these projects poses a serious fiscal challenge to the authorities and necessitates careful study of the associated fiscal risks and liabilities. Even if the implementation is stretched over a decade-considerably longer than currently foreseen-the annual average costs would exceed 320 million in current prices, in additionto about 100 million in annual maintenance costs. This requires a strengtheningof the comprehensive fiscal-sectoralstrategy, including all available options of private-sectorparticipation, the appropriatesequencingand timing of individual projects, the full reliance of propertender processes (thereby avoidingthe budgetary responsibilityfor considerableadditional cost, as seen by examples of direct procurementelsewhere in the region), and an open mind to reassessing the appropriatescope and size of these projects. Background 3.19 The transport system has long been acknowledged to be a necessary component in facilitating economic development and poverty alleviation. Montenegro's small size, the current narrowness of its economic base, with a strong reliance on tourism and agriculture, highlight the importance of developing an efficient and effective transport system to contribute to the generation of sustainable economic growth and poverty alleviation. In addition, Montenegro's geographical location and terrain-with 55 percent of the country above 1,000 meters-impact on trade, transport costs, and growth, underliningthe importanceof developinga moderntransport system and fully integrating it with those of the neighboringcountries inthe region. 3.20 The development of a core regional transport network is recognized as one of the most important objectives for the economic and social development of Southeastern Europe, which aims at strengthening intra-regional(trade) links and increasingaccess to the region's more remote areas. The EU has fully supported the core network development through continuous engagement and support, starting with the Transport Infrastructure Regional Study (TIRS) in 2001 and the Regional Balkans Infrastructure Study (REBIS) in 2003. In addition, the EU established in 2005 the South East Europe TransportOb~ervatory~~(SEETO) in 2005, chargedwith creatinga regionalconsensus to address existing problems and develop a core transport network in the region. It includes the Trans-European Network (TEN) Corridors in the region as well as other strategic routes connecting national capitals, regional centers, and the main ports and border crossings in a manner consistent with the Common Transport Policy of the European Commission (2001). The SEETO Secretariat, composed of regional experts, is required to produce five-year priority investment plans. The latest, the Multi-Annual Plan 2009-13, is currently under preparation(SEETO, 2007). 3.21 The SEETO core network amounts to 5,980 kilometers of roads, 4,584 kilometers of railways, 1,185 kilometers of inland waterways, 11 airports, 7 sea ports, and 2 river ports. Montenegrodoes not lie on any of the TENS,but it is crossed by two routes of the SEETO core road and rail network, viz., (i) Route 4, which runs from the port of Bar via Belgradeto VrSac on the border with Romania; and (ii) Route 2, which connects Podgoricawith the Durres-Tirana highway in Vore, Albania. The port of Bar and the Podgoricaairport are also defined as beingpart of the "core" transportnetwork. 43On June 11, 2004, the EuropeanCommission signed a Memorandumof Understanding with Albania, Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro on the development of the South East Europe Core RegionalTransport Network. 55 3.22 This chapter will review developments since the PEIR-1 in 2006. It will review actual and planned expenditures by mode, outputs, and financing needs (particularly given the ambitious development plans in this sector), and estimate the potential financing gap. It will also recommend improvements to reduce transaction costs, improve allocative efficiency in the sector, and underline the need for a greater contributionfrom private financial resources ifthese plans are to be realized.This will, in turn, require the strengtheningof the overarching institutionalframework and a careful assessment of the associated fiscal risks. The Institutional Frameworkof the Sector The Road Sector 3.23 Montenegro has made progress in the past few years in harmonizing the institutional framework for the transport sector with EU norms. In the road sector, a new law on state roads was adopted in mid-2004, harmonizing the national law with the requirements stemming from the acquis communautaire. In this process of approximation,the Directorateof Public Roads (DPR) was established as the body responsible for managing, maintaining, and building state and regional roads. In January 2005, when the new law was implemented, the DPR became operational as a line department within the Ministry of Maritime Affairs, Transportation, and Telecommunications (MMATT), which has overall responsibilityfor the sector. 3.24 These improvements have not resolved all challenges in the process of strengthening the capacity, administration, and management in the sector, not least because of the existence of human resource constraints, both in terms of numbers and capacities of the technical staff. For example, the Directorate of Transport is facing difficulty in attractingand retaining qualified engineers. Five of the 13 engineering positions have been vacant for more than a year, ostensibly due to salaries beingmuch lower than those prevailing in the private sector for comparable positions (see also Chapter IV). There is a similar capacity constraintat ministeriallevel. 3 -25 I n addition, planning and budgetary processes are weak-giving resultant investment estimates an indicative character. Furtherrefinements are urgently needed. The planningand budgetary processes includea number of deficienciesthat underminethe efficiency of expenditures, including(i) the absence of robust sector policies and adequate development ~trategies;~~ (ii)weaknesses in project identification and assessment; (iii)poor budgetary control; (iv) little use of the latest techniques to improve the efficiency of spending (such as performance-based contracting); and (v) little regular monitoring of the condition of the infrastructure assets. With regard to the latest point, there is, for instance, no road and structure inventory database. Only little information is gathered on traffic volumes and axle loads. Thus far, efforts in this regard have lacked a systematic approach and a robust application of methodologies. 3.26 The devolution of management responsibilitiesof the local road network to municipalities has proven difficult. The responsibility for the administrationand management of local roads lies with the municipalities. A recent World Bank (2008b) study has revealed that the devolution of the responsibility for managing tertiary (local and municipal) roads to local governments undermined the provision of adequate maintenance. Local revenue sources, such as vehicle registration charges, have 44 MMATT (2007) has developed a transport strategy, with support from the European Agency of Reconstruction (EAR), but whilst it providesa good overview o f the sector and highlights key priority projects, it includes neither a robust assessment of the institutional framework nor estimates of current and projected demand, all key elements required for determining an action and investment plan that is consistent with the fiscal envelope available to the Government. 56 generally proven insufficient, while transfers from the central Government tended to be inadequate or erratic.On the municipalities' side, administrativecosts are frequently too high and managerialcapacities weak. Whereas the situation in Montenegrois somewhat better than in some other countries in the region, the survey found that one-halfof the sampled localroad networkswere in poor condition. 3.27 There are no up-to-date, consistent design and construction standards in use. The current design standards for the road sector are based on old Yugoslav standards. The new design standards for road and bridge works, harmonized-to the degree possible-with relevant EU requirements and best international practice, await preparation.As a result, works on the road network have not yet achieved uniformity in the applicationand quality to EU standards. This weakness is particularly relevant for the local and municipal roads, for which the disparity between the current use of these roads, earlier standards, and availableresources is particularlypronounced. 3.28 The institutional coordination and management that is necessary to address road-safety problems is currently missing in Montenegro. The identification of road-safety problems is complex, not least because road-safety responsibilitiesare spread among various government agencies and shared by businesses and individuals. Reducing road deaths and injuries requires a systematic response that includes a strong focus on results, including interventions that address-and ensure compliance with- safety standards and rules for roads, vehicles, and users. It also requires robust implementation arrangements that include effective leadership, coordination, funding, legislation, promotion, and monitoring and evaluation. Currently, there is no strategy for addressing roads safety, and the coordinationamongthe different stakeholders is weak. 3.29 I n addition, there is no clear policy or set of regulations that would define the scope of private-sector participation. Although the 2006 "Strategy to Promote Foreign Direct Investment" specifically makes references to the granting of concessions for major infrastructure investments, there is no nationalPPP policy. The draft Transport Strategy does not present a sector-wideapproach to PPPs. In the road sector, a study funded by the Public-PrivateInfrastructureAdvisory Facility (PPIAF) is currently being prepared to assess available options for PPPs in the highway sector (ECORYS, 2008). It is envisaged that this study helps to define a clearer PPP strategy, permittingthe authoritiesto supersedethe current case-by-case approach with a more strategic one, taking into consideration all possible PPP options. 3.30 There is a clear commitment, however, to pursue a strategy aimed at accessing financial resources from the private sector. Not only does the state law on roads includeprovisionsfor the use of PPPs, but also is a new law covering PPPs and concessions is under preparation, aimed at replacingthe 2002 law on private-sectorparticipation in public services. Under that law, a Privatization Council had been made responsible for approving proposals for procuring investments with private-sector participation. Although some projects were implemented under the 2002 law, it was not considered appropriate for large road concession projects (ECORYS, 2008). A preliminary review of the draft concession law identified some issues but concluded that it was well drafted overall and a substantial improvement from the previous one. A Concession Commission is expected to be created and play a central role in the approval process for PPP projects. Although the staff of the Commission could use resources from the current Privatization Council, the new entity would have to be staffed quickly with very qualified PPP experts. 3.3 1 Capacity building beyond the operational establishment of the Concession Commission is critical for the realization of current development plans. The draft concession law has not been clear on the relationshipbetweenthe Concession Commissionand the line ministries (in some case there might be some conflicts between institutions on the authority for concessions). In addition, close coordination with the Ministry of Finance will be essential, not only to ensure alignment with the budget process but 57 also to properly manage the contingent liabilities that are associated with any PPP arrangement. Finally, although current efforts on transport PPPs are concentrated on only a few projects, a PPP capacity building program should be put in place at the level of the MMATT and transport-related public institutions,with a view to supportinga further development of PPP projects. TheRailway Sector 3.32 With the adoption of a new law in 2005, the regulatory framework for the railway sector is being adjusted. The new law reflects the relevant EU Directive, mandating the accounting separation between infrastructure and operations and among different lines of business. The law allows for the opening of the railway infrastructure to licensed local and international operators. Therefore, since January 2006, ieljeznica Crne Gore (ZCG) has become a holding company with two shareholder companies, one for operations and one for infrastructure.However, the current staffing profile with a skewed age distribution(81 percent of the staff are older than 41 years of age) might prove a constraint to further modernization. Further reform involving accountingseparation for each line of business, prior to organizationseparation and privatization, would be a logicalnext step. 3.33 The proposed regulatory body for the railway sector has yet to be created. At the ministerial level, the Department for Railway Transport within the Directorate of Transport has been endowed with the responsibilityof regulatingthe sector, includingthe establishment of an access charge regime and the definition of a common network statement. However, it has not yet developed the necessary capacity or been given requiredresources to undertakethese tasks successfully. TheAviation andMaritime Sector 3.34 The national airports are formally managed by Airports of Montenegro, a state-owned company created in 1999. Government purchased Podgorica and Tivat airports from JAT Airlines in 2003, through Airports of Montenegro. In November 2003, Government adopted a strategic Master Plan for the development of the sector. Immediately after this, Airports of Montenegroassumed responsibility for the modernization project of the airports in Podgorica and Tivat. However, this body is not fully functional, and there is an urgent need to restructure the administrative responsibilities and increase the effectiveness of the organizations.Analogous to the railway sector, this can be done most effectively by separating infrastructureand commercialoperations, while continuingto prepare for the restructuringand privatizationofthe state-owned enterprises. 3.35 Currently, Montenegro Airlines is the only national carrier. It has been created by Government in 1994 and made operational since 2000. It flies five airplanes on regular routes to European destinations in Belgrade, Budapest, Frankfurt, Ljubljana, Paris, Rome, Skopje, Vienna, and Zurich. The current dominant position of Montenegro Airlines may diminish after the newly signed agreement that would liberalize the sector and increase competition. There is no budget transfer to the airline from the statetreasury. 3.36 In the maritime sector, the separation of operational management and planning from regulatory functions is also at the center of efforts to modernize its institutional framework. This includesthe splitting of the port administrationto two port director offices.45The broader reform process requires the enactment of the new Port Law, which would turn Bar into a landlord port with a separate 45 One office covers the fjord (Boka Kotorska) with a head office in Kotor (and branch offices in Herceg-Novi, Zelenika, and Tivat) and the other one the Adriatic coastline and the Skadar Lake, located in Bar (with branch offices in Budva,UlcinjLJlqin,andVirpazar). 58 Port Authority and Port Operator Company, managed under a concession agreement. Notwithstanding some progress with the approval of the port master plan, delays in enacting the Port Law could lead to a delay in the reform process. 3.37 The port director offices are regional organizations under the MMATT, performing inspection and administrative duties and state control functions. These duties cover the construction, installationand maintenance of maritime lighting on maritime routes, technical examination of navigable and floating objects.The dedicated department within the MMATT comprises (i) the technical inspection of vessels and implementationof internationalregulation;(ii) safe navigation; and (iii) general affairs and administration.The Law on Port Operation, which is expectedto be enacted soon, will create a new port administrationand separatethe functionsof operations and planningfrom regulation. Expendituresin the Sector TheRoad Sector 3.3 8 Recurrent expenditure-following years of nominal cuts-has seen a moderate trend increase since 2005. Between 2005 and 2008, recurrent expenditure in the road sector increased by an average of 71 percent. Although the growth inthe last two years is lower than in capitalexpenditure, there seem to be an increasingimportanceput on allocatingmoreresourcesto maintenanceactivities. 3.39 The recent increase in budget allocations for recurrent expenses is now ensuringthat more resources are being allocated to routine maintenance. Historically, the maintenance budget was too low to cover the whole network.46During 2001-05, an annual average of only about 5 million was allocated to recurrent expenses needed for the routine maintenance of roads. The central Government's 2008 budget foresees about 1 2.8 million, with 10 million being allocated to routine maintenance. This amount is expected to increase to 16 million, equivalent to about 9,000 per kilometer in maintenance, which is reasonableby internationalstandards and very close to the needs of 18 million estimatedby the Directoratefor Transport. 3-40 The budget for investments in rehabilitation and reconstruction has been significantly increased, with additional funds being provided by international financial institutions (IFIs). Between 2001 and 2007, the total investment envelope for rehabilitation, reconstruction, and new roads has increased by a factor of three, from 10.4 million to 33.5 million.47However, investments from the budget have also increased significantly, by 7.9 million in 2007 and 13.8 million in 2008. Most of the investments in 2006-08 have been directed towards the rehabilitationof existing assets (such as roads or tunnels). Financingsources have become more diversified, with IFIs playing a bigger role in the financing of road infrastructure.The review of the 2008 budget shows that the implemented road works basically covered the upgradingof main roads, with a view to meetingEU standards, including the construction of by-passesand climbing lanes (ECORYS, 2008). 46In 2004, the financial resources allocated to road routine maintenancewas estimated to cover about 44 percent of needed maintenanceand 18 percentof needed improvements. 47Between2006 and2007, the investmentbudgetincreased by 25 percent. 59 Figure3.2: Capital and Recurrent Expenditure in the Road Sector, 2005-08 45.0 40.0 1 -.-35.0 - -=E 0 30.0 - 25.0 - &! --t.Recurrent ._ f 20.0 CI U 5 15.0 - 2 10.0 - 2003 2004 2005 2006 2007 2008 Source; Directorateof Transport;and World Bank staff estimates. 3.41 A positive but limited step to improving expenditure efficiency was taken three years ago with the subcontracting of maintenance works. Since 2005, following a competitive tender, Crnagoraput (now owned by Strabag) has been made responsiblefor the maintenance of the entire road network. Not sufficient emphasis has been placed, though, on applying performance-based contract principles.48At the time of the tender, Crnagoraput submitted lower proposals for each region, but only two compliant proposals from domestic firms had been received. While the subcontracting of maintenance activities to a firm selected through competitive bidding is a very positive step, it should be ensured that future tenders for this service receive more interest from (foreign) firms so as to allow for potentially cheaper maintenance costs per kilometer of road network. The current contract expires in 2010. 3.42 Montenegro has made first, preliminary experiences with private-sector participations in the financing of infrastructure investments. Montenegro has started to engage in PPP-type arrangements. The Sozina Tunnel between Podgorica and Bar was constructed and is maintained by Monteput, a JSC with the state as its main shareholder. In return, the company is allowedto levy tolls for a restrictedperiodof time. A road BOT PPP was recently granted by the Municipality of Herzeg-Novifor a contract to rehabilitate a 12.5-kilometer road segment and extend an existing road by 5.2 kilometers. The project was prepared with the involvement of the Privatization Agency under the Agency of Montenegrofor EconomicRestructuringand ForeignInvestment. 3.43 Budgetary obligations for the road sector will remain very high in the coming years, notwithstanding MMATT's efforts in assessing the economic and financial viability of private-sector participation in key road projects. Two road projects, for which Government expressed highest priority, are the Bar-Boljare and the Adriatic-Ionian Highway projects, estimated to cost 2.0 and 0.8 billion, respectively. For these two motorways alone, the costs represent about 109 percent of 2007 GDPS4' 48See also www.worldbank.org/transport/roads/resource-guide/index,html. 49The high costs for the 180-kilometer highway project between Bar and Boljare reflects the difficult terrain, necessitatingthe constructionof at least 42 tunnels and92 bridges. 60 Although the feasibility and the PPIAF-funded ECYROS (2008) studies are not yet completed, the Table 3.4: Montenegro: Railway Income Bar-Boljare highway has become the Government's Statements, 2006-07 (in millions of euro) "signature project", receivingpolitical support at the 2006 2007 highest level. The International Finance Corporation (IFC) has, in the meantime, been contracted as a Revenue 25 133 24 609 Operating revenue 13 143 14 850 lead advisor for the planned PPP arrangement. Subsidies 9 250 7 252 International experience has shown that highway Other revenue 3 340 2 507 concession projects are rarely implemented without Total expenses 33 754 32 181 Operating expenses 29 135 29 681 public contributions. In addition, the concessionaire Matenals, fuel, spare pans 4 226 3 150 often asks for either minimum revenue guarantee Electncity 2 009 2 314 (with the inherent risks of compensation payments Subsistence resources 0 665 0 692 Amortization 4 822 4 900 representing possibly considerable contingent Salary. wages, and personnel expenses 12 949 I5 696 liabilities for the budget). Other costs 4 464 2 929 Additional expenses 4 619 2 500 Operating losses -3 402 -5 072 Railways and Ports Net losses -8 021 -7 572 Source Montenegnn Railways (ZCG) 3.44 Like the other railways in the Western Balkans, the Montenegro railway company is not financially profitable and depends on Government subsidies. The railway has not been able to generate any positive net income in the last five years. Total aggregate operating losses from 2002 to 2007 stood at about 77 million. In 2007, net losses were around 7.6 million, with an operating ratio of 2.0 without subsidies. This performanceplaces Montenegro at the same level as-or only slightly better than-the railways ofthe neighboringcountries (Figure 3-3).However,these railwaysare all loss-making entities, depending heavily on Governmentsubsidies. 3.45 Although there is some capital investment in the railway sector, partly through IF1 financing, the level of investment remains lower than in the road sector. Between 2004 and 2007, total investmentin railway infrastructurehas been7.25 million, or 29,000 per kilometer of tracks. This figure is considerably lower than the 37,900 per kilometerof roads in the main network. Since 2003, the railway company startedtaking loans from IFIs to ensure investmentin infrastructure.A 15 million loan was contracted with EIB to upgrade rail infrastructure and equipment. Another 15 million loan was signed with the EBRD in 2007 to improve track safety and efficiency as well as a labor severance program.Additional financing is expectedfrom EIB (34million) and EAR (3 million). 3.46 Labor and low operating revenue remain a major constraint to profitability. The high operating ratio reflects a low revenue base for given expenses (Table 3.4). With 53 percent of operating expenses, costs for salaries and wages represent a very high share. In fact, total labor expenses, having increased by 20 percent from the previous year, exceeded total operating revenue. Although a reform program is beingprepared, includingwith plans for private-sectorparticipation, the financial performance of the railway will hingeon the success in rationalizingrailway linesand reducinglabor costs. 3.47 Budgetary allocations to the port and airport sectors are limited. Both sectors have their own revenue streams. Public investment in the port sector represents less than 5 percent of total transport budget; the ports largely rely on port dues for the financingof their activities.Private-sectorparticipation i s expected for the port of Bar, to be made possibleby the new law on port operations. Future investments in the port of Bar of about 35 million are expected to be financed directly through private-sector investment and via port revenues (that is, mainly port dues and concession payments). Since 2004, airports became self-sufficient through the introduction of user charges; they do not need any state support in addition to guarantees for loans contracted with IFIs (including the 1 1 million and 11.5 million loans in 2003 from EBRD and EIB, respectively, needed to complete the Podgorica airport modernizationplans). 61 Figure3.3: Railway of Montenegro Income Statement Summary (in millions of Euro) 5.00 4 5 0 - 400 - 350 - 300 1 2 50 2 00 150 1 00 0 50 Note: Total Revenue include capital grant ("sustaining programof railway infrastructure") Sources; MontenegrinRailways (ZCG); World Bank (2005). Outputs in the Sectors TheRoad Sector 3.48 The overall scale and scope of the road network appear adequate, but statistics can mislead. Montenegro has a road network totaling approximately 7,000 kilometers-with 884 kilometers of main and primary roads, 964 kilometers of regional and secondary roads, and around 5,000 kilometers of local roads. This is equivalent to a road network density of 500 kilometers per 1,000 square kilometers. This figure is broadly consistent with the density of regional comparators in Southeastern Europe (with an average of about 555 kilometers per 1,000 square kilometers of territory) but below the levels in the new EU member states (NMS) or the older EU countries (Table 3.5). Other factors, such as the size of the country, the distribution and density of the population, and the country's geography play a very considerable role in determining a country's road network. These effects become evident when making the comparison on a different measure of road density-viz., road kilometers per 1,000 people.With this measure, Montenegro is ahead of most of its regionalcomparators. With more than 11 kilometersof road per 1,000 inhabitants,Montenegro's figures are comparable to those of the NMS.As this reflects average density, and given the country's lower population, this figure as well explains as much as it obscures important elements in the marked disparity in road density and, equally importantly, the availability and accessibilityof roads betweenthe coastaland mountainous areas. 3-49 The overall road network infrastructure needs urgent maintenance investments;see below. Nearly one-half (47 percent) of the entire road network is in poor or very poor condition, reflecting inadequate maintenan~e.~~ A vast majority of the network is exhibiting widespread signs of pavement 50The full breakdown of the main road network is 15 percentgood, 39 percent fair, 37 percentpoor and 10 percent very poor. 62 distress and failure^.^' The many Table 3.5: Central and Eastern Europe: Road instances of patching also confirm the Infrastructure Coverage assessment of a weakened pavement that (inmillions of euro) i s in need of increased periodic maintenance interventions. These figures Road density imply that the road quality in km of roads per km of roads per 1,000 km' 1.000 people Montenegro slightly worse than in Croatia and considerably better than in Montenegro so0 11 1 Bosnia and Herzegovina.'* A recent Southeastern Europe, including Montenegro 555 5 9 survey undertaken by the World Bank Albania 657 3 5 (2008b) revealed that tertiary roads in Bosnia and Herzegovina 427 5 6 Croatia SO6 6 4 Montenegro are in a similar condition, Kosovo 780 3 3 with 50 percent of the sampled roads Macedonia, FYR SI3 6 4 beingfound to be in poor condition. Serbia so0 5 2 Select new EU member states (NMS) I.427 I 9 9 3.50 Czech Republic 1,646 12 5 The problem of poor public Estonia 1,320 41 2 infrastructure-and especially road Hungary 1,733 I S 7 infrastructure-has been widely Slovenia 1,007 I O 2 recognized. In the recent Global Regional averages Competitiveness Survey (World Europe and central Asia 580 8 6 Upper middle-income countries 1,076 9 2 Economic Forum, 2008b), Montenegro Lower middle-income countries 328 4 9 ranked a relatively high 82nd of 131 High-income countries (OECD) 1,340 I 7 3 countries surveyeds3-but only 99th for Source World Bank, WDI indicators and study data the quality of its overall infrastructure and 107th-forthe quality of its road infrastructure.For the latter sub-indicator, only Albania and Bosnia and Herzegovinascored lower amongthe countries in SoutheasternEurope (Figure3.4). 3.5 1 Inadequate maintenance increases the rate of network deterioration, creating considerable contingent liabilities (in terms of future rehabilitation costs) and economic costs (as a result of increased user costs). Without adequate maintenance, roads deteriorate at an increasing rate until reconstruction is necessary-at considerably greater expense than any short term saving in maintenance expenditure. Heggie and Vickers (1998) report that rehabilitatinga paved road, in current terms, is three times more expensive than maintaining it. Expressing this relationship in net present value terms, reconstruction exceeds consistent maintenance by about 35 percent. In addition, failing to maintain a paved road has been estimated to increase user costs by a factor of three-mainly for reasons of additional time, fuel, and vehicular wear and tear. Already, vehicle operating costs are high in Montenegro, given the fact that the network's design characteristics, in terms of speed and axle loads, are below European standards, affecting road safety and competitiveness. These include including longitudinaljoint cracking, longitudinalwheel path-cracking,and ravelling, rutting, and low-to-highundulationsanddistortions. 52 The comparative figures for Croatiarespectivelyare 32 percentpoor and22 percentvery poor and for Bosniaand Herzegovina43 percentpoor and22 percentvery poor. 53 This result makes Montenegro the most competitive country in the Western Balkans. Serbia was ranked 91st, Macedonia94th, BosniaandHerzegovina106th, and Albania 109th. 63 Figure 3.4: South Eastern Europe: Comparative Ranking of Infrastructure and RoadsAs Critical ElementinDeterminingRegionalCompetitiveness,2007 Overall Infrastructure Road Infrastructure Source: World Economic Forum (2008b). 3.52 Unresolved road-safety challenges have become an increasingly serious socio-economic problem in Montenegro. Provisional accident data were collected for this report (see Appendix), revealing that road safety has become a serious and increasing economic and social problem in Montenegro, comparable to those in Albania and Bosniaand Herzegovina(Figure 3.5). More than 2,000 people are being injured or killed every year in road traffic crashes. From 2004 to 2006, the number of injured or killed has increased by almost 30 percent, from 1,841 to 2,347. While the number of fatalities had remained broadly unchanged, at approximately 90 deaths per year, it increased sharply in 2007, in which year 122 people were killed on Montenegrin roads (Figure 3.6). Remaining challenges are considerable, amplified by Montenegro'smountainousterrain: the fatality rate of 7.3 per 10,000 vehicles i s nearly seventimes the rate ofthe "safest"-but flat-EU member countries. Figure3.5: Select EuropeanCountries:Fatalities Figure3.6: Montenegro:Fatalitiesand Injuries per One Million Inhabitants,2007 in Montenegro,2004-07 ` 2 1 II 0 'OooT T 140 . 2500 -- : 2000 E .- 2004 2005 2006 2001 64 3.53 The economic cost of traffic accidents is likely to exceed 2 percent of GDP, largely as a result of the risen number of registered vehicles. It has grown by more than 50 percent during 2004-07, contributing to the increase in the number of accidents and personal damages by more than 40 percent during the same period of time. As the number of vehicles is expected to grow even further, it can be deducted that, under ceteris paribus conditions, the number of traffic accidents and, with it, injuries and fatalities will continue to grow as well. Already, the socio-economic costs of traffic accidents are very high, with the large amount of accidents and fatalities presentinga growing burden for the health sector. With estimated economic costs exceeding 2 percent of GDP, the situation is worse than the typical situationfor middle-incomecountries, where the costs of road crashes averages about 1.5 percent of GDP (Peden et al., 2004). TheRailway andMaritimeSectors 3.54 Montenegrin Railways (ZCG) has a small network with rolling stock and tracks in poor condition. The railway company operates 330 kilometers of track, with a 167-kilometer main line connectingthe port of Bar with Podgoricaand the border with Serbia. In addition, ZCG maintains an 83- kilometer send line connectionbetweenNikSiC, Podgorica, and the Albanian border.During 2005-07, the number of carried passengers has been about 1 million, with a regular yearly average decrease in passenger transport for the last 17 years. Freight has seen a continuous increase since 2003, but the level i s still one-third of the volume of operations prior to the dissolution of SFR Yugoslavia. Speed is often below 50 kilometersper hour on key routes, largely due to the poor state of rail infrastructureand safety concerns. About one-half of the total number of vehicles (locomotives and trains) is not in working condition, and defective cars are used for spare parts. 3.55 Increased competition from the road sector, paired with unresolved safety concerns, constrain growth in railroad traffic, as reflected in the low (and uncompetitive) speed made necessary by safety concerns and the poor state of tracks and rolling-stock. The country's worst train accident in 2006 resulted in 45 deaths and 184 injured, further reducing the railway's attractiveness to passengers. With the majority of the passengertraffic occurring on the main north-southcorridor, the constructionof the Bar-Boljare highway will be to the detriment of ZCG. 3.56 The port sector (especially Bar) is in a better situation, as traffic and the potential for private-sectorparticipation increases.The port of Bar, carryingabout 95 percent of all harboractivities in Montenegro, is in the process of increasing private-sector participation as a way to improve its efficiency and performance. The port of Bar is well located in the Southern Adriatic Sea and has sufficient depth (12 meters) to be an attractive port destination. It has at its disposal a generally good infrastructure, which can accommodate additional traffic without major investments.Current trends are very encouraging: containertraffic, for instance, has increasedby more than 50 percent between2006 and 2007, partly reflectingthe large increase in imports. Expenditure Needs 3.57 The financing requirements of the sector are restricted to the road and rail sector, including four broad categories of need for future expenditures: (i) standard maintenance: recurrent expenditures for routine, winter, and scheduled periodic maintenance, which are necessary to ensure that the overall infrastructure does not further deteriorate and that recovered road network can be maintained: 65 (ii) maintenance backlog: capital expenditures requiredto clear the current maintenance backlogand returnthe roadnetworkto good condition; (iii) safety-related investments: capital expenditure required to improve the safety of road and rail networkand align infrastructurewith relevantEuropeanstandards; and (iv) new infiastructure: capital expenditure required to meet the development needs of the network, reflectingdemand projectionsand integrationobjectives in the transportnetworks. 3.58 Routine, periodic, and backlog maintenancecosts alone are estimated to exceed 0.5 billion during 2008-12 (see Table 3.6). Adjusted for inflation, the level of expenditure (other than recurrent expenditure) required to address backlog maintenance during 2008-1 2 is estimated to exceed 280 million, slightly more than that for routine, winter, and periodic maintenance (256 million). These estimates are based on the current road classification, implying that the updating of the current classification would likely lead to a reduction in both backlog and normal maintenance. However, these estimates include neither expenses for the maintenance of bridges and tunnels nor those for new constructionor m~dernization.~~ 3.59 The level of expenditure needed for recurrent maintenance of the road network is higher than the amount historically allocated for this purpose. The level of estimated recurrent expenditure required to ensure that the main and secondary road network remains in a "steady state" condition amounts to 30 million per year, about 60 percent more than is spent at this time. This estimate includes approximately10 million for routine and winter maintenance and 20 million for periodic maintenance. These sums do not include the 21 million necessary for the recurrent maintenance of the local road network-a sum far in excess of what has been spent for this purpose thus far. 3-60 I n addition, significant investments are Table 3.6: Indicative Maintenance Cost required to reduce road-safety risks on the most Projections for Road Network,2008-12 dangeroussections of the road network. The main (in millions of inflation-adjustedeuro) recommendations of the survey included the installation of guard rails in strategic locations, 2008-1 2 Annual average Total improving junctions, introducing speed reducing measures in towns and facilities for pedestrians, pre- Roadnetwork 1074 537 0 warning, and local speed limits in sharp curves. Maintenancebacklog 56 3 281 5 Routine and winter maintenance 21 9 1095 Based on the sample of roads surveyed, it was Periodic maintenance 29 2 1460 estimated that a budget of altogether 105-1 38 Main roads 43 5 217 5 million would be needed over a medium-term Maintenancebacklog 24 9 I24 5 horizon to improve the road-safety situation on the Routine and winter maintenance 5 7 28 5 Periodic maintenance 12 9 64 5 entire main network of 1,848 kilometers. Secondary roads 23 0 1150 Maintenancebacklog 1 1 8 59 0 Routine and winter maintenance 3 4 1 7 0 TransportSector Development Plans Periodic maintenance 7 8 39 0 Local roads 40 9 204 5 Maintenancebacklog 19 6 98 0 3.6 1 Government foresees 3.2 billion in road- Routine and winter maintenance 12 8 64 0 Periodic maintenance 8 5 42 5 sector investments. These include the two major highway corridors, with estimated coasts of 2 Source. World Bank staff estimates billion for the Bar-Boljare highway and 0.8 billion for the Adriatic-Ionian highway. In addition, the 54 By international standards, these costs are relatively high.They reflect (i) decades of negligence; (ii) a current use of the road network by heavy-weight lorries not foreseen at the time of construction; and (iii) the difficult topologicalconditions. 66 Draft TransportDevelopmentStrategy lists 13 road projectswith a total cost estimate of 588 million for the period 2008-15 (Table 3.7), including the reconstruction of the road between NikSiC and the border with Bosniaand Herzegovina. Table 3.7: Montenegro: StrategicallyImportant Road Infrastructure Projects Projected time Preliminary cost estimates of construction In billions in percent Implied annual (years) of euro of 2007 GDP average Strategic road projects 3 358 1320 Ofwhrch coveredby main road backlog 0 125 4 9 Strategic road projects, net of backlog 3 234 127 1 Construction of highway betweenBar and Boijare (border with Serbia) 5 2 000 78 6 0 400 Construction of Adriatic-lonian highway (between Croatian and Albanian borders) 6 0 770 30 3 0 128 Construction of mini by-pass in Podgorica 2 0 025 10 0013 Reconstruction of coastal road from Podgoricato the border with Croatia 3 0 035 1 4 0012 Construction of by-pass in Bljeio Polje 3 0 012 0 5 0 004 Reconstruction of road between NikSic and border with Bosnia-Herzegovina 9 0 093 3 6 0010 Construction of road betweenRisan and iabljak 9 0 093 3 6 0010 Constructionof road betweenGuSinje-Plavand VeruSa 4 0 035 1 4 0 009 Construction of road betweenCetinje and NikSic 5 0 085 3 3 0017 Construction of bypass in Roiaje 2 0 014 0 5 0 007 (Re)construction of road HercogNovi-Trebinje (section Meijine-Petijevici) 3 0 014 0 5 0 005 Construction of Verige bridge over Boka Kotorska bay 2 5 0 087 3 4 0 035 Reconstruction of Adriatic road 5 0 059 2 3 0 012 Reconstruction, modernization of road Podgorica-NikSic-Trebinje (border with 811 3 0018 0 7 0 006 Construction of bypass Golubovci 2 0 010 0 4 0 005 Upgradingof transport connectivity with Savnik and tabljak with arterial network 2 0 009 0 4 0 005 Source: Draft Transport Development Strategy, and MMATT 3.62 In the railway sector, the priority remains to improve the speed and safety on the main corridors and to implement the restructuring plan. One priority is to allow an increase of speed, which would require substantial investments in the reconstruction of tunnels and slopes. Although the railway network is relatively small, with only 250 kilometersof tracks, infrastructureassets are valued at 2.2 billion. Still, it remains one of the most expensive railways in Europe in terms of the unit costs of maintenance, which is mainly due to the country's mountainousness. As a result, maintenance costs are at about 70,000 per kilometer and year. For the main corridor Bar-Vrbnica, this means maintenance costs of about 1 1.8 million, significantly exceeding the total railway maintenance expenditures of 3-7 million in past years (MMATT, 2007). In addition, the 2006 railway accident made safety considerations a strategic priority, requiringinvestment in infrastructureas well as the rehabilitationof trains. Finally, an important objective of the railways company remains the implementationof its restructuringplan, which should not only improves its financial performance but also allow private participation in the operating company. For the port and airport sectors, financing needs are important but-as discussed above-will not requiresignificant public contribution. Revenuesfrom the Road Sector 3.63 The road sector has been a net contributor to the central budget.55The total revenue from road user taxes is estimated at 165 million (or 6.5 percent of GDP)-this is three times as much as the expenditures on roads. In this, Montenegrois not different from its neighbors in the Western Balkans, or ''It is standard practice not to establish a direct link between transport-sectorreceipts, which representbudgetary revenues, andthe sources of financing, which follow budgetallocationsto the sector. 67 indeed elsewhere in Europe. However, the relative importance of the fuel tax as a source of revenue is particular. As a share of tax revenues, fuel taxes amount to 21 percent. This figure contrasts to less than 10 percent in Albania, Kosovo, and the average in EU countries.An additional 6 million comes from a road tax, which is equivalent to a vignette for the use of roads. 3.64 Fuel is already taxed at high rates. According to GtZ (2007), on the basis of November 2006 fuel prices, only FYR Macedoniacould sensibly consider an increase intaxation for bothdiesel and petrol product^.'^ For Montenegro, together with Albania, Bosniaand Herzegovina, and Serbia, prices for these products are already at or above EU levels (Figure 3.7), and any further increases would need to be consideredcarefully, also for reasons of affordability and social and regionalcohesion. 3.65 In the railway sector, operating revenue is insufficient to cover operating expenses. Like several railways in the region, the Montenegrin railways company is a loss-making entity, unable to operate without subsidies. Given the increasingcompetition from the road sector, it is unlikely for the revenue base to be increased. Without further reforms, ZCG cannot bring revenues at par with operating costs. As discussed above, the implementation of reforms, combined with a reduction in loss-making activities, could help to bring into balance costs and revenues.Additional investments would be required to improvethe performance and safety of the railways. Figure 3.7: FuelPrice Comparisons in (South) East Europe, November 2006 Albania Bosnia a Kosovo WR Montenegro Serbia Slovenia Croatia Romania Bulgaria Hungary Greece Herzegovina Macedonia Source; GTZ (2007). Key Recommendations Strengthening theInstitutionalFramework 3.66 In recent years, the funding provided to the road and railway sectors have been insufficient to clear backlog maintenance and perform routine and periodic maintenance. This resulted in delays in implementingsome priority constructions.IfGovernment decidedto realizeexistingexpenditure plans, as discussed above, it would have to provide the fiscal space necessary for significant increases in the allocation from the budget, together with additional contributions from multilateral or bilateral development partners. The alternative is, of course, to radically revise the proposed implementation schedule for capital projects. 56Under the "user pays" principle, there is an issue with increasing taxes on diesel not used for motor vehicle purposesthat would needto be addressed. 68 3.67 Given very high socio-economic costs, a coherent safety strategy for all modes of transportation should be made a high priority, implying that sufficient resources be allocated so as to ensure that the necessarymeasures and reforms can be implemented.A clear transport investment plan is important to prioritize and sequence expenditures for backlog maintenance, to address challenges in recurrent and periodic maintenance, to upgrade the network and (re)construct road segments of strategic importance. It is thus crucial to base decisions on robust estimates of current and projected demand, specifyinga multi-annualfinancing framework for correspondingexpenditures. 3.68 A detailed medium-term budgetary program can develop into an important planning tool for prioritizing and sequencing public investments. As such, it places fiscal constraints over the transport strategy, requiringthe development of criteriaaccordingto which decisions on the identification of projects are made and available alternatives to public investments assessed. This requires a careful weighing of costs and benefits, includingtheir broader socio-economicimpacts.Sound feasibility studies represent an importanttool for this task, while careful project designs which integrate measures aimed at increasing safety features and decreasing maintenance requirements can reduce future rehabilitation or safety improvement works. Detailed designs of road projects should only be initiated after the corresponding feasibility studies were completed and budgetary resources been made available in the context of a medium-termexpenditure framework. 3.69 There needs to be a clear delineation between the roles of Government and those of the institution responsible for managingthe road network. Government should restrict itselfto settingthe policy agenda and promotingthe necessaryreforms and legislative actions. Management functions should rest with "company-like" bodies with competent staff and a clear mandate of strong performance.The management bodies should be given autonomy to manage their tasks independently, without undue interferencefrom Government. 3.70 There is a need for significant efforts in institutionalstrengtheningand capacity buildingin various institutions in the transport sector. The reforms being implementedwill create a high demand on the staff of existing and newly created institutionto perform their new functions.With the increase of budget in the road sector, the DPR would need additional resources for planning and supervising more works. An increased role of the private sector means that specific skills will have to be attracted and retain to design, procure and monitor PPP projects. Staff with the require expertise should be recruited and retained. The reforms in railways to make the railway company a more commercial entity and to regulate the sector would also require more modern techniques and skills less available in the public sector (such as experts in the finance, legal, and regulatory fields). ImprovingManagementStructures 3.71 To improve performance, the DPR's management structure needs to be modernized. Steps in this direction would include (i)a clearer delineation of responsibilities within the DPR; (ii)the definition of clear goals and targets, in close cooperationwith the MMATT (possiblythrough the signing of a bilateralperformance agreement); and (iii)human resource actions aimed at retainingand attractinga sufficient numbers of highly qualified staff (which probably need to be paid at wage levels equivalent to the private sector); and (iv) the provision of training programs, with a view to ensuring that the organization is up-to-dateregardinglatest developments and best practice in road management, planning, and prioritization,as well as methodsto ensure efficient spending. 3.72 There should be an up-to-date road inventory database that covers all the classes of roads under the agency's control, which should include details on the surface type, condition, drainage structures and usage (volume and type of traffic) on individual roads. It is important to standardize the road inventory and keep it as simple as possible so as to avoid incurring extra costs on collecting large 69 pieces of informationthat may not be useful. The road inventory would serve as an important instrument to review and update the functional classification system (accompanied, where necessary, by the strengthening of the overarchinglegal framework). The laws should be explicit in referringto the criteria for each class of road-that is, main, secondary and local roads-and in describing the procedures under which transfers from one category to another or those governing the designation for new roads. Responsible agencies for each class of roads should be mentioned, including clear chains of command, responsibility, and funding. Any changes to the road network, at any level, would need to be clearly reflected in the ownership record. 3.73 An asset management system should be maintained and updated. Data should be continuously collected on road inventory and basic traffic counts. Pavement conditions should be monitored on a rolling basis, as should be the revolving functional importance of different roads within the network. This would aid in the definition of network-wide maintenance priorities. The Asset Management System should support the preparationof bothannual and multiannualplans for maintaining the road networktaking into account the condition, function, available funding and prioritization. The use of economic decision models like the Highway Design and Management (HDM-4) model would be instrumental in assisting effective prioritization processes. 3.74 Good management practicesrequire increasedaccountability,transcending the term's narrow definition, which restrictedcompanies to simplyjustify the use of the funds received. The concept needs to be looked at more broadly, with road users as one principal target audience. This would require the agency to have (i) established good financial management systems and auditing processes; (ii)assessed the needs of road users (including through user satisfaction surveys); (iii) evaluated the performance of the agency against pre-determined performance criteria; and (iv) prepared annual reports that discuss the aforementioned elements. Recommendedmeasures 3.75 The private sector can play a more active role in the maintenance of the road network, resulting in possibly significant cost savings. This could be done throughthe widespread introductionof output- and performance-based (OPRC) maintenance contracts, defining a "final product". The work selection, design, and product delivery-including underlyingdecisions on the methods used-would be entirely the contractors' responsibility. Relative to traditional contract arrangements, OPRCs allocate a higher risk to the contractor.But this is intended, as they create incentivesto improve efficiencies in the process and a higher degree of effectiveness inthe design, technology, and management (as the contractor seeks to minimize cost for achieving a given output). Other innovations in the management and maintenance of the road network should be explored for the applicability to the Montenegrin situation, rangingfrom experiences made elsewhere with concession and maintenance contracts, management area contracts (used, e.g., by the UK Highways Agency), while applying stricter quality control to improve allocativeefficiency. 3.76 Current investment needs, notwithstanding the recent budget increaseand possible private- sector participation, will require a significant increase in public funds relative to previous years. Public funds are roughly adequate to ensure proper routine and periodic maintenance, leaving unfunded both backlog maintenance and plans for the construction of new highways. International experience shows that PPP arrangements for the construction of motorways require a significant participation from the public sector to make the project financially and economicallyviable-and this is more likely the case in a small, mountainous country like Montenegro. The already high level of user charges reduces the potential for further increases, while there has been only limited experience of toll roads in Montenegro. Such considerations suggest that a significant budget allocation is likely to be required in the coming years to implementthe planned investment program. 70 3.77 Montenegro needs a concession law that draws from best international practice. Internationalexperience has shown that successfully PPP projects benefitted from an overarching legal, regulatory, and policy framework that is consistent in itself. Montenegro is taking concrete steps towards increasing private-sectorparticipation, not only in the transport sector. However, international investors are likely to be more attracted to a pipeline of PPPs as it allows the costs associated with preparing a proposal across several projects. Moreover, smaller projects-certainly when viewed from an international perspective-would result in lower financing capacity thresholds required from potential bidders. Government could thus receive more proposals from local and regional investors. However, as the country's PPP program strengthens, the role for the strong legal, regulatory and institutional framework, includingon the management of relatedcontingent liabilities, is also becominga priority. The merits of establishinga specialistPPP unit should be considered. 3.78 The definition of a PPP agenda for the broad transport sector and the individual projects' scope and size presupposescaution and a sense of realism.Experienceof PPPshas shown that projects that require investments at the level foreseen for the Bar-Boljare project will only attract a handful of bidders that will have the requiredexpertise and financial strength. The level of borrowing required and the limited reliability of traffic forecasts make these projects very risky for lenders. One way to reduce this risk is to simply reduce the scope of the project, or implement it in phases (such as the initial construction a two-lane highway, which is to be extended to four lanes at a later point in time). In addition, the structuring and procurement of a complex PPP project requires time. This means that the invitation to bidders to submit proposals should start only when most of the concerns expressed by them have been addressed. Not doing so would likely reduce a project's attractiveness, limiting the number of bidders, and the value of the PPP option for Government. C. CONCLUDINGREMARKS 3.79 The public investment program outlined in the Chapter will be implemented during in a phase of the business cycle that will be less benign than during 200647. The international environmenthas deteriorated considerably,while endogenous and exogenous factors that have fueled the boom during the immediate post-independence period are beginning to dissipate. As a result, tax revenues-as a share of GDP-will decline. To protect the capital budget from the fluctuations in the overall business environment, and to be able to gradually increase public investments, very considerable efforts will have to be made, as discussed in the next Chapter, to contain recurrent expenditure obligations. Under the constraints and economic assumptions discussed in Chapter 11, the capital budget could increase, at 2008 prices, by about 30-40 percent between 2008 and 2012. However, the aforementioned investment plans in the two priority sectors energy and transport alone exceed the fiscal space by a considerablemargin(see Figure 3.8). 3.80 The realization of the Government's investment plans thus requires utmost care and caution. For every project, policymakersneed to carefully assess the degree to which the private-sector might find it economically profitable to (co-)finance these projects-whether in the form of PPPs, concessions, or outright privatizations. However, in order to be able to negotiate any form of private- sector participation, Montenegro needs to urgently adopt a concession law that draws from best internationalpractice.Some reformsand projects-for instance, those related to EPCG-openthemselves to the option of full privatization, while others are more effectively be realized by carefully negotiated PPPs or concession arrangements. It is critical that (i) feasibility studies address risks and costs as frankly as inherent potentials and benefits; (ii) possible contingent liabilities are carefully assessed; and (iii) proper procedures of tenderingare applied and "shortcuts" avoided. Government has to have the courage to reject those projects that-even after considerable "political capital" has been invested-proves economically not viable and would, consequently, present an undue burden to subsequent budgets. 71 Concomitantly, policymakers need to carefully assess whether the implementation period of a given project could be usefully expanded. For the two motorways, a lengthening of expected construction period-partly for the reasons mentioned in Box 2.1-would bring the timeline closer to the experiences with similar investments elsewhere. In addition, Government needs to strengthen its cross-sectoral development strategy, define criteria of prioritization, and reassessthe scope and size of projectscurrently foreseen. All of these measures, as summarized in Figure 3.8, could help to bring annual costs for public investments closer to the available fiscal envelope. And lastly, without strict control over the recurrent budget, these investments would soon be out of reach entirely. Figure3.8: Montenegro: Public Investmentsand FiscalConstraints 550 500 Average annual investments for other strategic road investments, (assuming IO-year implementation period) 450 Average annual investments for Adriatic-Ionian motonvay, (assuming IO-year implementation period) 400 5 350 Average annual investments for Bar-Boijare motonvay, 0) (assuming IO-year implementationperiod) ca 0 * 300 -'E $ 250 5 200 150 nstant 2008 prices), mist scenario(blue), Average annual road-sector maintenanceinvestments (backlog, routine, winter, and periodic maintenance) 100 in pessimisticscenerio (grey), 50 and in pessimisticscenario with Average annual investments for the constructionof adjustment to fiscal SGP criterion (red) new power-generationfacilities (up until 2025) 0 2007 2008 2009 2010 201 I 2012 72 APPENDIX BEYOND PRESTIGE OBJECTS: CHALLENGES OF ROAD SAFETY5' A3.1 Long periods of negligence incur large social and economic costs, necessitatingGovernment to undertake considerable investments for the existingroad 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. A3.2 The road safety situation in Montenegro is very poor, compared to both the EU average and neighbors in the region. The fatality rate on Montenegro's roads-measured as deaths per capita-is 50 percent higher than that of EU average. Taking into account that car ownership in Montenegro is still considerably lower than the European Union average, this situation will deteriorate even further if no actions are taken. Traffic accidents entail considerable economic losses, addinga development problemto human tragedy. In Montenegro, as well as in the other countries in the Balkans and the EU, efforts have been made in recent years to address this problem, but reforms were insufficient and inadequate-partly because addressingthe situation properly requiresconsiderableinvestments. A3.3 Even within a regional context, Montenegro has a very high fatality rate. The collected accident data show that road safety is a big-and increasing-problem, with more than 2,000 killed or injured every year. During 2004-07, the number of killed and injured has increased by an average 12.6 percent annually, from 1,841 in 2004 to 2,628 in 2007 (Table 3.8). Comparing Montenegro's figures, expressed in fatalities per one million inhabitants, to those of other European countries (see Figure 3.9) shows that Montenegro is ranking not only significantly higher than the 15 "old" EU countries but also higher than the 10 "new" EU countries. In Montenegro, 143 fatalities were registered per 1,000,000 inhabitants (average 2005/2006), while the EU-25 average in 2005 was 91 fatalities per 1,000,000 inhabitants (82 for EU-15 and 136 for EU-10)58.Montenegro has also a higher fatality rate from road accidents than some of the neighboring countries, such as Serbia (117), Bulgaria (1244', and Slovenia (129). Whereas the trend in EU is towards a decline in number of fatalities and injuries, Montenegro's figures point in the opposite direction. Montenegro's fatality rate, between 7 and 8 per 10,000 vehicles, is more than 5 times higher than some of the best performingcountries in EU, and higher than that of most of its neighbors. 57Preparedby Jesper Mertner, Senior Road Safety Expert,COWISA/S. Forthe full report, see COWIS A/S (2008). CAREdatabaseEU. 59Datacollected duringseveral studies inthe region. 73 Table 3.8: Montenegro: Car Accidents, Injuries, and Casualties, 2004-07 2004' 2005' 2006' 20072 Total accidents 5,377 6,192 7,185 8,760 Damageonly 4,157 4,845 5,63 1 7,008 With personaldamages 1,220 1,347 1,554 1,752 casualties3 1,841 2,037 2,342 2,628 Fatalities 91 95 85 122 Injuries(light and ~evere)~ 1,750 1,942 2,257 2,506 Sources: ' Louis Berger SAS, Road Accident Reduction Benefits, Technical Memorandum No. 12; Policy Directorate;and Consultant'sestimates, for 2007, basedon other data sources. Figure 3.9: FatalitiesPer One Million Inhabitants, 2000,2005 Killed per million inhabitants 250 200 150 100 50 0 A3.4 The economic cost of traffic accidents is estimated to exceed 2 percent of GDP. The number of registered vehicles has grown by more than 50 percent during 2004-07, while the number of accidents and personal damages has increased by more than 40 percent. As the number o f vehicles will grow further, it is likely that, under ceteris paribus conditions, the number of traffic accidents and injuries will continue to grow. Already, the socio-economic costs of traffic accidents are very high, with the large amount of accidents and fatalities presenting a growing burden for the health sector; see Peden et al. (2004). They reportthat, in many low- and middle-incomecountries, the burden of traffic-relatedinjuries 74 is such that they represent between 30 and 86 percent of all trauma admissions. Traffic accidents are very costly for a society, posing a development problem as much as they represent human tragedies. As reported in Louis Berger SAS (2008), apart from human suffering and the loss of life, accidents result in losses to the economy of at least 38 million a year (based on 2006 data), and these losses could well be in excess of 50 millions per year, depending on unit prices used. This is equivalent to at least 2 percent of GDP-a high figure when compared to the typical situation for middle-incomecountries, where costs of road crashes averages at about 1.5 percent of GDP (Peden et al., 2004). A3.5 Actions to improve road safety therefore need to be taken urgently. During the period 2004- 07, there have been almost 400 deaths and over 8,000 injuries in road accidents, resulting in estimated economic losses to the Montenegrineconomy of over 150 million. Unless urgent and effective action is taken to reducethe annual toll of deaths and injuries, such human and economic losses will continue into the future. No country howeverdeveloped can afford to sustain such losses year after year so Montenegro must address this growing problem by taking the necessary actions to improve road safety. Recurringand growing losses of this magnitude are undoubtedly inhibiting economic development and Government needsto recognizethat failure to invest in road safety will result in such lossescontinuingyear after year. Road Safety Inspection A3.6 For this PEIR, a EuroRAP-style road safety assessmentwas undertaken on a sample of the main and regional road network, providing also general impressions of problems and recommendations. A number of sample roads were selected for assessment of the road safety condition of the roads. The total length of roads inspected for road safety conditionwas 550 kilometers, accountingfor more than 60 percent of highways(885 kilometers)or 30 percent of regionalroads and highways(1848 kilometers). 0 136 kilometers on route M2: Podgorica-Mioska-KolaSin-Ribarevina-Bijele Polje- Borderwith Serbia (136 km); 0 137 kilometerson route M18: Podgorica-NikSiC-Pluiine-Border to Bosnia-Herzegovina; 0 37 kilometerson route M6:NikSid-Border to Bosnia-Herzegovina; 58 kilometerson route M2.3: Podgorica-Cetinje-Budva; 0 26 kilometerson route M2: Border to Croatia-Igalc-Kameneri; 40 kilometerson route M2.1:Kamenari-Risan-Kotor; 0 35 kilometerson route M2: Kotor-Radanovici-Budva-Petrovac; 0 47 kilometerson route M2.4: Petrovac-Bar-UlcinjNIqin; 27 kilometerson route M2: Virpazar - Podgorica; 0 13 kilometerson New Tunnel road: Sutomore-Virpazar, The EuroRAP methodology is basedon three protocols (see EuroRAP, 2006, and Lynam et al., 2007) that can be applied in any country assuming accident data are available, viz., (i)risk rate mapping; (ii) performance tracking; and (iii) roadprotectionscore: 0 Risk mapping is the preparationof colored maps showingthe risk of deaths and injured that road users face, divided into individual risk and community risk. The individual risk is based on registeredaccidents and traffic. The accident rate (for instance, killed and serious injured per year per million vehicle kilometers) is calculated and typically illustrated on maps. By presentingthe accidentrate, the risk comparedto the traffic may be assessed.The community risk is more targeted towards the road authorities and these maps will typically show the 75 density of accidents (for instance, fatalities and serious inured per kilometer). Other maps could be comparison with similar roads and the potentialfor accident reduction.Only limited accident data by road section were made available; however, for route M2, some accidents have been collected for a 1%-yearperiod as part of the feasibility study for M2j see Louis Berger SAS (2008b). Thus risk mapping may be illustrated for parts of M2 for the rather short period. Performance tracking is a way to for instance evaluate benefits of safety schemes by identifying the development of killed and serious injured on road sections over time. Typically, road sections which have shown a reduction in the number of accidents over time are identified as well as those with little or no changes. The data are checked for consistency. The measures applied on the road (remedial, enforcement, and education) that may explain the change are indicated. Until now, only Britain has presented results on performance tracking and road improvements, but work is also ongoing as part of national programs in Austria, Ireland, Italy, and Spain. There were insufficient data to allow for performance tracking in Montenegro. Road protection score is based on the EuroRAP-styleassessment of the roads. It is focused on addressing four types of accidents generally accounting for more than 80 percent of fatalities on non-urban roads-viz., head-on collisions, single-vehicle accidents, intersection collisions; and accidents involving vulnerable road users. Roads are assessed accordingto (i) how well the medians are treated (separation of directions); (ii) the design standard and frequency of intersections; (iii) how well the road sides are protected and how the edge of the carriageway is treated; and (iv) the availability of facilities for pedestrians and cyclists. The road is given a score between 1 (lowest) and 4 (highest score) for each of the four elements, andthe scores are aggregatedto produce a "risk rating" for the roads. Ifdata are available,the four elements are weighted accordingto the distribution of fatalities on rural roads among the four elements. Median treatment. To obtain 4 points on mediantreatment, the road should be divided by a wide median, while 1 point is given for typical undivided single carriageways as most of the Montenegrinroads. Thus, almost all rural roads in Montenegrowould presentlybe assessed to 1 with regardto the mediantreatment. Edge-of-road protection. To obtain 4 points on edge-of-road protection, there should be at least 3.5 meters hard shoulders, continuous safety barriers, or a 10-meter safety zone. In addition, the section should be rather straight and flat. Most of the inspected roads have no or only narrow shoulders, only barriers on most severe sites and are running through mountainous terrain with generally high frequency for sharp bends and crests and dips. Thus the Montenegrin roads were generallygiven a score of 1-2 points. Intersections. With regard to intersections, 4 points can be given if major intersectionsare out of level (mergingtraffic only) and the frequency of minor intersectionsare low, thus no 4-leg junctions and less than 1 T-junctions per kilometer. In Montenegro, most major intersectionsin the rural area are a T-level priority junctions, thus scoring 1 point while on most roads there is a rather low frequency of minorjunctions thus scoring 2-4 points, thus the score for intersections will typical be between 1.5 and 2.5 points. 76 0 Facilitiesfor non-motorizedtraffic. Roads should to obtain a rating 4 for the provision of facilities for non-motorized traffic. This could be provided with protected crossings where traffic moves slowly, and be provided with segregated footways and cycle-ways. If there is no provision the rating is 1. In the rural areas there are generally no facilities for non- motorizedtraffic, thus the score is generally close to 1, 0 Build up areas. In addition to the EuroRAP assessment, the survey also registeredfacilities that were used in linear villages, towns, and other build-up areas. Apart from a few footways, unprotected pedestrian crossings, and a very limited number of humps, there are generally no measures used in the build-up areas to support the lower speed limit. RoadSafety Inspection A3.7 The survey estimated a fatality accident rate of 0.06 per one million vehicle kilometerson the main M2 north-south route through Podgorica. This figure is three to eight times higher than in many other Europeancountries.For single carriageways, such as the M2, fatality rates are between 0.008 (Sweden), 0.01 (UK and Ireland) and 0.02 (Spain). In general, single carriageways tend to have the highest fatal rates (compared to motorways and dual carriageways). There are generally large variations in risk rates among countries, but also between single carriageway roads in a country. The same is the case on M2 in Montenegro.Average fatality rates vary from 0.00 to 0.19 fatal accidents per one million vehicle kilometers, with the highestfatality rate found betweenPodgoricaand BioCe; see Tables 3.8-3.9. A3.8 The average fatality density on M2 in Montengro is 0.13 fatal accidents per kilometer per year, varying from 0 to 0.38 fatal accidents per kilometer per year. The highest density of fatalities is found, again, between Podgoricaand BioCe; see Table 3.11. The data appear imply that the seriousness of the accidents tends to be highest in the mountainous areas to the North of Podgorica, where-on some sections-more than 50 percent of the accidents involve fatalities andor injuries. The underlyingreasons appear to be a combinationof two reasons, viz., (i) the traffic level near Podgorica is higher, resultingin lower average speed; and (ii)in the mountainousareas, an accident will not be as forgiving, leadingto a higher number of fatalities and injuries per accident. Table 3.9: Montenegro:Accidents on Route M2,2006-2007-S1 Accidents per year (2006 and first half 2007) From To km traffic fatalities injuries damages alI Barski most BijelO POlJe 13.0 5,518 0.7 18.0 32.0 50.7 Bijelo Polje Ribarevina 5.6 5,518 0.0 14.7 26.0 40.7 Ribarevina Slijepac most 6.0 5,052 0.0 7.3 7 3 14.6 Slijepac most Mojkovac 17.0 5,832 4.7 24.0 23.3 52.0 M o jkovac KolaSin 20.2 6,552 2.7 20.0 32.0 54.7 KolaPiin Mioska 17.1 4,325 2.0 24.7 21.3 48.0 Mioska Man Morava 7.2 4,485 0.0 4.0 16.0 20.0 Man Morava Bioce 32.0 4,485 4.7 24.7 46.0 75.4 Bioce Podgorica 7.1 5.380 2.7 18.7 54.0 75.4 Podgorica Golubovci 6.5 6,875 0.7 46.0 93.3 140.0 Golubovci Virpazar 20.1 6,875 I.3 12.0 42 0 55.3 Total 151.8 5,503 19.5 214.1 393.2 626.8 .Y/J)uI.LL' Cowis (2008) 77 Table 3.10: Montenegro: Accident Rates on Route M2,2006-2007-S1 Accident rates per million vehicle kilometers From To km traffic fatalities injuries damages all Barski most BijelO POlJe 13 0 5,518 0.03 0 69 1.22 1.94 Bijelo PolJe Ribarevina 5 6 5,518 0.00 1 3 0 2.3 I 3.61 Ribarevtna Slijepac most 6 0 5,052 0.00 0 66 0.67 1.33 Slijepac most Mojkovac I 7 0 5,832 0.13 0 66 0.64 1.43 Mojkovac KolaSin 20 2 6.552 0.06 0 41 0.66 1.13 KolaSin Mioska 17 1 4,325 0.07 0 91 0.79 1.77 Mioska Man Morava 7 2 4,485 0.00 0 34 1.36 1.70 Man Mora?a Bioce 32 0 4,485 0.09 0 47 0.88 I.44 Btoce Podgorica 7 1 5,380 0.19 I 3 4 3.87 5.40 Podgorica Golubovci 6 5 6,875 0.04 2 82 5.72 8.58 Golubovci Virpazar 20 I 6,875 0.03 0 24 0.83 1.10 Total 151.8 5,503 0.06 0.70 1.25 2.06 Source: COWIS (2008). Table 3.11: Montenegro: Accident Density on Route M2,2006-2007-S1 Accidents per kilometer per year From To km traffic fatalities injunes damages all Barski most Btjelo Polje I 3 0 5,518 0 05 138 2 46 3 89 BijelO POlJe Rtbarevtna 5 6 5,518 0 00 2 63 4 64 7 27 Ribarevma Slijepac most 6 0 5,052 0 00 122 122 2 44 Slijepac most Mojkovac 170 5,832 0 28 141 137 3 06 Mojkovac KolaSin 20 2 6,552 0 13 0 99 158 2 70 KolaStn Mioska 17 1 4,325 0 12 144 125 2 81 Mioska Man Mora?a 7 2 4,485 0 00 0 56 2 22 2 78 Man Mora?a Bioce 32 0 4,485 0 15 0 77 144 2 36 Bioce Podgortca 7 1 5,380 0 38 2 63 761 1062 Podgorica Golubovct 6 5 6,875 0 1 1 7 08 14 35 21 54 Golubovci Virpazar 20 1 6.875 0 06 0 60 2 09 2 75 Total 151.8 5,503 0.13 1.41 2.59 4.13 Source: COWIS (2008). A3.9 Most of Montenegro's road network is high risk, including those segments with a high traffic volume. Comparingthe distribution of risk rates by lengthof roads reveals an importantdifference with many other countries; see Figure 3.10. While most other countries tend to have a large proportion of road sections within the low-medium to medium risk rate, the M2 in Montenegrohas almost 90 percent of its sections in the high group. Of the roads surveyed, the high-trafficroute between Podgorica and Budva, as well as the roads linking Montenegroto Bosnia-Herzegovina,60are among the most dangerous. 6oGenerally, the road networks tend to deteriorate closer border stations, including Albania. 78 Figure 3.10: Distribution of Fatalitv Accident RiskRates 100 I 80 i I i 60 Mcdiuirr-low nsk 40 1 20 0 Montenegro Spain Sweden United Kingdom Source COWS A S (2008) Figure 3.11: Montenegro:Euro RAP Ratings for Select Roads -~ ... . . . . . . . . . .- LLroK.\P r m n d ...... Safrrt . . . . . New tunnel Sutornoie-virpaza ~ -1 , = - z M24 Petrovac-Bar--Uiclnj ! I---- - MI8 Podgorica-NikBiC , -1 J r-- M2 Virpuar-Podgorica I I-- L I M2 tintor- Budba-Petrovac -_______~- I i - M2 HK--lgalo--Kdmeneii 1 i -- - MZ I Kamenari-Kisan--tiotor , MI8 NikSic-Plutine-BiH I I 10 1 5 2 0 2 5 3 0 3 5 4 0 Souicc COWIS (2008) 79 A3.10 Generally, the key problems related to insufficient maintenance. The survey found that (i) guard rails tended to be missingon inner and outer side of road where there are deep and steep slopes; (ii) existingguard rails were often damaged, too short, in poor condition, with gaps, and mixed with concrete poles; (iii) fixed objects (such as trees, poles, stones, or rigid signs) were posted within safety zone of road; (iv) mountain sides, stones, and concrete were within the road's safety zone; (v) curves were lacking background markings, warnings, and speed limits, (vi) bridges were often missing guard rails on approaches; (vii) tunnel entrances were obstructed by fixed objects; (viii) longer tunnels were missing light and guiding; (ix) tunnel road surface and tunnel walls were in poor condition; (x) stones were falling on the road from mountain sides on many sections; (xi) the use of signs was often lacking (local speed limits were not consistentlyused and the endingof local speed limits rarely indicated); (xii) warningsigns for curves and steep gradients were not used consistently; (xiii) junctions were often designed too dynamic, often with very fast right turns; (xiv) the few pedestrian crossings were not always located properly and not clearly marked or protected; (xv) road markings were worn or missing; (xvi) there were no measures to motivateor force drivers to respect speed limits in build-up areas and in towns with speed limits; and (xvii) there were few or no facilities for pedestrians, forcing pedestrians onto the road. Road user conduct-with respect to speed, reckless overtaking, high speed in curves and build up areas- represents an additional risk element. A3.11 To remedy the aforementioned problems, based on the experience from similar roads in, for instance, Southern Serbia, the estimated cost per kilometer on the typical mountainous roads is estimated at around 60-80,000 per kilometer, only for road safety improvements. On the flatter segments, the costs may be in the order of 45-55,000 per kilometer. The assessed costs are generally based on the findings of the Feasibility study of the road betweenBelgradeand Montenegro; see COWIS (2007, 2008). The costs are mainly used to ensure the safety zone by guardrails, improvement of junctions, improvementof tunnels and improvement in built-up areas. This means that, only for the 550 kilometers on the road network sampled in this survey, the cost of applying the safety measures on the entire length would be in the magnitudeof 35-45 million. Basedon the available accidentdata from the M2 road, the cost assessments described above, the social costs of accidents used in the feasibility study in Serbia, and assuming an effect of 40 percent if all above described measures are applied will lead to economicbenefitsas shown in Table 3.12. Table 3.12: Montenegro: Economic Benefit of Investmentby Section (M2).2006-2007431 Accident reductions by year From To fatalities iniuries damages Benefits Costs Benefit/ serious light (per year, in euro) cost ratio Barski most Bijelo Polje 0 27 144 5 76 1280 159,893 910,000 17.6 BijelOPOlJe Ribarevina 0 00 117 469 1040 67,893 392,000 17.3 Ribarevina Slijepac most 0 00 0 59 2 35 2 93 31,680 420,000 7.5 Slijepac most Mojkovac 187 192 7 68 9 33 639,147 1,190,000 53.7 Mojkovac KolaSin I 0 7 160 640 1280 397,333 1,414,000 28.1 KolaSin Mioska 0 80 197 7 89 8 53 334,827 1,197,000 28.0 Mioska Man.Mora?a 0 00 0 32 128 6 40 22,080 504,000 4.4 Man Mora7a Bioce 187 197 789 1840 650,827 2,240,000 29.1 Bioce Podgorica 107 149 597 21 60 400,907 355,000 112.9 Podgorica Golubovci 0 27 368 1472 3733 294,187 325,000 90.5 Golubovci Virpazar 0 53 0 96 384 1680 2 16,907 1,005,000 21.6 Total 8 17 68 157 3,215,681 9,952,000 32.3 Source, COWIS (2008). 80 A3.12 To improve the road safety situation on the entire main network of 1,848 kilometers costs an estimated 6105-138 million. The remaining roads are not expected to be in better road safety condition than the sample roads inspected, and may even be in worse condition than the sample roads, partly because the latter include the most frequently traveled roads in Montenegro. However, assuming that the remainingroads are in similar conditionand that 80 percent are inmountainousareas would mean that, to improve all roads, the total costs would be in the range of 55-72 million on regional roads and another 50-66 million on highways. 81 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 thefollowing objectives concomitantly, viz., to (i) increase effectiveness and professionalism of the public administration in key areas criticalfor achieving the EU integration objective; (ii) prevent a "brain drain" towards theprivate 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 couldfoster 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 thepublic administration have revealed that overall efectiveness 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 stafl and outsourcing non-corefunctions to theprivate sector. A. BACKGROUND 4.1. Montenegro has made considerable progress towards creating a more efficient public sector, including by readjusting the composition of public-sector employment towards priority sectors. The reform process remains, however, work-in-progress; the relatively large public administration continues to be constrained by high costs and low effectiveness.The underlying problem transcends purely fiscal challenges. The large size of Government-due to the frequent existence of (i) overlapping functions; (ii) insufficient coordination; and (iii) ill-defined lines of accountability among ministries, agencies and other state subordinate entities-hampers decision-makingprocesses and reduces the quality of service delivery. There has been a proliferation of agencies and subordinate entities enjoying operational autonomy and, in many instances, revenue-raising capabilities. Government thus faces a double challenge.On the one hand, for reasons of fiscal sustainability,the overall wage bill needs to be contained,62while, on the other one, an unreformedpublic administration risks to hamper policy- making and implementation, impacting value-for-money considerations and the quality of service delivery. 4.2. Major elements of the 2003-09 Strategy for Public Administration Reform have already been implemented. The public-administrationreform has aimed at bringing public administration closer to EU standards and international best practices. The modernization program has included measures to increase overall efficiency in the delivery of public services-principally by (i) pursuing further decentralization; (ii) improving public service delivery quality; (iii) establishing competitive structures; (iv) creating a client-oriented public service; (v) accelerating administrative modernization, including through the increasingprovisionof e-government options; (vi) ensuringcontinued deregulation; and (vii) strengthening management and monitoring. The adoption of the public administration reform strategy, together with a clearly defined action plan, represented an important step towards the modernization of Montenegro's public administration.This becomes particularly evident when comparingthe experience in Montenegroto that of some of its Southeastern Europeanneighbors. 61Preparedby SanjaMad2areviC-$ujster,DanijelaVukajloviC-Grba, andDanijelNestiC(all ECSPE). 62Chapter I1recommendsa policy that aims at keepingthe wage bill constantin realterms. 82 4.3. The legal foundation for the reform process has been laid. In 2004, Parliament adopted the Law on the Civil Service and Employees, which addressed deficiencies that had previously existed in the legal definition of civil servants and state employees. Other changes affected, most notably, the de- politicization of the public administration (up to the level of state secretaries). Government introduced additional changes that strengthened rules for recruitment, promotion, and training, while regulating possible conflicts of interest. It streamlined the number of mini~tries,~~established and strengthened regulatory bodies, and made initial strides towards reforming the salary system and introducing a merit- based pay system. 4.4. The (sub-)legal framework for an efficient and effective public administration has been e~tablished.~~ In particular, the relevant laws that regulate salaries and compensations for civil servants, state employees, state officials, and employees in the judiciary have been adopted since PEIR-I (World Bank, 2006), while implementing regulations that (i)increasedthe decompression o f wage rates (from 36 to 38 classes); (ii)set the basic salary; (iii)defined fixed and variable portions of salaries for state officials, civil servants, and state employees; and (iv) introduced a performance appraisal system. A significant portion of the legislation was adopted or amended during 2007 and became effective in 2008. It is still too early to assess the overall impact of the recent reforms. Some clauses have already been challenged in the administrative and constitutional courts, typically for reasons that gave ministers too much discretion over individual salaries or the establishment of "specialized" positions (including extra bonuses), thereby diluting the underlying "equal pay for equal work" principle. For a summary of post- PEIR-I reforms, see Table 4.1. 4.5. Still, further progress is required to ensure convergence with EU standards. While the EU Progress Report (European Union, 2007) recognized the progress made towards a professional, efficient, accountable, transparent, and independent public administration, it refers to a number of existing weaknesses and inefficiencies. Additional efforts are needed to meet 1995 Madrid criteria6' and be able to implement and enforce the acquis communautaire. Government has worked closely with the EU to meet the requirements inherent in the integration process into the European Administrative Space66. 63 The new Government formed in 2006 has been smaller than the precedingone. Four deputy prime ministers and 15 ministers were replaced by two deputy prime ministers and 13 ministers. It has beenproposedrecently, however, to re-introduce a third Deputy Prime Minister. 64 Government introduced additional changes to the organization and work of public administration.It closed the Agency for Public Administration, establishedthe Human ResourceManagement Authority (HRMA), charged with the task of maintainingthe humanresource (HR) registry, includingsalary information, and providedpolicy support to Governmentin horizontalHR management issues. 65 Together with the Copenhagen criteria, the ones adopted at the Madrid EuropeanCouncil are so-called accession criteria. In 1993, at the Copenhagen European Council, the EU agreed that the associated countries in Central and Eastern Europe that so desire should have the right to become EU members. Concerning the timing, it was stated that accession would take place as soon as an associatedcountry was able to assume the obligations of membership by satisfyingcertain economic and political conditions, the Copenhagencriteria. Membership also required that the candidate country had to have created conditions for its integration through the adjustment of its administrative structures, as underlined by the Madrid European Council o f end-1995. According to the Madrid criteria, (i) EU legislation had to be transposed into national legislation; and (ii)the legislation had to be implemented effectively through appropriate administrative andjudicial structures. The latter requirement was viewed as a prerequisiteof the mutual trust required by EU membership; for details, see http://ue.eu.intlueDocs/cms_Dataidocs/pressdat~en/ec/ 00400-C.EN5.htm. 66 During the 8th meeting of EU Ministers of Interior Affairs in Strasbourg on November 7, 2000, participating delegates defined European Administrative Space as the "environment in which the national administrations are called upon to assure homogeneous levels of service efficiency and quality." 83 Table 4.1: PEIR-1Recommendationsand Policy RI irms, 2007-08 PEIR-I Recommendations Policy Reforms To develop a medium-term civil-service pay strategy that will leadto adecompression Largely fulfilled. Governmentadopted changes ofthe Law on Civil Servants of the salary structure for positions that are most difficult to recruit andretain and and Public Employees,resulting in a moderate decompression in salaries, but that can be implementedwithin a fiscally sustainable resource envelope insufficient to accurately reflect underlying demand for skills and expertise To reduce the impact of seniority-basedallowanceson total civil-servant pay and Largely unfulfilled. Seniority-basedallowanceshave not been removed restructurethe collective-bargaining process to facilitate future policy reforms from the new wage bill and the Law on Civil Servantsand State Employees; collective bargaining process was not restructured To enhance the capacity of the Civil Servie Administration (CSA) by Considerable improvement. The CSA becameapart of the Ministry for Interior implementing a credible performance-appraisalsystem and following through and was replacedby the Human ResourcesAgency (HRA). The HRA improved on other outstandingcivil-service reforms within a realistic timetable significantly the process of selectingcandidates within public administration, of training public-sector employees. of creating the data base. andof adopting a regulation with which extraordinary performancecan be rewarded There are still considerable implementation problemswith these reforms To strengthen the instituhonal arrangements for overseeingandmanagingthe Nor accepted, but public administration reform becomea part of agenda for EU implementation of the public admnistration reform, including by developing a integration. with managementof that reform being communicatedto individual sequence action plan with resource implications admnistrations rather than one administrative unit. To develop a consolidatedhuman-resource data base for planning and managingthe Notfulfilled Data base has not yet been compiled and does not contain dataon all entire public service public employees and/or their employment andworking history To plan and undertake a horizontal review of government functions and activities with Largely unfulfilled, Reviews havenot been carried-out in the major sectors, while the aim of abolishing "lefkover" structures from the previous system and strengthen some additional administrations were established, increasing administrative staff. capacities in areas most neededto support effective EU integration. To plan vertical functional reviews of three to four major sectorsor functions in order Partially fulfilled, Most of administrative units have preparedthe systematization to reduce inefficiencies and identify potential savings. o f postions,but without the significant cuts of their number, reflecting a certain unwillingness lay off staff and reduceinefficiencies. To carry out a comparativeassessmentof how the ELI integrahon processhas been Fulfilled, Comparative assessmentwas completedand presentedin National managed in countries of similar size (e g ,Lithuaniaor Estonia) Programfor Integration (Government, ZOOS). 4.6. I n parallel, the wage bill will have to be brought to a sustainable level, notwithstanding additional demands placedon the public administrationin the context of meetingthe challenges in the EU accession process (which entail increasingly complex policy coordination requirements and particular expertise). As discussed, the broader fiscal-policy objectives require this. The experience of EU-867 suggests that this will be a long haul-effort (World Bank, 2007b). More than two years after accession, it became clear that the harmonization with the acquis cornmunautaire-rather than being a "one-off' effort-needed to be supported by soundly performing systems across the whole government, with a professional and independent civil service in place, motivated by a merit-based remuneration and promotionsystems. B. EFFECTIVENESSPUBLIC ADMINISTRATION OF 4.7. Government effectiveness in Montenegro is still lower than among Eastern European and Baltic countries-but it is improving at a considerably faster rate. The World Bank, with its governance indicators, has sought to capture the quality of public administration worldwide (see, e.g., Anderson and Gray, 2006). Comparing Montenegro's results to other countries in the region highlights remaining weaknesses in terms of corruption, rule of law, regulatory quality, and government 61 EU-8 refers to eight, formerly Communist countries that joined the EU in the 2004 enlargement, viz., Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia. Cyprus and Malta, whichjoined the EU at the same time, are not includedin this aggregation. 84 effectiveness. It is probably not surprising that Montenegro lags behind the pre-2004 accession EU members (EU-15) between 57 percentage points (control of corruption) and 39 percentage points (government effectiveness).Although Montenegro compares well with other countries in the South and Eastern Europe, government effectiveness indicators still lag behind the ex-Communist EU members (EU-8+2); see Figures4.1. Among the five Western Balkan countries, Montenegro ranks only third with respectto control of corruption(Figure 4.la). The underlyingtrends, however, point in the right direction for all four indicators(Figure4.1b). 4.8. Selected Doing Business indicators (World Bank, 2008a) as well show the need for Montenegro to close remaining gaps with OECD countries in the areas of administrative and judicial processes. Transaction costs of obtaining building licenses have represented a particular challenge, as do those on the time required for registering property, starting businesses, or paying taxes (Table 4.2).68Some improvementshave been observed in various areas, and further improvementsshould be expected in the coming years, with the strengthening of regulatory agencies, the resolution of significant backlogof court cases and first successes ofthe landregistry reform. Figure4.1: Government Effectiveness and Regulatory Quality, 2007 100 , Regulatory qualify (regional Gov't effectiveness (regional average) SLO CZE SVK HUN LAT CRO POL TUR BUL ROM MNE MKD SRB KOS ALB BIH Sources: World Bank GovernanceIndicators. 68 To address those challenges, Government has requested World Bank assistance on addressing these type of challenges in the context of a project aimed at strengtheningland administrationand managementissues The project is in its final stages o f preparation. 85 Figure 4.la: Rule of Law and Control of Corruption, 2007 100 , Control of corruption (regonal average) Ill1I( EST SLO CZE HLJN LAT LIT SVK POL CRO TUR BUL ROM MNE MKD BIH SRB ALB KOS Sources: World Bank Governance Indicators. Figure 4.1b: Governance Indicators, 200647 80 0 Montenegro 0 Eastern Europe and Balttcs 60 2006 2007 B-.- 8E 40 g y/ 3 20 0 Government effectiveness Regulatory quality Rule o f law Control of corruption Sources: World Bank Governance Indicators. 86 Table 4.2: Selected Doing Business Indicators, 2008 No.of procedures perpayment Duration (in days*, inhours') Cost to total tax rate MNE OECD MNE OECD MNE OECD Starting business 15 6 24* 15' 6.2 5.1 Dealing with business licenses 19 14 185* 153* 559.6 62.2 Payingtaxes 88 15 372' 183' 31.6 46.2 Registering property 8 5 86' 28' 4.6 2.4 Enforcing contracts 49 31 443 * 545* 25.7 17.7 Source: Doing Business (2008). 4.8. Problems are well recognized within the country, but relevant institutions are severely understaffed. The Strategyfor Public Administration Reform for 2003-09 recognizedthe urgent need for reform, not only to increase the efficiency of the public administration and but also to strengthen the country's overall competitiveness.Together with tax rates and other more easily quantifiable indicators, the provision of effective public services represents a critical element to investors' ultimate decision regarding their preferred site of production. The Government rightly points out in its strategy that a competent, efficient, and motivatedpublic administration,simpler and cheaper operating procedures, and an efficient and independentjudicial system are basic institutional determinants that lead to a favorable businessand investmentenvironment. Efficiency Considerations 4.9. Public administration in Montenegro consists of five layers of organizational structure, viz., Government ministries (13); central state administrative offices (2); secretariats and commissions (4); public sector funds, agencies and institutes (27), and local self governments (2 1). While Montenegro's legislationconsolidates public-administrationemployees into only four separatecategories (civil servants, state employees, state officials and judicial employees), subordinate legislation (decrees and rulebooks) de facto differentiates public administration into six categories. These are (i)civil servants and state employees (including employees of local government units); (ii) public servants (including employees in health, education, and social welfare); (iii) judiciary; (iv) uniformed services (police, defense, and intelligence); (v) regulatory agencies and state fund employees and (vi) state officials. There is a vast set of legislation that regulates the employees in each of these categories which would require another consolidationattempt beyondrecent 2007 measures(Box4.1). 87 Box 4.1: Public Sector RemunerationPolicies in Montenegro Montenegro consolidated the rulesfor wage determination across the civil service through the amendments to the Law on Salaries of Civil Servants and State Employees, but there are over 60 legislative pieces on employment rights and obligations of thepublic administration in Montenegro. Only in the last two years, some 30 new pieces of legislation, including decrees and agreements, have been adopted, not necessarily contributing in an effective manner to the objective of increasing the transparency ofremuneration withinpublic administration. Collective agreements for civil servants. The 2004 Law on Civil Servants and State Employees (LCSSE) and the 2007 amendmentsregulate the rights, obligations,and responsibilitiesof civil servants, while defining their salaries as well as those of other state employees in the central government's administrationand other bodies that had been established to provide civil service. This generic law, covering public servants in health, education, culture, and social welfare, provides for the establishment of salary levels through collective agreements. However, different wage coefficientsand bonuses for similar posts can be appliedacross the civil service. De facto autonomy for local governments. Staff in local authorities is partially covered by the Law on Civil Servants and State Employees, but also through the Law on Local Self-Government (2003). While they are supposed to follow the same job classification as per the LCSE, the local governments preserve the autonomy in setting their own coefficients for different posts, different basic salary, and bonuses. Municipal administration officials in Podgorica are covered by a separate decree adopted in 2006, defining its own coefficients (see paragraph below). Special salaries and supplements to political appointees. The Law on Salaries and Other Compensationsof State Officials (2007) and the 2008 decrees regulate the coefficients and bonuses for political appointees, including top ranked civil servants. They determine their basic salary (36 percent higher than comparable remunerations for civil servants). In additions, the Decree on the Compensation for Participationof Deputies in Parliament (2008) defines a 20-percent deputy supplementfor members of parliament. Special laws for judicial-sector employees. The Law on Salaries and Other Compensations of Constitutional- Judicial Functions, adopted in 2007, regulates the coefficients, compensations and bonuses (such as the winter and housingbonuses and a 30 percent supplement) only appliedtojudicial staff. Separatelaws for policeand the military. Policeand army personnelare coveredby the Law on Police(2005) and the Law on the Army of Montenegro (2007), together with subordinated decrees from 2008, which determine the coefficients and bonuses (up to 30 percent for all police personnelrelative to state administrationemployees), with army personnel havingan entirely separate salary system. Special salaries for employees in state funds and specialized agencies. State funds (Development, Employment, Pension and Disability, Restitution, and Health Funds) and agencies (for National Security, Telecommunications, Energy, Radio-Diffusion,Tobacco, and Insurance) have separate salary systems, which are defined through organic laws, statutes, andrulebooks. Spending Efficiency 4.10. The wage bill of the general government is high. At 11.8 percent of GDP in 2006 (and 12.7 percent in 2007), the general government's wage bill is higher than that of most new EU member states (Figure 4.2). It is close to the average for the EU-15, countries, even though the quality of services remains much lower.69The EU accession process-as well as aspirations for further decentralization- 69In addition, the tax rates, especially for corporate and personal income taxes, are much lower than in the EU-15 countries, limiting the Government's ability to fund a large wage bill and an ambitious public infrastructure program. 88 will result in additional pressures on the wage bill. The EU integration process implies increased specialized services within Government.The transfer of responsibilitiesto the municipalitiesrequires new regulatory institutions.An additional source of pressure comes from the increasingneed to compete with the private sector over highly qualified staff. Enterprises are able to pay significantly higher salaries for highly qualified staff. Government will thus have to either agree to higher decompression in salaries (raising wage rates at the highest spectrum of skills and qualifications) or accepting an acceleratingrate of "brain drain" from the public administrationto the private sector, ultimately leaving the Government ill- equipped to addressthe considerable challenges it will face over the medium-to longer-termhorizon. Figure 4.2: General Government Wage Bill, 2006 14 12 - - - 12.2 11.3 11.4 I O ___ ~ I 105 __ IO. 1 I B I g g 9 0 9 1 - ' ~ 8 7 4 7.8 - g 6 C 4 2 0 j i-- rrl .-rrl .-rrl L n -m -a 0 -2a OD -m 8 m B Sources; Ministryof Finance; Eurostat;and World Bank staff calculations. 4.1 1. While still high, the wage bill has been gradually declining over the last three years as a share of the general government spending. More than one-fourth of general government spending remains spent on wages and other compensations to public administration (Figure 4.3). There are pressuresmountingon bothfactors: (i) Large across-the-boardwage increases limit the ability to decompress the wage scale. Partly in reactionto increasing(food and electricity) prices, Government agreedto a 30-percent increase in public-sectorwages in late 2007. The effects ofthis decision-together with a 10-percentbasic salary increase-will only become apparent in 2008 and subsequent years. The acceleration in food and oil price increases during the first semester of 2008, which has already led to strike actions, and politico-economicconsiderations surroundingthe electoral cycle, could easily result in pressurefor further across-the-boardpay increasesover the medium term. 89 Figure4.3: GeneralGovernmentWage Bill, 2002-07 15 36 1 1i as percent of total expenditure and net lending (right-hand scale) I Oi 1 2 6 2002 2003 2004 2005 2006 2007 Sources: Ministryo f Finance;and World Bank staff calculations. (ii) Additional public sector recruitment for reasons of EU integrationand decentralizationis not compensated by a corresponding decrease in staff elsewhere. The general government budget in 2007 supported 44,O 15 employees, or 6.9 percent of the populationand 16.3 percent of the labor force. The correspondingnumbers for 2006 were 42,873 and 6.8 percent of population (Table 4.3). Comparing four-year averages for 2002-06, Montenegro'sratio of public employees to population (7.4 percent)exceeds the values of relevant comparators by considerable margins. Croatia has a ratio of 6.2 percent, while the EU-8 (EU-15) countries have an average ratio of 5.4 (6.2) percent.About 5.5 percent of population is employed by the civilian public administration, almost double the median value of 3 percent in Europe and Central Asia. To some extent, this is due to the relatively high "fixed cost" proportion of public administration in a small country, which-irrespective of its size-has to provide the same services as large states without being able to exploit economies of scale. To some degree, however, this reflectsthe fact that increased staff numbers in priority areas are not fully compensated by a reduction elsewhere, leadingto a trend reversal in overall public-sector employment, with an increase of 1,142 in 2007 (Table 4.3a). Generally, in the structure of public administration,there has been a 30-percent increase in employment at sub-national levels since 2002 and a 40-percent increase in the judiciary since 2005. Almost one-half of total public sector employment is in the health and education sectors, regardless of unfavorabledemography. These increases have been made possibleby a significant reductionof army personnel (40 percent), with uniformed services representinga still significant 20 percent of public-sectoremployment. 90 Table 4.3: Montenegro: Relative Structure of Public Sector Employment, 2007 Inpercentof public sector population labor force Total public sectoremployment 100.0 6.9 16.3 Civil servants 26.0 1.8 4.2 Central government 20.7 1.4 3.4 Government and ministries 15.8 1.1 2.6 Agencies andextra-budgetaryfunds 4.5 0.3 0.7 Outside the executive 0.4 0.0 0.1 Other 5.3 0.4 0.9 Public servants 54.3 3.7 8.8 Teachers and other education staff 25.9 1.8 4.2 Employees in the health sector 20.0 1.4 3.3 Employees in the cultural fields 1.4 0.1 0.2 Social workers 1.3 0.1 0.2 Employees in thejudiciary 5.6 0.4 0.9 Uniformed services 19.7 1.4 3.2 Sources: Government o f Montenegro (Ministry of Finance and other ministries and agencies); Monstat; and World Bank staff calculations. Table 4.3a: Montenegro: Relative Structure of Public Sector Employment, 2002-07 2002 2003 2004 2005 2006 2007 Total public sector employment,by level of Government 48,671 46,870 46,201 44,435 42,873 44,015 Central government 45,227 43,348 42,601 40,757 38,847 39,530 Local self-government 3,444 3,522 3,600 3,678 4,026 4,485 Total public sector employment,by status 48,671 46,870 46,201 44,435 42,873 44,015 Civil servants 10,238 9,655 9,963 10,030 10,802 11,444 Central government 7,614 6,883 7,177 7,706 8,840 9,133 Governmentand ministries 6,794 6,133 6,363 6,352 6,776 6,959 Agencies and extra-budgetaryfunids 684 614 678 1,218 1,874 1,992 Outsidethe executive I36 136 136 I36 190 182 Other 2,624 2,772 2,786 2,324 1,962 2.31 I Public servants 23.795 23.448 23,295 23,363 23,354 23,895 Teachers and other education staff 12,460 12.1 1 I 1 1,943 1 1,872 I1,270 1 1,402 Employees in the health sector 8,320 8,410 8,500 8,590 8,790 8,807 Employees in the cultural fields 687 664 612 605 612 612 Social workers 606 545 522 537 543 592 Employees in thejudiciary 1,722 1,718 1,718 1,759 2,139 2,482 Uniformedservices 14,638 13,767 12,943 I1,042 8,717 8,676 Memorandumitems Public employment as percent of population 7 9 7 6 7 4 7 1 6 8 6 9 Public employment as percent of labor force 17 5 17 I I 7 8 I 7 3 16 9 16 3 Sources; Government of Montenegro (Ministry o f Finance and other ministries and agencies); Monstat; and World Bank staff calculations. 4.12. Therefore, to contain the overall cost while increasingindividual pay, Government will need to carefully assess priorities within public administration and downsize staffing overall. Some of the 91 areas, where staffing numbers could be reduced without affecting much the delivery of public services, seem to includethe following: 0 Central and local government administration. Further decentralization of functions to local government needs to be followed by respective cuts at the central government level, combined with a careful monitoring of local government employment. For the level of decentralized functions (which remains relatively low), local-government employment is high, with continuingpressures for further fragmentation of local self-government. 0 Internal affairs and defense. The defense sector reform has already resulted in a significant downsizing of military personnel and corresponding spending. However, with over 8,600 employees in internal affairs and defense, uniformed personnel exceeds the number in the central Government and ministries by 25 percent, leaving room for further downsizing of bothmilitary personnel and administrativestaff in the defense sector. 0 Public service and civilian staff. Recently, Government initiated reforms in the education and health sectors, where there is a potential for efficiency gains in bringing teacher-to-pupil ratios closer to the OECD average. In addition, there is scope to consider increased private- sector participationin the health sector. Functional reviews would show that there is a large scope for reducing the unnecessary administrative procedures in ministries and agencies, including by an increased reliance on IT technology employed to retrieve and maintain databases. 0 Contracting-out. Instead of trying to compete with the private sector on wage terms for some highly specialized skills, the government could outsource specialized services. Many staff hours are being spent on auxiliary services across the public administration that could easily be outsourced on the basis of public tenders (such as cleaning, catering, and security). In other countries that have adoptedthis approach, tenderingnon-coreactivities to the private sector has ledto significantefficiency gains. Linking Salariesto Performance 4.13. The public wage structure is too compressed. The wage compression ratio in Montenegro's civil service is about 4.95,'' This is not comparable to the levels prevailing in other countries. In the OECD countries, for example, this ratio falls within the range of 8 to 9 (that is, the differencebetweenthe highest and lowest wages is considerably larger). For the majority of employees in Montenegro, the basic salary range is within a narrow band. As a result, public wages for managerial posts are significantly below the private market in Montenegro. Anecdotal evidence suggests that this may be causing difficulties in recruitingand retainingwell-qualified staff. 4.14. Salary levels are primarily determined by "time in service" rather than performance. The general principles for the compensation of civil servants are providedby the Law on Civil Servants and State Employees (2004 and amendments in 2007). According to the law, the salary for civil servants is determined through a formula combining (i)a "task complexity" coefficient (fixed by Government regulation for the various workplaces); (ii) the wage calculation base" (established by a collective 70The compressionratio is the ratio of the wage level at the highest grade over that at the lowest grade. 71Governmenthad signed the tripartite Agreement on Determining the Lowest Price of Work with the Trade Unions of Montenegro and with the Association of Employees in 2007, setting it at 55 (net). This is different from practiceselsewhere and undermines social-insurancebenefits that employees are receiving from social contributions paid into the budget. Governmentagreed as well to gradually lower the rate of obligatory contribution for healthto 9 92 agreement and a decree); and (iii)a seniority supplement (0.5 percent per year of service up to 10 years, 0.75 percent from 10-20 years, and 1.0 percent per year with 20 years o f service and more). Taken together, the years of service are still the dominant determinant for promotion and pay level. The seniority supplement in the wage calculation formula allows for a 32.5 percent wage difference between new entrants into the grade and those with 40 years of service. Such a system makes the public administration less attractive to young qualifiedjob seekers. 4.15. There are over 15 different supplements and bonuses found in the state administration, of which only one relates (to some degree) to staff performance. Performance bonus differs from 10 to 30 percent and is provided as a regular part of pay to everybody employed in the judiciary and health sectors as well as in the extra-budgetary funds, without much reference to real staff performance. On the other hand, a performance bonus has yet to be introduced for civil servants. This non-uniform approach across the administration contributes to the upward pressure on effective wages, relating total remuneration to the strengthof bargainingpower rather than qualifications, merit, or performance. 4.16. Supplements for work conditions and bonuses create a large share of net civil servants salaries-but these are not included in the base of taxable income. About 11 percent of the overall wage bill is left untaxed and provided through discretionary bonuses (Figure 4.4). Except for the seniority supplement (0.5-32.5 percent), additional coefficients for working conditions (30 percent for police, judiciary, inspectors, tax and customs officials, up to 10 percent for class masters), rare skills' supplement7*(20 percent), overtime (40 percent), Sunday and holiday work and duty roster (10 percent), the rest of the bonuses are left untaxed-notwithstanding the fact that they create a significant portion of individual pay.73 4.17. The performanceappraisalsystem is still in its testing stage. Notwithstanding stipulations in the Civil Service Law that make career advancement a function of professional accomplishments, working capacity, and work quality, promotions to higher grades continue to be mostly based on time lapsed in the administration. The performance appraisal system allows for promotions to higher steps within the same grade for those marked "good" ("excellent") for five (three) consecutive years. However, the appraisal criteria stay undefined and are subject to a discretion and non-tran~parency'~. percent, from currently 13.5 percent. Within this Agreement, Government has also expressed an interest in transferringmeal and holiday bonuses into the basic salary. However, until the mid-2008 this initiative did not come to realization. 12 This supplement was temporarily given to IT and cleaning services, until a 2008 Constitutional Court decision reversedthis practise. 73Examples are meal (25-27.50), transportation (22) and holiday bonuses (1 50-165) which add 714-759 per year to one's salary (or even over 50 percent to lower grades). A winter bonus, the so-calledzimnica, is providedby some funds and agencies and amounts to three times the minimum net wage (165). The housing bonus, which is provided in judiciary and education, allows for covering the rental costs or housing credit cost up to the amount similar of that of other one-offbonuses. l4The Decree on More Detailed Criteria and Modesfor Determining the Variable Portion of the Salary of Civil Servants and Employees specifies criteria on the determination of the variable portion of an employee's salary, complementing the Civil Service Law. The law had introduced the variable part of the salary as a way to reward staff based on merits. However, the law only defined in general terms that the salary's variable portion should be granted based on the employee's quality of work. The decree ill-defines the education profile (such as university education) and "independence at work" aspect as merit-reward criteria, while it fails to define upper limits to the variable portion of salaries. While the current appraisal system-in principle-is the key instrument to be used to distribute annual performance bonuses, it is not applied consistently across the administration. In 2006, only 52 percent of institutions performed staff appraisals. According to HRMA figures, "excellent" marks were given to most public-sector employees, thereby defying the purpose of this exercise. As such, current practices contradict 93 Figure4.4: Montenegro: General Government Wage Bill Structure, 2003-07 1 , . . - '-. ... . . ... .__-. __._ .... ..... . ~ 1- g j ....I ' 3 2 7 1 ! 7 8 105 ! ..... . . . . . . . . . . . 35 2 ..... I 1 t ,,I I Other I'ayrull 1 persoilat taxesand income I surcharges 'i 2003 2004 2005 2006 2007 Sources: Ministryof Finance. 4.18. The inherent emphasis on seniority precludes sufficient performance incentives and, ultimately, lowers staff morale. As a result, older employees have even fewer incentives to leave, given that the salary structure rewards them for their seniority. Insufficient data are available on the structure of public administration by age, gender, education, and years o f service. An independent survey by the Institut Alternativa (2008) tried to fill this gap, and it confirmed results o f an internal exercise by the Human Resource Management Authority (HRMA) on a sample o f 12,640 employees in 2006 that suggested that two-thirds o f public servants are between 35 and 45 years o f age, while another 12 percent o f the public sector is older than 45 years. Administrative Efficiency 4.19. High public-sector employment is partly the result of a complex government organization, with the large number o f government entities leading to multiple-layer structures, overlapping functions, and competing responsibilities. These create costly inefficiencies. Over the last few years, Government created additional layers o f regulatory institutions, partly to administer and manage the EU accession process. However, not all o f the newly established positions can be explained by the need to establish EU- compatible functions. To assess the efficiency o f existing structures, Government might want to undertake further functional reviews across the public sector, at national and local levels, to eliminate any duplications and overlaps. In so doing, Government would determine the potential for hrther rationalizations o f administrative procedures and to employ existing staff more effectively with the Government's strategic objectives in mind. 4.20. Four years after the adoption of the Civil Service Law, not all institutions have completed the process of internal reorganization, including the (re)classification of individual positions. This OECD standards (Rexed et a]., 2007), according to which a good remuneration policy for the public administration should aim at providing equal pay for equal work. 94 stands in some contrast to the fact that the process of internal reorganizationand classification had been requested as a precondition for any new employment. Some state institutions, including the Ministry of Justice, have not done this, putting in question the legality of the current employment and salary levels in those organizations. 4.21. Current public-sector employees have a de facto advantage in filling public-sector vacancies, eroding the formally introduced principle of equal access to public-sector employment and healthy competition among new entrants. The Law on Civil Servants and State Employees had declared equal accessibility to employment in the state administration.This stands in contrast to current practice and supporting legislation, according to which all state organizations are encouraged to first try to fill their vacancies through internaladvertisement, beforeengaging in an open competition. 4.22. Accepting a severance package does not preclude re-employment in the public sector. The Law on Civil Servantsand StateEmployees stipulates that civil servants and state employees who are laid off in the process of reorganizationare entitled to a severance pay from the budget.Anecdotal evidence shows that some employees have used this opportunity to accept severance pay before their re- employmentwithin the public sector. The law should be changed in a way to limit the possibility of re- employment within the administration to instances, in which the termination process has not been concluded andthe severance payment not made. 4.23. The Ministry of Finance and the HRMA should work together on establishing a proper human resource management information system, which links personnel information to payroll payments. Although the Law on State Administration gave the Ministry of Finance the legal right to perform a control over the payment of salaries, the Ministry does not have the complete informationthat would be requiredto exert full control over the state administration's wage bill. Some parts of the state administrationare still not sharing with the Ministry of Financethe individual salary levels andthe details on underlyingfactors determining a given wage rate. Instead, only payment request for the overall wage bill are made. However, good progress has been made in creatingthe centralregistry for human-resource data, including informationon salaries. This is an important step forward. However, without a clear just- in-time link to the Treasury, these efforts of collectingpersonnel data would becomeoutdated quickly and lose their inherent value for policymakers. 4.24. The wage negotiation for civil servants in Montenegro is highly fragmented. While coefficients and bonuses on working conditions, overtime, Sunday and holiday work are from 2007, determined by law, the wage base and supplements, including bonuses, are agreed collectively between public sector entities and labor unions. These agreements are negotiated separately by the state government, local self-governments, and other administrative units. The result of this decentralized negotiation process is a fragmented and inconsistentremunerationstructure, resulting in a considerable variability of wage dispersion with the public sector (Figure 4.5). 4.25. Furthermore, fragmented collective bargaining mechanisms allow the various labor unions to negotiate salary increasesoutside the control of Finance Ministry and outsidethe regular budget preparation processes. Some sectors (like health, judicial, internal affairs, inspectors, and defense) are able to negotiate higher wages, especially through additional bonuses not linked to performance, thereby further eroding the key "equal pay for equal work" principle. This manner of deriving at collective- bargainingagreements reflects inherent weaknesses. Government needs to consider ways to reverse the delinking of the consultations process among social partners with the budget preparation process. Some efforts have been made in that regard, but-to allow for a consistent approach to fiscal policies-the central decision-makingpower ofthe Ministry of Finance needsto be further strengthened. 95 Figure 4.5: Wage Dispersionfor Selected General Government Occupations,2007 4 0 , Sources: Ministry of Finance; and World Bank staff calculations. 4.26. The lack of effective data collection and control system on wages and salaries in the public administration further increases the risk of an excessive dispersion of remunerations. Although there are, in principle, standard civil service rules for salaries' calculations, the fragmentation of government's organization hinders the implementation of effective controls. Agencies directly responsible to the Parliament have their own independent salary system. In addition, local governments unitsand their agencies are not reporting centrally their wages and salaries. Equity Considerations 4.27. I t is a common phenomenon also seen in othsr countries that wages in the government sector are lower than those in the private sector, as employees have greater job security and enjoy a number of other pecuniary and non-pecuniary benefits. This discount has been generally in the range of 10 to 20 percent. However, in Montenegro, the discount seems to be much lar er for high-level jobs when correcting for hours worked and other individual characteristics (Figure 4.7). `is Anothersymptom is 75 The wage disparity between the public and the private sector in Montenegro was analyzed by using the 2006 Labor Force Survey (LFS) data. The LFS is a regular survey conducted by the Statistical Office of Montenegro (MONSTAT) which reaches around 900 households per year. In 2006, there were 3131 individuals covered. We restrict our interest to wage comparisons by sectors, meaningthat only employees (over 15 years of age) for whom there were informationon their wages and sector of employment are available. Self-employedare excluded from the analyses because their income cannot be treated fully work-related; it also includes remuneration for their entrepreneurial skills. All in all, in 2006 there are 699 observations remained in the sample of wage employees. Distinction between the public and private sector is based on information on ownership of employers, which are provided by the LFS respondents. For analytical purposes, the public sector is sub-divided in two categories: (i) 96 that, while labor turnoverwithin public administrations is generally low, the only segment where mobility occurs is at the top end-as younger and more ambitious public servants leave for employment in the private sector after a few years of broadening experience and acquiring know-how. Past that point, the wage differential with the privatesector becomestoo highto be compensatedbyjob security. 4.28, The hourly wage of a worker with higher educationin budgetary public sector is on average 30 percent lower than for a comparable worker in the private sector (2.09 per hour vs. 2.63 per hour). Comparedto state-ownedenterprises, this differenceis approximately20 percent.Interestingly,the public sector benefits those with vocational secondary education (1-3 years of secondary school) by providing a higher averagewage than the privatesector. 4.29. Wages in the private sector are much more dispersed than wages in the budgetary public sector, and the compression is particularly high at the managerial posts. The Gini coefficient for wages in the private sector is 0.33, while for wages in budgetary public sector it is around 0.20 (Table 4.4). Percentileratios indicatethat differences in dispersion between sectors are to be found mostly in the upper part of the wage distribution. For example, plO/p50 percentileratio of 0.6 is observed in the private sector as well as in both parts of the public sector, but the difference is quite obvious at the p90/p50 percentileratio. In the private sector, wage of a worker at the 90th percentileis approximately 2.4 times the wage of the median worker (50th percentile), while in the budgetary public sector such a ratio stands at 1.5. In other words, compression of wages in the budgetary public sector is much stronger than in the private sector, particularly at the upper part of the distribution. Dispersion of wages in SOEs is somewhere half-way between wage dispersionthe private sector and the budgetary public sector. Figure4.6: Montenegro: Hourly Wage by Sector and Education, 2006 3 0 2 5 2 63 2 0 2 c 8 a 1 5 .... 2 c 122 1 0 0 5 0 0 Primae or less Vocational (secondaly) General (secondary) Higher education Sources; Authors' estimates, using2006 LFS (Monstat). budgetarypublic sector which covers public sector employees in public administration, education, and health care and social work, and(ii) state-ownedenterprises (SOEs) which cover public sector employees in all other activities. 97 Table 4.4: Montenegro: Dispersionof Hourly Wages, 2006 Percentileratio Gini p9Olp10 p9Olp50 p1OIp50 coefficient Private sector' 3.9 2.4 0.6 0.33 Budgetarypublic sector 2.6 1.5 0.6 0.20 State-owned enterprises 3.5 2.1 0.6 0.28 ' Figures refer to employees only; self-employed are not included. Sources: 2006 LFS; Monstat; and World Bank staff calculations. 4.30. Women earn substantially less than men in all sectors, but the dispersionof female wages is somewhat lower across sectors. In private sector, average female wage is 21 percent lower than average male wage, while in the budgetary public sector the gender gap is 14 percent (Table 4.4a). In SOEs, women earn some 22 percent less than men, and 8 percent less than women in private sector. In the budgetary public sector, women constitute slightly more than half of all employees, while in SOEs the share of female employmentis below 40 percent. Table 4.4a: Montenegro: Hourly Wage by Sector and Gender, 2006 Hourly wages (in euro) Relativewage (private = I) Female wage Fraction of male female male female (male wage = 1) female employees Privatesector' 1 7 8 I 4 1 I 00 100 0 79 0 46 Budgetary public sector 1 5 8 I 36 0 89 0 96 0 86 0 53 State-ownedenterprises 167 130 0 94 0 92 0 78 0 39 'Figures referto employeesonly; self-employedare not included. Sources: 2006 LFS; Monstat; and World Bank staff calculations. 4.3 1. High-skilled white-collar workers are disadvantaged in terms of wages by working in the public sector. Figure 4.8 shows rather wide wage gap between the private and the public sector for professionals and technicians, where the public sector wage "penalty" is around 25 and 50 percent, re~pectively.~~ A relatively large gap is found for clerks, too. One would expect to find a notable gap for high-rankedgovernment officials (legislators)as comparedto managers inthe privatesector. Presumably, underreporting in this case does not allow a reliable comparison; private-sector managers might receive only a part of remunerationin form of wage, while other part consist of bonuses and company shares that are not covered in the LFS data. 76The low number of observations by occupation groups permits only for as distinctionbetween wages between the private and overall public sectors (that is, the budgetarypublic sector and SOEs). 98 Figure 4.7: Montenegro: Hourly Wage by Sector and Major Occupation Groups, 2006 I 2 94 2 5 - 2 56 .~ . . .. . ~I 2 0 -I 2 1I f -B& 6 P a 1 5 e 1 56I W E: I 12b I O 0 5 0 0 I Technicians Professionals Legislators and Clerks Plant and Crafts and Elementary Service and managers machine related trades occupations sales workers operators Sources: Authors' estimates, using 2006 LFS (Monstat). Table 4.5: Montenegro: Hourlv Wage bv Sector and OccuDation. 2006 osco Description Hourlj wage (in euro) Relativewage code public sector private sector' (private = 1) 24 Business and administration professionals (economists, sales and marketingprofessionals) 1.81 2.68 0.68 3 1 Science and engineering associate professionals (technicians, controllers, supervisors) 1.82 4.69 0.39 41 Administrative clerks (general office clerks, secretaries, bookkeepers) 1.13 1.65 0.68 42 Counter clerks (customer service clerks, client information worker: 1.24 1.46 0.85 51 Personal service workers (cooks, waiters, personal care workers) 1.21 1.19 1.02 52 Service and sales workers (sales persons, cashiers, ticket clerks) 0.94 1.12 0.84 92 Simple professionsin trade and services (cleaners and helpers. maids, garbage collectors) 0.89 1.09 0.82 1 Figures refer to employees only; self-employed are not included. Sources: 2006 LFS; Monstat; and World Bank staff calculations 99 4.32. The difference in public-private wages varies widely across professions. Business and administration professionals, science and engineering associate professionals, as well as administrative clerks earn substantially lower wages in the public sector compared to the private sector. Table 4.5 compares the average wage for various occupations that are common in both the public and the private sector. For elementary occupations such as cleaners and helpers, the public sector offers some 18 percent lower wages than the private sector. 4.33. Salary levels differ among local authorities,and they are often higher than at the state level. While wages are calculated according to the same formula for the state government and the local administration, the basic wage is negotiated separately. The provisions of the Law on Local Self Government enable the municipalities to (i)collect incomes from sources other than the state budget; and (ii)determine independently specific posts' coefficients and base salaries (which range from 55 inthe North to 1 00 in the Southern municipalities). Wealthier municipalities have used this method to provide for salaries that exceed those at the central level, The law also allows for different basic requirements applied to the promotion to certain grades (years-in-grade requirements tend to be lower in municipalities than in the ministries). These differences complicate horizontal and vertical mobility and undermine equity principles within the public administration. 4.34. Budgetary public-sector wages are more comparable across regions. This uniformity stands in contrast to the salaries paid by firms. While state-owned enterprises pay implicit hardship bonuses to employees in the North, private-sector wages reflect local wealth and purchasing power (Figure 4.8). In all regions (except in the North), average wages in the private sector7' are above those in the public sector. Figure4.8: Montenegro: Hourly Wage by Sector and Region, 2006 2 00 191 1 60 iS8 I I.53 -24kgI 2 0 0 0 8 0 0 40 0 00 South Podgorica Central North Sources: Authors' estimates, using 2006 LFS, Monstat. 77The share of private-sector to public-sector employment is much lower in the poorer North (about 33 percent in 2006) than in the moreprosperousregions of Podgorica and the South (45 percent). 100 4.35. The existence of "opportunity costs" to working in the public sector is confirmed by the results of a wage regression. The average wage for employees o f the budgetary public sector is about 13.2 percent lower than for employees in the private sector, controlling for observable individual and regional characteristics'* (Table 4.6). Age and marital status are not significant explanatory variables for variations in individual wages. However, as discussed above, gender is an important correlate to the wage level; the average hourly wage for female employees is about 18 percent lower than for male employees with comparable labor market characteristics. A third major determinant o f wage levels-maybe not surprisingly-is schooling and training. Returns on education are progressively increasing with educational levels. After controlling for individual workers' characteristics and sector of employment, regional effects on wages are not ~ignificant.'~ Table 4.6: Montenegro: Determinants of Hourly Wage, 2006 Dependent variable: Coefficient Standard error Significance Natural logarithm of hourly wage Demographiccharacteristics Age 0.009 0.011 Age (squared) -0.008 0.014 Married 0.035 0.039 Female -0.181 0.032 at 1 percent Education(reference: primary or less) Vocational secondary 0.136 0.064 at 5 percent General secondary 0.251 0.057 at 1 percent 2-year college 0.449 0.089 at 1 percent Universitygraduate 0.745 0.064 at 1 percent Region(reference: Podgorica) Central 0.019 0.043 North -0.052 0.046 South 0.034 0.045 Sector (reference: private) Budgetary public sector -0.132 0.039 at 1 percent State-ownedenterprises -0.073 0.047 Constant -0.138 0.23 1 Memorandum items: Number of observations 699 R2 0.252 Source; Authors' estimates using 2006 LFS. '*Apart from looking at the bilateral correlation between the average wage by sector and certain characteristics, a joint influence of individual, regional and sectoral factors on workers' remuneration was analyzed, using the ordinary least square (OLS) estimate of the wage function. The more accurate estimate of the percentage effect is 100*[exp(-0.132)-1]= -14.1 percent. 79 This phenomenon is possibly the result of different approaches to salary determination applied by Government, state-ownedenterprises, and the private sector (as discussed above and summarizedin Figure 4.8). 101 C. POLICYOPTIONS 4.36. Reform options should aim at containing the growth in the wage bill while improving the effectiveness of public administration. Capacity will need to be built up to manage the process of EU accession and decentralization. The authorities have taken important steps towards reforming public administration through the Law on the Civil Service and the implementation of relevant regulations, includingon those definingthe civil service salary system. But considerable challenges remainto achieve the twin objective of developing afiscally sustainable and operationally effective public administration. On the basis of the above assessment, the following list summarizes recommendations of measures that could support policiesaimed at achievingthe two goals. 4.37. A strategy aimed at making the public sector more competitive with the private sector, requiring increaseddecompression in wages, is inconsistent with across-the-board wage increases. Within this context, the decision taken in late 2007 to increase salaries by a uniform 30 percent has reduced the fiscal space required to advance the agenda of a gradual decompression in wages. Similar decisions should be avoided in the future. Short-term measures 4.38. The Human Resource Management Authority (HRMA) needs to play a central role in defining the reform agenda. The reformmanagement has to be driven by the HRMA. It has to ensure an even closer cooperation with the Finance Ministry to allow for a full alignmentof fiscal and HR policies. 4.39. Government should initiate a pay and grading reform. The current pay system-based on characteristics of rank, education, and seniority-will need to be replaced by system that links remunerationand performance. An EAR-financed review (Human Dynamics, 2008) of the existingpay and benefits system, containing options and proposals for a civil and public service pay and grading reform, serves as valuable input for drafting the new legislation. These reforms should aim at decompressing the salary scale and establishinga promotion mechanism that is based on the input from a fair and transparent performance appraisal system. This will require devising a new job classification, wage scales, while introducing a reliable system of performance appraisals. The reforms should seek to harmonize remuneration across the various levels of government. This needs to be accompanied by a fiscal impact assessment of the proposed new salary system. 4.40. A tighter link between pay and performance needsto be established.Public sector employees currently receive an automatic annual increase of 0.5 to 1 percent in basic pay for each year of service. Moving towards a merit-based system, the salary formula should include a performance-based supplement, while the seniority supplement should be reducedor eliminated. 4.41. New job descriptionsand performance indicators should be developedas a precondition for the new salary system. Efforts need to be directed towards developing the performance budgeting together with an associated set of performance appraisal criteriaand mechanisms. To accomplishthis, the HRMA and Finance Ministry need to develop a jointly operated human resource management informationsystemto be able to link personnel informationwith payroll payments. 4.42. Recruitment rules need to be made more competitive to allow for new entrants (and additional skills). A termination from a post in the civil service, with the payment of severance pay, has to precludethe re-employmentin another state institution. 4.43. The collective salary bargaining process needs to be streamlined. It should start earlier each year and be concluded before the regular budget preparation process. It would be advantageous to 102 negotiate the gross rather than net minimal price of work (basic salary). The calculation formula for calculatinggross from net salary payments (usingthe coefficient 1.67)needsto be corrected, as it reflects the contribution rates from previous years. Adjusting for current social-security contribution rates, the contribution liability for the state on behalfof its staffwill be reduced. 4.44. The personal-incometax base needs to be broadenedto cover all bonuses and supplements, while many bonuses should be integrated into the basic salary. Winter and meal bonuses are an example of archaic practices that have been abandoned almost everywhere else in Europe. While additional coefficients for working conditions need to be reflected in job descriptions and job classifications,the rare skills' supplement should be eliminated, as it is prone to abuse and ill-equippedto increase the attractiveness of high-level public sector jobs with comparable ones in the private sector. Performance bonuses should be the main supplement to the basic salary. They need to be devised in a manner that they are linkedto a strengthened appraisal system, while remainingfinancially controllable. Medium-TermMeasures 4.45. Reduce public employment in selected areas. There are areas that have already been diagnosed as beingoverstaffed.The ongoingeducation reform efforts could serve as an example of how the process may be managed and designed. Staff reduction could be achieved through a combination of attrition with a partial and selective hiring freeze. Moreover, to accommodate selective increases in wages to decompressthe pay scales and hiring of new staff required for tasks relatedto the EU accession process, voluntary separations could be considered. A non-voluntary separation approach is better from a fiscal point of view, since there would be no additional costs related to severance payments. Assuming an attrition rate in the public sector of 1 to 2 percent per annum, accompanied with a hiring freeze would generate savings of about 0.4 to 0.9 percent of GDP per annum at 2007 wage rates. 4.46. Rationalize the structure of government operations. This would require a comprehensive functional review of the size, functions, and staffing of all government organizations.At 13, the number of ministries is not large but these ministries have a large number of subordinate organizations. The government should examine the possibility of eliminating some of these organizations through consolidation and providing better coordinated services to the beneficiaries while simultaneously reducingadministrativecosts. 4.47. The functional review process should be designed with the following considerations in mind: ( i ) A vertical functional assessment of sectors should be undertaken to review the mandates, the allocationof functions, and the alignmentof resourceswith those functions within a single sector. The primary purpose should be to identify areas where staff reductions are possible without disrupting service delivery. (ii) There is a strongcase for reviewingall o f the institutions individually, to determine whether each one is performing a useful function, to gauge whether their functions could be transferred to either a ministry or the private sector, and to ensure a clearly defined operational and fiscal responsibility towards one ministry. These reviews should also cover subordinate agencies. Government will need to develop policy criteriato facilitate decision-makingon whether or not a given function should be undertaken by central government. With an affirmative response, follow-up considerations would refer to the manner, in which this function should be organized, while in the case of a negative response, the questions arise whether that particular function should be dissolved, devolvedto local government, or privatized (on the basis of public tenders). 103 4.48. Some non-core functions should be outsourced. Non-civil servant positions in non-core functions-such as transport, security, mail, cleaning, catering, and maintenance-could be transferred, by public tender, to the private sector. The main source of inherent cost savings would come from the increased efficiency, with which the private sector can perform these tasks. If it were possible to outsource 400 positionsin the non-civil servant worker pool, Governmentcould expect to save about 0.15 percent of GDP-under conservative assumptions using2007 wage rates." 80The calculations on the outsourcing of 400 positions to the private sector have been done with the assumption of a cost reduction of 50 percent. 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