Report No. 32623-YU Serbia and Montenegro Republic of Montenegro: Economic Memorandum A Policy Agenda for Growth and Competitiveness October 27, 2005 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank Table of Contents ACKNOWLEDGMENTS.............................................................................................................. EXECUTIVESUMMARY ......................................................................................................... i1 1 RECENTECONOMICDEVELOPMENTS . ....................................................................... 1 A Background 1 B The EconomicReformsto Date .. ...................................................................................................................... ...................................................................................... Macroeconomic Stabilization.......................................................................................... 32 C TheResultsSo Far: Macroeconomic andPovertyOutcomes . Structural Reforms........................................................................................................... 4 ..................................... 7 Growth and Employment................................................................................................. 7 Inflation.......................................................................................................................... 10 Internal and External Balance........................................................................................ 13 Competitiveness ............................................................................................................. 11 DebtPosition.................................................................................................................. . . 14 Poverty and Social Welfare ........................................................................................... 15 D The ChallengesAhead: IncreasingGrowthandCompetitiveness . ............................ 2.LABORMARKETREFORMFORGROWTHAND COMPETITIVENESS .............16 20 A Key Characteristics of the Labor Market . ................................................................... 21 Participation and Employment....................................................................................... 21 Unemployment............................................................................................................... 24 Wage and Productivity Dynamics ................................................................................. 25 B How RestrictiveAre the Labor Regulations? C How Well Dothe CollectiveBargainingandSocialDialogueFunction? .. ............................................................. 32 D InstitutionsDealingwith HighUnemployment 33 E Conclusions andPolicy Recommendations .. .................28 ................................................................. .......................................................... 36 3.FISCALPOLICYREFORMFORGROWTHAND COMPETITIVENESS ...............39 A Background 39 B I s theFiscalPositionSustainable? 41 C I s the Compositionof ExpenditureSupportive of Growth? ... .................................................................................................................... ............................................................................... ...................................... 42 The Economic Composition o fPublic Expenditure...................................................... 42 The Functional Composition o fPublic Expenditure ..................................................... 45 I s Montenegro's Fiscal Policy Growth-Enhancing? ...................................................... 48 D BudgetProcesses, Medium-TermPlanning, andGrowth . ......................................... The Budget Formulation Process.,................................................................................. 51 51 BudgetExecution and the Arrears Problem................................................................... 51 Medium-Term Planning and Growth............................................................................. 54 E Conclusions andPolicy Recommendations . ................................................................. 54 4.PRIVATEAND FINANCIAL SECTORREFORMSFORGROWTHAND COMPETITIVENESS ......................................................................................................... 57 A Characteristics ofthe PrivateSector inMontenegro ............................................................................. ................................................. 57 B Why I s the Informal Sector Large? .. 59 The Regulatory andAdministrative Burden.................................................................. 59 C What Other ConstraintsLimit PrivateSector Investmentand Growth? . Governance and the InstitutionalCapacity to Enforce Rules........................................ 62 ................65 Privatizationand Enterprise Restructuring .................................................................... 65 Bankruptcy andEnterprise Exit..................................................................................... 66 Contract Enforcement and Property Rights ................................................................... 67 69 D ConclusionsandPolicyRecommendations . Financial Intermediation and the Cost of Finance......................................................... ................................................................... 74 5. THE CHALLENGES OF GROWTHAND COMPETITIVENESSINPRACTICE: THE CASE OF TOURISM .................................................................................................. 78 A Introduction 78 B The Contributionof Tourismto Montenegro'sEconomy 79 C Visitor Trends andTargets .. . ................................................................................................................... ......................................... 81 D TourismAssets, ProductsandCompetitiveness 82 E PolicyandStrategy: Analysis andRecommendations .. ........................................................................................... ......................................................... .............................................. 83 REFERENCES ............................................................................................................................. 93 ANNEXES .................................................................................................................................... 98 Annex 1 98 Annex 2 Montenegro- StatisticalTables ..Montenegro- Chronologyof Major Events,2002-2004 ......................................................................... .................................... 101 Listof Figures Figure 1.1. Montenegro's Growth Compared to South EasternEurope. 2000-2004 ..................... 7 Figure 1.2. Trends inEmployment and Unemployment. 2000-2003 ............................................. 9 Figure 1.3. Inflationby Major Component. 2000-2004................................................................ 10 Figure 1.4. Trends inMontenegro's Competitiveness. 2000-2004 ............................................... 12 Figure 1.5. Fiscal and Current Account Deficits, 2002-2004 ....................................................... 13 Figure 1.6. Official Grants to Montenegro, 2002-2004................................................................ 13 Figure 2.1. Trends inEmployment and Unemployment inMontenegro. 1997-2003................... 22 Figure2.2. Long-termUnemployment inMontenegro Relative to Other Countries inthe Region ....................................................................................................................................................... 25 Figure3.1. Consolidated General Government Expenditure, 2002-2004 (percent GDP) ............40 Figure3.2. Consolidated Public Revenueand Expenditure, 2002-2004 (percent GDP)..............40 Figure3.3. Trends inthe Composition ofRevenues, 2001-2004 (percent GDP)......................... 41 Figure 3.4. Sources of General Government Deficit Financing, 2001-2004................................ 41 Figure 3.5. Composition of Current Expenditures, 2004.............................................................. 43 Figure3.6. Capital Expenditure. Comparison with Other Countries inthe Region, 2003-2004 (% GDP) ............................................................................................................................................. 44 Figure3.7. Wage Bill. Comparison with Other Countries int.he Region, 2003-2004.................. 44 Figure 3.8. Montenegro's Functional Spendingby Major Components, 2002-2004 ...................45 Figure 3.10. Trends inDistortionary and Non-distortionaryTaxation. 2002-2004...................... Figure 3.9. Montenegro's FunctionalSpending Compared to Other Countries, 2003-2004........45 49 Figure 3.12. Central Government Arrears as at end-2004. by Functional Composition.............. 53 Figure 3.11. Trends inProductive andUnproductiveExpenditures. 2002-2004 ......................... 49 Figure 4.1. Total FDIAchieved inMontenegro through Privatization. 1997-2004..................... 58 Figure 4.3. Montenegro's Costs o fAdministrative Barriers Comparedto Regional Countries ...62 Figure 4.2. Perceived Constraints to DoingBusiness inMontenegro .......................................... 59 Figure 4.4. UnsolvedBankruptcyand LiquidationCases ,2003-2004 ....................................... 67 Figure 4.5. Duration o f Bankruptcy Cases. 2004.......................................................................... 67 Figure 4.6. Average Share of Sales Paid inAdvance by Clients (percent) .................................. 67 Figure 4.7. EstimatedDurationof Commercial Cases. 2004 ....................................................... 68 Figure 4.8. Commercial Court Cases Solved, 2000-2004 ............................................................ 69 Figure 4.9. UnsolvedCourt Cases. Endof2003 and2004........................................................... 69 Figure 4.10. Short-term Loans bythe Banking Sector, 2001-2004.............................................. 71 Figure 4.11. Long-tenn Loans by the Banking Sector. 2001-2004 .............................................. 71 Figure 5.1. Travel and Tourism, Contributions to GDP, 2000-2015 (percent) ............................ 80 Figure 5.2. Travel and Tourism, Real Growth Per Year, 2000-2015 (percent) ............................ 80 Figure 5.3. Travel and Tourism, Contributions to Employment, 2000-2015 ............................... 81 Figure 5.4. Travel and Tourism, Employment Growth. 2000-2015 ............................................ 81 Figure 5.5. Tourist Arrivals and Overnights. 2000-2004.............................................................. 81 Figure 5.6. Cost of 7 Night Vacation from London (4-Star Hotel, includingAirfare) .................83 Figure 5.7. Cost o f 7 Night Vacation from Belgrade (4-Star Hotel. includingAirfare)...............83 Figure 5.8. Capital Investment inTourism (Public andPrivate), 2000-2005............................... 85 Listof Tables Table 1.1.Montenegro's Unit Labor Costs. 2000-2004 ............................................................... 11 Table 1.2. Montenegro's Competitiveness. 2000-2004 ................................................................ 12 Table 1.3. Total Public Debt o fMontenegro. 2002 -2005 (% GDP) .......................................... 14 Table 1.4.Domestic Debt of Montenegro. 2002-2005 (inmillioneuros) .................................... 15 Table 1.5. Montenegro's Human Development Index. 2000-2003 .............................................. 16 Table 2.1. Labor Force Growth andEmployment-to-Population Ratios. Transition Economies.21 Table 2.2. EmploymentPopulationRatios. Participation, and UnemploymentRates in2003-0422 Table 2.3. GDP Growth and Employment Dynamics, 2000-2004 ............................................... 23 Table 2.4. Incidence and Composition ofPart-time Employmentin2003 .................................. 24 Table 2.5. Duration o fUnemployment inMontenegro ................................................................ 24 Table 2.6. The Dynamics of Average Wages inMontenegro, 2000-2004 (euros) ....................... 26 Table 2.7. Net Monthly Wages inEuros, 2000 and 2004............................................................. 26 Table 2.8. UndeclaredWork inCEE andBaltic States and inEUMember States (pre-May 1, 2004)" ........................................................................................................................................... 29 Table 2.9. Comparison of Additional Benefits to Workers Provided by the 1995 and 2003 General Collective Agreement (GCA) .......................................................................................... 30 Table 2.10. MainActivities of the Employment Bureauof Montenegro in2004 (January- October) ........................................................................................................................................ 34 Table 2.11.Public Expenditure on ALMPs in Some Transition Countries.................................. 35 Table 3.1. Theoretical and EmpiricalAggregation o fthe Government Budget into Distortionary andNon-distortional taxation Productive andNon-Productive Expenditures, 2002-2004 (percent GDP) ............................................................................................................................................. 48 Table 3.2. Montenegro's Capital Expenditure by Function. 2004" (euros) ................................. 50 Table 3.3. Budget Execution by Economic Items. 2002 - 2004 ................................................... 52 Table 4.1. Registered Businesses by Type. 2005.......................................................................... 57 Table 4.2. Starting a Business....................................................................................................... 60 Table 4.3. Income Taxes. Social Contributions and Other Fees and Surtaxes on Wages in Montenegro (percent o f gross salary) ........................................................................................... 61 Table 4.4. Recent Business Law Reforms inMontenegro and their Status o f Implementation...64 Table 4.5. Key Recent Contract Enforcement Legislation and ImplementationStatus ............... 68 Table 4.6. Structure ofthe Banking System, End-2004 ............................................................... 70 Table 4.7. The Size and Structure of the Treasury Bills Market. 2003-2004 (`000 euros) ..........73 Table 4.8. Credit Information Sharing and the Cost o f Creating Collateral................................. 73 ACKNOWLEDGMENTS This report was prepared by a World Bank team ledby Abebe Adugna (task manager) and comprising o f Lazar SestoviC, Arvo Kuddo, Branko RaduloviC, Agnes Kiss, and Lejla CatiC (consultant). The chapter on recent economic developments was prepared by Lazar SestoviC and Abebe Adugna. The chapter on labor markets was prepared by Arvo Kuddo. The chapter on fiscal policy was prepared by Lejla CatiC and Abebe Adugna. The chapter on private and financial sector reforms was prepared by Branko RaduloviC. The chapter on tourism was prepared by Agnes Kiss. The team visitedthe Republic o f Montenegro in February/ March 2005 and M a y 2005. The team would like to thank the Government o f Montenegro for providing excellent cooperation during both visits, as well as providing extensive comments on the draft report. The report benefited from comments by its peer reviewers, Edgardo Favaro, Balazs Horvath (IMF) and Magnus Alvesson (IMF). The report was prepared under the overall supervision o f Orsalia Kalantzopoulos (Country Director), Cheryl Gray (Sector Director), Bernard Funck (Sector Manager), Carolyn Jungr (Country Manager), and Ardo Hansson (Lead Economist). Bernard Funck and Ardo Hansson provided detailed comments on the draft report. Bruce Courtney and Norman Hicks (Consultant) provided input at an early stage o f the report. Valuable comments were also received from several other World Bank colleagues. The production o f the report would not have been possible without excellent support from Emily Evershed (consultant) in editing the document, and Amanda Carqani in processing the document. The support o f the Serbia and Montenegro Country office staff during the preparation missions i s gratefully acknowledged. EXECUTIVE SUMMARY 1. Since the late 1990s, Montenegro has undertaken a series of reforms designed to move its economy f r o m a socialist to a modern market-based economy. Started inthe late 1990s, Montenegro's economic reform program has gathered momentum since the early 2000s. Its reform program rested on two broad pillars: macroeconomic stabilization, and market-oriented structural reforms. With the implementation o f currency and fiscal policy reforms, it has succeeded to rein ininflation and bringabout macroeconomic stability. In parallel to the stabilization policies, it also implemented a number o f structural reforms, including price and trade liberalization, privatization, public administration reform, financial sector reform, and labor market and business environment reforms. The government has recently updated its Economic Reform Program for 2005-2007 to guide the implementation o f the remaining economic reforms. 2. T h e macroeconomic and structural reforms have yielded modest economic recovery and transition. Over the last four years, Montenegro achieved modest macroeconomic gains: real GDP grew by an average o f about 2 percent per year over 2000-2004; inflation dropped fi-om 24.8 percent at the end of 2000 to 4.3 percent at the end o f 2004; Montenegro's consolidated budget deficit was reduced from about 8 percent o f republican GDP in 2000 to about 3 percent in 2004; its current account deficit, although still high, i s improving; and, its principal human welfare indicators such as poverty, life expectancy, and adult literacy have remainedmoderate and stable. 3. Yet, significant challenges remain. Three key challenges confront policy makers in Montenegro. First, past economic growth has been inadequate. With an average annual population growth rate of about 0.5 percent per year, the per capita income grew by only 1.3 percent per year over 2000- 2004. H o w to move Montenegro to a higher growth path in order to achieve a higher standard o f living for its citizens i s the first challenge. Second, the limited growth recovery has not been accompanied by employment growth: registered employment declined by about 7 percent in 2004 relative to 1998, while unemployment remains high at about 23 percent. With the growth injoblessness, about 12 percent o f the citizens o f Montenegro have fallen below the consumption poverty line as o f 2003. Therefore, reducing unemployment and enhancing job creation i s another challenge. Third, despite reforms, Montenegro has become less competitive over the last four years. Its real exchange rate, based on movements inunit labor costs, has risen much faster than that o f the EU zone and the United States. The much more rapid increase in labor compensation than in labor productivity (by 12.3 percent in 2004) has reduced the economy's competitiveness. Increasingcompetitiveness, especially inview o f the country's strategic goal of EUaccession and its small size, i s the third challenge facing policy makers. 4. This Memorandum, the first of its kindfor Montenegro, sheds light on these key challenges. The considerable data problems in Montenegro limit the ability to make evidence-based analysis and to draw conclusions. On the basis o f the best evidence and information available, this report considers the various factors that may have constrained employment creation, growth and competitiveness in Montenegro. The report takes an in-depth look at Montenegro's labor market and at the extent to which, and areas in which the labor law and the collective agreements continue to be limiting. It examines the extent to which administrative and institutional capacity, property rights, contract enforcement, the high cost of capital, and low financial intermediation constrain growth and competitiveness in the private sector, and it takes a close look at fiscal policy, inparticular at whether the current level and composition o f public expenditure adequately supports growth. It also closely examines the challenges in tourism development, the main growth potential for Montenegro. Based on this analysis, the report provides a comprehensive, prioritized medium term policy reform agenda. This i s presented inthe table at the end o f this section. The report delineates five themes as key priorities for Montenegnn policy makers to address inorder to enhance employment generation, growth and competitiveness. .. 11 5. First, key labor market reformsneedto be undertakento increaseemployment, growth and competitiveness. Despite high unemployment, Montenegro's average net earnings more than doubled between 2000 and 2004. In contrast, the Montenegrin economy experienced a cumulative labor productivity growth o f only 18 percent (2000-2004). Even this low productivity growth derived mainly from a reduction in over-employment within Montenegro's formal sector, associated with enterprise restructuring and privatization. The wage dynamics most likely indicate the strong voice o f Montenegrin unions in putting pressure on wage levels. In contrast, employers are not well represented in collective bargaining and wage negotiations. The result has been rapid wage increases inthe public sector and a new 2003 General Collective Agreement, which imposed even greater non-wage (cash and in-kind)and non- taxable costs on employers. Compared to the previous 1995 Collective Agreement, the 2003 Agreement expanded the list o f supplementary benefits, with significant costs for all employers. Among other benefits, housing allowances and collective insurance for employees were added to the already extensive list o f additional benefits to workers. It i s estimated that the wage coefficients introduced in the 2003 General Collective Agreement were on average increased by 19 percent (Government o f Montenegro, 2005), in part reflecting the strength o f trade unions. In addition, Montenegro's labor regulations, although significantly improved in 2003, still hinder labor market flexibility. The relatively high labor taxation, coupled with poor tax administration, encourages informal sector employment. In order to facilitate job creation, growth and competitiveness, Government policies should help improve wage competitiveness and labor market flexibility. Specific measures include the following: 0 Control the rapid wage growth witnessed in recent years through: (i)implementing more vigorously public administrationreforms and the planned reduction in public sector staffs, many o f whom earn wages well in excess o f the average for the economy; (ii) nurturingthe emergence o f genuine private sector employers' organizations that would play a moderating role in the collective bargaining and wage setting process; (iii) the meantime, playing an active role in the in General Collective Agreement (GCA) process with a view to keeping nominal wage settlements inline with developments abroad andpossiblyre-openingnegotiations on the recent GCA to that effect. 0 Relax some aspects of the labor regulations. While the new Labor Law, adopted in 2003, has improved the flexibility o f the labor market considerably, it has not yet assured full flexibility. The specific reforms should focus on: (i)relaxing the contracting rules for employing "non- standard" workers, including employees on fixed term and part time contracts; (ii) reducing the costs for employers to terminate regular (i.e., permanent) employees for economic reasons; (iii) permitting more flexible arrangements in working hours; and (iv) limiting non-wage costs to employers. 0 Reduce the high rates of labor taxation in a fiscally responsible way to encourage formal employment. Recent reforms have helped reduce the payroll tax and contributions burden, yet the labor taxes (or payroll taxes) are still too highand among the highest inthe region. Montenegro's tax wedge, one o f the most important indicators o f tax burden, stood at about 52 percent o f the labor costs in 2004, while the comparative burden for the regional non-European member countries was 37.3 percent o f total labor costs. A further phased and well-planned reduction in payroll taxes--compensated by equivalent increases in other taxes, and with adjustments to compensate the resulting lost income o f the social funds-is desirable. The identification o f alternative sources o f revenue, such as the VAT or other indirect taxes, to make up for reduction inpayroll taxes is critical to maintainthe overall fiscal balance as well as the fiscal position ofthe health and pensions funds. Such reduction in payroll taxes should also be accompanied by improved enforcement o f taxes, including through more aggressive use o f bankruptcy as a means to deal with delinquent tax payers. Inaddition, reforms o f the health and pension systems (early ... 111 retirement, disability, maternity leave and sickness benefit) may need to be pursued inparallel to tighten eligibility criteria and eliminate abuses inthe systems. 6. Second, enterprise privatization and restructuring is well underway but would need to be completed to increase growth and competitiveness. The private sector's contributions to GDP and employment remain modest. The emerging private sector has not yet developed the critical mass to generate enough jobs to offset job losses in the public sector. Facilitating the privatization and restructuring o f enterprises, and promoting the entry o f new firms, i s necessary to achieve that goal. Many companies that were privatized through the mass voucher privatization (MVP) program still lack strategic investors to re-equip them with new technology and improve their profitability and competitiveness. They also continue to be saddled by the high costs o f excess labor and employment. There i s thus an urgent need to: Speed up the restructuring of the mass-voucher- privatized companies by: (i) making budgetary allocations toward covering the social costs o f restructuring-including severance payments for shedding o f f excess labor- for those companies in respect o f which the Government agreed to fund such costs; (ii) enforcing the new bankruptcy law for medium and large enterprises strictly privatized through vouchers, that have continuedto accumulate losses; and, (iii) strengtheningthe capacity o f courts to deal with such bankruptcy cases. Speed up the consolidation into majority shares of the companies' shares being traded on stock exchanges. With diffused ownership and lack o f majority ownership, the MVP has been fairly ineffective in inducing changes in management and corporate governance. Even where the MVP has led to management changes, the new management has continued to lack expertise in restructuring and developing viable business plans. Currently, shares o f companies and investment units privatized through the M V P are slowly being consolidated through trades in stock exchanges. However, the speeding up o f the consolidation o f shares into majority ownership i s needed to bringabout management changes, good corporate governance, completion o f the restructuring plans, and the introduction o f new capital and technology to generate better profitability and shareholders' value, and employment. 7. Third, key constraintsfacing Montenegro's emergingprivatesector, includingbusinessesin the informalsector, mustbe removed.The most highly visible feature o f Montenegro's economy is the large and persistent informal sector, contributing perhaps about 30 percent o f GDP and employing about 27 percent of the workforce (ISSP, 2004). The presence o f a large informal sector i s a symptom o f a high regulatory burden, including the high labor taxation and the unreasonably onerous General Collective Agreements, and a poor public administration and institutional capacity for enforcingrules. In addition to the measures discussed above, the following specific measures are needed: Remove specijk governance and regulatory bottlenecks: (i)speed up the issuance o f business licenses and inspections; (ii)ensure greater transparency, and a more consistent application o f rules, including an improved tax administration capacity to support rule-based tax collection; and, (iii)speed up the implementation of recently enacted business laws and regulations. The implementation o f legislation aimed at improving the business environment--contract enforcement, access to finance, corporate governance, and business exit-has not yet begun in most cases. Speeding up the implementation o f these laws will be critical to private sector investment and growth. 0 Reduce the backlog of commercial court cases and speed up contract enforcement: Investors see the poor functioning o f the court system as a major impediment to doing business (FIAS, 2004). The courts are too slow: it can take a year from the submission of a claim to the handing down o f iv ajudgment. Overall, according to court statistics, about 40 percent o f the commercial court cases are resolved within less than three months, 33 percent take up to six months, and about 28 percent take longer than six months. Speeding up the resolution o f cases that take longer than six months-which inmany cases also include bankruptcy and liquidation cases-is urgent.Specific steps may include (i) easing the resources and personnel constraints inthe Montenegrinjudiciary; (ii)ensuring that qualified and better trained judges are put in place, with better compensation; (iii)training court personnel; and (iv) upgrading the court system's infrastructure, which should include including the development and computerization o f the case management systedprocess. Improve land title transparency and property rights. Until recently, Montenegro's lack o f functional restitution law gave rise to uncertainty about the handling o f existing and future restitution claims; it caused potential investors to postpone investments; and it drove interest rates up to compensate for security risks.However, the Restitution Law, under development for some time, entered into force on April 8, 2004; accompanying implemented regulations were passed, municipal commissions were formed, as well as the Fund for Indemnity and procedures of restitution for taken away properties. Indemnities based on the said Law have started but would need to be strengthened and sped up. In addition, the Government needs to vigorously enforce land property rights and control illegal construction. With regard to land title, registration i s computerized and i s not overly time-consuming or costly, the Cadastral Office does not have adequate, reliable land information. The lack o f transparency and discretionary public access to land information makes land title transfers risky for investors and complicates the planning and approval activities o f municipalities. 8. Fourth,the cost of capital needsto be reduced and financial intermediation improved. Total credits from banks to the private sector amount to only 11 percent o f GDP in Montenegro. This i s quite low compared to the regional countries (42.3 percent in Bosnia and Herzegovina, 26.6 percent in Bulgaria, 57.3 percent in Croatia, and 42.7 percent inHungary), though credits to the private sector began to rise from fairly low levels in 2004. Interest rates as well as spreads remain high: the real interest rate has ranged between 11 percent and 20 percent in recent years. The aggregate interest spread was about 7.6 percent in 2004 (down from 9.6 percent in 2003). Most investors in Montenegro would be hard pressed to find a project whose real rate o f return would exceed 11-20 percent. The high cost o f capital and the wide variability o f interest rates are related to the weak framework for creditor protection and contract enforcement, the high country risk, and the low competition in the banking sector. Specific measures that the Government can take to reduce the cost o f borrowing and improve financial intermediationare as follows: Reduce the needfor treasury billfinancing through tightfiscal policy. This would help reduce the budgetary burden o f interest payments on treasury bills and would help create the conditions for the lower cost o f capital inthe economy by reducing the crowding-out o f Government. Establish an effective, broad-based institution, withfull credit information on all borrowers, to address the problem o f asymmetric information in credit markets. At present, Montenegro has neither a Credit Registry nor a Credit Bureau. Introduce more competition into the banking sector through the completion o fthe privatization o f Government-owned banks (inparticular Podgoricka Banka), and by promoting leasing operations inview ofthe small size ofthe Montenegrinmarket. 9. Fifth, the Government can help to increase employment creation, growth, and competitiveness by undertaking fiscal reforms. Montenegro's general government services (public V administration, public order and safety, and defense) and social protection each consume about a third (33 percent) o f total general government expenditure. Education and health combined account for another 25 percent o f total spending. Compared with other countries in the region, Montenegro spends substantially more on almost all o f these functions--general public services, defense and public safety, education, and health in that order. Despite the fact that Montenegro started its public sector reforms a couple o f years ago, the reforms have not yet resulted in a reduction o f public administration costs. Over the last three years public expenditure on general government services has grown instead of declining. To ensure fiscal sustainability, create a budgetary space for capital investment, and improve delivery o f social services the following steps are necessary: 0 Control the wage bill, and develop a well-targeted public investment program. The high wage growth has crowded out spending on public investment and on operations and maintenance- expenditures that are essential for growth. The wage growth thus needs to be controlled through (i)public administration reforms that would eliminate employment redundancies; (ii)other measures outlined under labor market above. Controlling wage growth i s essential both for fiscal sustainability and to create a budgetary space for public investment. At 2 percent o f GDP, Montenegro's domestically financed capital expenditure i s much below the level for other countries in the region. While the l o w numbers may indicate the need for more capital investment, in particular infrastructure investment, such a decision i s best guided by two prior conditions: (i)that there i s a trade-off between a public infrastructure investment program and macro stability/fiscal sustainability, and whatever investment in public infrastructure needs to be made within the broader macroeconomic and fiscal constraints; (ii)that a rigorous public investment project appraisal and screening system is put in place to rank public investment projects, and fund only those which are strongly growth-oriented and whose economic and social returns are high enough. InMontenegro, there i s a need to do both a strategic assessment o f what infrastructure investment may be needed, and which o f the many potential infrastructure projects warrant investmentbased on their economic and social returns. 0 Improve the budget processes and develop a comprehensive plan to eliminate arrears. This can be done through: (i) undertakmg a better and more realistic revenue projection as well as speedy expenditure decisions to be implemented by budget users in the event o f revenue shortfalls; (ii) strengthening the commitment control system o f spending agencies through better staffing, the upgrading o f accounting standards, and transparency; and (iii) developing a time-bound plan for clearing arrears, identifying the most costly ones and retiring those first. e Strengthen the link between policy priorities and the budget, especially with respect to tourism development and implementation of the Poverty Reduction Strategy Paper (PRSP). In the medium to long term, there is a need to develop a comprehensive medium-term expenditure framework as a basis for public expenditure planning, comprising the central government, the social funds, and local governments, and reflecting fully the policy commitments o f the Government. The PRSP should also be allocated a budget, with concrete monitoring and an evaluation framework. Montenegro's main potential source o f growth, tourism, should be supported through multi-year budgeting and the Government's Tourism Master Plan (TMP) needs to be provided with concrete budgets and interim implementation targets. 10. Finally,tourism holds considerable promise for Montenegro's export-oriented growth and employment creation. Inthe past the manufacturingsector and the metal industry,inparticular the most important aluminum company, KAP, played a dominant role in the Montenegrin economy. To date, KAP i s the single most important exporter, accounting for more than 40 percent o f total merchandise exports; it contributes significantly to value-added and employment in the economy. However, that may be changing. Tourism in Montenegro has recently shown strong growth in absolute terms and relative to the Vi economy as a whole. According to the World Tourism and Travel Council, the contribution o f the travel and tourism industry (TTI) to Montenegro's economy i s estimated at 8.5 percent o f total GDP and 9.1 percent o f total employment in 2005. The same study suggests an even more rapid growth in the future: with a projected average rate o f increase o f over 10 percent per year over the next decade. By 2015 the tourism industrywould account for about 13.6 percent o f GDP and 14.5 percent o f employment, and the broader tourism economy should account for about 21.1 percent o f GDP and 22.5 percent o f employment. Even though these projections could be overly optimistic, they are suggestive o f Montenegro's considerable potential intourism development. 11. However, turning this promise into reality requires substantial and well-targeted investments as well as the implementation o f most o f the policy recommendations outlined above. In many ways the tourism sector illustrates the challenges o f competitiveness and growth faced by Montenegro. To realize its tourism potential, Montenegro needs to overcome s t i f f competition from neighboring countries and other destinations worldwide, many o f which currently offer a more competitive combination o f quality and price to the same target markets. Several specific measures are needed inthat regard: e Facilitate the conditions for private investment in tourism by: (i)Focusing the effort to attract private investment to the coast on international flagship operators; (ii) strengthening land use planning, and property rights and controlling illegal construction at tourist sites; (iii)putting in place supportive, not oppressive, legislation and regulations, and sorting out a thorough review o f the body o f tourism regulations required for maintaining basic standards (health, safety, environment, etc.) and protecting consumers' interests, versus those that should be left to market- based mechanisms; and, (iv) reducing the cost o f capital and increasing access to credit for (domestic) private investment. e Help address the public infrastructure constraints-- in particular in water, roads, and waste management-for coastal tourism development. The water shortage during the short tourism season needs to be overcome; an adequate solid waste management system, including capital investment in landfills and strict and consistent enforcement o f anti-dumping laws, needs to be put inplace; and a strategy needs to be developed to use road and other transport infrastructure to steer tourism development to new areas. The Government needs to play a coordinating role in areas where donor infrastructure investments are ongoing, and play a complementary role o f filling the investment gap in the context o f its comprehensive public investment program (see recommendation on public investment above). e Help capture thepotential employment benefits of tourism. The potential employment benefits of tourism are not being captured. Local employment in the tourism sector i s relatively low and i s projected to grow at only a modest rate o f 1.7 percent in 2005. The main reasons seem to be the short tourism season and the highlabor taxation (or, conversely, the low non-resident taxes) that favor non-Montenegnn employment, but it would be important to carefully assess the reasons why Montenegro i s not capturingthe employment benefits, and to decide what adjustment, if any, should be made to labor regulations and collective agreements. Also, help address the shortage o f skilled labor and inadequate training facilities for tourism services as better skills at the service level are urgently needed to improve quality and competitiveness in the existing facilities. The first private faculty o f tourism, management and trade, established in 2004 by Atlas Mont Bank in Bar, i s a promisingtraining facility which must be encouraged. e Continue to diversib the tourism product, based on Montenegro's strengths. Most o f the attention for both public and private investment continues to be directed at expanding and upgrading coastal tourism, with relatively little attention given to non-coastal tourism. A diversified approach to tourism which promotes landscape-based tourism in Montenegro's hills vii and mountains i s important. Specific plans, programs and incentives need to be developed and implemented to catalyze non-coastal tourism investment and development with the coastal tourism development. 12. Given the small size o f Montenegro's domestic market, its future growth and prosperity will depend to a large extent on how successfully it develops its exports oriented tourism industry in a sustainable and environmentally responsible way. viii 1Montenegro:A PolicyReformAgendafor Employment,Growth, and Competitiveness PolicyMeasure 3meline for mplementation Labor Market Reform Rein in the rapid wage growth witnessed in recent years through: (i)establishing a more ihort-term balanced collective bargaining and wage setting process whereby the voices o f employers (including Government) are strengthened; (ii) undertaking a more vigorous implementation o f public administration reforms and the reduction inpublic sector staffs many o f whom earn wages well in excess of the average for the economy; and, (iii) promoting greater decentralization o f bargaining to the firm level. Relax some aspects of the labor regulations.While the new Labor Law, adopted in 2003, has dedium term improved the flexibility o f the labor market considerably, it has not yet assured full flexibility. The reforms in labor relations should focus on: (i) relaxing the contracting rules for employing "non- standard'' workers, including employees on fixed-term and part-time contracts; (ii) reducing the costs for employers to terminate regular employees for economic reasons; (iii) permitting more flexible arrangements inworking hours; and, (iv) limiting non-wage costs to employers. Reduce the high rates of labor taxation in a fiscally responsible way to encourage formal vIedium term employment. A further phased and well-planned reduction in payroll taxes--compensated by equivalent increases in other taxes, and with adjustments to compensate the resulting lost income o f the social funds-is desirable. T o decrease such highrates ina fiscally responsible way, reforms of the health and pension systems (early retirement, disability, maternity leave and sickness benefit) need to be pursued inparallel. Introduce or expand, through the Employment Bureau, other active labor market programs Short-term including: (i) employer contact services, which refer the best qualified applicants to employers; (ii) vacancy and job fairs designed to assist local employment agencies in matching labor supply and demand; (iii) job clubs for those with low self-confidence who have been unemployed for extended periods o f time; and (iv) virtual enterprises to develop teaching and training skills for operating a real enterprise. Improvelabor market data and information. Special and more detailed regular labor force data Long-term are needed to monitor employment, underemployment and unemployment; seasonal, occasional and informal employment; earnings and incomes; working time, by occupational and professional groups and regions; and work inthe informal sector and inhouseholds. The absence o f regular and reliable information on the labor market limits effective labor market monitoring and interventions. Fiscal PolicyReform Short-Medium Reducekontrol expenditures on the wage bill, transfers to households, and interest term payments, which have risen significantly over the last three years. The high wage growth has crowded out spending on public investment and operations and maintenance-expenditures that are essential for growth. It should be controlled through: (i) administration reforms that public would eliminate employment redundancies; (ii) controlling o f wage and salary increases. Increase the allocation toward well-targeted infrastructure investment that will support Mediumterm tourism development and growth. At 2 percent o f GDP, Montenegro's domestically financed capital expenditure is much below the level for other countries inthe region. Capital investment in infrastructure, at only about 0.4 percent o f GDP, is even less. Increasing capital investment, in particular ininfrastructure, i s necessary. The challenge would be to: (i) this ina way that would do not compromise fiscal and macroeconomic sustainability; (ii) carefully target and fund only those infrastructure investments that are strongly linked to growth and tourism development. ix Montenegro:A PolicyReformAgenda for Employment,Growth, andCompetitiveness rimelinefor 1 mplementation Eliminateheduce subsidies and lending to public enterprises by imposing a complete hard ihort-term budget constraint. Government subsidies and net lending now account for about 1.6 percent o f GDP. State-owned enterprises still lack hard budget constraints and budgetary discipline. This problem could be overcome through (i) increasing the transparency around which state-owned enterprises receive subsidies and transfers from the Government; (ii) completing the privatization o f these enterprises where privatization i s an option; and (iii) where privatization is not feasible, by improving the management o f such enterprises and defining strict financial performance criteria that would phase out subsidies and budget transfers. Increase the productivity of current expenditures on education and health care services. In ,ong-term the health sector the management o f public health funds should be improved, the reforms o f primary health care including prioritization o f treatment programs, should be continued, and public procurement procedures should be improved through improved legal framework for procurement. In education the disproportionate staffing cost should be reduced through school consolidation, and vocational training programs should be realigned to those demanded by the labor market. Improvebudget processes and eliminate arrears by: (i) undertaking a better and more realistic short-term revenue projection as well as making speedy expenditure decisions in the event o f revenue shortfalls; (ii)strengthening the commitment control system o f spending agencies through better staffing, the upgrading o f accounting standards, and transparency; and (iii) developing a time- bound plan for clearing the current stock o f arrears, identifying the most costly ones, and retiring those first. Strengthen the link between policy priorities and the budget, especially with respect to Medium-Long tourism development and implementationof the Poverty Reduction Strategy Paper (PRSP). term The Government budget generally, and public investment particularly, should be geared toward supporting the realization o f the growth potential o f tourism. The Ministry o f Tourism should move toward a multi-year budgeting and program implementation. In the medium to long term, there i s a need to develop a comprehensive medium-term expenditure framework as a basis for public expenditure planning, comprising the central government, the social funds, and local governments, and reflecting fully the policy commitments o f the Government. The PRSP should also be allocated a budget, with concrete monitoring and an evaluation framework. PrivateandFinancialSector Reforms Short-term Simplify and speed up the issuance of business licenses and inspections. Business operating licenses take a long time to be issued, and licensing and inspection activities are not conducted ina fair and transparent way (FIAS, 2004). A draft Law on Licensing, prescribing a faster and more efficient registration and listing o f business activities, should be implemented as quickly as possible. Improve governance and regulation through: (i) transparency, and a more consistent greater Short-term application o f rules, including an improved tax administration capacity to support rule-based tax collection; (ii)speeding up the implementation o f recently enacted business laws and regulations. The implementation o f legislation aimed at improving the business environment--contract enforcement, access to finance, corporate governance, and business exit-has not yet begun in most cases. Speeding up the implementation o f these laws will be critical to private sector investment and growth. X I Montenegro: A PolicyReformAgendafor Employment,Growth, andCompetitiveness Policy Measure rimeline for [mplementation Speed up the restructuring of companies privatized through the MVP by: (i)faster Short-term consolidation o f the shares o f these companies being traded on stock exchanges into majority shares; (ii) making budgetary allocations toward covering the social costs o f restructuring- including the shielding o f excess labor and severance payments - for those companies for which the Government agreed to fund such costs; (ii) strictly enforcing the new Bankruptcy L a w for medium and large enterprises privatized through vouchers that have continued to accumulate losses; and (iii) strengthening the capacity o f the courts to deal with such bankruptcy cases (see below, on courts). Reduce the backlog of commercial court cases and speed up contract enforcement through: (i) Medium-term easing the resources and personnel constraints in the Montenegrin judiciary; (ii) ensuring that qualified judges are put in place; (iii) training court personnel; and (iv) upgrading the court system's infrastructure, including the computerization o f case management. Improve land title transparency and control illegal construction. Lack o f transparency o n land Medium-term titles and registration represents one o f the greatest threats to the future prospects o f Montenegro's tourism industry, particularly in the few remaining high-potential tourism sites (e.g., Ulcinj, and inland areas close to national parks and other natural attractions). The Government needs to vigorously enforce land property rights and control illegal construction. Reduce the cost of capital and improve financial intermediation through: (i) reducing the need Short-term for Treasury bill financing through a tight fiscal policy. This would help reduce the budgetary burden of interest payments on Treasury bills and would create the conditions for the lower cost o f capital inthe economy by reducing the crowding-out o f Government; (ii)establishing an effective, broad-based institution, with full credit information on all borrowers, to address the problem o f asymmetric information in credit markets. At the moment Montenegro has neither a Credit Registry nor a Credit Bureau; (iii) introducing more competition into the banking sector through the completion o f the privatization o f government-owned banks (inparticular Podgoricka Banka), and by promoting leasing operations inview o f the small size o f the Montenegrin market. TourismDevelopment Diversify the tourism product, based on Montenegro's strengths. Most o f the attention for Medium-Long both public `and private investment continues to be directed at expanding and upgrading coastal term tourism, with relatively little attention given to non-coastal tourism. A diversified approach to tourism which promotes landscape-based tourism in Montenegro's hills and mountainous areas i s important. Specific plans, programs and incentives need to be developed and implemented to catalyze non-coastal tourism investment and development. Focus the effort to attract private investment on flagship operators. Because Montenegro is Short-term currently relatively unknown in many prospective tourism markets, high priority should be given to attracting a few high quality "flagship" operators whose presence could help provide the reassurance that many travelers need inorder to try out a new destination. Facilitate the conditions for private sector investment in tourism by: (i) strengthening land use Short-Medium planning, and property rights and controlling illegal construction at tourist sites; (ii) putting in term place supportive, not oppressive, legislation and regulations and carrying out a thorough review o f the body o f regulations required for maintaining basic standards (health, safety, environment, etc.) and protecting consumers' interests versus those that should be left to market-based mechanisms; (iii)reducing the cost of capital and increasing access to credit for (domestic) private investment in IPolicyMeasure rimelinefor [mdementation Help address the public infrastructureconstraints-- in particular in water, roads, and waste Mediumterm management-for coastal tourism development. The water shortage during the short tourism season must be overcome; a strategy needs to be developed to use road and other transport infrastructure to steer tourism development to new areas; and an adequate solid waste management system, including capital investment in landfills and strict and consistent enforcement o f anti- dumpinglaws, should be putinplace. Help capture the potentialemploymentbenefits of tourism. The potential employment benefits Short term o f tourism are not being captured. Local employment inthe tourism sector i s relatively low and is projected to grow at only a modest rate o f 1.7 percent in 2005. The main reasons seem to be the short tourism season and the high labor taxation that makes employers favor non-resident employment, but it would be important to carefully assess the reasons why Montenegro i s not capturing the employment benefits, and to decide what adjustment, if any, should be made to labor regulations and collective agreements. Help address the shortage of skilled labor and inadequate training facilities for tourism Mediumterm services. Better skills at the service level are urgently needed to improve quality and competitiveness inthe existing facilities. A higher level o f professional training in a wide range o f skills, with an emphasis on modem information technology, management, and flexibility and "multi-tasking" i s needed. Such training facility can be private sector-led. The Ministry o f Education has recently introduced "tourism and catering" as a vocational stream, but this would need to be strengthened. The first private faculty o f tourism, management and trade, established in 2004 hv Atlas Mont Bank inBar. i s a uromising initiative which mustbe encouraged. xii 1. RECENTECONOMIC DEVELOPMENTS A. BACKGROUND 1.1 Serbia and Montenegro(SAM) is a unionof two looselyaffiliated republics,' the Republicof Serbia and the Republic of Montenegro. Twelve years after the breakup o f the Socialist Federal Republic o f Yugoslavia in 1991, the Constitutional Charter o f Serbia and Montenegro was enacted in February 2003 by the Parliament o f Serbia, the Parliament o f Montenegro and the Parliament o f the Federal Republic o f Yugoslavia to give birth to "Serbia and Montenegro," a country that has come to replace the former Federal Republic o f Yugoslavia. 1.2 Montenegro is by far the smaller of the two republics in the State Union of Serbia and Montenegro. Geographically, it is a small, mountainous, and picturesque area o f about 13,2 14 square kilometers, located in the Western Balkans region o f Southeast Europe, with about 293 kilometers of coastline on the Adriatic. According to the November 2003 population census issued by its Bureau o f Statistics, Montenegro i s approximately one-sixth the geographical size o f Serbia, with 620,145 inhabitants (less than one-tenth o f Serbia's population). Its economic base consists o f significant deposits o f natural resources (bauxite), aluminum, a great potential for tourism development, some tracts o f arable land, and a pool o frelatively slulled labor. 1.3 Although much remains unclear about the political future of Montenegro; EU accession remains an overarchingstrategic goal. Followingthe "Belgrade Agreement" o f 2002, Montenegro and Serbia agreed on the so-called "Action Plan for Harmonization o f Economic Systems o f Member States o f the State Union o f Serbia and Montenegro for the purpose o f Preventing and Removing Obstacles to Free Movement o f People, Goods, Services and Capital" ("Action Plan"), whose purpose was to bring the two economic systems together so that they could move jointly toward EU accession. In practice, however, the harmonization o f tariffs and trade policy proved difficult, with the result that in October 2004 the EUproposed a "two-track" approach to EUaccession. The twin-track approach allows the EUto deal with Serbia and Montenegro separately on issues relating to trade, customs and economic and sectoral policies, while seeking to reach an agreement with the union on internationalpolitical obligations and human rights. Given its small domestic market, Montenegro's EU (and WTO) accession3 and further regional integration will be fundamental to its growth and prosperity (see Box 1.1.). Maintaining its competitiveness inthese markets, too, will be critical. In2002, Montenegro signed the Accord onprinciplesinrelations between Serbia andMontenegro("Belgrade Agreement") with Serbia and the EU, which established a new State Union o f Serbia and Montenegro. As presently constituted, the Unionhas limited responsibilities inthe area o f foreign affairs, defense, human rights, intellectual property rights, standardization and technical regulations, metrology and statistics. All other areas are at responsibility o f the member states. * The final shape o f the Union with Serbia is unclear. Three years after the establishment o f the State Union, the member states have`the right to hold a referendum on withdrawal from the State Union. The European Union (EU) published its feasibility study for the initiation o f negotiations on Stabilization and Association Agreement (SAA) in M a y 2005. InOctober 2005, Serbia and Montenegro officially started the negotiations with the EUon the SAA. Box 1.1. Montenegro: Why RegionalIntegration and EUAccession? Market integration within the framework o f the EU and WTO accessions is vital for a small economy like Montenegro's for several reasons. First, in view of its small size, it is fundamental to increase specialization and efficiency inthe production of goods and services. If Montenegro remained a closed economy, its economy would be forced to produce a larger range o f products, under less than efficient conditions. The lack o f specialization reduces efficiency and income. On the other hand, trade ingoods would allow a small country like Montenegro to specialize ina smaller range o f goods and services following its natural resource base, and importing other goods from the rest o f the world. It would also enlarge the set o f opportunities a consumer has well beyond Montenegro's own production possibilities. Trade in goods and services, however, depends on transportation costs, tariff and quantity restrictions and "behind the border barriers." That is why the issues o f tax harmonization and the removal o f barriers to the fiee trade o f goods and services inthe context o f EU accession are important for Montenegro. Second, regional integration and EU accession are also essential to reduce the cost of doing business and for risk diversification. The establishment o f idiosyncratic institutions by small states like Montenegro may imply a higher per capita cost o f providing public goods and higher costs o f doing business. Indeed, empirical evidence shows that small states have higher costs o f producing public goods (Alesina and Wacziarg, 1998). Furthermore, small size implies difficulties in diversifying risk within borders. For example, a bank forced to hold onto portfolio mortgages generated within the small Montenegrin market may face a larger risk than if it had access to a larger market. Finally, regional integration and EU accession can help reduce the high income volatility that small states like Montenegro often experience. Empirical evidence suggests that there i s a negative correlation between population size and the standard deviation o f per capita income (Easterly and Kraay, 1999). This is not surprising since, with a given level o f shock, the impact on consumption will be more rapidly felt in a small state. Regional integration may make it possible to smooth income and consumption arising from such shocks. Conversely, regulations imposing restrictions on the flow o f capital and labor may prolong the cost o f adjustment to shocks. Where feasible, trade in institutions, such as when a country adopts an institution o f another country relinquishing its national institution or independent policy (e.g., the euro as a currency, a defense agreement which puts a small state under the umbrella o f a larger regional power), may also help reduce costs, ensure stability and reduce risks. I Source: Based on Favaro (2003). B. THEECONOMIC REFORMS DATE4TO 1.4 Montenegro, like all other regional states, inherited a legacy of four decades of inefficient economic management and institutional policies that stifled growth and private initiatives. For nearly a decade following the breakup o f the former Federal Republic o f Yugoslavia, regional conflicts and international isolation crippled the economy and delayed the start o f the transition to a market economy. Since 1997, however, Montenegro, with the support o f the international community,' has been engaged in a long series o f reforms designed to move its economy from a socialist to a modern market- based economy. In 2003, the Government o f the Republic o f Montenegro formally adopted its Economic Reform Agenda (ERA) covering the period 2003-2007, and a Poverty Reduction Strategy (PRSP) aimed at reducing poverty. The ERA established a broad strategc vision o f a liberalized, market-based economy, on which subsequent economic reforms have been based.6The ERA has recently been updated to guide economic reformprogram for the period 2005-2007. See Annex 1for a chronology o f main events in Montenegro, including dates o f some key policy reforms. Main donors inMontenegro include USAID, EAR, World Bank, UNDP. See Republic o f Montenegro Economic Reform Agenda, 2003. The main goals o f the ERA are the establishment o f an open economy based on the private sector, the creation o f a favorable business environment attractive for 2 1.5 Montenegro's economic reform program since 1997 has rested on two broad pillars: macroeconomic stabilization, and market-oriented structural reforms, including extensive price and trade liberalization, privatization, public administration reform, financial sector reform, and reforms aimed at improving the business climate and the labor market. Macroeconomic Stabilization 1.6 Currency reforms. A cornerstoneof the Montenegrinstabilizationprogramwas the adoption of first the DM and then the euro as the legal tender in the Republic. In November 1999, the Montenegrin Government declared the Deutsche Mark (DM) an official parallel currency to the Yugoslav dinar. One year later, in November 2000, the Central Bank o f Montenegro (CBM) declared the DM the sole legal tender inthe Republic. On January 1,2002, the euro replaced the DM as Montenegro's official currency. 1.7 Both economic and political factors underpinned Montenegro's adoption of the DM, and subsequently the euro, as the official currency (Bogetic, 2002). The economic rationale had to do mainly with the monetary policy o f the federal government, which resulted in two devastating hyperinflations in 1990 and 1992-93. The political reasons largely reflected Montenegro's growing estrangement from Milosevic's policies o f the late 1990s, and the consequent decision by the Montenegrin authorities to take control o f some state functions that were previously inthe federal domain (e.g., customs, foreign representation). While the currency reforms-in particular euroization--laid some solid foundations for stability and economic recovery, it has also reduced policy flexibility (see Box 2.2). Inflation (CPI) fell from 67 percent in 1999 to 24 percent in 2000, and has continued in a gradually declining trend. Since 2002, inflation inMontenegro has been held to single digits. 1.8 Fiscal reforms. Fiscal reformin Montenegro started in 2001. Many laws were adopted with a view to establishing a more transparent and efficient collection o f budget revenues. A new value added tax replaced a previous sales tax system in 2003; the Treasury o f the Republic of Montenegro was established; fiscal cash registers were introduced and tax identification numbers applied; and most recently, the monopoly o f the domestic payment services (the former payment bureau, called ZOP) was abolished, allowing commercial banks to initiate and settle inter-bank payments without the mandatory intermediation o f any institution or agency. The establishment and enforcement o f the Law on Public Procurement has raised the level o f transparency as well as the efficiency o f public expenditure control. Revenues, which were previously distributed through extra budgetary funds and other institutions, have been centralized within the Budget o f the Republic. The introduction o f a medium-tern expenditure framework has been initiated, and programmatic budgeting i s being developed on a pilot basis in two institutions: the Ministry o f Transport and Navigation and the Institution for the Execution o f Penalties (penitentiary). The internal audit was established in2004 within the Ministryo f Finance, and the Supreme Financial Institution for Auditingwas established inApril 2004. 1.9 The Government has, however, made progress is containing fiscal deficits. Supported by the IMF programs in Serbia and Montenegro,' Montenegro's consolidated budget deficit was cut from about foreign investors, accession to the EU and the WTO, and the reform and development o f various sectoral policies. The Economic ReformProgram deals with Business Environment and Trade, Fiscal Reform, Financial System, Privatization, Reform of the Pension System, Sectoral Policies (Tourism, Energy, Agriculture), Public Administrative Reform, Judicial Reform, Civil Society, Information Society, Macro-Economy and Statistics, and Management o f the Reform. 'The macroeconomic policies o f S A M were supported by three successive IMFprograms. The first program, the Emergency Post-Conflict Facility, was approved inDecember 2000 and was followed by a Stand-by Arrangement 3 8 percent o f republican GDP in 2000 to about 3 percent in 2004. Chapter 3 o f this report will examine whether this fiscal deficit i s sustainable, and where the Government might tighten and/or reallocate expenditures to support the goal o f macroeconomic stability and faster growth. Box 1.2. The CostsandBenefitsof Euroization Euroization has several benefits. First, it eliminates the risk o f a nominal devaluation o f the country's exchange rate. This can inturnhelp avoid a sudden stop incapital flows motivatedby fear o f devaluation; and lower the cost o f borrowing from international market, through reduced country risk. As such, it can contribute to buildinga stronger financial system, and facilitate financial integration. Second, euroization can help rein ininflation. The . reasoni s simple. Under euroization there is no domestic monetary authority that could expand the quantity o f money. Third, euroization also makes commercial integration with the rest o f the world easier because it eliminates the transaction costs associated with currency exchange. Finally, euroization can have a disciplining effect on fiscal policy, although it does not prevent fiscal indiscipline. While the Central Bank cannot monetize fiscal deficits under euroization, the authorities can still engage infiscal profligacy through excessive borrowingto finance large fiscal deficits. On the other hand, euroization has several costs. Among these are: (a) the sacrifice o f an independent monetary policy; (b) the loss o f the lender o f last resort; (c) the sacrifice o f the inflation tax; and (d) the loss o f seigniorage. An independent monetary policy is clearly lost under euorization. For example, if the authorities believed that some insulation o f the domestic financial system is needed for the purposes of, say, improving its stability, through the imposition o f capital controls, they would find such measures difficult to accomplish, because it would always be possible for private agents to convert their assets to euro cash. Second, the lack o f a lender o f last resort puts even greater importance on the need to have a strong banking sector supervision and management o f liquidity in the financial system. Third, euroization limits policy flexibility, and puts the full burden o f adjustment to shocks on prices, fiscal policy, and most importantly structural reforms including labor market reforms. Structura1Reform s 1.10 Parallel with stabilization policies, the Republic o f Montenegro also implemented a program o f structural reforms, including price and trade liberalization, privatization, public administration reform, financial sector reform, and labor market and business environment reforms. 8 1.11 Price liberalization. Beginning in 1998, the Government of Montenegro launched a concerted reform effort to liberalizeprices and foreign trade. Most price categories were liberalized by the early 2000s except for some public utilities such as electricity. Even in electricity, continuedprice adjustments since 2001have further reduced the need for electricity subsidies, although full cost recovery prices are not yet in place. Overall, Montenegro's pricing policy i s based on market principles, and price liberalization i s almost complete. Only a small number o f products are currently subject to administrative price control, including medicines for human consumption, oil and derivative products, and postal services, while local authorities may control the prices o f certain utility services 1.12 Foreign trade liberalization. In June 2000, Montenegro significantly liberalized its foreign trade regime. The Government adopted a temporary regulation taking over the jurisdiction of customs from the federal authorities, pending the preparation o f the new Customs Code. According to the Temporary Act on Custom Tariffs, only Montenegrin laws and institutions regulate all international o f SDR 200 million approved inJune 2001. A three year Extended Arrangement (EA) o f SDR 650 million was approved inMay 2002 and spans the period through end-December 2005. For a more detailed description o f the structural reforms agenda after 2003, see the Government's Economic ReformAgenda o f 2003. The Government i s currently revising and updating its Economic Reform Agenda for 2005-2007. 4 transactions. All customs rates, previously determined by the federal legislation, are now set by Montenegro's authorities. The trade reform has significantly simplified Montenegro's trade regime by substantially reducing and simplifying licenses, quotas and tariffrates and structure. According to the new Law on Customs (January 30, 2002), imports face six tariff rates; 0, 1, 3, 5, 10, and 15 percent. The average duty i s a low 3.5 percent. Most notably, the tariff structure contains no high, very protective peaks. More than 95 percent o f imports are no longer subject to quota or license requirements. Manufacturers importing equipment, materials and components face reduced but constrained tariff rates and difficulties with customs procedures. Firms with export opportunities which are entitled to obtain rebates on import tariffs paid for materials or components used in their production do not often receive these rebates, as there i s no effective duty drawback system. Inthe context o f its participation inthe SEE Stability Pact, Montenegro as a member o f the state union along with other signatories has established a network o f 28 bilateral free trade agreements (FTAs) in the region and all the 28 agreements are being implemented. Box 1.3. Montenegro's History of Privatization State-owned companies in Montenegro were transformed, under the Law on Ownership and Management Transformation (RM OG No. 2/92, 27/94, 23/96), in the early 1990s. Under that Law, employees were granted 10 percent o f shares free o f charge and up to 30 percent more, to be paid in installments with a discount based on the working period that had been spent in a company. The remaining 60 percent or more o f the shares were transferred to three state-owned funds: the Development Fund(60 percent), the Pension Fund(30 percent) and the Employment Fund (10 percent). Approximately 350 companies were involved in this process. Subsequently, 117 o f these companies were sold through different methods o f sales including direct sales o f majority or minority stakes and auction sales. The Privatization Council was established in 1998 to manage the privatizationprocess. Based on proposals made by the Privatization Council, the Government has since issued an annual privatization plan and conducted privatizations o f state-owned enterprises in accordance with the annual plans. The plans contain the number o f shares in each company to be privatized or given back to former owners o f industries nationalized after World War 11. The Government earnestly embarked on the privatization process with the launching o f the mass voucher privatization (MVP) o f 2002. Through this process, more than 400,000 citizens o f Montenegro acquired vouchers for free and exchanged them for shares o f companies or investment units o f privatization investment funds. About 66.47 percent o f voucher points were invested in privatization funds and 29.05 percent directly in the companies. More than 200 companies, covering about one-fourth o f the socially owned companies, were privatized through the MVP process. Today, shares o f companies and investment units are traded on the two stock exchanges, NEX Montenegro and the Montenegro Stock Exchange. Yet the trade in shares is slow, so that new majority owners are not found quickly. Overall, Montenegro has to date privatized more than 60 percent o f the former socially owned capital. In addition, about 80 percent o f the capital in another 179 f i r m s has been privatized, as has 70 percent o f the capital in 27 companies. However, insome o f the largest companies there is still a little private capital, but the Government plans to relinquishmajority shares inthese companies through international tender inthe near future (2005). 1.13 Privatization. Montenegro's privatization program dates back to the early 1990s when some state-owned companies were transformed, under the Law on Ownership and Management Transformation, to employee ownership (see Box 1.3). However, the privatization program was launched with renewed vigor in the late 1990s with the establishment in 1998 o f the Privatization Council (to oversee the tenders and auctions inlarge enterprises) and the launching o f the mass voucher privatization (MVP) for small stakes in selected enterprises in 2002. In the MVP program, completed in 2002, vouchers were distributed to all citizens, and widespread share ownership was established for more than 200 socially owned companies, comprising about 25 percent o f the state-owned companies inMontenegro (see Box 1.3). 5 1.14 Montenegro has recently accelerated its privatization plans and expects to wrap up the privatization of its biggest companies in 2005.9 In mid-2004 the largest steel producer Niksicka Steelworks was privatized. In 2005, the local telecommunication monopoly, Telekom Montenegro, and the largest aluminum producer, Kombinat Aluminum Podgorica (KAF'), contributing about half o f the nation's merchandise export, were sold. An international financial advisor for the privatization o f PodgoriEka Banka, the largest state-owned bank, was selected inFebruary. The authorities have prepared a time-bound strategy for the privatization o f majority and minority-owned equity stakes inthe remaining state-owned banks. Besides, hotels and other minor assets have been privatized. Another 120 small and medium-size companies are expected to be offered for sale on the stock market. 1.15 Public administration reform. Montenegro adopted its public administration reformprogram in June 2003. Soon after the adoption o f the program, the Government made some effort to reduce employment in the public sector, mainly in the police and education sectors (some police officers were laid off inAugust 2003). InMarch 2003, the Government adopted an employment and wage policy action plan, which foresaw a reduction o f redundant public employees-especially in the education sector--by 3,000, as well as a larger differentiation o f salaries to increase the incentives for qualified staff inpublic administration. In2003-2004, the Ministry o f Education and Science conducted a rationalization o f the education system, which reduced the number o f employees by 728 workers. In 2004, the Ombudsman Office was established and staffed. New procedural legislation (administrative litigation) and the Code o f Conduct for civil servants were prepared, and regulations governing the status o f civil servants were developed, with the aim o f introducing professionalismand more transparency through obligatory public competition for all posts apart from ministerial posts and a very limited number o f personal advisers. Most recently, a separate organizational unit for human resources management has been established, and a new salary law introduced to decompress the salary system and create a transparent reward system for civil servants (although it remains unimplemented to date). The Ministry o f Justice has led the introduction o f many o f these reforms, and today an adequate legal and regulatory framework exists in Montenegro for public administration reform, but the more difficult phase o f institutional building i s yet be fully implemented. 1.16 Financial sector reform. In the financial sector several reforms were carried out. The institutional framework for banking supervision has been strengthened over the past years with the introduction o f new regulations on licensing, minimal capital requirement, asset classification and provisioning and large exposures. The finalizing o f the privatization in July 2003of the Montenegro Banka, formerly the largest bank inthe Republic, contributed to banking sector stability. Since the sale o f Montenegro Banka and the closure o f some smaller banks, all banks operating in Montenegro are now considered to be liquid and to be in compliance with capital requirements. In 2003 the Ministry o f Finance revoked all licenses given to offshore banks registered inMontenegro. An anti-money laundering law was adopted in 2004, and Montenegro became the member of the Egmont Group in Washington on June 29, 2005. The importance o f membership i s manifold, both for Montenegro and for the Administration for Money Laundering Prevention, and includes exchange o f confidential information on money laundering. In January 2005, the Montenegnn Central Bank completed the transfer o f the inter-bank payment system (known also as ZOP) from the Central Bank to the jurisdiction o f commercial banks, a move which i s expected to help consolidate financial transactions at commercial banks and reduce the banks' hightransactions fees. The privatization of the last bank with majority public ownership, PodgorickaBanka, i s currently under way. ~ Further details are contained in the Government's document: "Montenegro PrivatizationPlan for 2005". 6 1.17 Business environment reform. Finally, several reforms aimed at improving the business climate and labor market flexibility were initiated in recent years (see Chapter 4). The Government enacted new enterprise, bankruptcy, and secured transaction laws to create a more favorable business environment. A new energy law was enacted, which provides a basis for the development o f a regulatory framework, together with energy industry restructuring and liberalization. A new labor law, aimed at increasing labor market flexibility, was enacted in2003. 1.18 In summary, Montenegro has made significant progress in terms o f both macroeconomic and structural reforms. With the implementation o f currency and fiscal policy reforms, it has succeeded to rein in inflation and bring about macroeconomic stability. Inparallel to the stabilization policies, it has also implementeda number o f structural reforms, including price and trade liberalization, privatization, public administration reform, financial sector reform, and labor market and business environment reforms. Yet, despite the progress, many structural reforms remain to be carried out. The Government's recently updated Economic Reform Program for 2005-2007 provides a framework for what economic reforms remain to be done over the coming years. c. THERESULTS SO FAR:MACROECONOMIC AND POVERTY OUTCOMES structural reforms pursued since the 6 _."_ ................................. .. .__ii .. I _I__I ~ ~ late 1990s have supported four years of I i l modest economic recovery and 5 transition. Pervasive data problems exist s 4 - in Montenegro, which highly constrain -5 i l the analysis and derivemake ability to evidence-based e 3 (3 conclusions (see Box 2 - ' I ~ 1.4). Basic national accounts statistics are ' I ! (3 I either too old (the latest official GDP ii1- figure available from MONSTAT, the 2 0 - I Republican statistical office, i s for 2002), -1- . . . . . . . . . . . . 2000 2001 2002 . . . 2003 "^ . . - 2004 " .......... Growth and Employment 1.20 With the reforms of the late 1990s and early 2000s, real output growth has shown modest recovery. With the advent o f reforms, it was expected that the Montenegrin economy would grow rapidly The actual results, however, show that growth i s still sluggish.: average annual real GDP growth over 7 2000-2004 was only about 2 percent, significantly below the regional average growth rate (Figure 1.1). Moreover, the recorded growth of output remains below its potential, as Montenegro's GDP remains far behind its pre-transition levels. 1.21 On the demand side, the recorded growth came mainly from high domestic consumption (both private and public) during 2000-2002. The latest period for which demand composition i s available i s 2000-2002. According to these data, both private and public consumption grew. While investment declined in real terms by 16 percent in 2002, it i s estimated to have recovered in 2003 and 2004. Even so, Montenegro's investment, at around 20 percent o f GDP, remains below the levels Icharacteristic of leading transition countries. Box 1.4. Montenegro-Key StatisticalIssues Montenegro's statistical system i s weak, basic macroeconomic data are not available at all or are not timely, and their compilation does not fully comply with international standards. Real Sector. Real sector statistics are compiled and published by MONSTAT, the statistical agency o f Montenegro. MONSTAT has recently produced estimates o f GDP by activity and by expenditure for 2000-2002. However, no official GDP estimates are available for 2003 and 2004, and no quarterly data are available. Generally, the methodology follows the System ofNationa1 Accounts (1993 SNA), but there are problems with the scope o f the accounts and the basis for recording that are not broadly consistent with the international standards. Overall, the data quality i s poor, and the data sources are in need o f improvement. The statistical techniques used for the national accounts compilation also need further improvement. There is a master plan for the improvement o f statistics, developed with the assistance o f EUROSTAT, which has been approved by the Government but not fully implemented. Further, the restructuring and staffing plan for MONSTAT, although under preparation for some time,, i s yet to be approved and implemented. Balance of Payments. Balance o f payments statistics are currently compiled by the Central Bank o f Montenegro (CBM). The principal sources o f data are customs data on merchandise trade as processed by the Central Bank and information on foreign exchange transactions provided by banks and exchange bureaus. An IMF balance o f payments technical assistance mission to the C B M in JuneiJuly 2004 provided recommendations to improve international trade statistics, external debt. Imports and exports are not accurately captured, especially with Serbia. Government Finance. Fiscal statistics for Montenegro are compiled by the Montenegro Ministry o f Finance. The principal data sources are the Republican Treasury and the budget execution reports o f the spending ministries and the first level budget units. Montenegro now reports the Republicanbudget implementationdata on a monthly basis. Fiscal data for the central government o f Montenegro are based o n the new GFS classification. Data for the Social Security Funds, reported directly by the funds, are compiled with significant delays and not on a GFS basis. A new chart o f accounts was introduced in Montenegro in 2001, but it still needs to be hlly implemented by local governments. Local governments are not yet integrated into the consolidated general government revenues and expenditures. Monetary Accounts. Monetary and financial statistics are compiled by the CBM, broadly following the methodology set forth in the Monetary and Financial Statistics Manual. Estimates o f cash in circulation are not regularly available. The Republic o f Montenegro introduced new charts o f accounts for the CBM (January 2004) and for the commercialbanks (December 2003). The CBM i s now compiling monetary statistics from data collected based on the new charts o f accounts. The monetary and financial statistics mission o f the IMF (2004) made recommendations to the CBM for improving (i) the classification of financial instruments, including loan-loss provisions and depreciation, (ii) the mapping between the charts o f accounts o f the CBM and other depository corporations with the respective sectoral balance sheets. While many o f these recommendations have been implemented, there i s still room for further improvement. Source:Bank Staff assessment; IMF Statistical Note on Serbia and Montenegro. 8 1.22 On the supply side, industry and agriculture contributed most to the growth of GDP during 2000-2002, but data are not available for later years. Services, manufacturing, and agriculture are the most important economic sectors, with shares in GDP o f about 60 percent, 25 percent and 13 percent, respectively. Within services, tourism plays an important role. Within manufacturing, the metal industry (which includes the most important factory, KAP) plays a dominant role. KAP i s not only the single most important exporter, accounting for more than 40 percent o f total merchandise exports, but it also has about 3,000 employees and contributes significantly to value-added in the economy. According to the available data, since 2003 the main sources o f growth in Montenegro appear to have been industrial production and tourism, with annual increases o f about 6 percent and 10 percent, respectively. (see Box 1.5 for possible drivers o f growth). 1.23 The limited output recovery was not accompanied by employment growth (see Figure 1.2). Like many other transition Figure 1.2. Trends inEmployment and Unemployment, 2000-2003 countries, Montenegro has faced "jobless growth" (or 190 -r 80 even "job loss growth"). Recorded employment has f 185 on average declined over the a a 180 last 15 years. Labor Force Surveys for Montenegro 5C 175 show that the numbers o f the .-% 170 employed in companies (so - 165 20 E called "wage-earners") 0 declined by about 7 percent 160 5 E over 1998-2004. The 2004 155 11100 Labor Force Survey shows 1997 1998 1999 2000 2001 2002 2003 2004 that employment recovery has continued. ---cErrploymnt(LFS)--c-Unenploymnt(LFS) Source: MONSTAT, Labor Force Survey (various years). 1.24 Yet, average monthly net wages doubled over the last 4 years, from EUR 96.3 in 2000 to EUR 195.9 in 2004. Only in 2004, real wages in Montenegro went up by 9.11per cent. This has ledto a wage growth far inexcess o f productivity, thereby seriously endangering Montenegro's competitiveness (see competitiveness section below). 1.25 Unemployment persists as a structural problem in Montenegro. It i s exceptionally high, and long-term unemployment i s widely prevalent. According to the 2004 labor force survey data (October), there were 71,800 unemployed at age o f 15 and over, with the unemployment rate o f 27.7 percent. In April 2005, the Employment Agency had 58,000 registered unemployed on the roster, a 23.5 percent decline compared to 2004, mainly because o f the legalization o f existing informal sector jobs. Long-term unemployment i s widely prevalent. More than one-fifth o f the registered unemployed are on the roster for more than eight years. The skills and work habits o f many o f the long-term unemployed have eroded and to a large extent the reintegration o f this group into the labor market i s complicated, at least without an upgrade o f their human capital. Long-term unemployment constitutes an additional burden on the social funds and on the families o f the affected. The persistence o f high unemployment and growing under-employment even after more than a decade of economic growth suggests that the new private sector, comprised o f small firms, has not yet developed the critical mass to generate enoughjobs to offset the job losses in the old public sector. Facilitating the entry o f new firms and the growth o f small enterprises i s necessary for faster job creation, the reduction o f unemployment, and economic growth (see Chapter 4). 9 Box 1.5. Drivers of Growth in Montenegro Sectorally, the services sector-in particular tourism-holds the greatest potential for growth. The manufacturing sector and the metal industry, in particular the most important aluminum company KAP, play an important role in the Montenegrin economy. KAP is currently the single most important exporter, accounting for more than 40 percent o f total merchandise exports. It also contributes significantly to value-added and employment in the economy, although its contribution to the future growth o f the economy will depend on the amount o f investment, technology, and innovation that will be brought in by the new owner o f K A P (i.e., Rusal). To a lesser extent, forestry (inparticular wood processing) and agriculture also contribute to the growth o f the economy. Geographically, Montenegro i s characterized by huge differences (in terms o f population density, and level o f development) between its northern, central and southern parts. The northern region, primarily a mountainous region, i s the least developed region and depends mostly on industry and small agriculture. The central region, including Podgorica, i s more developed, and industry and services, and to a lesser extent agriculture, constitute the basis o f its economic activity. Inthe southern region-i.e., the coastal area-services, tourism and transport provide the basis o f the economy. These regional differences would need to be taken into consideration in designing a regional approach to development. The northern region has a good potential for landscape-based tourism, as it has many hills, mountains, rivers, canyons and lakes. To a lesser extent, it has the potential for timber industry, small scale agriculture and food processing. Tourism development in this area would be o f great importance to the Republic to overcome the problem o f the high seasonality o f coastal tourism and the related economic activities. The central region has considerable potential for the further development o f services (transport, tourism, financial services) and some agriculture and food processing. The southern part, besides tourism, could benefit from further increases of transport services (shipping, ports, land transport, etc.). There i s also the possibility for the recovery o f fruit production. Injlation 1.26 Montenegro's adoption of the DM and then the euro as the sole legal tender helped rein in inflation. With currency reforms, inflation dropped from 24.8 percent at the end o f 2000 to 4.3 percent at the end of 2004. By the main components o f the CPI, the prices o f Figure 1.3. Inflation by Major Component, 2000-2004 .~ -~ services grew much more than the other components (Figure 1.3). On the other hand, the prices o f agricultural products have decelerated since 2004. 30 i 1.27 With the adoption of the euro 25 as the official currency C iI ("euroization"), the role of monetary E :", 1 policy has been severely curtailed. The L o i Central Bank o f Montenegro (CBM) can 5 i 1 no longer engage in any active monetary 0 policy. Its role has been limited mainly -5 j to the supervision of banks and the .x)1 ... .. . " .. .... .. .,,. " . . .. ..". .. . . privatization of the remaining state -Overall Inflation - +- Ind. prod. banks. The latest estimate available o f - the currency in circulation as o f January --Agrc.-_. -.--.Services prod. . . 2003,shows the amount o f euro 250 Source; Central Bank o f Montenegro. 10 million. Competitiveness 1.28 The evidence suggests that over the last four years Montenegro has become less competitive. 10To be sure, competitiveness i s shaped by a number o f factors, including: factor endowments; the country's infrastructure and support systems such as transport, energy, and communications as well as research and development; government policies and the regulatory environment; enterprise structure, strategy, and competition; demand conditions; and exogenous events. While these are ex ante determinants o f competitiveness, ex post competitiveness can be measured ina variety o f ways. 1.29 One of the most useful indicators of international competitiveness is movements in the real exchange rate based on unit labor costs. With the adoption o f the euro as the official currency, Montenegro has by definition fixed its nominal exchange rate to the euro zone. Yet its real exchange rate-adjusted for differences in Montenegro's rate o f inflation for the euro zone or its trading partners more generally-may have moved significantly. Montenegro's main exports are aluminum and tourism, and its main trading partners are the euro zone countries and Montenegro's main exports are aluminum and tourism, and its main trading partners are the euro zone countries and the United States. Its main imports are oil and oil derivatives, fuel, pharmaceutical products and electricity. For exports, the biggest trade partners o f Montenegro, besides Serbia and Kosovo, are mainly EU countries (Italy, Greece, Cyprus, Hungary) and Switzerland. For imports, its biggest trade partners are countries in transition- Serbia, Croatia, Bosnia and Herzegovina -followed by European countries-Greece, Italy, Germany, Slovenia and Great Britain. Given that Montenegro's larger share o f exports go to the EU countries and regional states, movements in the real exchange rate against the euro zone may be a reasonable index o f Montenegro's competitiveness. Table 1.1. Montenegro's Unit Labor Costs, 2000-2004 2000 2001 2002 2003 2004 Nominal GDP, million euros 1022.2 1244.8 1301.5 1433.0* 1535.0* GDP deflator 23.1 22 2.8 8 3.1 Annual real GDP growth rate 3.1 -0.2 1.7 2.3 3.7 Real GDP in2000 prices, million euros 1022.2 1020.2 1037.5 1061.4 1100.7 Employment (official data), inthousands 140.8 141.1 140.1 142.7 143.5 Average monthly gross wage (official data), euros 150.9 176.2 251.3 271 302.6 Total wage fund, million euros 206.1 241.3 342.9 363.9 398.3 Labor compensation, million euros** 300 342 478 507 539 Unitlabor costs*** 0.293 0.335 0.461 0.478 0.491 Unit labor costs index 2000=100 100 114.3 157.3 163.1 167.6 ***Estimated.wages ***Includes and salaries in cash and wages and salaries in kind as well as employers' social contributions. Calculated as the ratio of compensationper employeeto real GDP per employee. Source: MONSTATand World Bank staff calculations. 1.30 Table 1.1 shows the evolution o f Montenegro's unit labor costs for the period 2000-2004. The rise in the ratio o f Montenegro's unit labor costs relative to those o f the euro zone or o f the United States loItis important to note that Montenegro embarked onprice liberalization, currency reforms, andtrade reforms during 2000-2002. The implementation o fthese reforms could inpart explain the surge inwages and unit labor costs experienced during this period. The choice o f 2000 as the base year for measuring trends in competitiveness i s thus not ideal, as it could give a more alarming loss o f competitiveness than is the actual case. Yet, data availability constrains the use o f any longer period. weighted by the nominal exchange rate suggests that Montenegro has become less competitive over time. The fall inthis ratio indicates improved competitiveness. These indices are giveninTable 1.2. Table 1.2. Montenegro's Competitiveness,2000-200411 2000 2001 2002 2003 2004 NominalExchangeRate (euro/ 1US%) 1.0832 1.1171 1.0578 0.8838 0.8040 Unit Labor Cost Index (2000=100) Montenegro 100.0 114.3 157.3 163.1 167.6 Euro zone 100.0 102.8 105.0 107.1 107.6 United States 100.0 101.8 101.9 101.6 102.1 Index of Competitiveness Euro zone vs. United States 1.08 1.11 1.03 0.84 0.76 Montenegro vs. euro zone 1.oo 0.90 0.67 0.66 0.64 Monteneero vs. United States 1.08 1.oo 0.69 0.55 0.49 Note: Annual nominal exchange rate data between the US$ and the euro are obtained from the FedeXReserve Statistics (Statistical Releasesfor January 3, 2005 and January 5,2004). EU inflation (harmonized index of consumer prices, HICP) data are obtained from the EuropeanCentral Bank ("Statistics Pocket Book, May 2004"). EU unit labor cost data are obtained from Eurostat ("Statistical Annex of EuropeanEconomy"). Source: U S unit labor cost and inflation data are from the US Bureau of Labor Statistics (wv.bls.gov). labor compensations have increased I, (Y120--.. . . .. . .,"".,,, a > ,,,. ....,.,,i rapidly and are far ahead o f labor ;E , P O 0 . I I productivity--by 12.3 percent only in 0 s 0.80 II 2004-- thus reducing the I.B Q 0 6 0 . competitiveness o f the Montenegrin `Z u 0.40 (Y o economy. In addition, the presence o f a -0 z g ~ 8 : relatively rigid labor regulation, which 020 0 .s x 0 0.00 ~ '* Nominal exchange rate weighted by unit labor cost index. EU zone refers to the narrow definition, composed o f 15 EU countries. All unit labor costs inthe table refer to nominal unit labor costs, defined as the ratio o f total labor compensation per employee to real GDP per employee. The decrease in the index o f competitiveness means appreciation o f the real exchange rate, and therefore a decline in competitiveness. To generate comparative trends, it i s assumed that Montenegro adopted the euro since 2000 (although the actual adoption of euro came in 2002 and Montenegro was using the Deutsche Mark between 2000 and 2002). 12 Internal and External Balance 1.32 One of the macroeconomic challenges facing Montenegro is that of maintaining sustainable internal and external balances. Both the general government deficit and the current account deficit have remained high and unsustainable (at 4 percent and 12.8 percent in 2004, respectively) (Figure 1.5). Internally, loose fiscal policy characterized the early years o f transition. Fiscal deficits before grants remained high at between 5 percent o f GDP in 2001 and 3 percent in 2004. The high Figure 1.5. Fiscal and Current Account Deficits, 2002- deficit was financed primarily through the 2004 huge inflow o f foreign grants and 0 concessional borrowing and through the domestic Treasury Bills market.]' -5 Expenditures on wages and social transfers 8 U -10 not only constitute a significant proportion U o f public spending but are also much above $ -15 8 average for the region. At the same time, the share o f capital expenditures in total -20 expenditures remained low. Also, arrears -25 were accumulated in the central government Year accounts as well as in the social funds. Thus may be a need not only to reduce the overall IGeneralgovernmntdeficit(beforegrants) 0 Current account balance (before grants) public spending but ais0 to shift public -~ ~~ - --__J expenditure from current to capital Source: Central Bank o f Montenegro; IMF. expenditure (see Chapter 3). 1.33 Externally, the recorded current Figure 1.6. Official Grants to Montenegro, 2002- account deficit before grants l3 has declined 2004 (from about 20 percent of GDP in 2002 to 12.8 percent in 2004), but it remains large. Montenegro's merchandise exports are not diversified and remain largely dominated by the export o f aluminum, which accounts for almost 50 percent of merchandise exports. Merchandise exports remained stable at about 25 percent o f GDP in 2002 and 2004, while imports were reduced from about 57 percent of GDP in 2002 to about 53 percent in 2004. Recorded private remittances have almost 2002 2003 2004 doubled, from about 5 percent to about 9.5 Year percent, while net non-factor service receipts, which include mainly tourism receipts, have Source: Central Bank of Montenegro. grown ~1ightly.I~ resultedina current account deficit before grants o f 12.8 percent o f GDP in2004. This 1.34 The financing of the high current account deficit has been made possible in part by the exceptionally high grants Montenegro received during the period. Such grants, however, have Privatization revenues as source o f financing deficit were low except in2002. l3 Montenegro's Balance o f Payments data prior to 2002 are unreliable. For 2002-04, imports are probably overestimated since a significant proportion is actually "exported" onwards to Serbia. Also some of the financing items inthe capital account, such as the FDIdata, may not be reliable. l4 Foreigntrade statistics probably does not capture well the contributions o f tourism to foreign exchange earnings. 13 progressively declined over time (from 7 percent of GDP in 2002 to about 3 percent in 2004) (see Figure 1.6), and are set to continue to decline further in the future." On the other hand, it i s worrisome that foreign loans to Montenegro have been rising, from almost none in 2001 to about 7 percent of GDP in 2004. While it i s not unusual for transition countries such as Montenegro to run a high current account deficit in view o f low domestic savings and the current account deficit facilitating a capital replacement, there i s a need to for Montenegro to adjust to a lower current account deficit especially in view o f the declining grants and rising loans and debt service payments. Furthermore, inthe case of Montenegro, the highcurrent account deficit has ledto a highprivate sector foreign borrowing to finance it. This puts an even greater importance for a strong Central Bank banlung supervision and monitoring to ensure sustainable financial sector development. 1.35 With euroization, such adjustment to a lower current account deficit will necessitate either domestic demand restraint through a prudent fiscal policy and/or the expansion of exports. Fiscal policy i s discussed in detail in Chapter 3; opportunities for export expansion through tourism development are discussed in Chapter 5. 1.36 Montenegro is expected to receive substantially higher than expected privatization revenue in 2005. The government currently expects proceeds o f 165-180 million in 2005. For fiscal sustainability and macroeconomic stability, it will be extremely important that the receipts are used to reduce the domestic debt (Le. retiring the debt to domestic banks and amortizing T-bills falling due in 2005) and buildup reserves instead o f increasing deficit spending. Additional public investment spending i s best considered after a strong macroeconomic and fiscal performance has been established. Debt Position 1.37 Montenegro began its transition as a moderately indebted republic. The restructuring o f debt toward the Paris club and bilateral donors and IFIs in 2001 helped improve the external debt position of S A M . With most o f the debts o f S A M currently being allocated between Serbia and Montenegro, the external debt o f Montenegro i s becoming clearer. At the end o f 2004, the total debt stood at 31.8 percent of GDP, down from 32.2 percent o f GDP in 2003. (Table 1.3). Although there has been a rise in the absolute amount of borrowing since 2000, foreign borrowing as a ratio o f GDP records relative actually slightly fell. With an expected debt write-off to Montenegro o f some 26 million euros by the Paris Club creditors by end-2005, the debt position could further improve. Table 1.3. Total Public Debt of Montenegro, 2002 -2005 (YOGDP) 2002 2003 2004 2005* Domestic debt 19.6 17.4 16.6 11.6 Foreign debt 68.7 32.2 31.8 30.9 Total public debt 88.3 49.6 48.4 42.5 *Memo:forGDP (million euros) 1,301 1,433 1,535 1,644 Data 2005 cover only through end-September 2005. Source:Montenegrin Ministry o f Finance. 1.38 The total public debt -inclusive both of foreign and domestic debt-stood at about 48 percent of GDP as of end-2004. Total public debt includes debt for the repayment o f Frozen Foreign Currency Deposits (FFCDs) whose repayment deadline i s 2017; debt toward commercial banks; T-bills 15 USAID, Montenegro's main donor, expects its assistance to Montenegro to be lower inthe next five years compared to the past five years. The World Bank's Country Assistance Strategy for Serbia and Montenegro envisages about US$ 50 million inprogram and project aid to Montenegro over the next three years. 14 debt and other debts on behalf o f Government institutions or for which guarantees were issued; local governments' debt; budget liabilities or arrears; and foreign debt. Of this, domestic public debt accounted for about 20 percent at end-2004 (or under 10 percent o f GDP) (see Table 1.4). Total outstanding FFCDs as at end-2004 stood at about 8 percent o f GDP (123 million euros). Debt outstanding for issuedtreasury bills at end-2004 was about 2 percent o f GDP (37.4 million euros), while as o f end-Sept 2005 it was decreased to 12.5 million euros (less than 1 percent of GDP). Budget liabilities or arrears have been reduced from some 100 million euros in 2002 to 61.8 million euros by end-2004. The repayment plan suggests that the Government will needto allocate between 1.5 and 2 percent (21 and 33 million euros for debt service) each year over the next six years. Montenegro has shown a lot o f progress in containing public debt in recent years, but further control through clearance o f the Treasury bill debt and arrears, the buy back o f FFCDs, and controlled external borrowing would be necessary to ensure debt sustainability and macroeconomic stability. Table 1.4. Domestic Debt of Montenegro, 2002-2005 (in million euros) 2002 2003 2004 2005* Credits 18.2 19.5 8.9 1.45 T-bills 9.8 19.7 37.4 12.5 FFCDs 127 127 123 118 Budget Liabilities/ Arrears 100.6 83.5 61.8 35 Local Government Debt 0 0 23 23 Total Domestic Debt 255.6 249.7 254.1 154.95 Domestic Debt (% GDP) 19.65 17.42 16.55 11.6 Memo: GDP (inmillioneuros) 1,301 1,433 1,535 1,644 * Data for 2005 cover only through end-September 2005. Source: Montenegrin Ministry o fFinance. Poverty and Social Welfare 1.39 With only limited economic recovery in Montenegro over the last four years, living standards remain low relative to historical standards. With only a modest average GDP growth o f about 2 percent per year over 2000-2004, and with jobless growth, unemployment has remained high. According to the official poverty line for 2003,16 about 12 percent o f the citizens o f Montenegro fell below the consumption poverty line. Consumption distribution i s highly concentrated around the poverty line, and about 25 percent o f the population has a consumption level that i s less than 50 percent above the poverty line." This suggests that even small economic shocks can have potentially large effects on poverty. Conversely, a sustained economic growth i s likely to result in a disproportional decline in poverty. 1.40 There are significant differences in living standards among the different regions of Montenegro. Generally, the poverty rate in the northern region i s twice that in the central and southern regions (14.9 percent in the north versus 6.5 percent and 6.8 percent inthe central and southern regions, respectively). Relative to the national average, a larger percentage o f households in the north receives social assistance (4.9 percent versus 3.9 percent for the national average) and private transfers (23.3 percent versus 19.3 percent for the national average). l6According to the Poverty Reduction Strategy Paper o f the Government o f Montenegro, the official poverty line for 2003 stood at 116.2 euros per person per month. See World Bank, 2003, Serbia and Montenegro Public Expenditure and Institutional Review, Volume 3: Montenegro. 15 Table 1.5. Montenegro's Human Development Index, 2000-2003 2000 2001 2002 2003 Life expectancyat birth(years) 73.4 73.4 73.0 73.1 Adult literacy rate (%) 94.9 94.9 94.9 94.9 Combinedprimary, secondary and tertiary gross enrollment ratio (%) 75.28 72.61 73.4 75.19 Overall humandevelopmentindex (HDI) 0.760 0.766 0.773 0.789 Source: ISSP and UNDP. 1.41 In the broader dimensions of welfare, Montenegro has fared relatively well (Table 1.4). Life expectancy, at 73 years, has remained stable over the last four years. The level o f educational attainment i s generally high. The adult literacy rate stands at about 95 percent, and only about 5 percent o f the population aged 16-24 i s not in school or does not attend secondary school (Serbia and Montenegro Poverty Assessment, 2003). According to the population census o f 2003, the number o f illiterate population in Montenegro i s only about 2.5 percent. Combined primary, secondary and tertiary gross enrollment stands at about 75 percent and has not changed much over the last four years. An overall human development index (HDI), recently calculated for Montenegro by ISSP and the UNDP,l8 shows that it has slowly improved. An international comparison o f such indices shows that Montenegro falls in the middle group in the HDI (between 0.5 and 0.8), with a level o f development similar to those in Bulgaria, Russia, Macedonia, Albania, Bosnia and Herzegovinaand Romania. D. THECHALLENGES AHEAD:INCREASING GROWTH AND COMPETITIVENESS 1.42 Montenegro's macroeconomic and structural reforms, pursued since the late 1990s, have yielded modest economic recovery and transition. Real GDP grew by an average o f about 2 percent per year over 2000-2004; inflation dropped from 24.8 percent at the end o f 2000 to 4.3 percent at the end o f 2004; Montenegro's consolidated budget deficit was reduced from about 8 percent o f republican GDP in 2000 to about 3 percent in 2004; its current account deficit, although still high, i s improving; and, its principal human welfare indicators such as poverty, life expectancy, and adult literacy have remained moderate and stable. 1.43 Yet, Montenegro needs to move to a higher growth path if it i s to achieve a higher standard of living for its citizens. The Montenegrin economy grew by an average o f only 1.8 percent per year between 2000 and 2004. With an average annual population growth rate o f about 0.5 percent per year, the per capita income grew by only about 1.3 percent per year. As demonstrated earlier, the country's competitiveness, too, has declined over the last four years. 1.44 The key question, then, is why growth and competitiveness have been weak and what can the Government do to increase them? According to a simple growth model'' in which low growth could be due to three principal factors-low social returns, low private appropriability, and the highcost of finance, or a combination o f any o f these-the low social returns could be due to lack o f macroeconomic stability, or to lack o f investment in complementary factors o f production (human capital, technical know- how, infrastructure, or poor geography). Private appropriability could be reduced for a variety o f reasons, including poor public administration, high regulation and poor property rights and contract enforcement, as well as the highcosts o f factor inputs. '*The HDIhas beencalculatedby the UNDP and ISSP, andtakes into account average life expectancy,literacy rate, and GDP per capitabasedonpurchasingpower parity (as a proxy for the living standard). l 9See Rodrik, Hausmannand Velasco (2004). This model has recently been used as a framework to look into country-specific constraints to growth ina select set of client countries of the World Bank. 16 1.45 Although Montenegro has shown considerable progress in attaining macroeconomic stability (inflation is single digit, and the twin deficits have been reduced), there are still concerns about its high fiscal and current account deficits. Unless these deficits are addressed, they could pose a risk to continued macroeconomic stability and could also reduce social returns. Adjustment to a lower current account and to fiscal deficits i s necessary, especially in view o f declining foreign grants. On the other hand, there is no strong reason to believe that lack o f growth has been due to insufficient investment in complementary factors of production (human capital, technical know-how, infrastructure, or poor geography). Montenegro enjoys a unique geographic location, being on the coast o f the Adriatic Sea, with easy connections to the regional states as well as Western Europe. The labor force i s relatively well educated, and there i s a reasonable pool o f skilled labor. Although investment in infrastructure (particularly inwater supply and solid waste management inthe coastal areas) may be critical for tourism development, the Republic enjoys a decent infrastructure. 1.46 Private appropriability of returns to investment in Montenegro seems to be low for several reasons. Although taxation i s among the lowest inthe region (especially after the recent tax reforms), the following factors also serve to reduce the private appropriability o f the returns to private investment: (i) the highregulatory burden and poor public administration, as well as corruption and lack o f transparency; (ii) propertyrightsandcontract enforcement; and(iii)labor-capital conflicts, includingthehigh poor burden imposed on capital (employers) by the labor law and the collective bargaining agreements, and the labor unions inwage negotiations. 1.47 Montenegro's high regulatory burden and poor public administration and institutional capacity are manifested by the presence o f a large informal sector on the one hand, and a highbureaucracy and a considerable presence o f discretion and corruption in regulations and the enforcement o f rules on the other. Its poor property rights and contract enforcement are manifested by the existence o f an "implementation gap" for business-related laws such as mortgage law, restitution law, bankruptcy law, and company law, and by the lack o f a speedy resolution o f commercial disputes by courts. While significant progress has been made with regard to reforming and improving the legal and regulatory framework as it affects the private sector, there has been weak implementation o f these laws. The lack o f effective land registration and administration in the coastal areas i s a clear example o f poor property rights. The presence o f labor-capital conflicts is evident inthe still high costs imposed by the labor law and the new collective bargaining agreements, although the recent changes to the labor law were steps in the right direction (see Chapter 2). 1.48 The cost of finance in Montenegro is high and the economy seems credit-constrained. The nominal lending rates are very high,inthe range o f 15-20 percent. With inflation ranging between 3 and 7 percent in recent years, the real interest rate has ranged between 10 and 15 percent. The Republican Development Fund, and the Employment Fund o f Montenegro lend funds to SMEs at subsidized interest rates (4-10 percent), but they are relatively marginal in terms o f their share in private sector credit. Given Montenegro's limited opportunities in Greenfield investments, most investors would be hard pressed to find a project whose real rate o freturnwould exceed 10-15 percent. 1.49 Several factors may explain the high cost of finance in the economy. Montenegro's national savings are low, but household savings with the banking sector have increased in recent years. Several other non-savings factors may be responsible for the high costs o f finance and the poor financial intermediation. First, because of relatively high demands for credit by the public sector for deficit financing, the Treasury bills market actively competes for banking sector funds which could otherwise be directed to the private sector. The Treasury bills rate i s high, between 8 and 12 percent.*' The 2oThe Tbills rate has been significantly reduced in 2005-to less than 5%--as government cleared some o f its domestic debt using the large privatizationrevenue. 17 Government's fiscal policy, inparticular the control o f domestic financing, i s therefore one key factor in the poor financial sector intermediation and high real interest rates. Second, although Montenegro has made progress in recent years in terms o f banhng sector reforms, the banking sector i s not competitive. Most o f the banks are still either majority owned by the Government, or indirectly owned by the social funds (Pensions Fund, Health Fund). The banking services for the Government and for the main state- owned entities such as the KAP, EPCG are concentrated at a handful o fbanks. Therefore, the competition exists mainly in theory, rather than in practice. Finally, there i s a high spread between the deposit and lendingrates o f commercial banks because o f the highrisks associated with collaterals, loan recovery and liquidity problems, the high administrative costs o f commercial banks, and the very small size of the Montenegrinmarket. 1.50 The above cursory examination of Montenegro's economy would lead to five hypotheses on the binding constraintsto growth in Montenegro: e Fiscal policy and the composition of expenditures: Although significant progress has been made towards macroeconomic stability, the large current account deficit, coupled with euroization and falling aid flows (in particular grants), threatens macroeconomic stability and growth (i.e,, low social returns). Furthermore, it i s not clear whether the composition o f fiscal expenditures i s supportive o f growth or whether there i s a need for reallocationtowards capital and infrastructure investments. High regulatory burden and poor administrative and institutional capacity: Despite reforms, corruption and inefficiency reduce investment and increase the informal economy (i,e., low private appropriability o f social returns). e Poor property rights and contract enforcement as manifested by the existence o f an "implementation gap" for business-related laws such as mortgage law, restitution law, bankruptcy law, company law, and the lack o f speedy resolution o f commercial disputes by courts limit private investment and growth (i.e., low private appropriability). e The high cost of finance and poor financial intermediation, as manifested by high real interest rates ranging between 10 and 15 percent and low credit to the private sector, has limited private investment and growth (i.e., low private appropriability). 0 Poor labor market conditions, including the rapid real wage growth witnessed in recent years, and the highcosts imposedby the labor law (despite recent improvements) and the new collective bargaining agreements, and the lack o f labor market flexibility, have limited private investment and growth (ie., low private appropriability) 1.5 1 How do these growth hypotheses relate to competitiveness? With a sound fiscal policy and continued macroeconomic stability, a further loss in competitiveness could be avoided by moderating wage increases in line with productivity growth. Furthermore, public expenditure reallocation towards infrastructure and capital investment could reduce the costs o f doing business for the private sector by supplying public goods which are complementary to private investment. Poor administrative and institutional capacity increases the effective cost o f doing business and may, by encouraging informal sector activities, undercut the competitiveness o f firms in the formal economy. Conversely, cutting red tape for importers and exporters, and serving their needs through building strong institutions and a competent bureaucracy, can help promote the competitiveness o f firms. Similarly, improving access to credit and reducing the cost of capital and labor would be important to increase the competitiveness o f companies and businesses. 18 1.52 The rest of this report examines these hypotheses with greater scrutiny of the Montenegrin data. InChapter 2 we take an in-depth look at Montenegro's labor market and its main characteristics, the extent to which the areas inwhich the labor law continues to be restrictive (despite recent improvements), and we examine whether the collective bargaining and social dialogue are supportive of growth and private sector employment creation. In Chapter 3 we examine Montenegro's fiscal policy, including whether the fiscal position i s sustainable and whether the current level and structure o f spending are supportive o f growth, and what reallocation may be needed, if any, to support growth and competitiveness. In Chapter 4 we examine the extent to which poor administrative and institutional capacity, poor property rights and contract enforcement, and the high cost of capital and low financial intermediation are holding back growth and competitiveness in Montenegro. These are treated under the theme o f constraints to private sector investment, growth and competitiveness. In Chapter 5 we use tourism as a case study to illustrateMontenegro's challenges of competitiveness and growth inpractice. 19 2. LABORMARKETREFORMFORGROWTHAND COMPETITIVENESS 2.1 Montenegro has had high unemployment rates throughout the past decade- over 20 percent. This is mainly because to date very few employment opportunities have been created in the emerging private sector. Owing to the low demand for labor, a significant share o f the able-bodied population i s "forced" to stay out o f the labor markets. The lack o f demand for labor inturn stems from a business environment which i s not conducive to investment and job creation, and from the impact o f current labor regulations, which hinder private sector activity and encourage informality (see Chapter 4 on private sector development). Government policies that would send people back to work, including the promotion o f private investment as well as further improvement to the labor market regulations, would significantly help the growth and competitiveness o f the economy. 2.2 During 2000-2004, Montenegro's real wage grew by much more than the productivity growth, thereby undermining the growth and competitiveness of the economy. The prime source o f productivity growth i s technological change, but sources o f productivity growth also depend on macroeconomic institutions and regulatory factors. Since 2000, the Montenegrin economy has experienced a cumulative labor productivity growth o f 18.2 percent (2000-2004).2' That productivity growth has derived largely from a reduction in the degree o f underemployment among workers who are primarily within Montenegro's formal sector, associated with enterprise restructuring and privatization. On the other hand, average net earnings doubled (growing by 103 percent) between 2000 and 2004. The rapid increases in labor costs in the last few years have reduced competitiveness, growth, and employment.22 2.3 Montenegro's labor market is characterized by a relatively high level of job protection and rigidity, a high degree of unemployment, and a high share of employment in the informal sector. The legacy o f the "self-management" system for enterprises has, to a large extent, shaped the high level of job protection and the overall rigidity present in the economy. Although the 2003 reform o f the Labor Law made dismissal procedures less complex and less costly (for example, minimumseverance payments were reduced from an extremely high 24 months' wages to 6 months' wages), firing procedures are still fairly inflexible and costly. Second, unlike many other socialist countries, the former Yugoslavia had open unemployment as early as inthe 1960s which increased even further during the turbulent mid-1980s and 1990s. Finally, duringthe 1990s, informal employment was tolerated by the Government since it was one of the key survival strategies. About one-third o f total employment i s estimated to be in the informal economy, which in turn has reduced the Government's ability to collect various tax and social insurance revenues. 2' Labor productivity i s calculated using the employment data from annual labor force surveys as a proxy for employment dynamics, and the reported real GDP growthrates. 22Inthe short term, productivity and employment stand ininverse relationto one another. A. KEY CHARACTERISTICS OF THE LABOR MARKET Participation and Employment23 2.4 The labor supply in Montenegro is affected by many demographic factors, including the still relatively high fertility rates. In 2002, the total fertility rate in the Republic equaled 1.66, which is highcompared to other transition countries, excluding the Central Asian states. Inthe coming years the number o f new labor market entrants will have a significant impact on the labor supply. 2.5 Despite the growth in the working age population, the labor force has not increased, which suggests that the more able-bodied population is becoming inactive (see Table 2.1).24 Inthe next five years, around 25,000 people will leave the working age bracket but the number o f new entrants the reaching working age will be around 44,000. The country also has relatively modest old- age dependency burdens among the Central and Eastern European transition countries: the population share o f those 65 years and older i s only around 12 percent o f the total population. The labor supply i s also affected by the recent inflow o f refugees from the neighboring countries, although the number o f refugees i s rapidly declining. At one time (January 1993), over 64,000 refugees were living temporarily in Montenegro. By the latest estimates (September 2004), 8,474 refugees and 18,047 IDPs were still registered in Monteneg1-0.~~ Table 2.1. Labor Force Growth and Employment-to-Population Ratios, Transition Annual labor force growth Employment-to-population rate (YO) ratio (YO) 1998-2003 2003 Transition economies 0.7 53.5 Central and EasternEurope 0.4 49.1 Montenegro* 0.0 40.6 Baltic States -1.1 50.8 Commonwealth of IndependentStates 0.9 55.6 * - MONSTAT: Labor Force SurveyData. Source; ILO 2004. 2.6 Montenegro's labor force participation rate, defined as the share of employed and unemployed in the total working age population, also remains among the lowest inthe region (Table 2.2). According to the 2004 Labor Force Survey, about 52 percent o f the population at age 15 years and older are economically active but the relatively highparticipation rate masks the highunemployment rate among the able-bodied population. By age group, youth (especially young females) have the lowest participation and employment rates, more than four times below the average employment rate for EU-15 countries. More than halfo f the youth o f age 15-24 in the labor force are unemployed. 23Montenegro has several sources of labor market data: first, the official data of MONSTAT on employment and unemployment derived from the labor force survey conductedregularly inOctober each year; second, the registered unemployment data published regularly by the Employment Service; third, the household survey data which are collected, published and analyzed regularly by the ISSP. For analytical purposes, the labor force survey data (ILO methodology) tendto be the most reliable source of labor market information. 24By the labor force survey data, there were 180,400 employed and 50,700 unemployed individuals in 1998,and 187,300 employedand 71,800 unemployed individuals in2004. UNDP (2004). Household Survey of Roma, Ashkelia and Egyptians,Refugeesand Internally Displaced Persons. Podgorica; Governmentof Montenegro (2005). Strategy for permanent solution ofrefugees and IDPs issue in Montenegro. Podgorica. 21 Table 2.2. EmploymentPopulationRatios, Participation,and UnemploymentRatesin2003-04 Czech Age Montenegro Serbia MacedoniaHungary Republic Poland Slovakia EU-15 OECD LFS 2004 2003 Employment/Populationratios 15-64 40.6 53.5 38.5 57.0 64.9 51.4 57.7 64.8 65.0 15-24 10.3 18.6 12.1 26.7 31.4 19.6 27.6 42.6 43.6 25-54 56.6 68.2 50.7 73.7 81.7 67.6 76.0 76.9 75.1 55-64 20.6 38.1 28.5 29.0 42.3 28.6 24.6 42.3 50.8 Labor forceparticipation rates 15-64 65.1 66.6 61.3 60.0 70.4 64.2 70.0 70.3 69.8 15-24 34.1 36.3 35.3 30.8 38.1 34.4 41.2 50.0 50.3 25-54 82.6 82.4 76.4 77.8 87.8 81.7 89.5 82.6 79.9 55-64 40.0 42.0 35.8 29.8 44.2 32.2 28.5 44.9 53.4 Unemploymentrates 15-64 23.0 19.5 37.1 5.9 7.8 20.0 17.6 7.8 6.9 15-24 51.5 48.8 65.7 13.4 17.6 43.0 33.1 14.7 13.3 25-54 20.1 17.2 33.7 5.3 7.0 17.3 15.1 7.0 6.0 55-64 8.1 9.3 20.5 2.8 ~. 4.4 11.2 13.6 5.7 4.7 Source: OECD Employment Outlook 2004. Paris, Serbia and Montenegro: MONSTAT. Labor Force Surveydata. 2.7 As a result, Montenegro has the lowest overall employment rate in the region, with only about 40.6 percent of Montenegro's working age population being employed. Limited job opportunities in Montenegro have led to discouragement and massive labor force withdrawal, especially among younger and older cohorts as well as women. The combined effect o f unemployment and labor force withdrawal was a substantial fall in the employment to population ratio: out o f an aged 15-64 working age population of 413,000 (by the 2003 population census data), only 167,700, or around 40.6 percent o f the total, are employed. The average employment rate o f the able-bodied population Figure2.1. Trends inEmployment and for the transition economies i s 53.5 percent, UnemploymentinMontenegro, 1997-2004 .---- (Table 2.1). The existence o f high (`000 people) unemployment not only translates into higher 200 I T poverty and lower economic growth but also 1 8 0 - indicates the low ability o f the Montenegrin 160 140 ~ ` ~ c _ _ _ _ S _ - ? c - - - - l economy to createjobs. ~ 120 - 100 2.8 According to the Labor Force Survey data, employment has declined in Montenegro since 1999 (Figure 2.1). This is a another indication that for various reasons 2o 0 discussed below, the economy i s not generating 1997 1998 1999 2000 2001 2002 2003 2004 jobs. In the last four years (2000-2004) the &hployment(LFS) -m-- tinployrent (official) elasticity o f employment with respect to output +Unemployment (LFS) +Unemployment (official data) inMontenegro was negative of -1.30, i.e. each *LFS=Labor Force SurveyData. percent Of Output growth in 1'3 percent o f employment cut, indicating that the job Source: MONSTAT; Labor Force Survey data; ISSP 2004. 22 market has not responded to economic growth and in that fact we have the phenomenon o f "job-loss economic GDP growth is thus largely due to a labor productivity growth attributed to enterprise adjustment and restructuring (Table 2.3). Jobless growth i s quite widespread in CEE and SEE countries, although there seem to be some exceptions such as Hungary (which experienced only one year o fjobless growth), the Czech Republic (which experienced two episodes o f more than 3 percent growth with modest job destruction) and the Slovak Republic. According to the preliminary 2004 labor force survey data, employment at age 15 years and over has rebounded to 187,300 individuals. Table 2.3. GDP Growthand EmploymentDynamics,2000-2004 Actual Estimate 2000 2001 2002 2003 2004 GDP, million euro 1022.2 1244.8 1301.5 1433.0 1535.0 GDP, real growth rate 3.1 -0.2 1.7 2.3 3.7 Employment LFS (thousands) 181.7 176.6 177.6 168.5 187.3 Employment dynamics (% o f previous year) -1.7 -2.8 0.6 -5.1 11.2 Labor productivity growth rate 8.1 2.2 5.3 6.0 0.3 Source; MONSTAT. 2.9 The public sector continuesto bethe main employer in the Montenegrineconomy. Fromthe 2003 labor force survey data, 59.2 percent o f employment took place in the public sector (including in Government-provided public services, such as the civil service, the health and education sector, and social protection), 25.7 percent in the private sector, and 0.8 percent in firms o f mixed ownership. By sector, agriculture, trade and tourism related services are the key employers in the economy. More than 64 percent o f total employment i s in the services sectors. Compared to other transition countries in the region, the share o f self-employed inMontenegro i s higher - 9.7 percent o f total employment. InHungary and Poland the share o f self-employed was above 5 percent o f total employment, while in Croatia the ratio was close to three percent (end-1990s; EBRD, 2000). The share o f employment in SMEs, in contrast, i s a low 20 percent out o f the total employment. Therefore, large enterprises still dominate inthe formal sector o f the economy. 2.10 Flexibleforms of employment (part-timeandtemporary work) are almost entirely absent in the Montenegrin economy (with some exception in the tourism sector). Only 2.0 percent o f the employed had part-time jobs, indicating that there are constraints on part-time employment (see Section 2B). In comparison, in Poland 11.5 percent o f jobs i s part-time work, as are 16.6 percent in the EU-15 countries (Table 2.4). 26 The employment elasticity (which shows the responsiveness o f employment to economic growth) can be calculated by dividing the net new-job growth rate by the economic growth rate. The official GDP should be treated with caution. In particular, MONSTAT calculates only 8.8-9.8 percent of GDP as originating from the informal sector while other sources (ISSP, for example) estimate that at least 30 percent o f GDP is produced in the informal sector. 23 Table 2.4. Incidence and CompositionofPart-timeEmploymentin2003 (percent) Part-timeemployment as a proportionof employment Women's share Total Men Women inpart-time employment Montenegro 2.0 1.5 2.7 54.9 FYRMacedonia 5.7 5.2 6.5 45.5 Czech Republic 3.2 1.6 5.3 71.9 Hungary 3.5 2.1 5.1 69.0 Poland 11.5 7.1 16.8 66.2 Slovak Republic 2.3 1.3 3.6 69.1 EU-15 16.6 6.3 30.1 78.5 Source; OECD (2004); Montenegro: Labor Force Survey data. Data on Macedonia refers to age group 15- 64 only. Unemployment 2.11 Perhaps the most important characteristic of the Montenegrin labor market is its high unemploymentrate. According to the 2003 Labor Force Survey data, 71,800 unemployed at age of 15 and over were registered, with the unemployment rate o f 27.7 percent out of total labor force.27InApril 2005, the Employment Agency had 58,000 registered unemployed on the roster, which i s a 23.5 percent decline compared with the same period in 2003. Despite these positive developments in the last year, the unemployment rate in Montenegro remains well above the average for CEE countries, which in 2003 stood at 13.8 percent. Table 2.5. DurationofUnemploymentinMontenegro Durationof Employment Bureau data Labor force survey unemployment data 2000 2003 2003 Less than 6 months 12.0 26.6 7.6 6-9 months 6.2 5.1 0.9 9-12 months 7.1 3.7 7.0 1-3 years 25.1 18.0 21.4 3-5 years 16.2 12.3 23.0 5-8 years 14.0 12.3 16.8 More than 8 years 19.4 22.0 23.3 Total 100.0 100.0 100.0 Source: MONSTAT; Employment Bureau. 2.12 Montenegro's unemployment is of long-term duration, as more than one-fifth of the registeredunemployedis in the roster for more than eight years (Table 2.5). About 85 percent of the registered unemployed are out of job for more than one year, and this i s a much higher percentage than that for other regional countries and i s almost twice the level for EU-15 countries (Figure 2.2). The skills and work habits o f many o f the long-term unemployed have eroded and to a large extent their reintegration into the labor market i s complicated, at least without an upgrading o f their human capital. 27 InMontenegro, the registered unemployment i s rather close to the actual number, due to incentives in the form of health and pension insurance entitlements provided to the registered Unemployed. By the 2003 labor force survey data, more than 90 percent of the unemployed had registered themselves at the Employment Agency thus making themselves available to various employment services. 24 Long-term unemployment constitutes an additional burden on the social funds and the families o f the affected. The persistence o f high unemployment and growing under-employment even after more than a decade o f economic growth i s worrisome. For the reality o f a rather stagnant unemployment pool with a high incidence o f long-term unemployment is at odds with the idea o f a rapid reallocation o f workers across firms and sectors. Many households have turned to subsistence agriculture and petty trade, to stave off poverty, while jobs inthe formal sector have continued to disappear. 2.13 As in other SEE and CEE countries, unemployment mainly affects the young (those below 25 years of age) and females.According to the 2003 Labor Force Survey, about 50 percent o f those aged 15-24 years are unemployed (Table 2.2). International experience shows that low levels o f youth employment and participation often reflect lengthy schooling and/or the Figure2.2. Long-termUnemployment inMontenegroRelative high costs o f hiring and firing.28 to Other Countries inthe Region New entrants in particular face more serious impediments in 90 "...... " ..." -. ..- ... ". " .... .. .. _. I" accessing employment than other 2 80 groups o f workers. 5 0) 70 Almost two-thirds o f the registered - 0 60 unemployed (66.4 percent) are first E time job seekers, and one-quarter 50 (23.4 percent) are youth at age 24 U 40 0 years and less; 52.7 percent o f the U 30 registered unemployed in 2004 .-c$ 20 were females (in 2000 the share c 10 was 58.4 percent). In contrast, s. u, older workers have high recorded 0 employment and participation rates, lower levels o f unemployment, but very long durations o f unemployment once they lose theirjobs. Source: OECD 2004; MONSTAT: Labor Force Survey Data. Wage and Productivity Dynamics 2.14 Despite high unemployment, Montenegro's avera e net earnings more than doubled between 2000 and 2004 (Table 2.6).29The average gross wagJo increased from 150.9 euros in 2000 to 302.6 euros in 2004, while average net earnings increased from 96.4 euros to 195.3 euros over the same period. In2004 alone, real wages increased by 12.3 percent. 28See Garibaldi and Mauro (1999). 29Thereare no officially reported statistics o n wages, other than the household survey data. By the household survey data, there are only around 110,000 employed in the country (extrapolating the data from the survey to the whole country) (ISSP 2004). The surge in wages could have in part been due to price and trade liberalization, which occurred in2000-2002 inMontenegro. 30 Gross wage contains a significant share o f non-wage (cash and in-kind) compensation o n a non-taxable basis, established according to the General Collective Agreement. The most significant from the fiscal standpoint are food allowance and compensation for transportation, and seniority (wage) premium and additional holidays associated with the service length of the employee. This shifts compensation away from wages to non-taxable incomes. 25 Table 2.6. The Dynamicsof AverageWages inMontenegro,2000-2004 (euros) Average Total Average Ratio of The Minimum gross contribut net Annual dynamics of Labor wage wage ions and earnings mwage real net productivity, taxes ** to net 7 earnings, yo 2000=100 earnings 2000=100 2000 37 150.9 55.5 96.4 38.4 36.1 100 100 2001 42 176.2 68.5 108.0 38.9 21.8 92.0 102.2 2002 so* 229.2** 87.1** 142.2** ... 16.8 103.7 107.9 2003 50 271.0 97.2 174.0 28.7 6.8 118.9 114.1 2004 50 302.6 107.5 195.3 25.6 3.2*** 129.3 ... Note: Since the new Personal Income Tax Law was applied in July 2002 (the tax base was broadened to cover all payments to employees), MONSTAT has changed the methodology for calculating the average wage. * Since July 2002. ** An average for 1-6/2002 to 7-12/2002, ISSP data. MONSTAT reported data on gross wage in2002 was euro 251.3 *** Estimate by the Center for Entrepreneurship and Economic Development. Source: ISSP 2004; MONSTAT. 2.15 The growth in net wage earnings has been much higher than that of many other countries in the region (Table 2.7) (with the exception o f Serbia, where the data suggest that net monthly wages grew fourfold since 2000). Ultimately, wage growth must be compatible with productivity. If the wage increase i s not justified by productivity, employment will fall until the resulting increase in unemployment exerts enough downward pressure on wages (see Layard, Nickel1 and Jackman, 1990; Gilles, 2004). Table 2.7. NetMonthlyWagesinEuros, 2000 and 2004 2000 2004 Wage growth in Gross National Income 2000-2004, % per capita, US$ Albania 99.1 169.3 70.8 1740 Bosnia and Herzegovina 191.2 258.2 35.0 1540 Bulgaria 94.9 122.6 29.2 2130 Croatia 435.4 556.6 27.8 5350 Macedonia, FYR 172.4 201.0 16.6 1980 Montenegro 96.3 195.9 103.4 1910* Romania 107.2 147.2 37.3 2310 Serbia 45.4 193.0 425.1 1910* Notes: Albania - public sector wages only; Bosnia and Herzegovina - average in Republika Srbska and Federation o f B&H; Bulgaria - data for 2004 are for 4 4 only. * Data for Serbia and Montenegro (excluding Kosovo). Source: Bank calculations; GNI-World Bank Atlas 2004, Washington, DC. 2.16 Montenegro has one of the highest labor taxes amongthe transition countries. There are two alternative indicators of the wage tax burden: the non-wage labor cost and the tax wedge on the labor market.31 By our calculations, in 2004 the tax wedge-taking into consideration all the social contributions (pensions, health insurance and employment contribution, as well as fees and surtaxes established according to the General Collective Agreement, the Law on Communal Taxes and Compensations and other laws-is estimated at 52 percent o f the labor Non-wage labor costs 31The non-wage labor cost is defined as the ratio between payroll taxes and gross wages, The tax wedge o n labor is the difference between the labor cost to the employer and the take home pay (net wage) expressed as a percentage o f total labor cost. 32In2005, this legal basis for compensation (tax) for the use o f goods o f common interests o f 3 percent o f gross wages was replaced by the Law on Local Self-Government Financing, which allows the municipalities to introduce a surtax o f 13-15 percent of the calculated personal income tax. 26 were estimated in 2004 at 35 percent. InOECD countries, the total burden on the labor market i s 51.8 percent among Europeanmember countries and 37.3 percent for non-European member countries, (ISSP, Montenegro Economic Trends, 2004).33 Labor taxes lower the labor demand by raising labor costs. But they also lower labor supply by reducing the real consumption wage. The high wage tax burden has contributedto lower employment, higher informalization, and higher (long-term) unemployment. 2.17 Most recently, the Government of Montenegro has reduced the amount of tax and social contributions payable by employed persons, to stimulate employment creation and formalization. According to the Decree on Tax Relief for New Employees, from April 2003 to December 2004 all newly employed workers were registered under favorable conditions, which means that companies that, within a business year, will hire new employees for a contract o f at least two years will be allowed to reduce their tax base by the amount o f gross salaries paid to these employees, augmented by the employer's portion o f the social contribution. By official estimates, this measure led to a shift o f 30,000 jobs currently in the gray economy into the official economy and helped to create more than 5,000 new jobs (see Government o f Montenegro, 2005). 2.18 Inaddition, the decree on Employment of Nonresident Persons, which established a relatively low "tax" o f EUR 2.5 per day for employing non-residents, has resulted in the registration o f around 50,000 nonresident workers and has made it possible to collect additional revenues o f 1.7 million Local employers are interested in hiring foreign workers, especially for seasonal employment. For example, on average, the cost o f labor for construction workers from Serbia and the Republic o f Srpska i s 20-30 percent less than that o f Montenegrin workers because o f lower taxes for non-resident persons and lower bargainingpower. 2.19 Still, Montenegro's new General Collective Agreement imposes additional non-wage (cash and in-kind) and non-taxable costs to employer^:^ thereby effectively preserving some of the rigidities removed through reforming the labor law in recent years. Compared to the previous 1995 Collective Agreement, the 2003 Agreement expanded the list o f supplementary benefits, which has significant fiscal cost implications for all employers including the Government. Inparticular, the housing allowance and the collective insurance o f employees were added to the already extensive list o f additional benefits to workers (see Table 2.11). Among other benefits, an employee i s entitled to paid absence from work in the course o f a calendar year o f up to 7 days for various family events, allowances for annual leave, transport and meals, seniority (wage) premiums, and additional annual leave for years o f service. In addition, employers have to pay 0.7 percent o f gross earnings to the Housing Fund for employees (see Table 2.9). This will significantly increase non-wage labor costs, which are especially burdensome for SMEs. 33 Inaddition to personalincome tax, PI0 contribution and contribution to the Health Fund, the employeeshave to pay from their wages also unemployment contribution, 0.5 percent of gross wages; the employers, inaddition to the PI0 contribution and the contribution to the Health Fund, have to pay an unemployment contribution 0.5 percent of gross wages; fee to the Chamber of Commerce - 0.32 percent of gross wages; fee to the Confederation of Independent Trade Unions - 0.20 percent of gross wages; payment to the housing fund for employees - 0.7 percent of gross wages; compensation for use of public goods - 3.0 percent of gross wages (replaced in 2005 by 13-15 percent of personal income tax (PIT); meal allowance 50 percent of the minimumwage (EUR 25), and transport allowance25 percentof the price of gasolineper km.(See Table 4.15 for details.) 34 The actual resultmight be slightly lower due to the double-counting ofnon-residentschanging work places and asking for new work permits. 35 The most recent General Collective Agreement was signed by the Chairmen of the Council of Union of IndependentTrade Unions of Montenegro and Managing Board of the Chamber of Commerce of Montenegro, and the Prime Minister ofthe Republic of Montenegro on December 19,2003. 27 2.20 The minimumwage is moderate and inlate 2004 equaled 50 euros per month, or around 17 percent of the average gross wage (Table 2.6). However, the 2003 General Collective Agreement increased the minimum wage coefficients depending on a person's education and qualifications. For employees with a university or higher education degree, the minimumwage i s set at 165 euros, or a high 54 percent o f the average wage. This may have an impact on employers' hiring decisions, especially regarding new entrants with a higher education. Empirical evidence indicates that the minimumwage set at a moderate level usually does not have a substantial dis-employment effect, but at the same time it has only a limitedand often transitory impact on the earnings o f low-wage workers. B. HOW RESTRICTIVE ARETHE LABOR REGULATIONS? 2.21 A flexible (adaptable) labor market facilitates economic restructuring, promotes productivity growth and competitiveness, and helps the economy adjust to supply and demand shocks. Employment protection legislations (EPLs), especially on hiringand termination, are often hotly debated for good reasons. On the one hand, they define the job security o f workers and as such are very important; on the other hand, they typically make it harder for certain groups, including women and displaced older workers, to enter or re-enter the labor market. They also strengthen labor market "insiders," and increase long-term unemployment. In addition, by discouraging hiring and firing, EPLs may slow down adjustment to shocks and impede the reallocation o f labor, with potentially significant efficiency losses. Recent studies also indicate that greater flexibility in the host country's labor market relative to that inthe investor's home country i s associated with larger foreign direct investment 2.22 InMontenegro, the general framework of labor regulations is determined by the Labor Law of 2003 (as amended in 2004), and the General Collective Agreement o f 2003, which applies to employees with an employer headquartered inthe Republic o f Montenegro, employees sent by an employer to work abroad, public officials and employees inpublic administrationbodies, and local self-government units- i.e., to all hired employees. The social protection o f the unemployed and the provision o f employment services are regulated by the Law on Terms and Conditions o fEmployment, approved in 2003. 2.23 Montenegro's current labor regulations, although significantly improved in 2003, still hinder the efficient reallocationof labor and provide incentives for informality.The Government improved the labor regulations significantly through the 2003 key amendments to these regulations, but the Labor Law continues to over-regulate employment relations and discourage hiring. The Law i s still highly directive and prescriptive. It reaches into the direct relationship between the employee and the employer - even prescribing the scope and nature o f the disciplinary action that an employer may take when an employee transgresses (USAID, 2004). This has contributed to a stagnant formal sector labor market, with high unemployment and limited opportunities for new entrants, and a large informal sector. Thus, it has also hampered the required labor reallocation, thereby wasting a potential for economic growth. 2.24 The share of undeclared work in Montenegro is estimated by the Institute for Strategic Studies and Prognoses (ISSP) as at least at 30 percent of GDP and is among the highest in the region (Table 2.8). The recent EUreport shows that former socialist economies with the most protective labor laws and the most rigid labor policies also have the highest level o f shadow economy/undeclared work. Conversely, it shows that economies with liberal labor regimes have l o w levels o f undeclared work. When there are fewer job opportunities inthe formal sector, inequality often rises as people turn to the informal sector, which offers lower pay and no health insurance or social benefits. 36 See Javorcik, Beata and Mariana Spatareanu. Do Foreign Investors Care About Labor Market Regulations? World Bank Policy Research Working Paper 3275. April 2004. 28 Table 2.8. Undeclared Work in CEE and Baltic States and in EUMember States (pre- May 1,2004)* CEE Statesand Yo of GDP EUMember States Yo of GDP Baltic States (pre-May 2004) Montenegro** - 30 Austria 1.5 Bulgaria 22-30 Belgium 3 CzechRepublic 9-10 Denmark 5.5 Estonia 8-9 Finland 4.2 Hungary 18 France 6.5 Latvia 18 Germany 6 Lithuania 15-19 Greece 20t Poland 14 Italy 17 Romania 21 Netherlands 2 Slovak Republic 13-15 Portugal 5 Slovenia 17 Sweden 3 UK 2 Source: EuropeanCommission 2004. * Undeclaredwork defined as "productive activities i s that are lawful as regards to their nature, but are not declared to the public authorities, taking into account the differences inthe regulatory systembetweenMember States." EuropeanCommission2004.**ISSP 2004. 2.25 Employment protection measures refer to hiring and firing arrangements, and can be thought of as distributed on a continuum of rigidityhlexibility. These measures include the kinds of contracts that are allowed, the conditions under which contracts can be terminated, occupational standards, and rules for mass layoffs (Betcherman et al. 2001). They include hiringprocedures, probation, fixed-term employment relationships, the supplying of labor by third parties, so-called atypical employment relationships, and last but certainly not least, termination o f employment and protection against unjustified dismissal. A labor market with strict rules to protect job security - for example, with rules that restrict nonstandard forms o f employment -- has more stable jobs but also more long-term unemployment and non-participationthan labor markets without these protections. 2.26 The present Labor Law places obstacles in the way of employing persons for fixed-term, second or third jobs and places restrictions on the type of work that can be considered "temporary work." Fixed-term employment contracts, currently limitedto a set o f pre-determined activities, could be useful for expanding employment in certain sectors, occupations and activities. According to the Law, employers have to involve the Employment Fund when recruiting or selecting employees. If these very strict regulations were enforced they would protect jobs for incumbent employees while limiting opportunities for the unemployed and new entrants (e.g., youth, women re-enteringthe labor market). 2.27 The Labor Law still imposesa very rigid regime ofworking hours. Fullworking hours should amount to 40 hours per working week, and overtime i s allowed only in exceptional cases associated with earthquakes, floods, fires, etc., but may not surpass 10 hours per week. Requirements to notify the Labor Inspectorate o f overtime working, and to take annual leave in a specific way, are outdated and unnecessary. 29 Table 2.9. Comparisonof Additional Benefitsto Workers Provided by the 1995 and 2003 General CollectiveAgreement (GCA) Benefits GCA, 1995 GCA, 2003 (based on currentbasic minimumwage levels) Allowance for annual leave 3 minimumwages 3 minimumwages (150) Retirementof workers 6 minimumwages 6 minimumwaies (e 300) Compensationfor work stoppage Iftheworker isnotresponsible 50%oftheemployee'swage Not regulated the employer shall pay Transport allowance Half o fthe cost 25 56 of the price o f gasoline perkm Meal allowance (per month) 50 % minimumwage 50 56 minimumwage ( 25) Contributionto unions 0.20 % of gross wage 0.20 % of gross wage Employees are entitled to awards after 10, 20 and 30 years of service, not less than 2 minimum wages. Also annual leave shall No obligation for monetary awards. Annual be increased according to the length of leave shall be,increased according to the length years - by 2 working days; over 30 years - by 3 of service: 1-15 years - by 1 working day; 15-30 Awards service: 1-15 years - by 1 working day; 15- years - by 3 working days; disabledperson 30 years - by 2 working days; over 30 working days; disabled person - 3 working - 3 working days; parent of child with days; a parent of a child with physical and physical and mental problems - 3 working a a mentalproblems - 3 working days. days. Housing allowance No obligation Conipulsory payment to the housing fund for employees, 0.7 % of gross earnings Seniority (wage) premium for Up to 10years - 0.5 % ofwages; Up to 10years - 0.5 % of wages; each year of service 10-20years - 0.75 %; 10-20years- 0.75 %; Over 20 years- 1.O % Over 20 years - ?LO 1.O Marriage- up to 5 business days; birth of child up to 3 business days; moving- up Birth of child - up to 3 business days; severe - to 2 business days; severe illness of the illness of the immediate family member - up to immediate family member 7 business days; voluntary blood, tissue and - up to 7 organ donation- up to 3 business days; care of Additional annual leave business days; work examination - up to 3 business days; emergencies due to natural child with physical and mental retardation- up catastrophes to 3 business days; emergencies due to natural - up to 3 business days; participation in competition in work or catastrophes - up to 3 business days; production - up to 2 business days; participation in competition in work or personal reasons- up to 2 businessdays. production-up to 2 business days. Minimum wage coefficients depending on the group of jobs Between 1.O and 3.2 of the basic minimum Between 1.0 and 4.0 of the basic minimum (based on education and wage wage of 50. qualification) Collective insurance of An employer shall provide employees with employees No obligation collective insurance from accidents at work and outside work, and risks of death due to illness. Note:-in italics -newly introducedbenefits and entitlements. Source: General Collective Agreement 1995 and GeneralCollectiveAgreement 2003, 2.28 Dismissal costs in Montenegro are still high. Employment may be terminated through notice, owing to economic, technological, structural or similar transformations, but the process i s unnecessarily cumbersome and costly to employers. In such an environment firms are not able to easily adjust to market changes. Despite recent significant improvements (compared to pre-2003), mandatory minimum severance payments are still capped at six monthly salaries with no regard for length o f service. Moreover, the base wage for severance pay calculation should not be lower than the average wage inthe Republic. This adds an undue cost to the dismissal o f workers who have short periods o f employ~nent.~~ 3' This is still a step forward compared to the pre-2003 Labor Law, inwhich severance pay was established at up to 24 monthly wages basedon the wage level of the previous month prior to dismissal. Invalids could have stayed until 30 Bymaking dismissal for economic reasons more difficult or costly, these employmentprotectionrules are intended to increase job security. However, the trade-off again i s that employers may be reluctant to hire workers ifthey face constraints indismissingthem for business reasons down the road. 2.29 Dismissalof disabled workers is still The 2003 Labor Law prohibited the dismissal o f disabled employees, irrespective o f whether there was work for them. In 2004 the L a w was amended and now the labor contract with the disabled employee can be terminated on par with other individuals, except ,that the severance package was established in the amount o f not less than 24 average monthly wages in the Republic if the disability was caused by injury out o f work or disease, or not less than 36 average wages, if the disability was caused by injury at work or occupational disease. This i s a step in the right direction, but nevertheless these provisions, together with the restrictions on female workers with young or disabled children, make it harder for these groups o fjob seekers and new entrants to findjobs. 2.30 Montenegro has one of the longest maternity leaves in the world of 365 days from the beginning of exercising the right to it. According to the existing Law on Social Protection, the maternity leave benefit should be paid by the employer, and then at the request o f the employer it will be reimbursed by the state. Since the state budget does not have sufficient funds for reimbursement, the payment o f maternity leave benefits i s in arrears. Moreover, such generous entitlements have already had an impact on the labor market. According to the latest available labor force survey data (October 2004), 46.5 percent o f males at age 15 years and older were working while among the females, the employment rate was 28.8 percent. The employment rate o f females i s traditionally lower than for males but this gap to Ia large extent reflects the rigidities associated with female labor (see also Box 2.1) Box 2.1. MaternityLeave andWomen's Labor MarketParticipation Under the 1992 EU Maternity Leave legislation, EU Member States are requiredto provide at least 14 weeks (98 days) of paid maternity leave. Currently in Europe the duration o f paid maternity leave varies from less than 100 days in Germany, Ireland and Portugal to 365 days in Slovenia and Albania, and 270 days in Macedonia. The most typical duration in transition countries i s 126 days, and the basis for benefit calculation i s average monthly wages for at least the last three months o f work. In many countries, only half o f the wages i s paid in maternity benefits, and wage limits for benefit calculations are also established. Extended maternity leave can potentially adversely affect women's labor market participation by leading to an actual or perceived erosion o f skills. Extended leave entitlement, especially if accompanied by a decline in childcare places, may also enforce the notion o f women as second earners, and diminish their economic and social roles in favor o f their maternal functions. Thus, it i s important to create a flexible and widespread network o f childcare options to ensure equal opportunities for women in the market economy, and relieve an unsustainable financial burden from the Government related to maternity leave transfers (UNICEF 1999). Many transition countries have established a partially paid parental (childcare) leave o f up to two to three years, a flat rate benefit paid from the state budget. This i s much less burdensome to the budget and employers, if they are paying the benefit, and can avoid discriminationagainst female labor inthe formal labor market. 2.31 In sum, the Labor Law should ease the conditions for concluding fixed term contracts, contracts for temporary, casual and seasonal employment, and full-time and part-time labor contracts. Labor market rigidities are especially burdensome for private small and medium enterprises they retired or were willing to accept any other job offer. If the worker had less than 5 years to retire, the employer had to pay a severance for the period up to 5 years. 38 It i sestimated that there are around 12,000 disabled workers inthe formal sector, or around 11percent o f the workforce. 31 (SMEs), which have been a dynamic source o f new job creation in many transition countries in the region. Changes inthe Labor Law should create a more favorable environment for SMEs. c. HOW WELL DO THE COLLECTIVEBARGAINING AND SOCIAL DIALOGUE FUNCTION? 2.32 Collective bargainingcan play an important role in determining wages and other conditions of work. The representation o f the worker's voice through unions and collective bargaining can reduce discrimination. In addition, by instituting dispute resolution mechanisms, it can reduce arbitrary management decisions, increase job tenure and investment in training, and improve work safety conditions. These positive effects o f unions would contribute towards greater labor productivity. Another major issue for social dialogue will be the introduction and widespread use o f so-called atypical employment relationships, such as part-time and fixed-term contracts, triangular arrangements or probationary contracts, which could serve the interests o f both employees and employers. The role o f serious and continuous dialogue should be that o f strilung the right balance between the interests o f the two parties inthe industry. 2.33 Montenegro's recent trends in wage dynamics may indicate a strong voice on the part of Montenegrin unions in putting pressure on wage levels. It i s well known that, ceteris paribus, unions can raise wage pressures, and that wages bargained collectively are generally higher than those bargained individually. InMontenegro union membership i s very high compared to most other transition countries. On average, 75,000 workers and employees pay their trade union membership fees (depending on the month, between 71,000 and 82,000), which means that the union density rate i s around 68 percent o f the formal sector employment and 45 percent o f the total e m p l ~ y m e n t .For comparison, the weighted ~ ~ average trade union density o f 10 new EU Member States i s 22 percent. (USAID, 2004). In addition to highunion density, bargainingcoverage inthe formal sector o f the Montenegrineconomy is close to 100 percent4' It i s estimated that wage coefficients introduced in the 2003 General Collective Agreement were on average increased by 19 percent (Government o f Montenegro, 2005), in part owing to the strength o f trade unions. The Confederation o f Independent Trade Unions o f Montenegro i s the main representative o fworkers and employees. 2.34 In contrast, employers are not well represented in collective bargaining and wage negotiations. Until 2004, the Chamber o f Commerce was the only authorized body to represent employers in collective bargaining and to sign mandatory agreements binding all employer^.^^ The ILO Conventions state that the social partners can only be the voluntary organizations o f workers and employers, and not the chambers o f commerce that exist on the basis o f the legal obligation o f the companies to be registered with the chambers and to pay the contribution to them (see L O Convention No, 144 and Recommendations No. 113 and 152 on tripartite consultations). InMontenegro, membership in the Chamber of Commerce and the payment of relevant fees (0.32 percent o f gross wages o f their employees) i s mandatory for all legal entities. Thus, this practice o f representation contradicts the ILO Conventions. 2.35 In 2004 an important amendment was made to the Labor Law to define the criteria for the representativeness o f employers' associations. According to this amendment, the authorized association 39Serbia and Montenegro is an ILO member since 2000 and has so far ratified 68 ILO Conventions (67 o f them are inforce). 40Union density refers to the proportion o f workers who are members o f a union. Union coverage refers to the proportion o f workers who are covered by collective agreement bargaining. 4'Since September 2005, a g o v e m e n t decree has established that the Union o f Employers o f Montenegro must be a party to all collective bargaining and other negotiations at all levels o f the social dialogue. 32 o f employers shall be the one whose members have a minimum o f 25 percent o f employees in the economy o f the Republic and that participates in the gross domestic product of the Republic with a minimumof 25 percent. Two o f the newly emerging associations o f employers, such as the Montenegrin Union o f Employers (around 2,000 registered members) and the Montenegro Business Alliance (around 400 registered members), may thus qualify for the status o f nationally representative employers' organizations. 2.36 The current system of labor agreements takes little account of the individual employer's circumstances or of individual sector circumstances. Currently, according to the Labor Law, the General Collective Agreement shall be negotiated for the territory o f the Republic and shall apply to all employees and employers. Inthis way, it sets the framework for measures on social protection at work, supplementary benefits, and other aspects o f labor relations. In most other countries in Europe and elsewhere, the majority o f collective agreements is at the sector or company level (or even for the public sector and the private sector). Although the Montenegnn Labor L a w provides for collective agreements at national, branch and employer levels, there are very few collective agreements at the firm level in practice. Moreover, while all collective agreements are typically effective for a fixed term, and while negotiations should be carried out in a tripartite manner with representative participation o f each party, the General Collective Agreement in Montenegro i s concluded for an indefinite period o f time. There are almost no articles inthe General Collective Agreement indicatingthe process of labor bargaining on some core labor market issues, such as wage adjustments (except minimum wage), working time, or atypical work arrangements (i.e., on labor issues and situations that may change annually or even seasonally). 2.37 Regular social dialogue at the national level with representative social partners is not functioning. Montenegro's Social and Economic Council, established by the Government Decree o f February 1, 2001, consists o f 3 8 members, including 7 representatives o f workers appointed by the Union o f Independent Trade Unions o f Montenegro, 7 representatives o f the industry appointedby the Chamber o f Commerce, 7 renowned experts and public figures appointed by the Government, and 5 representatives o f labor, education and health, nominated by the Ministry of Labor. However, the Council has had only occasional meetings and has not become a player in social dialogue. Moreover, other associations o f employers, such as the Montenegnn Union o f Employers and the Montenegro Business Alliance, are not represented inthe Council. 2.38 Montenegro's Labor Inspectorate has been constructive in resolving individual labor disputes (complaints from over 800 workers were submitted in 2004) and in enforcing the legislation on legalizing the informal activities. The Labor Law and other related laws in Montenegro call for labor arbitration in the resolution of labor disputes, the composition, procedure and method o f which shall be defined in the collective agreement. This i s in line with international best practices o f moving away from court-based procedures and adversarialism and towards alternative non-court approaches that emphasize fact-finding, conciliation, and a r b i t r a t i ~ n . ~ ~ D. INSTITUTIONS DEALINGWITH HIGHUNEMPLOYMENT 2.39 The Employment Bureau of Montenegro is the main institution providing employment services to job seekers (see Table 2.10). As noted above, there were 58,000 registeredunemployed inthe 42 Effective dispute resolution relies o n three key principles. First, prevention i s always better than resolution, and adequate enforcement o f labor laws goes a long way toward preventing labor disputes. Second, if a dispute i s unavoidable, the parties to a dispute ought to attempt to resolve it themselves. Third, if a dispute cannot be resolved, thirdparty intervention ought to involve the disputing parties as muchas possible (Heron and Vandenabeele 1999). 33 roster o f the Bureau by April 2005 ,43 InMontenegro, employers are obliged to report to the Employment Bureau on the available vacancies and the related working conditions. On an exceptional basis, the employer may enter a labor agreement without a previous public announcement o f vacancies. The Bureau publishesjob vacancies within five days from the day on which the employer submits the application. The requirement for actively seeking employment and accepting adequate employment i s applied only to recipients o f the unemployment benefit. The right o f the unemployed person to financial compensation ceases if, among other reasons, the person, without justification, fails to contact the Bureau for two subsequent months, or refuses to participate in the program o f active employment policy, or does not respond to a vacancy announcement, as instructed by the Bureau. Table 2.10. Main Activities of the EmploymentBureauof Montenegroin2004 (January- October) ActivityDndicator No of individuals Average number o f registeredjob seekers 66242 Newly registeredjob seekers 29550 Recipients o f unemployment compensation 42439 Number o f advertised vacancies 27388 Number o fjob seekers individual employment plans 60127 Numberofparticipants o f information and motivation seminars 2980 Participants o f training programs 2075 Number o f employed interns 852 Employment o f non-resident individuals 28062 Provision o f information to unemployedyouth 20000 Source: Employment Bureau o f Montenegro. 2.40 Montenegro's unemployment benefits (UB) are quite modest and therefore not a limiting factor to job creation, but the programis under-funded(see Table 2.11). Inthe 2004 budget for the Bureau, 4.3 million euros was allocated for the benefits, but by December only 1.2 million euros was received. Currently, the benefit payment i s in arrears for one year on average. This erodes the ability o f the unemployment benefit system to act as an effective social safety net and drives people into the informal sector. The insured person whose employment was terminated without hisher request, consent or fault, and who has been employed full time for a minimum o f 9 months continuously, or 12 months with interruptions, in the past 18 months, has the right to financial compensation if that person registers with the Employment Bureau within 30 days from the day that the employment ceased. The financial compensation (unemployment benefit) i s equal to 60 percent o f the minimumwage, or currently 30 euros. The duration o f the unemployment benefits payment i s 3 months if the insured has had unemployment insurance for 9 (12) months, and up to 12 months if the insured person has paid insurance contributions for 20 to 25 years. The unemployed person with over 25 years o f insurance contributions has the right to financial compensation until that person finds new employment. The low coverage and generosity o f benefits may have reducedthe otherwise adverse impact o f unemployment benefits onjob creation. 2.41 In contrast, Montenegro spends significant resources on active labor market programs (ALMPs), amounting to 0.55 percent of GDP (Table 2.11).44 There are two main characteristics of Montenegro's public employment service (PES). First, around half o f the budget on ALMPs i s spent on activities related to different counseling and job search assistance programs. Second, in recent years Montenegro spent significant resources on micro-credit programs. The structure o f expenditures confirms that, compared to some other countries in the region, Montenegro has a much higher level and share of 43According to the Law on Terms and Conditions o f Employment, high school and university students and farmers at age 15-64 who are actively seeking employment cannot be considered as unemployed. 44Calculations are based on the 11months' actual spending o f the Employment Bureau and estimated GDP for 11 months. 34 public expenditures on ALMPs, spent mainly on in-house services such as counseling and job search assistance as well as on youth and direct job creation measures through a micro credit scheme. The country has a relatively low share o f expenditures on unemployment benefits (Table 2.11). Table 2.11. Public ExpenditureonALMPs in Some Transition Countries (percent of GDP) Monten Czech Hungary. Slovakia, egro, Republic, 2002 2002 2004" 2002 1.PES and administration 0.29 0.07 0.12 0.15 2. Training 0.08 0.02 0.06 0.04 3. Youth measures 0.07 0.02 0.01 Measures for unemployed and disadvantagedyouth 0.02 0.01 Support of apprenticeshipand generalyouth training 0.07 4. Subsidizedemployment 0.11 0.06 0.34 0.21 Subsidiesto regular employment inthe private sector 0.02 0.08 0.06 Supportto unemployed persons starting enterprises 0.01 0.06 Directjob creation 0.11 0.03 0.26 0.09 5. Measures for the disabled 0.00 0.01 0.04 Vocational rehabilitation 0.00 Work for the disabled 0.00 0.01 0.03 6. Unemployment compensation 0.09 0.27 0.37 0.48 7. Early retirement for labor market reasons 0.01 TOTAL 0.74* 0.45 0.90 0.94 Active measures (1-5) 0.55 0.17 0.52 0.46 Passive measures (6-7) 0.09 0.27 0.37 0.48 * - Montenegro: January-November 2004 using an estimated GDP for 11 months; additionally, 0.10 percent of GDP was spent by the Employment Bureau on repaymentof credits and on investments. Source: OECD Employment Outlook 2004. Paris; Employment Bureauof Montenegro. 2.42 The micro-credit scheme is the costliest labor market program offered by the Employment Bureau, but its impact on unemploymentis yet to be properly assessed. The Bureau provides micro- credit for new business start-ups for those who are unemployed and who may face major difficulties in trying to secure a loan at the market interest rate. Although the efficiency o f the program may have improved in recent years, Montenegro's program remains costly - the program spends on average 3,000 euros per job created and embraces only a limited number o f participants (around 1,000 jobs are created through the program annually).45 International experience suggests that micro-credit programs are successful if supported by technical services such as training, counseling, and assistance in developing and implementing a business plan. The micro-credit program in Montenegro i s yet to be properly evaluated in terms o f placement rates, career development o f participants, and small business survival rates. 2.43 International experience indicates that, even under the best scenarios, payoffs to most ALMPs are modest (Box 2.2). It is difficult to address the problems o f large-scale unemployment through these programs. They may work for specific groups in specific circumstances - hence, the need for careful targeting. On the other hand, labor market interventions have a large potential for improving labor market performance. International experience suggests that counseling andjob search assistance are more cost-effective in tackling frictional unemployment. In particular, counseling can be crucial in 45Micro credits provided by the Employment Bureau through the commercial banks are for three years with a one year grace period and an interest rate of 3 percentannually while regular commercial credits are at an interestrate up to 20 percent annually. Around 16percent of the participants have failed to repay the loan. 35 helping individual workers obtain information about education, training, and alternative job opportunities. The provision o fjob search assistance or placement services--which provide information on labor markets andjob openings, the registration o fjob seekers, the selection and referral o fjob applicants, and follow- up with employers after referral-also helps to enhance labor mobility. Inany case, the positive impact of labor market policies cannot be taken for granted, which points to the importance o f the need for monitoring and evaluating the effectiveness o f ALMPs inMontenegro. Box 2.2. How and Which ALMPs Are Effective? A recent World Bank review o f ALMPs around the world, based on the 152 scientific (i.e., control-group) evaluations, drew the following general conclusions (Betcherman et al. 2004)": Job search assistance. These services generally have positive impacts on the post-program employment and earnings o f participants. Costs are relatively low (usually assistance is provided by PES staffl so the cost- benefit ratio i s often favorable. Trainingfor the unemployed. Participants often benefit from these programs interms o f higher employment rates but not in terms o f higher earnings. The few evaluations in developing countries paint a less favorable picture. Programs seem to work best with on-the-job training and active employer involvement. Results are more positive for women than men. Retrainingfor workers in mass layofls. These programs most often have no positive impacts, although there are exceptions. The few successful cases typically include a comprehensive package o f employment services to accompany the retraining. However, these are generally expensive. Trainingfor youth. These programs are almost always unsuccessful in improving labor market outcomes, at least in developed countries. It makes much more sense to invest earlier in the education system to reduce drop-outs and other schooling problems. While there are few studies in developing countries, evaluations in Latin America do find positive impacts for programs that integrate training with remedial education, job search assistance, and social services. Wage/employmentsubsidies. Most often these do not have a positive impact and have substantial deadweight and substitution costs. Targeting and monitoring may help but at the cost o f reducing take-up rates. Public works. This can be an effective short-term safety net but public works do not improve future labor market prospects for participants. Micro-enterprise development/self-employment assistance. There i s some evidence o f positive impacts for older and better-educatedworkers. However, take-up i s very low. Note: * These reviews were based almost exclusively on the experience o f industrialized countries because very few evaluations existed anywhere else. 2.44 Montenegro has not yet established a Labor Fund, despite the need for such a fund to facilitate restructuring and labor redeployment. The L a w on Terms and Conditions o f Employment anticipates the establishment o f a Labor Fundto provide transitional income support, including severance payments and other social contributions, for employers who are unable to secure assets for payments. The Fund is supposed to be established by the Government, the association o f employers, and the authorized trade unions. However, the Fund has not become active despite the need for such a fund. It i s expected that the reduction in the number o f employees in the formal sector o f the economy will continue: in accordance with the Economic Reform Agenda, the reduction i s estimated at 5,000 persons in 2005. The launching o f the Labor Fundwould be instrumental in supporting the displaced workers intheir search for alternative employment and inpreventingthese workers and their families from slippinginto poverty. E. CONCLUSIONSAND POLICY RECOMMENDATIONS 2.45 In view o f the highunemployment rate in Montenegro, improving labor market performance is critical for the political sustainability o f market-oriented reforms, growth, and competitiveness. The 36 following measures can improve the institutional fiamework for labor relations and employment creation inMontenegro: 0 Relax some aspects of the labor regulations. While the new Labor Law, adopted in 2003, has improved the flexibility o f the labor market, considerably it has not yet assured full flexibility (Government o f Montenegro, 2005). It i s still focused on the protection o f existing work places in the Government and inthe recently privatized companies rather than on opening new work places inthe private sector. The reforms inlabor relations should focus especially on the following: (i) relaxing the contracting rules for employing "non-standard" workers, including employees on fixed-term and part-time contracts; (ii) reducing the costs for employers to terminate regular (i.e., permanent) employees for economic reasons; (iii) permitting more flexible arrangements in working hours; and (iv) limitingnon-wage costs to employers. Reduce the high rates of labor taxation and strengthen the enforcement of labor taxes to encourage formal employment. Recent reforms have helped reduce the payroll tax and contributions burden, yet the labor taxes (or payroll taxes) are still too high and among the highest in the region. Montenegro's tax wedge, one o f the most important indicators o f tax burden, stood at about 52 percent o fthe labor costs in2004, while the comparative burden for the regional non-European member countries was 37.3 percent o f total labor costs. A further phased and well-planned reduction in payroll taxes--compensated by equivalent increases in other taxes, and with adjustments to compensate the resulting lost income o f the social funds-is desirable. The identification o f alternative sources o f revenue, such as the VAT or other indirect taxes, to make up for reduction inpayroll taxes i s critical to maintain the overall fiscal balance as well as the fiscal position o f the health and pensions funds. Such reduction inpayroll taxes should also be accompanied by improved enforcement o f taxes, including through more aggressive use o f bankruptcy as a means to deal with delinquent tax payers, as well as regular payments o f contributions for health insurance by all users o f health care. The reductions should be done in a way that does not hamper the financial sustainability o f the both the health and pensions funds. In addition, further reforms o f the health and pension systems (early retirement, disability, maternity leave and sickness benefit) may need to be pursued in parallel to tighten eligibility criteria and eliminate abuses in the systems. The legal frameworks have already been laid for pension and health sector reforms, but further reforms are necessary both to improve financial sustainability and service delivery to the people. Rein in the rapid wage growth witnessed in recent years. This can be undertaken by: (i) establishing a more balanced collective bargaining and wage setting process whereby the voices of employers (including Government) are strengthened; (ii) promoting greater decentralization o f bargaining to the firm level; and (iii)undertakmg a more vigorous implementation o f public administration reforms and the reduction in public sector staffs (many o f whom earn wages well inexcess ofthe average for the economy). 0 Introduce or expand, through the Employment Bureau, some other active labor market programs which haveproven to be cost effective in other countries in the region. Those would include: (i) employer contact services, which match applicants' skills and refer the best qualified applicants to employers; (ii) vacancy andjobfairs designed to assist local employment agencies inmatching labor supply and demand; (iii) job clubs for those with low self-confidence who have been unemployed for extended periods o f time; and (iv) virtual enterprises (or a practice $rm) to develop teaching and training skills for operating a real enterprise. Inaddition, an assessment o f the net impact o f ALMPs needs to be undertaken. 37 Improve labor market data and information. Available data do not allow a detailed analysis o fthe labor market inMontenegro. Special and more detailed regular labor force data may be needed to monitor the following: employment, underemployment and unemployment; seasonal, occasional and informal employment; earnings and incomes generated; working time involved, by occupational and professional groups and regions, on alternatives to formal sector employment; and work in the informal sector and in households. The absence o f regular and reliable information on the labor market limitsadjustments inlabor market interventions. 38 3. FISCAL POLICYREFORMFOR GROWTHAND COMPETITIVENESS 3.1 Montenegro's euroization has limited its options for macroeconomic management to fiscal policy. Its high current account deficit (before grants), at about 12 percent o f GDP at end-2004, remains unsustainably large. In the past such a large current account deficit was financed through high official grants, loans and privatization revenues. However, official grants have declined in recent years (from 7 percent o f GDP in 2002 to about 3 percent in 2004) as have privatization revenues, while net foreign borrowing has increased. With declining grants and rising debt service payments, adjustment to a smaller current account deficit i s necessary. With euroization, the main policy tool for such adjustment remains fiscal policy. For that reason, fiscal sustainability remains a serious concern. However, while restraining demand through prudent fiscal policy i s necessary, it i s equally important for the Government to ensure that the composition o f expenditures i s supportive o f growth, through increasing expenditure allocation to investment inpublic goods, inparticular to infrastructure. 3.2 The chapter is organized as follows. Section A provides a background on the evolution o f general government expenditures and revenues inrecent years. Section B examines Montenegro's current fiscal situation, in particular whether its fiscal position i s sustainable. It provides estimates on the level o f a long-term sustainable fiscal deficit for Montenegro and discusses the adjustment needed to regain fiscal sustainability and where that adjustment may come from. Section C considers the allocation o f public expenditure across key spending categories, to identify where the spending level may be excessive or inefficient, and also where more spending may be needed. The section looks into both the economic and the functional composition o f general government expenditures to draw conclusions on the extent to which the current composition o f expenditures i s supportive o f growth. Section D looks at the legal and institutional processes for budget management and planning, and the improvements that the Government may make to strengthen the linkbetween fiscal policy and growth, while Section E provides conclusions and recommendations. A. BACKGROUND 3.3 Montenegro's consolidated general government expenditure accounts for about 42 percent of GDP (Figure 3.1).46 Of this, Central Government accounted for 22.2 percent o f GDP, the extra- budgetary social funds for 15 percent o f GDP, and municipalities for about 4.2 percent o f GDP. Further decomposition o f expenditures by economic and functional classifications i s provided later inthis chapter. 3.4 Over the last three years, consolidated expenditures have declined from about 43 percent of GDP in 2002 to about 41.5 percent in 2004, which suggests that the role o f the Government in the economy declined only marginally. Current expenditures, accounting for over 90 percent o f total general government expenditure, declined from over 38 percent o f GDP in 2001 to about 34 percent in 2004, while capital expenditures, net lending and general reserves, which together account for less than 10 percent o f the total, remained more or less steady. On the revenue side, consolidated general government 46The IMFdata on consolidated fiscal operations for Montenegro do not cover local governments/ municipalities. However, Montenegro has local government data available for 2002-2004, although the quality o f the data may be weak. To provide a more complete picture of consolidated general government inMontenegro, we supplement IMF data with such data on local governments. Since by law and inpractice, local governments cannot generate deficits, their revenues (net of central government transfers) are equal to their expenditures. Inthat sense, exclusion of local governments does not introduce material difference into the IMF fiscal targets. revenue increased from about 39 percent o f GDP in 2002 to about 41 percent o f GDP in 2004 (Figure 3.2), including revenues o f local governments. Central government revenue and grants accounted for about 25 percent o f GDP, social funds for about 11 percent o f GDP; and local governments for about 4 percent o f GDP. Consolidated general government inMontenegro i s defined inBox 3.1. Box3.1. The Concept of ConsolidatedGeneralGovernmentinMontenegro The concept o f consolidated general government in Montenegro includes consolidated data for the Montenegrin Republican budget (central government), three extra budgetary funds--the Pensions Fund (PIO), the Health Insurance Fund (HIF), and the Employment Fund-and local governments. Local governments in Montenegro are represented by 21 municipalities, and their expenditure and revenue data are not always complete. Own revenues o f the social funds and local governments are supplementedby transfers from the Republican budget. Fiscal data for the central government o f Montenegro are based on the new GFS classification. However, data for the extra budgetary funds, reported directly by the funds, are not on a GFS basis and are generally compiled with delays. Montenegro's budget for 2005 already contains tables with consolidated budgets for the central government and the social funds, but the municipalities have not yet adopted a new harmonized chart o f accounts that would allow for the consolidation o f municipal budgets into general government. Figure3.1. ConsolidatedGeneralGovernment Figure3.2. ConsolidatedPublicRevenueand Expenditure,2002-2004 (percent GDP) Expenditure,2002-2004 (percent GDP) 45 0 - 4 51 4 27 40 0 43 0 35 0 5 1 ~- ~ 42 0 30 0 e Municipaldies 41 0 25 0 I % GDP Social Funds 40 0 20 0 I 39 0 15 0 22 7 Central 1 I 38 0 10 0 Government ~ ~ 37 0 5 0 2002 2003 2004 0 0- , 2002 2003 2004 I 0 Total Revenue GI Total kpendlture 1 ~~ Source: IMF; Montenegrin Ministry o f Finance; U S A I D Source: IMF; Montenegrin Ministry o f Finance; U S A I D Urban Institute for Local Governments data. Urban Institute for Local Governments data. 3.5 The compositionof revenues has shifted significantly over the last three years, owing mainly to the revenue reforms undertaken by the Government. By composition, social security contributions and value-added tax (VAT) account for about 62 percent o f the total tax revenue (Figure 3.3). Personal income tax revenue and the excise tax each account for an additional 12 percent o f total tax revenue. International trade taxes account for 7 percent and corporate income tax accounts for only 3 percent o f total revenue. The Government has introduced several tax reforms over the last three years. The Personal Income Tax Law, which came into force on July 1, 2002, replaced a proportional 19 percent income by progressive rates ranging from 0 to 25 percent. The ValueAdded Tax Law came into effect in April 2003. The sales taxes of 12 percent on services and 24 percent on most goods were replacedby the VAT rate o f 17 percent. The Corporate Profit Tax Law, which also came into effect in July 2002, replaced a flat corporate profit tax rate o f 20 percent by progressive rates o f 15 percent for profits up to 100,000 euros and 20 percent for profits over 100,000 euros. This L a w was further amended in the last quarter of 2004, which decreased the corporate tax rate from the prior progressive rates o f 15 and 20 percent to a proportional rate o f 9 percent. As a result, Montenegro now has the lowest corporate profit tax rate in 40 Southeast Europe. Inlarge part because Figure 3.3. Trends in the Composition of Revenues, o f these reforms, the composition o f 2001-2004 (percent GDP) revenues has changed. Personal income I . .... tax revenues and revenues from 14.0 . international trade taxes have declined, while revenues from social contributions and the retail sales t a d VAT have increased (Figure 2.3). Other revenues, L including revenues from excises and corporate income tax, have remained more or less stable. 2002 2003 ---+-Social security contributions --Retail sales tax /VAT ' B. I S THE FISCAL POSITION - - - -Personal incorre tax + Taxes on international trade ~~ SUSTAINABLE? Source; IMF; MontenegrinMinistry o f Finance; USAID Urban Institute for Local Governments data. 2004 (with program aid increasing from zero to 0.9 percent o f GDP and 6 project aid increasing from zero to 1.2 5 percent o f GDP); privatization receipts 4 3 declined from about 5 percent o f GDP 2 in 2002 to about 0.5 percent in 2004.47 8 1 Domestic borrowing, including the L3 $ 0 i 0Rivatizationreceipts issuance of short-term securities -1 2003 2004 (Treasury bills), fluctuated, in part j I -2 ~-0verall balance depending on the Government's -3 I , - including grants I ` privatization revenues. In 2004, -4 -5 domestic financing accounted for about _. - 3.7 Fiscal sustainability requires that the present value o f the government's primary balance must equal the current debt-to-GDP ratio. At the end o f 2004, Montenegro's estimated debt-to-GDP ratio was 43.8 percent o f GDP. Under the simplifyingassumptions that the economy grows at a constant real rate o f 4 percent per year, and that the real interest rate i s constant at 5 percent, a recent analysis by the World Bank finds that a primary budget balance o f 0.4 percent i s needed for Montenegro to achieve long-run fiscal sustainability. 48 3.8 Montenegro is thus currently very far from achieving a sustainable fiscal balance. Inthe past two years, estimates o f the primary fiscal balance in Montenegro put it at close to a deficit o f 2 percent o f 47 The government expects to receive a muchlarger amount-about 10 percent o f GDP-in privatization revenues in2005. Whether the government uses these receipts to reduce deficit spendinginstead ofincreasing itwillhave `*importantsimplications for fiscal sustainability and macroeconomic stability. This i based on an internal World Bank document: "Debt Sustainability inSerbia and Montenegro", June 2005, 41 GDP. Current projections for the primary balance suggest a deficit o fjust over 1percent o f GDP in2005. This i s well short o f the surplus o f 0.4 percent o f GDP needed for fiscal sustainability. Currently the effective nominal interest cost o f Montenegro's debt i s a little below 3 percent o f its stock o f debt. Ifone were to assume that real interest rate i s 1percent (rather than 5 percent as assumed above) inthe long-run, a primary deficit no greater than 1.3 percent o f GDP would be needed to maintain a stable debt-to-GDP ratio. Regardless o f the level o f interest rate assumed, the analysis suggests that, a substantial fiscal tightening-in the order o f 1 percent o f GDP- i s needed to achieve fiscal sustainability. While a higher growth rate and access to concessional financing can supplement such effort, fiscal reforms would take center stage. The next section highlightswhere such adjustment may come from. c. I S THE COMPOSITION OF EXPENDITURE SUPPORTIVE OF GROWTH? 3.9 While further fiscal tightening i s needed to ensure sustainability, it i s equally important for the Government to ensure that the composition o f expenditures i s supportive o f growth by ensuring adequate investment inpublic goods such as infrastructure. TheEconomic Composition of Public E ~ p e n d i t u r e ~ ~ 3.10 T w o key conclusions emerge f r o m an analysis o f the economic composition of expenditures. First, Montenegro spends about three-fourths o f its expenditure on Wages, and various social benefits to households. A comparison with regional states shows that Montenegro's wage billboth as a proportion o f total government expenditure and as a proportion o f GDP i s far above the average. On the other hand, capital expenditure i s much below the level for other countries inthe region (see Figure 3.6). Inparticular, the high wage growth has crowded out spending on public investment and operations and maintenance- expenditures that are essential for growth. Second, subsidies and lending to public enterprises have been progressively reduced over the last three years, but a lot remains to be done to impose a full hard budget constraint on public enterprises. Combined, direct enterprise subsidies and loans to enterprises accounted for about 1.6 percent o f GDP in 2004. Despite several years o f efforts at privatization and enterprise restructuring, incompletereforms across the economy feed into the budget via enterprise subsidies and net lending. State-owned enterprises still lack hard budget constraints and budgetary discipline and therefore take resources away from other priority areas o f expenditure, such capital investment in infrastructure. The scope for further fiscal tightening, as well as reallocation to public investment, lies in reducing expenditures on the wage bill, transfers to households, lending to public enterprises, and interest payments. 3.11 T w o economic items--social welfare and transfers to households50and the wage bill--account for over 75 percent o f total current expenditures (Figure 3.5). The other expenditures, including expenditures on the purchase o f goods and services, the payroll tax, interest payments, subsidies to enterprises, and other non-interest current expenditures, account for only about one-quarter o f total expenditure. Transfers to households principally include government-funded social protection benefits for children and families, and for war veterans and maternity benefits, benefits to pensioners through the Pension Fund, benefits to the unemployed through the Employment Fund, and medical protection and health insurance through the Health Fund. 49Analyses o f both the economic and functional composition o f expenditures do not include data for loca] governments/ municipalities. 50Transfers to households includes transfers and social benefits, transfers to individuals, transfers to humanitarian organizations and NGOs, transfers to the three social funds, transfers to other units o f government at a lower level (Le. local governments), and social insurance and protection. Transfers to the social funds are netted out inthe consolidated general government expenditure. 42 Figure3.5. Compositionof CurrentExpenditures,2004 B W Transfers to households 1 1 2% -2% 0 Netwages, salaries and allowances ~ ` I 0 Purchasesof goods and 10 services d Payroll Tax 49% Interest payment I 1i Other non-interest current ~l expenditure 0 Subsidies to enterprises Source: IMF; Montenegrin Ministry of Finance. 3.12 Montenegro's public sector wage bill is high as a proportion of general government expenditure, although it is less than the average for the EU-15 countries. (Figure 3.7). In2004 the total public sector wage bill expenditure represented about 9.1 percent of GDP (or 27 percent o f total expenditure). However, this substantially underestimates the true level o f the wage bill, since it does not include the wage bill in the health sector (financed under contractual arrangements through the Health Fund) and other wage bills concealed under transfers to semi-autonomous institutions, such as higher education. Incomparison to other countries inthe region," Montenegro's wage bill i s substantially higher as a share o f GDP (over 9 percent against about 7 percent for most other countries inthe region). 3.13 The high level of the wage bill is due mainly to the over-employment in the public sector. Average gross monthly wages in Montenegro increased from about 150 euros in 2000 to 302.6 euros in 2004-a cumulative growth rate o f 103 percent injust four years. The public sector continues to be the prime employer in the Montenegrin economy, accounting for about 60 percent o f total formal employment (according to the 2003 Labor Force Survey). 3.14 The high and growing wage bill and transfers to households have crowded out essential public expenditures on operations and maintenance and capital investment. Budgetary spending on operations and maintenance declined from around 6 percent o f GDP in 2001 to about 3.5 percent in 2004. Montenegro's capital expenditure has remained not only low but also volatile. Capital expenditure decreased from 2 percent o f GDP in 2001to 1.5 percent in 2002, but increased to about 2 percent o f GDP again in 2004. The volatility seems to arise from treating capital spending as a residual spending in the event o f revenue shortfalls and other budgetary pressures. Montenegro's capital expenditure i s also one o f the lowest inthe region, accounting only for less than one-half o f the average regional spending as a share o f GDP (2 percent inMontenegroversus 5 percent inmost other countries) (Figure 3.6). 3.15 Subsidies and net lending to enterprises stood at about 0.6 percent and 1 percent of GDP, respectively, in 2004. Direct subsidies to public enterprises declined from about 1.2 percent of GDP in 2001 to about 0.6 percent in 2004. Still, this i s not only lax but it also understates the real magnitude of subsidies in the economy, since state-owned enterprises also receive subsidies through the local ''Wage bill data for countriesinthe regionrepresents three-year averagescovering mostlythe period 1999-2001, For Montenegro the figures represent three-year averages covering the period2002-04. 43 governments (municipalities). Net lending by the Government, which includes loans to public enterprises, has fluctuated in recent years but remained significant at about 1 percent of GDP in 2004. There is n o adequate transparency surrounding the lending to state-owned enterprises, including the terms and repayment condition^.^^ Finally, interest payments increased from 0.1 percent of GDP in 2001 to 1.6 percent in2004.s3 Figure3.6. CapitalExpenditure,Comparison Figure3.7. Wage Bill,Comparisonwith Other with Other Countriesinthe Region,2003- Countriesinthe Region,2003-2004 2004 (Yo GDP) (% GDP) ~ 9 0 ,,,,.-..l" ... ..".. ... . .. ,, ....,, 16 8 0 1412 7 0 6 0 10 I n n. c1 5 0 0 W W 0 4 0 s 6 I 3 0 2 0 4 1 0 2 0 0 0 Source: IMF;Montenegrin Ministry o f Finance; Source: IMF;Montenegrin Ministry of Finance; Funck Funck 2002. 2002. 52 Loans to public-owned companies have very favorable conditions - 2 percent interest rate, 1year grace period, and a 3- year repayment period. 53 Besides debt repayment, interest payment has been the only expenditure where budget outturn has been higher than planned. 44 TheFunctional Composition of Public Expenditure 3.16 A look at general Figure 3.8. Montenegro's Functional Spending by Major government expenditure Components, 2002-2004 by functions54 suggests where some of the I ~ 1 SocialWelfare and , priorities for expenditure 16 Rotection I reform might lie. Four 14 GeneralPublic Services conclusions emerge from 12 I such an analysis. First, B(3 10 Health general government $ 8 services (public Education 6 administration, public ~ 4 Defence, Public Order and order and safety, and 2 Safety defense) and social I I 0 Q EconomicServices protection each consume I 2002 2003 2004 about a third (33 percent) -~~~ ______.. - ~~ -____ of total general government Source: IMF; Montenegrin Ministry of Finance. expenditure. Education and health combined account for another 25 percent o f the total spending. The rest goes to economic services, and housing, sports and recreation (about 5 percent). Second, compared with other countries inthe region, Montenegro spends substantially more on Figure 3.9. Montenegro's Functional Spending Compared to Other almost all o f these Countries, 2003-2004 functions--general public services, defense and 20 0 18 0 public safety, education, n 16 0 and health in that order 14 0 9 ':: 12 0 (Figure 3.8).j5 Third, despite the fact that 6 0 Montenegro started public 4 0 sector reforms a couple o f 2 0 0 0 years ago, the reforms have not yet resulted in a reduction in the costs o f public administration and -~ ____-__ 0 SocialWelfare and Rotection m General Fublic Services public order and safety. 0 Health o mucation Instead, the costs o f these I I Defence, mblic Order and Safety 0 Economic Services functions have continued Source IMF; Montenegrin Ministry o f Finance; Funck (2002). to grow. Fourth, although spending on social protection is more in line with other countries in the region, the dominance of spending on pensions and veterans' benefits means that a relatively small proportion o f spending is targeted towards poverty related programs. j4Due to lack o f data, the table does not include municipal spending by functions. Public and economic services and education are financed primarily through the central government budget; health services are financed through the Health Insurance Fundandpensions through the Pensions Fund. General public services do not include interest payments. "Montenegro data are average for 2002-2004, and do not include municipal expenditures and part o f the externally financed projects, and exclude interest payments. Comparator country data refer to three-year averages for 1999- 2001 except for Albania (2000-2002) and Hungary (1999-2000), and exclude interest and amortization charges. 45 General Government Services 3.17 Montenegrospends substantially higher amountsthan other countriesinthe region- about 9 percent of its GDP-- ongeneral public sewices (Le., public administration)(Figure 3.9). Despite the high spending, the general view is that public administration is poor, as standards within the public administration are not optimal and staff are often poorly trained and equipped for the functions that they are required to perform. In view o f this, it remains essential for the process o f public administration reform, which has begun recently, to provide budgetary space by not only reducing the very highlevel o f spendingon public administration but also by improving standards and service delivery (see Box 3.2). Box3.2. Public AdministrationReformandBudgetary Space Public administration reform remains critical to creating budgetary space inMontenegro. So far, some basic steps have beenundertaken. A new Civil Service Agency has been established, a new Law on Salaries for public administration employees has been approved, and a new systematization o f working posts i s expected to lead to the rightsizing o f the public sector. The basic reasonwhy the wage bill is so highi s because o f the excess staff inthe public sector as well as a generous salary and wage increase inrecent years. Public administration reforms are fundamental to addressing this problem. The reforms to date have not effectively addressed the excess staffing and the issues o f the different types o f allowances (hot meals, transportation, annual leave grants) that continue to burdenthe wage bill. While the Government has recently taken some steps to bringpublic sector employment and wage bill spending more into line with Europeannorms (e.g., by reducing excess staffing inthe education sector by almost 700 employees thus generating savings inthe wage bill o f around 3 million), there is a needto extend such steps to other sectors, such as public administration, with its excess staffing and inefficiencies. The Government plans to reduce employment in the public sector by 4,200 by the end o f 2005, which i s expected to generate an estimated savings o f about 10 millions6,but it remains to be seen whether this reform will be implemented. Inaddition, fbture elements o fpublic administration reformwill needto be planned and executed within a realistic budgetary resource framework. Where proposals lead to additional costs, it will be necessary to show how these costs are to be covered from elsewhere within the public service wage bill. 3.18 . Defense andpublic order and safety, at about 6 percent of GDP in 2004, was higher than the average levels in CEE countries, driven primarily by spending on the police service. Reforms are needed to bring staffing progressively in line with norms inthe region in order to control spending on this particular component. Community and Social Services 3.19 Spending on social welfare and protection, by far the largest functional component, accountingfor 14.6 percent of GDP,is comparablewith the spendinglevelsinother countriesinthe region(Figure 3.9). As elsewhere inthe region, pensions and pensionrelatedbenefit spending dominates, accounting for 80 percent o f this spending. The level o f spending on poverty-related social assistance programs has been among the lowest for countries inthe region. 3.20 Expenditure on health care services accounts for about 6 percent of GDP. Anecdotal evidence suggests that health spending in Montenegrois not efficient?' In the health care system, 56 The government i s planning to reduce defense staffing by 3,200; the rest o f the redundancy is expected to come from the public administration, which ifcompleted should generate significant budgetary savings. j7 See, World Bank, Serbia and Montenegro, Montenegro PEIR, Volume 3. 46 large inefficiencies, distorted incentives, and a lack o f accountability have resulted in substantial resource waste and poor service delivery. Improving the efficiency o f health services delivery i s therefore essential to containing costs without sacrificing services. This could be achieved through improvements in the management of public health funds, prioritization inresource allocation towards preventive programs and priority treatment programs, and improvements inpublic procurement procedures inthe sector. 3.21 Montenegro's spending on education, at about 5.4 percent of GDP in 2004,58 is above that of other countries in the region (Figure 3.9). This i s comparable to the OECD standards (5.5 percent for the OECD and 5.4 percent for Montenegro) as well as the standards o f other countries.59The structure o f education spending may suggest some degree o f inefficiency in the sector (Box 3.3). Out o f the total recurrent expenditure on general education, 94.6 percent was spent on the wage bill, while only 5.4 percent o f total recurrent expenditure was spent on non-staff items. The OECD average for the share of non-staff cost in total recurrent expenditure i s 19.7 percent. Furthermore, the match between vocational skills produced by schools and skills demanded by the private sector seems poor in Montenegro. There are a number of vocational profiles currently being offered inschools for which little or no demand exists in the labor market (Montenegro PRSP).60Further efficiency gains can be obtained by reducing the disproportionate staffing costs in education, as well as streamlining the vocational training programs to bringthem into line with the skills demandedbythe labor market. Box 3.3. I s Public Expenditure in Education Efficient? Regional comparisons demonstrate higher levels o f public spending inMontenegro on a number o f key functions and indicate that there i s probably a substantial scope for increasing the efficiency and effectiveness o f many programs within existing resource allocations. One such sector appears to be education. Out o f 455 active elementary school units, one-third o f the total number (148) have 10 or fewer students; 337 units (including 42 mother schools or a quarter o f these units) have fewer than 80 students, which would be 4 classes o f 20 students. The studendteacher ratio i s very low in many cases. There are 14 satellite (elementary) schools with only 1 student per class and 93 school units (13 mother schools and 80 satellite schools) with fewer than 5 students. In addition, there are many large urban schools with small classes, contributing to the number o f employees and directorship or supervisory positions. To address this problem, the M E S has recently produced new Norms and Standards, linkedto the number o f students rather than the number o f classes. Economic Services 3.22 Economic services absorbed only about 2.3 percent of GDP in 2004 (Figure 3.9). This represents less than half o f the average level o f spending for other countries in the region. Spending on economic services as a share o f total expenditures has remained volatile inMontenegro. Within economic services, spending on agriculture has remained constant as a share o f total expenditures in the last three years, while spending on tourism-related economic services has been increasing both in nominal terms and as a share o f total expenditure. 58This includes spending by social funds as well. 59Only Malaysia, Tunisia and Mexico have similar proportions o f education spending. 6oAccording to Montenegro PRSP, there are about 3, 953 different vocations inMontenegro (based on data from the Employment Fund), o f which there i s demand inthe labor market for only 750 o f them. On the other hand, there are 262 vocations for which demand exists but the school system does not produce adequate trainees. The MES has recently initiated a ))tracking(( project that would monitor secondary school graduates untilthey find ajob, which should help to better link education with the needs o f the labor market. 47 I s Montenegro's Fiscal Policy Growth-Enhancing? 3.23 A large body of economic literature is concerned with whether (and what kinds of) public expenditures enhance growth.6' The recent theoretical literature emphasizes that, in evaluating the impact o f fiscal policy on growth, the structure o f both taxation (i.e., financing) and expenditures should be taken into account.62One way to do this i s to divide the government budget into four categories: distortionary or non-distortionary taxes and productive or non-productive expenditures (see, for example, Kneller, Bleaney and Gemmell, 1999). Shifting the revenue stance away from distortionary to non- distortionary taxation has a growth-enhancing effect, whereas switching expenditure from productive to non-productive forms i s growth retarding. In this ffamework, income and corporate taxes are treated as di~tortionary,~~while taxes on domestic goods and services are treated as non-distortionary. On the expenditure side, those expenditures with a substantial physical or human capital component are treated as p r o d ~ c t i v ewhile expenditures on social security and welfare, recreation, and economic services are , ~ ~ regarded as unproductive (see Table 3.1). Table 3.1. Theoretical and Empirical Aggregation of the Government Budget into Distortionary and Non-distortional taxation Productive and Non-Productive Expenditures, 2002-2004 (percent GDP) Theoretical classification Functional classification 2002 2003 2004 Distortionary taxation Taxation on income 4.4 4.4 4.2 Corporate income tax 1.o 0.9 1.1 Social security contributions 11.5 10.6 11.2 Taxation on payroll and manpower Taxation on property Non-distortional taxation Taxation on domestic goods and services 12.6 13.7 14.3 Other revenues Taxation on international trade 3.0 2.7 2.4 Non-tax revenues 2.3 2.2 1.7 Other tax revenues 0.4 0.3 1.5 Productive expenditures General public services expenditure 7.5 11.8 9.0 Defense, public order and safety 4.0 4.3 6.0 Educational expenditure 4.5 5.6 5.4 Health expenditure 7.3 7.0 6.3 Housing expenditure 0.1 0.1 0.1 Transport and communication expenditure 0.8 0.4 0.8 Unproductive expenditures Social security and welfare expenditure 15.1 15.3 14.6 Expenditure on recreation 1.2 1.o 0.7 Expenditure on economic services 1.7 1.9 1.5 Other expenditures Other expenditure (unclassified) 0.1 0.1 0.0 ... Source: Kneller, Bleaney and Gemmell(l999) for the framework; IMF and the Montenegrin Ministry o f Finance for the data. 3.24 We apply this framework to the case of Montenegro for the period 2002-200465 to see whether the composition of fiscal policy has shifted in favor of or against growth. We will use the framework to answer two basic questions. First, on the financing side, have distortionary taxes increased 61 See, for example, Barro (1990), Barro and Sala-i-Martin (1992), Barro and Sala-i-Martin (1995), Deverajan et al. (1996), Easterly and Rebelo (1993), Glomm and Ravikumar (1997), Kneller et al. (1998). 62Levine and Renelt (1992) convincingly demonstrate that a framework that does not specify the full government budget constraint will lead to biased estimates o f the impact o f public expenditures on growth. 63 See Barro (1990). 64 See Barro and Sala-i-Martin (1995); and Devarajan et al., (1996). 65This framework is more suitable for a long-term analysis, but Montenegro's public expenditure by functional composition i s available only for the period 2002-2004. 48 or decreased over the last three years? Second, on the expenditure side, have productive expenditures increased or decreased over the last three years? 3.25 On the financing side, Montenegro has slightly increased its non-distortionary taxation (from 12.6 percent in 2002 to 14.3 percent in 2004), while distortionary taxation has remained at about the same level (Figure 3.10). Owing to the revenue reforms undertaken by the Government since - 2001, the personal income tax and the corporate tax (both distortionary) have declined, while the retail sales tax and VAT (non-distortionary) have increased (see Figure 3.3). Social security contributions (distortionary) have increasedbut have been more or less off-set by the decline inpersonal and corporate income taxes so that distortionary taxation has remainedmore or less constant. Figure 3.10. Trends inDistortionary and Non- Figure 3.11. Trends in Productive and distortionary Taxation, 2002-2004 Unproductive Expenditures, 2002-2004 I 20 0- 30 0 15.0- %GDP 10.0 I 20 0 %GDP I 5 0 ' 10 0- I o o L 2002 2003 2004 2002 2003 2004 ~- -.. Roductive expenditures Unproductiveexpenditures i Other expenditures L~~I~~__~_______-~.=____=. .. - ... Source: Kneller, Bleaney and Gemmell(l999); Source: Kneller, Bleaney and Gemmell(l999); Montenegrin Ministry o f Finance for the data. Montenegrin Ministry o f Finance for the data. 3.26 On the expenditure side, productive expenditures have increased while unproductive expenditures have declined slightly (Figure 3.11).Productive expenditures-defined as the sum total o f expenditures on general public services, defense, public order and safety, educational expenditures, health expenditures, housing expenditures, and expenditures on transportation and communications-rose from abut 24 percent o f GDP in 2002 to 27.5 percent in2004. On the other hand, unproductive expenditures- consisting o f social security and welfare expenditures and expenditures on recreation and economic services-declined from 18 percent in2002 to 16.8 percent in2004. 3.27 Onthe whole, it appears that Montenegro's fiscal policy over the last three years has shifted slightly in favor of growth. Still, it has a long way to go. On the one hand, distortionary taxation and unproductive expenditures were reduced; on the other, non-distortionary taxation and productive expenditures were increased. These changes should generally bode well for growth. However, two points should be emphasized. First, the aggregation o f the functional classifications into distortionary/ non- distortionary and non-productive/productive expenditures in Table 3.1 i s not uncontroversial. In particular, productive expenditures in Montenegro rose in large part because the framework classifies general public administration and defense and public order and safety expenditures as productive expenditures. However, while a reasonable level o f spending on basic law and order, police, and administration can rightly count as productive, it could be argued that these expenditures are not wholly productive in Montenegro in view o f the excess staffing prevalent in public administration and in the police and public order sector. Second, even if there were no issues with aggregation, the conclusion would mean that, while progress has been made over the last three years, Montenegro still needs to reorient its fiscal policy towards growth by increasing productive expenditures and reducing distortional sources o f financing. 49 Montenegro's Public Investment Program 3.28 Montenegro's domestically financed capital expenditure in 2004 accounted for about 2 percent of GDP (Table 3.2). Capital expenditures financed through program and project loans are not integrated into the Government data on capital expenditures, but are estimated to constitute slightly over 50 percent o f total capital expenditures in Montenegro (Ministry o f Finance). Data on donor-financed capital expenditure are neither regularly reported by donors nor collected by the Government. Similarly, although local governments/municipalitiesare involved in the provision o f basic utilities, their capital investment is not tracked by the Ministry o f Finance, in part because local governments are not yet integrated into general government reporting (charts o f accounts for local governments are being finalized). Table 3.2. Montenegro's Capital Expenditureby Function, 2004" (euros) Functional classification Capital expenditures % of Total Other economic affairs 6,335,000.0 22.68 Generalpublic services 6,016,972.0 21.54 Transportation 6,O 10,703.4 21.52 Health service 3,2 18,794.7 11.52 Public order and safety 3,086,264.8 11.05 Education 1,347,280.0 4.82 Militaryandcivil defense with administration 1,000,000.0 3.58 Social welfare and social protection 502,000.0 1.80 Sports, cultural andreligious activities 326,000.0 1.17 Housing and utility affairs and services 64,100.0 0.23 Agriculture, forestry, hunting and fishing 20,000.0 0.07 Other expenditures 5,000.0 0.02 Energy 0.0 0.00 Mining 0.0 0.00 TOTAL 27,932,114.9 100.00 Table does not include externally financed capital expenditure. Source: Montenegrin Ministry of Finance. 3.29 In 2004, over 85 percent of domestically financed capital expenditures went to five major functions-economic affairs, general public services, transportation, health services, and public order and safety, in that order. Within economic affairs, by far the largest share-nearly 90 percent -of the capital investment went to development projects. Tourism received only 30,000 euros, or about 0.5 percent o f the capital investment on economic affairs. Within general public services, capital investment was made in general services (about 67 percent) and executive and legislative bodies (about 32 percent). There was virtually no investment inresearch and development (only 2,000 euros). The bulk o f capital investment in public order and safety went to police and firefighter protection (over 85 percent). Capital investment in health and in education accounted for about 11 and 5 percent, respectively, of total capital investment. 3.30 Capital investment in infrastructure accounted for only about 20 percent of total capital investment, or about 0.4 percent of GDP. Within infrastructure, most o f the capital investment was made in land transportation, namely, construction and maintenance o f roads (slightly over 50 percent), and railroad transportation (about 33 percent). The rest went to water transportation and communication (about 10 percent). Air transportation, pipelines and other transportation systems, and communications affairs received no capital investment. Montenegro would need to create budgetary space for capital investmentingeneral, and, inparticular, for well targeted infrastructure investment that would effectively support the development o f its tourism industry-the main potential for growth. 50 D. BUDGETPROCESSES,MEDIUM-TERM PLANNING,AND GROWTH 3.3 1 Apart from tackling sustainability and allocation issues, Montenegro would need to strengthen its budgetary processes and institutions to ensure a more efficient and transparent utilization o f existing public expenditures. Effective budget management, including medium-term sectoral plans effectively tied to the budget, i s central to maximizing the impact o f current public expenditure on growth and service delivery. While Montenegro has made progress in recent years, there are still challenges with respect to addressingthe arrears problem (a symptom of bothbudget preparationand executionproblems) as well as establishing a medium-term expenditure plan that effectively links sectoral development plans with the budget. TheBudget Formulation Process 3.32 Montenegro's Organic Budget Law, adopted in 2001, provides a framework for budget formulation and execution. The Law assigns responsibilities to the Ministry o f Finance (MoF) to issue detailed subordinate regulations to guide the processes. The M o F i s responsible for managing the budget preparation process for the central government. The budgets o f municipalities and social funds are prepared by their respective bodies. Montenegro's budget for 2005 already contains tables with the consolidated budgets o f the central government and social funds, but a new harmonized chart of accounts i s being adopted that would allow for the consolidationo f municipal budgets into the general government budget as well. The budget, however, i s still not fully comprehensive as it does not include municipalities and, insome cases foreign-financed programs and projects. 3.33 Montenegro's budget preparation process begins in June with the preparation of the macroeconomic and fiscal policy framework for the next fiscal year, which in turn defines the overall budget resource envelope.The MoF then issues circular instructions, with expenditure ceilings for each spending agency and the formats for budget submission. Requests for funding would also include planned spending from the so-called "own revenues" o f budget users. While the M o F i s not responsible for funding those programs and activities planned to be financed from own revenues, all own revenues realized at the level above the plannedfigure become public revenues and cannot be usedby budget users. 3.34 The spending agencies then prepare their budgets according to the format provided by the MoF and submit their budgetsto the MoFin September. Budget planning at the spending agencies is based mainly on historical costs. Although the Government has recently developed a medium-term fiscal framework covering three years (2005-2007), very few budget users have started preparingprogrammatic budgets. The final budget allocation outcome would involve negotiations. After negotiations, budget analysts from the M o F work with the budget officer o f the respective spending agency to fit demands within the approved level of spending. The consolidated draft budget i s then approved by the Government and forwarded to the Parliament in November for voting. The voted budget i s published in the official Gazette to informbudget users and citizens o f budget allocations. Budget Execution and theArrears Problem 3.35 All budget users, except for higher education and institutions of culture, pass through a central Treasury system. The Treasury approves and sends a monthly spending schedule to each budget user. Also, it closely monitors revenue collection each month and pays the invoices sent by budget beneficiaries, according to available funds. A quarterly analysis o f the compliance o f execution with plans 51 i s conducted. At year-end, the M o F prepares final accounts, which are then audited by an independent auditor.66 3.36 Montenegro's overall budget execution has improved in recent years, but execution varies considerably across categories (Table 3.3). The overall index o f budget execution-expressed as a ratio o f the actual budget outturn to the planned budget-improved from about 90 percent in 2002 to 97.7 percent in 2004.67Yet there have been significant variations by economic and functional composition. By economic composition, debt servicing (with a persistent execution several hundred times higher than plan) and interest payments, and the wage bill, had the highest index o f execution. The items with the lowest index o f execution were capital investment (57 percent) and maintenance and operational costs (77 percent). By functional composition, actual spending on general public services has consistently exceeded plan, with an index o f execution o f over 100 percent. The lowest ratio o f budget outturn to plan has been withregardto economic services, with only 52.2 percent o fthe plannedbudget actually realizedin2003. Table 3.3. Budget Executionby Economic Items, 2002 2004 - Economic classification 2002 2003 2004 Gross salaries 75.7 89.7 94.9 Allowances 88.4 77.6 95.4 Goods and services 78.5 84.6 77.1 Interest 72.2 55.7 135.3 Rent 72.2 84.1 91.8 Subsidies 74.1 87.2 92.2 Grants and social benefits 84.1 85.8 78.1 Other expenditures 71.9 80.9 88.7 Capital expenditures 69.0 59.4 57.1 Loans and credits 64.5 55.9 84.6 Reserves 99.3 85.6 123.8 Total 89.5 94.5 97.7 Source: Montenegrin Ministry o f Finance. 3.37 Montenegro's large arrears, defined as the difference between accrued and paid expenditures, are symptomatic of continued budget formulatiodexecution problems. As at end- 2004, total arrears o f the central government6' stood at 1.3 percent o f GDP (19.7 million). By functions, the largest arrears have been generated toward defense and police (31 percent) and the Health Fund (27 percent), followed by economic services (18 percent) and education (13 percent) (Figure 3.12). Within economic services, most arrears have been generated in the transportation and infrastructure sector. By economic items, the bulk o f the arrears constituted unpaid social benefits and transfers (32 percent), unpaid maintenance and operational costs (26.6 percent) and unpaid health insurance contributions to the Health Fund(16.4 percent). Until2005, Deloitte & Touche, a private auditing firm, has audited government accounts inMontenegro. For the first time in2005, government accounts are expected to be audited by the new Supreme Audit Institutionof Montenegro (which hasjust been established). 67 This is a simple average o fthe ratio o f actual budgetto plannedbudget across all economic classification items. General government arrears, inclusive o f arrears generated by social funds and municipalities, are probably much larger but no complete data are available. 52 3.38 Arrears seem to arise for several reasons in Montenegro. They arise first of all because revenue projections by the M o F often turn out to be more optimistic than actual revenues. Inthe recent years there have been consistent shortfalls inrevenue collection o f 3 percent to 5 percent each year, inpart because o frecent tax cut measures by the Government. Withrevenue shortfalls, the Treasury takes expenditure measures to bring expenditures in line with resources, and advises spending agencies to adjust their spending a~cordingly.~'However, this notification comes each time with several months' delay, thereby creating the conditions for the arrears to be generated by the spending agencies or budget users. The time gap between the points at which revenue shortfalls are identified and expenditure measures are adopted by the M o F and the spending agencies leaves a gap o f months for budget users to create arrears. The following year, budget users have to first pay o f f the arrears before malung any new commitments. However, while budget users are paying last year's arrears, new arrears in the current year would be generatedthat roll over to the next year, thereby perpetuating the cycle. 3.39 However, not all of these arrears are due to poorly planned revenues. The problem arises in part because of lack of good commitment control at the spending agencies. The Department o f Internal Auditing was formed within the M o F only about a year ago. With the establishment o f the Department, several internal controllers have been trained to review transactions related to the inflows, commitments and outflows o f budget users in 2004. By the end o f 2004, the Internal Control conducted budget reviews for seven minor budget beneficiaries. The preliminary findings o f this assessment are: (1) all budget users do not properly plan their needs and often are forced to spend funds budgeted for one item On something (ii) there is a lack o f budget officers and Figure 3.12. Central Government Arrears as at end-2004, by accountants in some institutions; FunctionalComposition ~ (iii)the even existing budget ~~ officers are not well enough trained I Health to perform all o f the expected Economc services Public safety tasks; and (iv) there i s a need to Defense improve the quality o f financial I Education statements as well as transparency. General governmnt services I Sport, recreation and religion 3.40 Arrears undermine 7% Social protection ~ budget efficiency, effectiveness 16% Housing and growth for two main predictability of reasons. First, arrears weaken the budget and Source. IMF; MontenegrinMinistry of Finance. planning by spending agencieshudget users. Budget users cannot plan in advance or focus on program effectiveness, efficiency, and improved productivity ifthey must spend most o f their time fighting arrears or battling for funds to operate their program. Second, arrears may be costly, especially when they are owed to suppliers o f goods and services and especially if interest has accrued on them. For these reasons, the Government of Montenegro would need to take two key steps to address the arrears problem. First, the Government would needto prevent arrears from ansingbyproviding better and more realistic revenue projections as well as speedy expenditure decisions to be implemented by budget users in the event o f revenue shortfalls and by strengthening the commitment control systems at the spending agencies through the upgrading o f staffing, accounting standards, and transparency. Second, the Government would have to develop a serious plan to clear the current stock o f arrears. Unfortunately, the Government has not yet initiated a systematic plan to audit and clear the arrears. Such a plan should identify the most costly arrears, and attempt to retire those first. 69In2004 the MoF issuedso-called "Saving measures" where it announced budget cuts of14.9 million (proportionally across beneficiaries). Most o f the cuts came from capital spending, maintenance and operational costs and subsidies to enterprises. 53 Medium Term Planning and Growth - 3.41 The MoFhas already takenthe initialstepstoward providing a Medium-TermExpenditure Framework. In its current form, the framework consists o f projections o f revenues, expenditures by economic item and financing for the central government for the next three years. While this i s a step forward, it i s far from being a full MTEF. The framework lacks the consolidation o f total public expenditures, in particular the budgets o f municipalities, as well as bottom-up medium-term sectoral budgeting and analysis. Bottom-up costing and multi-year budget planning by budget users i s critical to achieving an effective link between sector policies and budgets at the micro level, and between broad national policy and development priorities and the budget at the macro level. 3.42 The link betweenpolicy prioritiesand the budget is weak in Montenegro. Many sectors and spending agencies lack medium-term planning and budgeting, which weakens not only the link between policies programs and the budget but the link between public expenditures and growth. A good example i s provided by the tourism sector. Tourism i s indicated as a priority sector for development in virtually all Government papers, including the Economic Reform Agenda. The Ministry o f Tourism has a very detailed strategy (called Tourism Master Plan) for tourism development, which indicates programs and activities that would need to be undertaken in the medium term to long term. However, the strategy has not been translated into a programmatic budget, and the Government remains uncommitted to any medium-tern budget for tourism development even though the sector i s regarded as the main source o f growth. This lack o f an effective link between the medium-term tourism development strategy and the budget inturn undermines medium-term growth inMontenegro." Similarly, Montenegro's PRSP remains unimplementedto date inpart because it has not been well linked with the budget. 3.43 Finally, a functioning MTEF could be an effective way to capture the various sources of funding for public investment, including investments by municipalities.Municipal spending is very important in infrastructure, as many o f the investments are undertaken at this level o f government. Again, to take tourism development as an example, most o f the programs are likely to be multi-year and multi- sectoral (involving different institutions at the same or different levels o f government). Short-term budgeting i s not an optimal arrangement for ensuring the financial commitments o f various implementing agencies inguaranteeing program sustainability and growth. E. CONCLUSIONS AND POLICYRECOMMENDATIONS 3.44 Montenegro's current fiscal position is not sustainable. At the end o f 2004, Montenegro's estimated debt-to-GDP ratio was 43.8 percent o f GDP. Under the simplifying assumptions that the economy grows at a constant real rate o f 4 percent per year, and that the real interest rate i s constant at 5 percent, a recent analysis by the World Bank finds that a primary budget balance o f 0.4 percent i s needed for Montenegro to achieve long-run fiscal sustainability. Yet, Montenegro's primary fiscal balance over the past two years was close to a deficit o f 2 percent o f GDP, and current projections for the primary balance suggest a deficit o f just over 1 percent o f GDP in 2005. This i s well short o f the surplus of 0.4 percent o f GDP needed for fiscal sustainability. A substantial fiscal tightening-in the order o f 1percent o f GDP-- i s needed to achieve fiscal sustainability. While a higher growth rate and access to concessional financing can supplement such effort, fiscal reforms would take center stage. 3.45 The scope for further fiscal tightening as well as reallocation to public investment lies in reducingexpenditures on the wage bill, transfers to households, lendingto public enterprises, and interestpayments.Montenegro spends about three-fourths o fits expenditure on wages and various social ' OThis o f course assumes that money allocated to tourism development would be usedeffectively. 54 benefits to households. A comparison with regional states shows that Montenegro's wage bill as a proportion o f total government expenditure and o f GDP i s far above average. On the other hand, capital expenditure i s much below the level for other countries inthe region. Inparticular, the high wage growth has crowded out spending on public investment and operations and maintenance-expenditures that are essential for growth. Subsidies and lending to public enterprises have been progressively reduced over the last three years, but much remains to be done to impose a full hard budget constraint on public enterprises. Combined, direct enterprise subsidies and loans to enterprises accounted for about 1.6 percent o f GDP in 2004. The large, yet-to-be-privatized state-owned enterprises (e.g., KAF', EPCG) still lack hard budget constraints and budgetary discipline and therefore take resources away from other priority areas o f expenditure such as capital investment ininfrastructure. 3.46 A more vigorous public sector reform is fundamental to creating a budgetary space for capital investment and rationalizingthe state's functions, and also reducing the role of the state in the economy. The following measures deserve priority consideration in order to ensure fiscal sustainability and macroeconomic stability, create a budgetary space for capital investment, and improve the delivery o f social services. 0 Reduce/control expenditures on the wage bill, transfers to households, and interest payments, which have risen significantly over the last three years. Inparticular, the high wage growth has crowded out spending on public investment and operations and maintenance-expenditures that are essential for growth. The high wage growth should be controlled through public administration reforms that would eliminate employment redundancies as well as through the controlling o f wage and salary increases (see chapter 2 for other measures). 0 Eliminateh-educesubsidies and lending topublic enterprises by imposing a complete hard budget constraint. Government subsidies and net lending now account for about 1.6 percent of GDP. State-owned enterprises still lack hard budget constraints and budgetary discipline. This problem could be overcome through (i) increasing the transparency around which state-owned enterprises receive subsidies and transfers from the Government; (ii)completing the privatization of these enterprises where privatization i s an option; and (iii) privatization i s not feasible, by where improving the management of such enterprises and defining strict financial performance criteria that would phase-out subsidies and budget transfers. 0 Develop a sound public investment program that will support tourism development and growth. At 2 percent o f GDP, Montenegro's domestically financed capital expenditure is muchbelow the level o f other countries in the region. Capital investment in infrastructure in 2004 accounted for only about 0.4 percent o f GDP. While the low numbers may indicate the need for more capital investment, in particular infrastructure investment, such a decision i s best guided by two prior conditions: (i) that there i s a trade-off between a public infrastructure investment program and macro stabilityhiscal sustainability, and whatever investment in public infrastructure needs to be made within the broader macroeconomic and fiscal constraints; (ii)that a rigorous public investment project appraisal and screening system i s put in place to rank public investment projects, and fund only those which are strongly growth-oriented and whose economic and social returns are high enough. In Montenegro, there i s a need to do both a strategic assessment o f what infrastructure investment may be needed, and which o f the many potential infrastructure projects warrant investment based on their economic and social returns. There i s n o doubt that increasing capital investment, inparticular in infiastructure, i s necessary. The challenge would be to do this ina way that does not compromise fiscal and macroeconomic sustainability (i.e., createbudgetary space), and to carefully evaluate and fund only those infrastructure investments that are strongly linked to tourism development and growth (i.e. well-targeted investments). 55 Increase the productivity of current expenditures on education and health care services. Compared with other countries in the region, Montenegro spends more on education and health. In the health sector it is important to improve the management o f public health funds, continue the reform o f primary health care, including preventive programs and priority treatment programs, and improve public procurement procedures by passing new regulations. In education the disproportionate staffing costs should be reduced through school consolidation, and vocational training programs should be realigned to suit those demandedby the labor market. 3.47 Furthermore, the Government would need to strengthen institutional and budgetary processes, in terms o f both controlling arrears and strengthening the link between budgets, plans and programs. The following specific steps are necessary to increase the effectiveness o f the Government budget and its link with growth: 0 Prevent arrears from arising through the following: (i) providing better and more realistic revenue projections as well as speedy expenditure decisions to be implementedby budget users in the event o f revenue shortfalls; (ii) strengthening the commitment control systems at spending agencies through better staffing, the upgradingo f accounting standards, and transparency. Develop a serious plan to clear the current stock of arrears. Unfortunately, the Government has not yet initiated a systematic plan to audit and clear the arrears. This plan should identify the most costly arrears and attempt to retire those first. 0 Strengthen the link between policy priorities and the budget, especially in tourism development and PRSP implementation. There i s a need to develop a comprehensive medium term expenditure framework as a basis for public expenditure planning. This should comprise the central government, the social funds, and local governments, and should reflect fully the policy commitments o f the Government. The Government budget generally, and public investment particularly, should support the realization o f the growth potential o f tourism. The Ministry o f Tourism should move toward multi-year budgeting and program implementation, with specific milestones and monitorable targets. 56 4. PRIVATEAND FINANCIALSECTOR REFORMS FOR GROWTHAND COMPETITIVENESS 4.1 The development o f a competitive private sector, including a vibrant SME component, i s essential for generating sustainable economic growth and employment. This chapter addresses three questions. First, in view o f Montenegro's large informal private sector, it seeks to answer the question of why the informal sector is large and what the Government can do to expand the formal economy. The emphasis will be on the incentives and disincentives for operating inthe informal economy, including the highburdens and the poor administrative and institutional capacity o f the Government to enforce rules and operate in a transparent way. Second, the chapter will look into other key constraints that hold back private investment and growth, in both the formal and informal sectors o f the economy. Consistent with the hypotheses laid out in Chapter 1, we will examine closely the extent to which enterprise restructuring, property rights and contract enforcement, bankruptcy and exit, and the cost o f finance and financial intermediation constrain private sector investment and growth. Third, the chapter will identify policy priorities and suggest recommendations for private sector growth and competitiveness inMontenegro. A. CHARACTERISTICSOFTHE PRIVATESECTORINMONTENEGRO 4.2 Under the socialist system of the former Yugoslavia, socially owned industries and services generated most of the income (GDP) in the Republic. During the socialist period, the Government made large investments in state-owned enterprises (S0Es)-notably aluminum production, steel production, ship -building and repairs and tourism-that served the captive former Yugoslav markets. With Montenegro's transition reforms, many o f these socially owned enterprises have been privatized. According to the Montenegrin Privatization Council, more than 60 percent o f the former socially owned or state-owned capital has been privatized. However, as o f the start o f 2005, controlling shares in the 17 or so largest companies still remain in the hands o f the Government and social funds. Among these companies are the Aluminum Combine Podgorica (KAP) and the Power Company o f Montenegro (Elektroprivreda Crne Gore), which continue to play an important role in terms o f production and employment. Table4.1. RegisteredBusinessesby Type,2005 Businesses Number Joint Stock Companies 377 LimitedLiability Companies 10,319 Limited Partnerships 627 General Partnerships 68 Entrepreneurs 13,090 Brancheslaffiliates o f foreign companies 265 NGOs 226 Institutions 704 Other 99 Total 25,775 Source: Commercial Court Podgorica, January 2005. 4.3 Interms of employment,the publicsector continuesto dominate the Montenegrineconomy. According to the 2003 Labor Force Survey data, 59.2 percent o f employment took place in the public sector (including the Government-provided public services, such as the civil service, the health and education sector, and social protection), 25.7 percent took place in private sector, and the rest was in mixedownership. More than 64 percent o ftotal employment is inthe services sectors, and by the number of employees, agriculture, trade and tourism-related services are the key branches in the economy (see Chapter 2). 4.4 The private sector's contributions to GDP and employment remain modest. Business registration data show that there are over 10,000 limited liability companies, over 300 joint stock companies, and over 13,000 entrepreneurs (Table 4.1). While it i s very difficult to extrapolate from such data the extent o f the contribution o f the private sector to income and employment, most o f the limited liability companies are likely to be SMEs in the private sector. In terms o f employment, the emerging private sector, comprised o f small firms, has not yet developed the critical mass to generate enough jobs to offset job losses in the public sector. The result has been a rise in unemployment over the last several years (see Chapter 2 for more details). Facilitating the entry o f new firms and the growth o f small enterprises i s hence necessary to create morejobs and reduce unemployment. 4.5 Over the years, the Government's Figure 4.1. Total FDIAchieved in Montenegro privatization program has clearly helped through Privatization, 1997-2004 encourage private investment, including foreign direct investment (FDI), in 80 Montenegro. During 1997-2004, total FDI in 70 - Montenegro amounted to 382 million euros. Of { this, the largest amount was achieved through /A\ 39.99 4 0 - the privatization process. Over the same period, .i30 - the total price o f assets sold through privatization a 2 0 ~ amounted to 141.4 million euros, while the new 10 - owners made a total additional investment in the 0 amount o f 144.09 million euros (see Figure 4.1). While Montenegro had the lowest total inflow o f foreign investments in the region in absolute Source:Agency for Restructuring and Foreign terms, FDI per capita (71 euros) remained close Investments. to the regional average. 4.6 The privatization o f Telecom Montenegro and KAP, completed as o f early 2005, and the expected privatization o f the remaining large strategic SOEs, mainly in the area o f infrastructure and public utilities in 2006, are expected to bring further FDIinflows. Thus, in the short run the FDI inflow will depend predominantly on progress inprivatization. However, inthe mediumto long-term, Greenfield investments in Montenegro will depend upon broader investment climate factors such as political stability, the protection o f property rights, and contract enforcement (in particular, land property rights, regulations and governance) and financial intermediation and the availability o f credit. These issues are discussed at length throughout the rest o f this chapter. 4.7 The most highly visible feature of Montenegro's economy, however, i s the large and persistent informal sector. It i s estimated that the informal economy contributes about 30 percent o f GDP and employs about 27 percent o f the workforce (ISSP, 2004). A large number o f firms (or entrepreneurs) do not participate inthe formal sector because they seek to avoid taxes, and regulation and other administrative processes. Apart from purely gray economy firms, a significant number o f registered enterprises under-report their business activities to avoid taxes and administrative hassles. Even formal sector enterprises try to keep their activities "blended" with informality in order to avoid the administrative and financial burdens o f regulation. According to the Productivity and Investment Climate Survey o f 2003(PICS, 2003), firms in Montenegro perceived that their competitors reported on average only 70 percent o f their business activities. Whether a firm i s unregistered and entirely in the informal sector or i s only partly outside the formal economy, it poses a threat to those firms that operate legally. 58 4.8 A large informal economy limits growth and competitiveness in a number o f ways. First, by definition, the sector i s beyond the realm o f government control, and as such, does not contribute to government revenue. Inturn, the sector does not receive property right protection and other services that formal sector businesses enjoy. Second, informal businesses pose an undue competition to those in the formal sector as they are not subject to tax and other government obligations. Indeed, in Montenegro a recent PICS survey shows that the uneven playing field posed by informal businesses i s a major barrier to doing business (Figure 4.2). For these reasons, conversion o f informal businesses into formal businesses through reforming the underlying policy, regulatory and administrative barriers affecting the former would be essential for growth. Figure4.2. PerceivedConstraintsto DoingBusinessinMontenegro ~- B. WHY I STHE INFORMAL SECTORLARGE? 4.9 Businessescomparethe costs and benefits of operating in the formal sector against those of the informalsector to make decisions about whether to operate formally or informally.On the one (incentives) hand, there are often regulatory and administrative costs involved in complying with formal sector government rules, including registration and licensing, level of taxes and other contributions required o f formal sector businesses, and other operational costs associated with being in the formal sector. On the other hand, businesses also take into account the extent to which they can continue to operate in the informal sector without facing negative consequences for failing to comply with Government rules, and the question o f whether they would face legal actions by the Government. 4.10 According to the EBRD's Transition Report 2000, incentives for participation in the informalsector differ depending on the country's stage of reform.Ineconomies at a mature stage of reform (e.g., Central and Eastern European countries), the motives tend to be more "market-related" and guidedby a desire to evade taxes and avoid other bureaucratic constraints. Ineconomies at an initial stage of reform, informal activity may be driven by poor opportunities in the formal sector and could be providing a "coping strategy" for survival. In Montenegro, the key reasons for the large informal economy seem to be the high regulatory and administrative burdens on businesses on the one hand, and the poor administrative and institutional capacity and the relatively poor opportunities inthe formal sector on the other. TheRegulatory and Administrative Burden 4.11 Montenegro has recently simplified its business registration system. Heavier regulation o f 59 entry i s generally associated with greater corruption and a larger informal economy.71Since end-2002, Montenegro has had a much reformed new business registration system in place. A burdensome registrationprocedure which had involved 38 steps and 45 days was streamlined to 4 steps and 3 days.72 The new Company Law has lowered the minimumcapital requirement for limitedliability companies to 1 euro. Table 4.2 compares the indicators for starting a business in Montenegro with the region and the OECD countries. The outcome has been a reporteddoubling o f business registrations over a period o f one year, most o f which have been drawn from previously unregistered businesses engaged in the gray economy. Notwithstanding other remaining regulatory and administrative deficiencies, business registrationreform clearly demonstrates how the removal o f the regulatory burdencould help enterprises move from the informal to the formal economy. Table 4.2. Starting a Business Indicator Montenegro Regional Average OECD Average Number o f procedures 9 9 6 Time (days) 11 42 25 Cost (% o f income per capita) NA 15.5 8.0 Min.capital (% ofincomeper capita) 0.1 52.8 44.1 Source: World Bank, Doing Business in 2005: Removing Obstacles to Growth, Washington, DC, 2004; CEED usingthe DoingBusiness methodology. 4.12 Despite the simplified registration process, licensing and inspection problems remain cumbersome and slow, and deter formality and private investment. Recognizing this problem, the Government prepared the draft Law on Licensing, prescribing a faster and more efficient registration at the municipality level and listing the business activities that do not need a license. However, the simplified procedure has not yet been implemented. According to the Law on Local Self-Government, the 21 municipalities in Montenegro are responsible for urban planning, including zoning and building permits, general licensing o f businesses and related permits, the provision o f utility services (waste collection, water, sewerage and electricity distribution), and also various inspections. However, as a recent FIAS study shows (FIAS, Montenegro Investment Environment Diagnostics, 2004), business operating licenses take a long time to be issued, if they are issued at all. Licensing and inspection activities are not conducted in a fair, professional way. While visible and legal businesses are extensively inspected, there i s no noticeable effort to crack down on illegal businesses that operate without a license, avoid tax and social security payments, and/or establish the business premises without buildingpermits. Local land use plans are not adjusted to accommodate the needs o f business expansion. These factors are regarded as key impedimentsto doing business inthe regulatoryjurisdiction o f local governments. 4.13 Payroll taxes and social contributions are still high in Montenegro, discouraging formal sector operation. Several taxes apply to formal sector businesses in Montenegro. The most important o f these are the value-added tax (at 17 percent), the corporate tax (at 9 per~ent)'~and the personal income tax (ranging from 0 to 23 percent, with the maximum rate applied to personal income over 4,572). While these taxes are not out o f line with the regional rates, and, indeed, the corporate tax rate i s one o f the lowest, the high payroll taxes raise the cost o f labor, thereby creating incentives for hiring workers informally. 71 See Djankov S., R. L a Porta, F. Lopez de Silanes and A. Schleifer. "The Regulation o f Entry", Quarterly Journal o f Economics, 117, 1-37, (2002) 72 CEED, 2003, "Montenegro business registration process analysis"; and, CEED "Starting a business". 73Amendments to Montenegro's Corporate Tax Law inthe third quarter of 2004 decreased the corporate tax rate fromthe prior progressive rates of 15 and 20 percent to a proportional rate of 9 percent, one ofthe lowest corporate taxes inthe region. 60 4.14 Recent reforms have helped reduce the payroll tax and contributions burden. Table 4.3 shows the total labor cost as a percentage o f gross salary for employees and employers inrecent years. In April 2003, in response to widespread avoidance and non-compliance, the Government of Montenegro reduced the overall income tax, and social contributions (pensions, health and unemployment insurance) by the employer for newly registered labor, effective for one year untilMay 2004. The effective rate tax wedge on labor, which takes account o f tax deductions, different social contribution levels by sectors, and non-compliance, was thus reduced to about 48 percent in 2003, At the same time, fines were increased for employing unregistered labor and inspections were strengthened as part o f the 2003 reforms. According to Ministry o f Labor officials interviewed, the policy resulted in 14,300 new registrations by the end o f June and a claimed 26,000 by the end o f September. Table 4.3. Income Taxes, Social Contributions and Other Fees and Surtaxes on Wages in Montenegro (percent of gross salary) Employed Newly employed Employed in Contribution beforeApril betweenApril 2004 and hired Employedsince January 2o05 2003 December 2004 2003 and beforeApril 2003 1. Employees'share of contributions Pension-invalidinsurance -PI0 Fund 12.00% 12.00% 12.00% 12.00% HealthFund 7.50% 7.50% 7.50% 7.50% Unemployment 0.50% 0.50% 0.50% 0.50% 2. Employers' share of contributions Pension-invalidinsurance 12.00% 0% 10.8% 9.6% Health care 7.50% 0% 6.5% 6.0% Unemployment 0.50% 0% 0.5% 0.5% Compensation for use of public goods 3.00% 13-15% OfPIT 13-15% OfPIT Housing allowance 0.7% 0.7% Allowance for annual leave 150.0 150.0 150 150 Meal allowance 25.0 25.0 25 25 Montenegrin Chamber of Commerce 0.32% 0.32% 0.32% 0.32% Yugoslav Chamber of Commerce 0.125% 0% 0% 0% Alliance of IndependentTrade Unions 0.20% 0.20% 0.20% 0.20% 3. Total taxes and contributions 43.6-68.6% 20.5-44.5% 39-63y0plus 37 -60% PIUS Source: ISSP, 2003,2005. 4.15 Despite the recent reforms, the labor taxes (or payroll taxes) are still perceived as too high and as one of the major factors discouraging operation in the formal sector. There are two alternative indicators o f the wage tax burden: `the non-wage labor cost and the tax wedge on the labor market.74By our calculations, in 2004 the tax wedge-taking into consideration all the social contributions (pension, health insurance and employment contributions) as well as fees and surtaxes established according to the General Collective Agreement, the Law on Communal Taxes and Compensations and other laws-is estimated at 52 percent o f the labor Non-wage labor costs were estimated in2004 at 35 percent. In OECD countries, the total burden on the labor market i s 51.8 percent among European member countries 74 Non-wage labor cost i s defined as the ratio between payroll taxes and gross wages. The tax wedge o n labor i s a difference between the labor cost to the employer and the take home pay (net wage) expressed as a percentage o f total labor cost. 75 In2005, this legal basis for compensation (tax) for use o fgoods o f common interests o f 3 percent of gross wages was replaced by the Law on Local Self-Government Financing which allows the municipalities to introduce a surtax o f 13-15 percent o f the calculated personal income tax. 61 and 37.3 percent for non-European member countries. (ISSP Montenegro Economic Trends, 2004).76 Labor taxes lower labor demand by raising labor costs. But they also lower labor supply by reducing the real consumption wage. The high wage tax burden has contributed to lower employment, higher informalization, and higher (long-term) unemployment. 4.16 Administrative and bureaucratic costs are also high (Figure 4.3). The cost and time tax7' Figure 4.3. Montenegro's Costs of o f administrative processes and bureaucracy i s high Administrative Barriers Compared to Regional in Montenegro. According to PICS 2003, senior Countries management spends an average o f 13.6 percent o f I its time in dealing with requirements imposed by ~ government regulations such as taxes, customs, labor regulations, licensing and registration. The PICs data also shows that the procedures for obtaining licenses, permits and certificates required for business operation in Montenegro are not sufficiently transparent, which results in corruption. Together with Serbia, Montenegro appears higher on the bribe tax. Among surveyed firms, over 5 percent o f total annual sales were paid inunofficial Source: PICS 2003 for Montenegro and Serbia, BEEPS payments in Montenegro, more than twice the I1for other countries. regional average, excluding Serbia. Yet Mintenegrin firms perceive corruption to be a less severe obstacle to their business relative to other impediments, such as the cost o f finance, regulatory uncertainty, and contract enforcement and the judicial system. Governanceand the Institutional Capacity to Enforce Rules 4.17 Governance and the institutional capacity to enforce rules are weak Administrative and regulatory burdens, while providing incentives to being inthe formal economy, are not the only reason for the thriving informal sector. The lack o f effective and consistent application o f rules by the public sector contributes equally to the problem. 4.18 The regulatory process is characterized by inconsistency in the application of rules. According to the law, public servants shall effect the issuance o f permits, licenses and certificates in compliance with the law on General Administrative procedure, and a complainant i s secured the right to take his case before the Administrative Court. Inpractice, public servants use wide discretionary powers in making decisions that affect, for example, the issuance o f permits, licenses and certificates, and tax collection (FIAS, 2004). Visible and legal businesses are extensively inspected, but no noticeable effort i s made to crack down on illegal businesses that operate without a license, avoid taxes and social security 76Inadditionto personal income tax, P I 0 contributionand contributionto the HealthFund, the employees also have to pay from their wages an unemployment contribution o f 0.5 percent o f gross wages, the employers, in addition to P I 0 contribution and contribution to the Health Fund, have to pay an unemployment contribution o f 0.5 percent o f gross wages, a fee to the Chamber o f Commerce - 0.32 percent o f gross wages;, fee to the Confederation o f Independent Trade Unions - 0.20 percent o f gross wages; payment to the housing fund for employees 0.7 percent - of gross wages; compensation for use o f public goods - 3.0 percent o f gross wage (replaced in 2005 by 13-15 percent o f personal income tax (PIT); meal allowance o f 50 percent o f the minimumwage (EUR 25), and transport allowance 25 percent o f the price o f gasoline per km.(See Table 4.15 for details). 77The time that senior managers have to spend dealing with government officials and regulatory activities provides a measure o f the burden(so called "time tax") that regulationplaces on firms. 62 payments or establish a business premises without building permits. Such inconsistency provides opportunities for bribe taxes and corruption. Improvements in the quality o f regulation through greater transparency and a more consistent application o f rules, and an improved tax administration capacity to support rule-based tax collection, are needed. 4.19 The enforcement of rules is weak becauseof lack of skills and poor institutionalcapacity in the public sector. Although an adequate legal framework has been put inplace for public administration reforms, the Government has yet to fully implement the reforms. In March 2003 the Government approved a Public Administration Reform Strategy, which sets out the key objectives o f public administration reform and puts forward an ambitious structural and legislative reform agenda for the reorganization and re-orientation o f the state administration. The Strategy seeks to introduce new forms o f administrative accountability based on more flexible, result-oriented contractual models, including competition mechanisms in the provision o f public services. It also emphasizes the principles o f client- orientation and the importance o f a modem information system for enhancing the efficiency and quality o f public services. The Strategy divides the process o f administrative reform into three main stages: the first stage, from 2003 to 2004, concentrates on the development o f a legal fkamework; the second and third stages, from 2004 to 2006 and 2007 to 2009, are devotedto the implementation o f the Strategy and the adoption o f new rules and procedures. In accordance with the reform phases, a set o f key public administration laws-such as the Law on the State Administration, the Law on the Ombudsman and Law on Inspection Control, the Law on Administrative Procedure and the Law on Administrative Dispute - were approved by Parliament in 2003. A further set o f laws, including the Law on Civil Service and the Law on Salaries, was adopted in2004. 4.20 Yet Montenegro is only inthe beginning stages of the more difficult phase of implementing the public administration reforms.Agency heads are typically political appointees, which undermines effective administrative coordination and the continuity o f skills and knowledge, The public sector i s overstaffed and under-productive. L o w rates o f public sector pay contribute to the problem o f attracting and retaining competent professionals. Whatever the underlying factors, a modern public administration system, characterized by transparent, non-discretionary processes, and efficiency--although within reach in the medium term-- is yet to be created in Montenegro. This would require the putting in place of appropriate incentive and accountability systems and significant institutional capacity building through education, training, and the application o f information technology, as well as a coordinated action from a number o f key players to avoid the risk of administrative fragmentation. 4.21 Further, implementation of the new laws and regulations governing the private sector requires stronger institutional and administrative capacity. In the past three or four years, Montenegro has overhauled much o f its legal and regulatory framework regarding the private sector but implementation i s lagging behind (see Table 4.4). It was only in 2003 and 2004 that the Parliament o f Montenegro adopted 45 laws and 67 laws, respectively, out of which roughly 35 are related to the business environment or the financial sector. It i s hard to find an area that i s not covered by a new law or by a law being drafted, particularly in regard to the activities o f business and commerce (Table 4.4). While the new laws provide an adequate legislative framework for the development o f a well-functioning market economy, significant implementation gaps are emerging. Many o f the new laws have not yet been fully appliedby the administration, thejudiciary and the municipalities. Inmost cases, implementation o f legislation aimed at improving the business environment (contract enforcement, access to finance, corporate governance, and business exit) has not yet begun. Because o f the country's history, most o f the professionals do not have the experience, skills and motivation required for this kind o f work. One consequence has been that new legislation i s not broadly understood and i s not implemented with any effectiveness. 63 Table 4.4. Recent BusinessLaw Reforms inMontenegro and their Status of Implementation Group Businesslaw Legislati LegislationDate Implementatio FiscaYTax laws Tax AdministrationLaw 5 EnactedDec 2001 improved Personal Income Tax Law 5 EnactedDec 2001 improved CorporateProfit Tax Law 5 EnactedDec 2001 improved' ExciseTax Law 5 EnactedDec 2001 improved VAT Law 5 EnactedDec 2001 improved Budget/Treasury BudgetLaw 5 EnactedAug 2001 improved Law on Assumptionof Debt 5 EnactedOct 2003 improved Public Debt Law 5 EnactedFeb 2004 improved Law on State Auditing Institution Enactedearly 2004 started Anti-Corruption PublicProcurementLaw 5 EnactedAug 2001 improved Initiative Laws Anti-Corruption Practice Law 4 Anti-Money LaunderingLaw 5 EnactedOct 2003 improved Law on Participationof PrivateSector 5 EnactedJun 2002 weak inDelivery Public Services Digital SignatureLaw 5 EnactedOct 2003 not implemented E-commerceLaw 5 EnactedDec 2004 not implemented E-communicationsLaw 0 Privatization TelecommunicationsLaw 5 EnactedDec 2000 complete EnergyLaw 5 EnactedJun 2003 improved Tourism Law 5 EnactedJun 2002 improved RestitutionLaw 5 EnactedMar 2002 replaced(new) RestitutionLaw, New 5 EnactedMar 2004 ongoing BusinessLaw Business OrganizationLaw 5 EnactedJan 2002 weak Secured TransactionsLaw 5 EnactedJul 2002 improved AccountingLaw 5 EnactedJan 2002 (new draft) MortgageLaw 5 EnactedJul2004 started Revision- RealPropertyLaw 0 Anti-Monopoly Law 3 Unfair CompetitionLaw 3 Law on Licensing 2 ConsumersProtectionLaw 3 Law on ForeignTrade 5 EnactedApr 2004 ongoing ContractEnforcement Law on Enforcement Procedure 5 EnactedMay 2004 weak Litigation Law 5 EnactedMay 2004 weak Law on ExpertWitnesses 5 EnactedDec 2004 weak Bankruptcy+ CrossBorder Insolvency 5 EnactedJan 2002 weak Law BankingSector CentralBank Law 5 EnactedNov 2000 complete Law on Banks 5 EnactedNov 2000 complete Bank Bankruptcyand Liquidation Law 5 EnactedOct 2001 complete InsuranceLaw 3 Pension/SocialSector PensionLaw 5 EnactedSep 2003 ongoing Capital Markets Securities Law 5 EnactedDec 2000 weak Securities Law Amendments 1 InvestmentFundsLaw 5 EnactedJul2004 weak Status: 0 in preparation; 1 draft -working group; 2 draft -generalreview; 3 final draft submittedto GRM; 4 inParliament;5 enacted. Source; USAID; ht~:l/www.skur,stiria.cC!,yu/;World B a n k staff assessment. 4.22 There is lack of administrative and institutional capacity at the municipal level as well. Important decisions at the municipal level are often perceived by businesses as driven by narrowly determinedspecial political interests. Businesses feel that municipal decisions, taken or not taken, are ad hoc and non-transparent and do not reflect an appreciation o f commercial realities (FIAS, 2004). 64 c. WHAT OTHER CONSTRAINTSLIMITPRIVATE SECTOR INVESTMENTAND GROWTH? 4.23 Conversion o f the large informal economy to the formal economy-although a major challenge for the Government o f Montenegro-is not the only factor, nor perhaps even the most important constraint, affecting private sector investment and growth. Several other constraints that cut across the formal and informal sectors would needto be alleviated. Privatization and Enterprise Restructuring 4.24 Enterprise privatization and restructuring are far from complete. Though significant privatization o f socially owned enterprises has been accomplished over the years (see Chapter 1 for a summary), enterprise restructuring remains far from complete, and many companies privatized through the MVP continue to face significant economic and social problems. Although 12 foreign banks and investment funds took part in the establishment o f six privatization (investment) funds, the privatization funds could not function well (e.g., as mutual funds operate in the West), in part because most o f the shares owned by the voucher funds had no real market. The Montenegrin MVP program corporatized medium to large SOEs o f almost any quality and issued their shares in return for vouchers. Thus, the funds ended up with a portfolio full o f shares that were essentially illiquid at any significant price ("junk shares"). In addition, the trade in shares o f so many diffused owners has been slow at consolidation, making it difficult to find majority owners quickly. Restructuring has progressed more slowly than expected, partly because o f the much diversified ownership structure, which would require time to be concentrated in the process o f free trade in shares. In the meantime, the transition costs to the shareholders o f the companies and to the Government have been considerable. 4.25 Most companies privatized through the MVP lack the capital injection necessary to re- equip them with new technology, equipment and practices, andthus improvetheir profitabilityand competitiveness. By the nature o f their privatization, these companies did not have a strategic foreign investor that could bring the necessary capital and technology. Furthermore, even if with a strategic investor, under the Business Organization Law a two-thirds majority i s requiredto effect re-capitalization, and it appears that this i s creating an obstacle. Citizens, workers and investment fund shareholders appear reluctant to see their positions diluted, even if that would lead to higher profitability. There have been cases where potentially interested foreign investors have walked away in the face o f this obstacle (e.g., regardinginvestment ina shoe factory). 4.26 There is a lack of management and restructuringskills, even in cases where the privatized companies have been placed under new management. With diffused ownership and lack o f majority ownership, the MVP has been fairly ineffective in inducing changes in management and corporate governance. Even where the M V P has ledto management changes, the new management has continued to lack expertise in restructuring and developing viable business plans. In the absence o f restructuring expertise the companies have continued to perform poorly, which further undermines profitability, shareholders' values, and the private sector's ability to generate employment and growth. 4.27 Many of the "privatized" companies continue to be saddled with the high costs of excess labor and employment.Restructuringplans to shed excess labor remain unimplemented to date for two main reasons. The first reason i s that because the "privatization funds" lacked staff and resources, which rendered them ineffective in supporting company restructuring, including the shedding o f excess labor. The second reason is that, the Government agreed to fund the (social) costs of restructuring in many companies but inmany cases has not yet provided the fundingor severance payments needed to complete the reshcturing. Anecdotal evidence suggests that only 15 out o f 32 companies for which the Government promised to meet the social costs have been restructured. A relatively small number o f 65 significantly large companies continue to face the problem of severance payments expected from the Government which have not been made available to date.78 4.28 Lack of restructuring in many of these companies has severely curtailed the growth of the formal private sector. Inthe absence o f new investment and technology, and faced with the problem o f excess labor, and lack o f good corporate governance and management skills, many enterprise managers have performed poorly. The large unrestructured companies not only maintain a large excess capacity but also continue to tie labor and capital. The rates o f excess capacity among Montenegnn companies, as reported by the PICS 2003 data, average a high o f about 55 percent. While producing under capacity, these plants continue to occupy buildings and land located next to infrastructure (electricity, water and sewage connections) that could be better used in other productive activities. A more vigorous implementation o f restructuring and o f the Bankruptcy Law (see below) would permit, among other things, a faster reallocationo f assets and labor toward more productive activities. 4.29 However, there is hope that this is changing, if only very slowly. Currently, shares o f companies and investment unitsprivatized through the MVP are slowly being consolidated through trades in two stock exchanges, NEX Montenegro and the Montenegro Stock Exchange. This consolidation of shares into majority ownership may lead to management changes, the completion o f the restructuring plans, the introduction of new capital and technology, and better profitability and shareholders' value o f these companies. Bankruptcy and Enterprise Exit 4.30 An effective bankruptcy regime promotes efficiency and productivity in two ways. First, it supports creditors' rights and facilitates lending to firms that are going concerns. Second, the bankruptcyAiquidation regime promotes efficiency by enabling bankrupt firms to be financially or organizationally restructured, or by shuttingthem down and disposing o f their assets ifthey are not viable as going concerns. An efficient insolvency regime may also allow loan prices to remain l o w and facilitate access to credit. 4.31 Montenegro's new Bankruptcy Law, enacted in January 2002 and effective since July 1, 2003, is not yet fully implemented. By the end o f 2004, a bankruptcy procedure was initiated for 145 small enterprises, o f which 85 have been completed and 60 are ongoing. The procedure therefore seems expeditious for small private companies, and lasts from 3 to 6 months. 4.32 While the new bankruptcy law79seems to function reasonably well for small private companies in financial distress, it has worked less well for large companies privatized through vouchers that continue to accumulate losses. Most o f the unsolved bankruptcy cases as of the end o f 2004 (238 cases)(Figure 4.4) are for mediumand large enterprises. Of 194 bankruptcy cases started for medium and large enterprises before 2004, there are 134 still to be resolved (most o f which are linked to former MVP companies). A strict interpretation o f the Bankruptcy Law (Law on the Insolvency o f Business Organizations), which mandates that a corporation that has been illiquid for 60 days shall enter the bankruptcy procedure, would have implied a larger number o f bankruptcy cases, as there are many more illiquid companies. Furthermore, the duration o f cases i s much longer for medium and large enterprises, with the latter accounting for the bulk o f cases lasting over one year (21 percent) (Figure 4.5). ''The 2005 republicanbudget contains no allocation for such restructuring and severance payments. 79A new Bankruptcy Law was enacted inJanuary 2002 and took effect from 1July 2003. 66 Figure 4.4. Unsolved Bankruptcy and Figure 4.5. Duration of Bankruptcy Cases, 2004 Liquidation Cases ,2003-2004 250 238 200 - O w 1 Year I 150 - L Less than 3 100 Months 43% 50 0 Unsolved Cases at b d of 2003 Ulsolved Cases at b d of 2004 33% I No. of cases Bankruptcy ~iquldation I Source: Commercial Court of Podgorica. Source: Commercial Court of Podgorica. Contract Enfor cement and Property Rights 4.33 Most businesses in Montenegro do not rely on the courts to resolve commercial disputes. Figure4.6. Average Share of Sales Paid in Evidence shows that firms depend extensively on Advance by Clients (percent) informal practices and other institutions to enforce I contracts and reduce uncertainty in transactions. In particular, they rely heavily on pre-payments and on 25 1 buildinglong-lastingrelationships with suppliers and customers (Figure 4.6). In Montenegro, the average share o f sales paid in advance by business clients i s about 20 percent of the total sales value. This i s not only high but i s more than double the regional average, excluding Serbia. 4.34 The pro-debtor bias in the system stems - partly from the lack of capacity to enforce UAvarage share Of sales paid in advanos by ~lients(%) contracts in courts and from debtor provisions in Source: PICS andBEEPS. key legislation. Recently passed laws relating to contract enforcement" provide an improved legal framework for contract enforcement, through, among other things, shiftingthe burden o f proof fi-om courts to parties indispute, setting deadlines for submitting evidence, introducing the obligation o f the second instance court to reach a verdict and not to give a case back to the first instance court, etc. Nevertheless, the implementation o f the new laws has been weak to date (Table 4.5). These laws include: Law on Civil Procedure or LitigationLaw, Law on Enforcement Procedure, Law on Civil Lawsuit, Law on Criminal Procedure,Law on Courts, Law on Enforcement of Criminal Sanctions, Law on Executive Proceedings, Law on Assessors, and Law on Mortgage. 67 Table 4.5. Key Recent Contract EnforcementLegislationand ImplementationStatus Law LegislationDate ImplementationStatus" Law on Enforcement Procedure EnactedMay 2004 weak LitigationLaw EnactedMay 2004 weak Law on Expert Witnesses Bankruptcy + Cross Border Insolvency Law EnactedDec 2004 weak EnactedJan 2002 weak * Bank staff assessment. Source: USAIDand httu:/lwww.skuustina.cg.vu/ 4.35 In Montenegro, domestic and foreign investors see the poor functioningof the court system as a major impediment to doing business (FIAS, 2004). Business people's confidence in the independence o fjudges is low despite the judiciary's formal independence. Corruption in the courts i s a serious concern. Foreign investors perceive that preferential treatment is generally given to domestic investors in the courts. Investors hope that the new Law on Courts, which provides new procedures for judicial appointment' will create a pool o f more independent judges capable o f acting with greater independence and integrity. Also, many judges, particularly at the lower court level, appear to have difficulties in keeping abreast o f the rapid rate o f legislative changes and the associated new concepts being introduced inthe transition to a market economy. 4.36 The courts are too slow: it can take a year from the submissionof a claim to the Figure4.7. EstimatedDuration of Commercial handing down of a judgment. Enforcement Cases,2004 o f a title can take another 6 to 12 months (FIAS, 2004). Resorting to an appeals court could take a further 12 months. Overall, about 12% 40 percent o f the commercial court cases are .. resolved within less than 3 months; 33 percent ,,I UpTo3Months take up to 6 months; and about 28 percent o f 40% Up To 6 Months the cases take longer than 6 months (Figure ' Up To 9 Months 4.7). The average duration is too long, with Up To 1Year about 60 percent o f cases taking longer than Over 1Year six months to resolve. ___ 33% 4.37 Yet, the courts' performance has recently improved, in particular during 2004 (Figure 4.8). The introduction o f new legislation coupled with accelerated Source; Commercial Court of Podgorica. enforcement procedures, has helped to reduce somewhat the backlog, especially o f lawsuit and execution cases in 2004. While this reduction inthe backlog o f commercial cases is encouraging, commercial courts as well as courts in general are still overloaded with inactive or abandoned cases (Figure 4.9). 4.38 To further reduce the backlog of commercialcases and to speed up contract enforcement, several institutionalbottlenecks would need to be removed. First, the Montenegrinjudiciary has been under resources and personnel pressure for an extensive period o f time, and this would need to be reversed. Second, the system lacks qualifiedjudges, partly because the pay is low. Without qualified and independentjudges it is difficult to win public confidence in the courts. Finally, there is a strong need for court personnel to be trained, evaluated and compensated adequately, and for the court system's infrastructure to be upgraded, including the implementation o f a strong Judicial Information System. 4.39 With regard to property rights, land seems to be a key area in which further improvements are needed. The lack o f secure land property ownership is regarded as a significant problem for investors inMontenegro (FIAS, 2004). Montenegro's lack o f good property rights over landarises from absence o f good and readily available land titles information. Although land titles registration is computerized and not overly time consuming or costly, the Cadastral Office does not have adequate, reliable land information. This lack o f transparency and discretionary public access to information makes land title transfers risky for investors, and complicates the planning and approval activities o f municipalities. Figure 4.8. CommercialCourt Cases Solved, Figure 4.9. Unsolved Court Cases, End of 2000-2004 2003and2004 1600 7 6000 8oool 282 Number Of 40001 cases 2000 Lr E 600 542 579 400 194238 200 2000 2001 2002 2003 2004 67 23 Law suit Executions Bankruptcy Liquidation 11lawsuit IBanknrptcy o liquidation o Executions1 Type of Case 10Lhsotved Cases at h d of 2003 IUnsolvedCases at h dof 2004 Source: Commercial Court of Podgorica. Source: Commercial Court o f Podgorica. 4.40 Uncertain property rights in Montenegro would be reduced considerably if the land title information was made available by the Cadastral Office, and if it was required that land titles be accompanied by a certified site survey and pegging. In most developed countries, every parcel o f land and every building is represented in a property document that can be used as collateral for credit. The single most important source o f funds for new businesses in the United States i s a mortgage on the entrepreneur's house. Inthis way, life is injected into assets and they generate capital. FinancialIntermediation and the Cost ofFinance 4.4 1 Empirical evidence shows that the private sector obtains less external financing, especially less term financing, in countries with weak legal and financial systems.81The ability to finance activities through the sale o f equity on the capital markets will not become available to firms until the institutions supporting such a system are adequately developed. In the absence o f such finance, firms are forced to rely mostly on internal funds and retained earnings. This also means that financial sector reforms must extend beyond legislative reforms or bank restructuring and privatization, to the building o f institutions that underlie firm transparency and accountability. In addition, the small size o f the Montenegrin market poses a significant obstacle for the development o f a well-functioning financial and banking sector. 81Laporta, R., et a1,(1998); DemirgiipKunt, A. and V. Maksimovic, (1999), DemirgiipKunt, A. and V Maksimovic, (1998), Pagano, M(1993). 69 4.42 In the past four years the Montenegrin authorities have taken steps to improve the functioningof the financial sector, including privatizing state-owned banks and permitting the entry o f foreign banks.82 While these measures have helped improve the performance o f the financial sector, privatization and restructuring alone will have limited effects on the competitiveness o f the banking sector because o f the small size o f the market. A process o f further financial integration, in addition to having a positive effect on the development o f the national financial market, could help attract intermediaries from the more developed markets and enhance the access o f Montenegrin firms to financial markets, cross- border loans, and other financial services to the Montenegrin firms. Table 4.6. Structure of the Banking System, End-2004 State-owned Foreign-owned Banks Banks Local Private Total Number o f banks 2 3 5 10 Total Assets (million euros) 72.8 137.8 233.8 444.4 Share in Total 16% 31% 53% Total Capital (million euros) 21.5 29,2 40.0 90.8 Share in Total 24% 32% 44% Total Funds-mobilized 44.5 63.6 165.1 273.2 (million euros) Share in Total 16% 23% 60% Source: CentralBank of Montenegro (2005). 4.43 As of end-2004 Montenegro's banking system was comprised of ten banks,with 444 million euros in total assets (about 29.1 percent o f GDP)(Table 4.6). The total banking system assets increased by 95 million euros or about 27 percent in2004. Similar to that o f other transition countries, the financial system is centered on banks with the share o f bank assets over total assets held by financial institutions (banks, insurance companies, pension funds, securities firms, investment funds, etc.) of over 90 percenteg3 The Government holds a majority interest intwo banks and a direct or indirect minority ownership infive additional banks (about one-quarter o f the capital i s state owned). There i s no apparent shortage o f banks (compared to the other countries in the region, Montenegro leads in terms o f banks per 100,000 inhabitants - 1.6), but the cautious entry o f foreign banks into the Montenegrin market has thus far produced only limited gains: competition has increased slightly and some new products and services have been introduced. 4.44 Nevertheless, confidence has begun to return to the Montenegrin banking system recently. Progress in bank restructuring and the expansion in the market share o f foreign-owned banks have provided confidence in the banking sector. In 2004, loan-loss provisioning grew by 43 percent. Montenegro's overall ratio o f loan-loss provisions to non-performing loans (NPLs) now stands at 65 percent, in line with some better performing neighboring countries.84Reflecting the increasing confidence in the banking sector, total deposits increased by 29.5 percent in 2004 (reaching 273 million euros as of end-2004). The growth in deposits helped to produce the rapid increase in lending by commercial banks to private companies and natural persons (Figures 4.10 and 4.11). The credit growth appears to be linked 82Other reforms inthe financial sector includedthe establishmentofthe Central Bank and introduction of the euro as a legaltender, transfer ofthe clearing house functions to commercial banks and several legislative changes. 83Inmost CEEand SEE countriesthe share ofbank assetsover total assetsheldby financial institutions (banks, insurance companies, pension funds, securities firms, investmentfunds, leasingcompanies) exceeds 85 percent. 84However, as witnessedby the recent problems with Hipotekarna Banka, where significant roll-over ofnon- performing loans almost ledto a bank run, further loanprovisions are likely to be necessary as these new loans to private sector mature and some portion becomes delinquent. 70 to firms that generate high profits or to enterprises that have high revenue from partly informal operations. 4.45 However, total credits from banks to the private sector amount to only 11 percent of GDP. This is quite low compared to the regional countries (42.3 percent in Bosnia and Herzegovina, 26.6 percent in Bulgaria, 57.3 percent in Croatia, and 42.7 percent in Hungary),'' although credits to the private sector started to rise from fairly low levels in 2004. The ratio o f domestic credit to GDP, however, i s only a rough indicator o f financial intermediation, not least because credit may include non-performing loans from the past. Directed loans to state and socially owned enterprises or firms that were privatized :`::I through voucher privatization may not be declared fully as non-performing even though many o f these are overdue and are being rolled over. Figure 4.10. Short-term Loans by the Banking Figure 4.11. Long-term Loans by the Sector, 2001-2004 Banking Sector, 2001-2004 3c 40 t740 50 .- -I20 30 20 10 0 0 2001 2002 2003 2004 2001 2002 2003 2004 +General Government -+--State O w e d Companies -4- GeneralGovernmnt -+- State Owned Conpanies +PrivateCompanies - -x- -Natural Persons --bRivateConpanies ++Natural Rrsons Source: Central Bank of Montenegro. Source: Central Bank of Montenegro. 4.46 Interest rates remain high though spreads vary widely among banks in the Montenegrin banking system. High interest rates, ranging between ranged between 11 and 20 percent, decrease the number o f bankable projects with a suitable risk-return profile. Because o f the high cost o f capital, there i s a high degree o f dependence on internally generated cash flows among firms. Lack o f access to credit limits businesses to using only their own funds, retained earnings, or money borrowed from friends and family and removes an im ortant motive for businesses to formalize-thus o f the informal economy. z contributing to the persistence The aggregate interest spread was about 7.6 percent in 2004 (down from 9.6 percent in 2003). The wide variability o f interest rates within the system relates to the weak framework for creditor protection and contract enforcement, the high country risk, and low competition in the banking sector. It also partly reflects the different features and strategies o f individual banks and their credit assessment skills and operational (in)efficiencies. The variability o f interest rates does suggest that some competition exists and that interest rates are likely to be driven further downwards through greater competition. 85 The data as of end-2002. 86 The PICS survey indicates that dependence on retained earnings was well over 80 percent. While it is not unusual - even indevelopedeconomies -- for retained earnings to constitute a major source of enterprise finance, the absolute level in Montenegro was substantially higher than the corresponding figures in Croatia (52 percent), Hungary (63 percent), Bulgaria (66 percent), Poland (68 percent), the Slovak Republic (69 percent) and Romania (70 percent) and slightly higher than Serbia (85 percent). 71 Why I s the Cost of Capital High? 4.47 Among the main reasons for the high cost o f capital are the following: the relatively large Treasury bills market, caused by the large domestic financing needs o f the Government; the high risks and low creditor protection; the high overhead costs associated with small-scale operations; and the small size o f the market and low competition amongthe banks. 4.48 First, the Treasury bills market is relativelylarge and crowds out private sector credit.The size and structure o f the Treasury bills market is shown in Table 4.7. This market, measured by the amount o f Treasury bills issued and sold, grew significantly in2004. Indeed, only 2004, the Treasury bills market grew by 117.8 million euros. The reasons for such large growth are increased budget expenditure in July and August o f 2004 owing to the payment of the old foreign currency savings, and poorer collection o f revenues. Only a slight reduction o f interest rates was observed on all types o f governmental bills. 4.49 The demand for Treasury bills by banks significantly exceeds the level that the banks allocate to Treasury bills as part of the mandatory reserve funds with the Central Bank of Montenegro. During 2004, the banks of Montenegro allocated on average some 6.5 million euros in obligatory reserve funds in the form o f Treasury bills (both 28-day and 56-day bills), while the amount purchased o f Treasury bills alone ranged between 10 and 15 million euros per auction. The demand by banks for Treasury bills is high because o f the high interest rates and relatively low risk, although their liquidity is exceptionally poor (Le., there is no possibility o f converting Treasury bills into cash before the maturity date). The high demand by banks for these bills also continued because o f the lack o f quality alternative opportunities for the marketing o f free financial resources. As a result, the amounts due from the previous issuances were mainly reinvested (that is, interests were capitalized). 4.50 Second,banks face high risks inMontenegroas the institutionalarrangements for collateral and creditors' rights are underdeveloped. In deciding whether to extend credit and at what interest rates, lenders need to know what share o f debt they can recover if the borrower defaults. The value o f collateral depends largely on the ease o f creating and enforcing security agreements, and in Montenegro this appears to be somewhat problematic.The reasons includeweak institutional arrangements for valuing and enforcing collateral (especially mortgages) and lack o f information on the credit history o f the client. Since practically all lending to enterprises in Montenegro i s backed by collateral, legislation that would facilitate the use o f collateral is particularly important. However, the amount o f collateral requested by banks varies widely, depending on the risk assessment o f the client. It sometimes exceeds 200 percent o f the loan principaLg7While the Government has recognized the existing weaknesses and has made efforts to reform the legal framework and create the necessary institutions (e.g., the Secured Transactions Registry)," the risks that creditors face are high for a variety o f reasons. 87The PICS survey reportsthat in almost all cases creditorsrequired collateral or deposits for the credits (PICS average for 2003 was 135 percent). However, due to the very high numberof missing values, this could be usedjust as arough indicator. 88The Registry is situated at the Commercial Court in Podgorica. Registration takes place either directly on-line for registeredusers (currently limitedto lawyers who are membersofthe Montenegrin Bar Association and commercial banks) or by submitting an application form in personor by fax to the registrar inPodgorica. 72 Table 4.7. The Size and Structure of the TreasuryBillsMarket, 2003-2004 (`000 euros) 2003 2004 Issued Sold % sold Interestrate % Interest rate (annual %) Issued sold (annual%) 28-Day T Bill 108,500.0 100,709.5 92.8 10.0 179,800.0 174,633.5 97.1 10.1 56-Day T Bill 48,500.0 37,512.5 77.6 10.1 60,200.0 53,827.0 89.5 10.0 91-Day T Bill -_ _ _ 43,100.0 20,100.0 46.6 9.1 182-Day T Bill -_ _- ____ __-_ 9,500.0 7,500.0 78.9 10.0 Total 157.000.0 138.222.0 85.2 10.1 292.600.0 256.060.5 78.0 9.8 Source: CentralBank of Montenegro. 4.51 There is no central system or register for credit records in Montenegro. Credit information registries and credit bureaus can serve as key institutions in improving access to finance and reducing creditor risk, but Montenegro has no such institutions (Table 4.7). Businesses are not able to obtain reliable data on the creditworthiness o f a potential customer and depend therefore on their ownjudgment and on information obtained through other informal channels. An effective, broad-based credit information registry, with a full scope of credit information, is critically important for developing the means to control and price credit risk, thus making possible reduced screening costs o f loan applicants, lowered risk, and increased repayment rates. 4.52 Until recently, mortgages or real estate could not be effectively used as instruments for creditor protection in Montenegro.There were many practicaldifficulties involved inthe realization o f mortgage rights in the banking sector under the old mortgage regulations. The main problem was that the creditor could realize the mortgage only after the credit term had passed. However, this was too risky for creditors and generally led to lower credit and higher interest rates. In view o f these problems, the Government o f Montenegro adopted the Law on Mortgage in July 2004. Under the new Law, creditors are granted more legal protection through mortgage.89 However, as its implementation hasjust begun, the full impact of this Law remains to be seen. Given the size o fthe market and, the potentially low demand, the impact ofthe improved mortgage system may still be limited. Table 4.8. Credit Information Sharingand the Cost of CreatingCollateral Indicator Montenegro Regional OECD Average Average Cost of creatingcollateral (YOof income per capita) 2.47-5.75 7.7 5.2 Credit Information Index 0 2.0 5.0 Public credit registry coverage (borrowers per 1,000 adults) 0 6.3 76.2 Privatebureau coverage (borrowers per 1,000 adults) 0 46.7 577.2 Source: DoingBusinessWorld Bank and CEED for Montenegro. 4.53 Informal operations limit the ability of banks to assess real income and to lend.Enterprises generate significant revenues from partly informal operations (e.g., cash payments on top o f official salaries are common). In many cases tax evasion i s the main source o f financing investments. Although 89A list of all subscribedmortgages is to be collected and published on the website of the Agency for Real Estate within one year of the passage of the Law, which should facilitate notification of third persons on subscribed mortgages. 73 banks in Montenegro use various strategies to deal with customers in the informal sector operations:' the formalization o f firms and the growth o f the formal economy would improve the ability o f the bank to provide good quality credit risk. 4.54 Third, banks' operationalcosts are high and competitionis low because of the small size of the market. Operating expenses at the aggregate level are high and amounted to 25. 5 million euros in 2003. In 2004 overhead expenses increased to 32.7 million euros, a growth o f 28.4 percent injust one year. Operating expenses represent between 5 and 8 percent o f average assets and increased in 2004. Overhead expenses to core earnings (net interest and fee income) amounted to 75.5 percent in 2004, up from 73.4 percent in 2003. 4.55 Finally, the small size of the economy limits economies of scale and competition.One way o f increasing the competition is to have foreign banks establish their affiliates. According to the Law on Banking the affiliates o f foreign banks are required to have a minimum capital o f 5 million euros. Given the small size o f the market, it is questionable whether such a high level o f capitalization should be required. Nevertheless, this issue should be considered once the current bank privatization and restructuring plans are completed. More important, the development o f leasing industries may be better suited to the small market o f Montenegro. Leasing may be a superior option to secured lending in a system with weak creditors' rights and a small size. The passage o f the Leasing Law laid the foundation for more rapid development o f the leasing industry in Montenegro. At the moment there are four leasing institutions operating in Montenegro, three o f which are banks. The potential demand for leasing services i s large, and all o f the leasing companies planned to expend their businesses in 2004. Through this system, many SMEs should benefit from the increasing competition and the availability o f new leasing products. D.CONCLUSIONSAND POLICYRECOMMENDATIONS 4.56 Montenegro's high unemployment and low growth are in large measure a reflection of a businessenvironmentwhich is not conducive to investmentand job creation.Montenegro's emerging private sector, comprised of small firms, has not yet developed the critical mass to generate enoughjobs to offset job losses in the public sector. Facilitating the entry of new firms and the growth of small enterprises is, hence, necessary to create morejobs and increase growth and competitiveness. Government policies that would help increase private investment and the growth o f small enterprises hold the key to higher employment, growth and competitiveness inthe medium term. 4.57 The most highly visible feature of the Montenegrin economy is the large and persistent informal sector, which contributes about 30 percent o f GDP and employs about 27 percent o f the workforce (ISSP, 2003). The presence o f a large informal sector is a symptom o f a highregulatory burden and a poor public administration as well as poor opportunities inthe formal sector. While Montenegro has simplified its business registration system considerable since end-2002 (a burdensome registration procedure which had involved 38 steps and 45 days was streamlined to 4 steps and 3 days, and a minimum capital requirement o f 1 euro) other regulatory and institutional barriers continue to hinder the formalization o f small businesses. The following measures deserve priority consideration to increase the formalization o f small businesses: e SimpliJL and speed up the issuance of business licenses and inspections. The 21 municipalities in Montenegro are responsible for the licensing o f businesses and related permits, and zoning and 90 One bank even indicated that they take into accountthe unreported income, as otherwise they would not be able to lend. 74 building permits, and in general the provision o f utility services (waste collection, water, sewerage and electricity distribution), as well as various inspections. However, business operating licenses take a long time to issue, and licensing and inspection activities are not conducted in a fair and transparent way (FIAS, 2004). While visible and legal businesses are extensively inspected, there i s no noticeable effort to crack down on illegal businesses that operate without a license, avoid tax and social security payments, or establish business premises without building permits. A draft Law on Licensing, prescribing a faster and more efficient registration and listing o f business activities, should be implemented as quickly as possible. 0 Reduce the high rates of labor taxation to encourage formal employment. Recent reforms have helped reduce the payroll tax and contributions burden. Yet the labor taxes (or payroll taxes) are still perceived as too high and as among the highest in the region. Montenegro's tax wedge, one o f the most important indicators o ftax burden (defined as the difference between the labor cost to the employer and the take home pay [net wage] expressed as a percentage o f total labor cost) stood at about 52 percent o f the labor costs in 2004, while the comparative burden for the regional non-European member countries was 37.3 percent o f total labor cost. A further phased and well- planned reduction in payroll taxes (compensated by equivalent increases in other taxes, and with adjustments to compensate for the resulting lost income o f the social funds) could be considered as soon as offsetting fiscal measures have been identified. To decrease such high rates in a fiscally responsible way, reforms o f in the health and pension systems need to be pursued to make the systems more efficient and sustainable. In particular, a review o f early retirement, disability, maternity leave and sickness benefit policies should be part o f the reform agenda with the aim o f tightening the eligibility criteria and eliminating the widespread abuse o f the system. 0 Improve governance and consistency in the application of rules. A modern public administration system, characterized by transparent, non-discretionary processes, and efficiency i s yet to be created in Montenegro. This would require the putting in place o f appropriate incentive and accountability systems and significant institutional capacity building through education, training, and the application o f information technology. The presence o f high discretionary power often creates an opportunity for corruption. Improvements in the quality o f regulation through greater transparency, and a more consistent application o f rules, including an improved tax administration capacity to support rule-based tax collection, are essential. 13, Enterprise privatization and restructuring are not complete. Many companies that were privatized through the mass voucher privatization (MVP) program still lack strategic investors to re-equip them with new technology and improve their profitability and competitiveness. They also continue to be saddled by the highcosts o f excess labor and employment. There is thus an urgent needto: 0 Speed up the restructuring of the mass-voucher- privatized companies by: (i)making budgetary allocations toward covering the social costs o f restructuring-including severance payments for shedding off excess labor- for those companies in respect o f which the Government agreed to fund such costs; (ii)strictly enforcing the new bankruptcy law for medium and large enterprises privatizedthrough vouchers, that have continuedto accumulate losses; and, (iii) strengthening the capacity o f courts to deal with such bankruptcy cases. 0 Speed up the consolidation into majority shares of the companies' shares being traded on stock exchanges. With diffused ownership and lack o f majority ownership, the MVP has been fairly ineffective in inducing changes in management and corporate governance. Even where the MVP has led to management changes, the new management has continued to lack expertise in restructuring and developing viable business plans. Currently, shares o f companies and investment units privatized through the MVP are slowly being consolidated through trades in 75 stock exchanges. However, the speeding up o f the consolidation o f shares into majority ownership is needed to bring about management changes, good corporate governance, completion o f the restructuring plans, and the introduction o f new capital and technology to generate better profitability and shareholders' value, and employment. 4.58 The implementation of recently enacted business laws and regulationsis lagging. Inthe past three or four years Montenegro has overhauled much o f its legal and regulatory framework as regards the private sector, but implementation is lagging. It was only in2003 and 2004 that the Parliament adopted 45 laws and 67 laws, respectively, out of which roughly 35 are business environment or financial sector laws. While the new laws provide an adequate legislative framework for the development o f a well- functioning market economy, significant implementation gaps are emerging. The implementation o f legislation aimed at improving the business environment-contract enforcement, access to finance, corporate governance, and business exit-has not yet begun in most cases. Speeding up the implementation o f these laws will be critical to private sector investment and growth. 4.59 Contract enforcementand property rights are weak. Investors see the poor functioning o f the court system as a major impediment to doing business (FIAS, 2004). The courts are too slow: it can take a year from the submission o f a claim to the handing down o f ajudgment. Enforcement o f a title can take another 6 to 12 months. Resorting to an appeals court could take a further 12 months. Overall, about 40 percent o f the commercial court cases are resolved within less than 3 months; 33 percent take up to 6 months; and about 28 percent take longer than 6 months. Speeding up the resolution o f cases that take longer than six months (which frequently include bankruptcy and liquidation cases) i s urgent. As for property rights, land title registration i s computerized and not overly time consuming or costly, the Cadastral Office does not have adequate, reliable land information. The lack o f transparency and discretionary public access to land information makes land title transfers risky for investors, and complicates the planning and approval activities o f municipalities. The specific measures that the Government can undertake to improve contract enforcement and property rights are the following: Reduce the backlog of commercial court cases and speed up contract enforcement through: (i) easing the resources and personnel constraints in the Montenegrin judiciary; (ii)ensuring that qualified judges are put inplace, with better compensation; (iii) training court personnel; and (iv) upgrading the court system's infrastructure, including the computerization o f case management. Improve land title transparency and control illegal construction. Lack o f transparency on land titles and registration represents one o f the greatest threats to the future prospects o f Montenegro's tourism industry, particularly in the few remaining high-potential tourism sites (e.g., Ulcinj, and inland areas close to national parks and other natural attractions). The Government needs to vigorously enforce land property rights and control illegal construction. 4.60 The cost of capital is high and financial intermediationis low. Total credits from banks to the private sector amount to only 11 percent o f GDP in Montenegro. This is quite low compared to the regional countries (42.3 percent in Bosnia and Herzegovina, 26.6 percent in Bulgaria, 57.3 percent in Croatia, and 42.7 percent in Hungary), though credits to the private sector have started to rise from fairly low levels in 2004. Interest rates as well as spreads remain high: the real interest rate has ranged between 11 and 20 percent in recent years. The aggregate interest spread was about 7.6 percent in 2004 (down from 9.6 percent in 2003). Given Montenegro's limited opportunities in Greenfield investments, most investors would be hard pressed to find a project whose real rate o f return would exceed 11-20 percent. The high cost o f capital and the wide variability o f interest rates within the system relate to the weak framework for creditor protection and contract enforcement, the high country risk, and the low competition in the banking sector. Specific measures that the Government can undertake to reduce the cost o f borrowing and improve financial intermediation are the following: 76 e Reduce the needfor Treasury billfinancing through a tightfiscal policy. This would help reduce the budgetary burden of interest payments on Treasury bills and would create the conditions for the lower cost o f capital inthe economy by reducingthe crowding-out of Government. e Establish an effective, broad-based institution, withfidll credit information on all borrowers, to address the problem of asymmetric information incredit markets. Introduce more competition into the banking sector through the completion o fthe privatization o f government-owned banks (in particular Podgoricka Banka), and by promoting leasing operations inview ofthe small size o fthe Montenegrinmarket. 77 5. THE CHALLENGESOFGROWTHAND COMPETITIVENESSINPRACTICE: THE CASE OF TOURISM A. INTRODUCTION 5.1 Tourism has always been an important part o f Montenegro's economy, and has focused mainly on the local and regional market. After almost ten years o f steep decline during the 1990s, tourism has shown a strong recovery over the past four to five years. Tourism i s widely regarded as Montenegro's main prospect for export-oriented economic growth in the coming years, based on a strategy aimed at greatly increasing the number of foreign visitors. Both the Government o f the Republic o f Montenegro (GFW) and the World Travel and Tourism Council (WTTC) have made optimistic projections for growth in tourism numbers, revenues and contributions to the economy over the next ten years (GFW Tourism Master Plan, 2001; WTTC, 2004, 2005). If these goals are achieved, Montenegro could have the fastest growing tourism economy inthe world by 2014. 5.2 However, the Government's own Tourism Master Plan (2001) offers a frank assessment o f the challenge: Montenegro's position is weak: the country lacks financial resources, a commercial product and adequately qualified specialist personnel. The number of overnight stays has declinedfromjust about I I million in the 80's to 5 million today. All theforeign markets have broken away; remaining demand is confined to Serbia and Montenegrofor six weeks in midsummer and the cheapest accommodation facilities. The hotel sector is a low earner, underutilized and standards arefar too lowfor the demanding guest.... Although tourism in Montenegro has recovered since 2001, and significant progress has been achieved in upgrading infrastructure and hotel facilities, there are a number o f challenges still to be overcome, including ensuring the environmental sustainability o f the coastal tourism and achieving greater diversification o f tourism products. 5.3 Montenegro has the potential to regain a substantial share of the burgeoning regional and internationaltourism market. Development of a diversified tourism offering is the key to capturing such market, with particular emphasis on nautical tourism at the coast and on nature- oriented tourism inthe interior.'Greater support for tourism development inthe interior o f the country i s also important for its potential to stimulate economic development and reduce poverty in these areas. Inboth coastal and inland areas, careful planning o f tourism growth and management o f its environmental and social impacts are necessary to ensure sustainability. Montenegro's limited comparative advantage against regional and international competitors and the need to balance coastal tourism growth with environmental sustainability means that, in the long-term, the prospects for growth in the beachibathing sub-sector are limited. Sustainable long term tourism growth will depend on Montenegro's ability to attract tourists to destinations other than the coast. 5.4 Montenegro faces stiff competition from neighboring countries and other destinations worldwide, many of which currentlyoffer a more competitivecombination of quality and price to the same target markets. Success in increasing its market share will depend upon addressing both quality and cost aspects. A large stock o f old-fashioned, homogeneous and run-down tourism accommodation i s one o f the country's weaknesses. The Government's strategy to encourage private sector investment i s generally sound, and to date significant modernization and reconstruction o f privatized hotels have taken place. However, physical upgrading o f existing facilities through privatization will not be sufficient to capture the high-end tourism market that the country rightly targets. Investment in new and diversified facilities will be needed, including the entry o f some recognized international investors and operators. Greater clarity and security o f land rights will be fundmental to attracting such investment. The regulatory environment also needs to be supportive o f serious investment by experienced operators. While it i s important for government to establish and ensure basic health and quality standards consistent with international practice, beyond this the private sector needs flexibility to adapt to market demands. 5.5 While progress has been made in recent yearsg1, further improvements in public infrastructureare needed for continued tourism recovery and development. Despite the stated focus on tourism as a major source o f future economic growth, Montenegro presently invests comparatively little in public infrastructure and services to support the tourism sector. Success will require well-targeted infrastructure investment planning, clear priorities and interim targets in accordance with the available resources. The Government needs to play a coordinating role in areas where infrastructure investments are ongoing with donor assistance, and a complementary role o f filling the investment gap in the context o f its comprehensive public investment program that rigorously screens public infrastructure investment for their economic and social returns, including in tourism. Equally important i s a strong commitment to enforcement o f laws and regulations that have a large impact on tourism, such as land use and waste disposal. This i s essential both for attracting tourism investors and clients, and for ensuring that tourism development i s environmentally sustainable and results inimprovement, rather than decline, inthe quality o f life for Montenegrins. 5.6 While traditionally a labor-intensive sector, the potential employment benefits of tourism are not being fully captured in Montenegro. Contributing factors which need to be addressed include the narrow emphasis on bathingheach tourism (with its very short season), labor market regulations that create incentives to draw upon the large regional pool o f expatriate seasonal workers under flexible contractual arrangements rather than employing Montenegrins in full time positions under standard full time contracts, and a lack o f skilled personnel and o f tourism training facilities and opportunities. At the same time, growth in the tourism sector, while highly desirable, must be managed properly to achieve environmental sustainability and to make a strong and lasting contribution to the economy as a whole. B. THECONTRIBUTIONOF TOURISMTOMONTENEGRO'S ECONOMY 5.7 Tourism in Montenegro has recently shown strong growth, in absolute terms and relative to the economy as a whole, and even more rapidgrowth is projected for the future.The WTTC Tourism Satellite Account (TSA) included Montenegro for the first time in 2004 (OEF/WTTC, 2004). It indicated that Montenegro's tourism sector i s on its way to regaining the economic importance it enjoyed during its peak in the 198O's, when total tourist overnights reached almost 11 million, including a substantial proportion o f international visitors. The 2005 TSA (OEF/WTTC, 2005) estimated the contribution o f the travel and tourism industry (TTI) at 8.5 percent o f total GDP92 (over 132.61 million) in 2005, and 9.1 percent o f total employment. The 9' Recent improvements to tourism infrastructure include construction o f the Sozina tunnel, and improvements inroads, solidwaste, andwastewater management. 92 Direct Gross Domestic Product (value-added) associated with "Travel and Tourism Consumption," Le., the supply-side industry contribution of T&T that can be compared one-for-one with the GDP contribution o f other 79 contribution o f the greater travel and tourism economy (TTE) which captures broader "economy- wide" linkages associated with tourism,93was estimated at 14.8 percent o f GDP (over 23 1.9 million) and 15.8 percent o f employment. Real growth was estimated at about 9.7 percent for the tourism industryand 4.9 percent for the broader tourism economy. With a projectedaverage rate o f increase o f over 10 percent per year over the next decade, by 2015 the tourism industry should account for about 13.6 percent o f GDP and 14.5 percent o f employment, and the broader tourism economy should account for about 21.1 percent of GDP and 22.5 percent employment (see Figures 5.1 - 5.4). Figure 5.1. Travel and Tourism, Contributions to Figure 5.2. Travel and Tourism, Real Growth GDP, 2000-2015 (percent) Per Year, 2000-2015 (percent) I I I 10 I I ` 5 1 I ~ 0 2005 2014 2015 2000 2001 2002 2003 2004 2005 2014 2015 (est) (est) (Proj) (pro]) _ _ _ ~ - i ~~ I 1- ` t T o u n_s m and____ Industry +-Trawl 1- _ Trawl and Tounsm Economy ~~ ~ ~ ~ . - Source: Oxford Econormc Forecasting, for World Source: Oxford Economic Forecasting, for World Tourism and Travel Council, 2005 (Satellite Account Tourism and Travel Council, 2005 (Satellite Account Tables). Tables). 5.8 This projected economic growth rate is significantly above the projections for the Montenegrin economy as a whole, and well above the projected average (among 174 countries ranked in the TSA reports) o f about 3.8 percent for global tourism economy growth over the same period. However, these projections into the next decade must be treated with some degree o f caution as even the Government's tourism Master Plan (TMP) considers the OEF/WTTC revenue projections overly optimistic. Furthermore, the projected growth in tourism-related employment i s modest, in both absolute terms and as a percentage o f total employment. In fact, formal employment in the tourism sector increased by only 400 jobs between 1993 and 2003, with an average salary o f about 120, which i s significantly below the national average o f about 195 (without taxes and contrib~tions).~~Montenegro currently ranks seventeenth among 174 countries worldwide with respect to the contribution o f the tourism industry to total employment, but ranks only in the middle when compared to its neighboring and major competing countries. Clearly, Montenegro's tourism industries inthe economy. Includes traditional T&T providers such as airlines, hotels, car rental companies, restaurants, etc. 93Direct and indirect GDP (value-added) associated with "Travel and Tourism Demand," representing the broadest measure o f T&T's contribution to the resident economy. Includes establishments included inTTI as well as manufacturing, construction government, etc., that are associated with capital investment and government services that directly or indirectly support tourism. 94The Employment Fundstatistics indicate that 3,000 jobs were added inthe tourism sector in2004; however, this figure arises from the legalization o fjobs that already existed prior to the Government's legislation exercise. 80 development model i s not generating the local employment that could be expected: an important issue, considering the highunemploymentrate inthe Republic. Figure 5.3. Travel and Tourism, Figure 5.4. Travel and Tourism, Employment Contributions to Employment, 2000-2015 Growth, 2000-2015 40 35 30 rn ,"20 -g25 .E 15 ;10 . e : - n 0 $ 2 7 5 -5 0 -10 -15 _ _ _ ~ _ _ _. _~ +Tourism andTravelhdustry &Travel andTourismEconomy ! +Tourism - and Travel Industry -+-Travel and Tourism Econorry t- __ Source: Oxford Economic Forecasting, for World Source: Oxford Economic Forecasting, for World Tourism Tourism and Travel Council, 2005 (Satellite and Travel Council, 2005 (Satellite Account Tables). Account Tables). C. VISITOR TRENDS AND TARGETS 5.9 Tourism growth results from increasing the number of visitors, the Figure 5.5. Tourist Arrivals and Overnights, 2000- average length of stay, and the 2004 amount of money that they spend in the country. The Government's 1,400,000 Tourism Master Plan aims at all three 1,200,000 lntemat tounst factors, with specific targets for amlals (top 10 increasing the number and proportion o f 1,000,000 1 source markets) international standard (more expensive) 800,000 inDomestictounst beds and the average length o f stay for amlals (Sebia & 600,000 1 foreign visitors. Actual tourist numbers foreign Montenegro) have shown respectable, though variable, 400,000 tounst growth since 2000 (See Figure 5 3 , but olemtghts (top 10 200,000 source markets) the 2004 figure o f 4.5 million total overnights remains well below the 1989 0 peak o f 11million. 2000 2001 2002 2003 2004 5.10 Still, the Government's target Source: 2000-2003 data: WTTC, 2004; 2004 data on overnights: Ibid (covers first 9 months o f 2004); 2004 data on of 15.68 million overnights by 2010 arrivals: Ministry of TourisrdNational Tourism Organization and 25.8 millionby 2020 seems overly Bulletin, January 2005 (covers first 11months of2004). ambitious,. given the country's small - area and limited environmental carrying capacity. The TMP includes some measures for distributing the burden, such as extending the main summer tourism season to 165 days and increasing visitation to destinations other than the coast. (In 2004 87 percent o f all overnights fell 81 between June and September, with 56 percent in July and August, and 96.7 percent o f all tourist overnights were spent within the six coastal municipalities). However, to increase overnights by some 11 million would mean accommodating an additional 30,630 people per day, assuming equal distribution throughout the year. More likely, a large proportion o f the increase would occur during the summer, and much o f it at the coast. Montenegro has made a constitutional commitment to be an "Ecological State," and it i s encouraging that planning for the proposed 25,000 bed new coastal resort complex at Ulcinj includes an environmental assessment, which presumably addresses carrying capacity in some manner.95 5.11 Montenegro's tourism strategy strongly emphasizes increasing international, rather than domestic, tourism. This represents a major change from the historical situation, inwhich the market has been very heavily domestic (from Serbia and Montenegro). The Government strategy aims to increase the number and proportion o f international visitors, particularly from Western and Central Europe, by upgrading accommodation to international standards, improving environment management (wastewater and solid waste disposal), and through marketing and promotion. International arrivals did increase by almost 32 percent in 2004 (compared with a 12.6 percent increase in domestic arrivals), and expenditures by foreign visitors increased by 33 percent, to an estimated 173 million (199.4 million if the broader tourism economy is considered). Even so, in 2004 domestic tourists still accounted for almost 75 percent o f the total. The TSA estimates reflect an impressive 130 percent growth in foreign tourist expenditures between 1995 and 2002 (albeit from a low base) and projects an equally impressive growth o f 12.1 percent per year, compared with 5.5 percent per year within the EU, and 5.8 percent per year globally. However, airport arrivals have not increased significantly since 2000, indicating that the increase in foreign tourists to date i s mainly from regional (car-accessible), not international, markets. D. TOURISMASSETS,PRODUCTSAND COMPETITIVENESS 5.12 Montenegro has significant tourism assets and attractions, which have not beenused or developed to the best advantage and which need rehabilitation, protection and careful development. The coast is, and will likely continue to be, the major element o f Montenegro's tourism industry, but its beach product alone i s not highly competitive and i s unlikely to lift the country out o f its current status as a mainly low-end to mid-end local and package charter destination. The main prospect for significant transformation lies in combining the coastal element with the beautiful inland mountain landscape and the appeal o f a high level o f natural and cultural diversity within a small area. The country has a few unique attractions, such as Boka Kotorska (Europe's most southern, and the Mediterranean's only, fjord), Skhadar Lake (Europe's second largest lake and largest bird preserve), the Tara River Canyon (one o f the deepest canyons in the world), and Ulcinj (one o f the few remaining large, relatively pristine, sandy beach on the Adriatic). Other strong features include a few relatively well-known destinations and facilities (Sveti Stefan, Ialo health spa), some attractive historical sites such as the old capital o f Cetinje, and easy access to transborder attractions (Dubrovnik, sites in Bosnia-Herzegovina). There i s a considerable prospect for a well- planned tourism development centering on these few limited high-value assets, but these i s also a great risk that, inthe absence o f strong Government commitment to capture this value, they could be ruined in the near future through unplanned, poorly executed tourism development and other impacts (e.g., pollution and huntinginLake Skhadar). 5.13 Montenegro needs to increase its competitiveness as a tourism destination through attention to both quality and price. A recent bench-marking study (Yanofsky, 2004) found that 95An environmentalassessment is requiredfor all new Greenfieldprojectsunder the Montenegrinlaw. 82 Montenegro offers an inferior quality o f facilities and services at higher prices, compared to its main regional competitors, for both foreign and Serbian visitors, particularly during the peak summer season (see Figures 5.6 -5. 7).96 Figure 5.6. Cost of 7 Night Vacation from Figure 5.7. Cost of 7 Night Vacation from London (4-Star Hotel, including Airfare) Belgrade (4-Star Hotel, includingAirfare) 1000i1 1076 925.25 700 800 600 In e 6M) 488 4 u1 500 w 4M) I=e400 300 2M) 200 0 100 0 Montenegro Turkey Egypt Tunisia Bulgana ~ o M a yuAugus1~ 0 May BAugust' Source: Yanofsky, 2004. Source: Yanofsky, 2004. 5.14 The authors attributed this "competitiveness gap" to complacency on the part o f coastal tourism operators, who untilrecently enjoyed a largely captive domestic market. They reported that the coastal owners and operators interviewed generally showed little inclination to change pricing practices or improve services, since they continue to enjoy full occupancy during the short summer season, just as they had done in the past. However, this attitude runs counter to the Government's strategy o f attracting the value-conscious international market. Furthermore, even the historically reliable local market i s likely to slip, as the younger generation o f Serbs i s not bound to the Montenegro coast by tradition and habit, and i s increasingly pursuing better value for money in Turkey, Egypt, Tunisia, Greece, and other such destinations. E. POLICY AND STRATEGY: ANALYSISAND RECOMMENDATIONS 5.15 The Government's strategy centers on stimulating private sector investment to renovate and develop high quality tourism facilities, on providing public infrastructure and services, and on using regulation and licensing as a tool for upgrading quality to international standards (see Box 5.2 for lessons of experience). The division o f responsibilitiesbetween the private and the public sectors i s largely appropriate, but implementing this strategy calls for a clear understanding o f the needs, priorities and constraints o f the local and international tourism industry. This includes being able to respondto the market in a flexible way without undue bureaucratic obstacles. Product Diversification 96 Itshould be emphasizedthat this is a limited sample study-and the only study available benchmarking Montenegro to other destinations. Giventhat there are no four-star hotels inMontenegro, the applicability o f the study to the case of Montenegro is questionable. Further benchmarking studies with large samples and comparisons are needed to get a better understanding o f Montenegro's competitiveness intourism. 83 5.16 Investment must be targeted at diversifying the tourism product, based on Montenegro's strengths. Most o f the attention for both public and private investment continues to be directed at expanding and upgrading coastal tourism. By contrast, the Government i s paying relatively little attention to the considerable potential for diversifying and extending the tourism product through the careful development o f inland assets. The Strategic Framework for Sustainable Tourism Development in Northern and Central Montenegro still lacks an economic impact analysis, which needs to be completed. Investment innon-coastal tourism development i s presently limitedto a few small, donor-funded pilot projects. There have been several initiatives to prepare strategies for developing sustainable tourism in the northern and central region~,~'and the TMP makes references to developing year-round and nature-based niche offerings, while the plan for the summer o f 2005 mentions mountain tourism, "wellness" tourism, nautical tourism, etc. However, specific plans, programs and incentives need to be developed and implemented to catalyze non-coast tourism investment and development. The emphasis should be on improving the tourism package and restarting winter tourism , with due attention to environmental sustainability and to the expansion o f economic opportunities for local communities. The strategy should also take in a broad perspective o f tourism-related options. For example, as the TMP points out, the purchase and renovation o f vacation homes by prosperous expatriate urbanites has become a substantial segment o f rural economic development in a number o f countries with attractive landscapes, cultural attractions and proximity to European economic centers. 5.17 Continued attention should be paidto broadeningtourism's economicimpact. Linkedto the diversification objective i s the objective o f broadening and deepening tourism's contribution to the economy by reducing leakages through increasing the participation o f local investors. The importance o f tourism's linkages to the broader economy i s fully recognized in WTTC's Tourism Satellite Accounts98but it i s not addressed in the Government's TMP, which focuses only on the development o f the tourism industryper se. Consequently, little attention i s paid to strengthening such linkages in the MOT'Sannual plans and programs, aside from general promotional activities (e.g., .``The Year o f Good Food" and "Made in Montenegro" campaigns o f 2004). The 2005 plan includes an itemo f "Linking lodging economy and agricultural producers," but it i s mainly limited to generalities (such as "Maintenance o f regular communication between agricultural producers and tourist economy," and "Program o f development of highquality gastronomic offer"). It also vaguely proposes a "guarantee fund" which sounds similar to the subsidies credit for small and medium scale hotel development, and shares its shortcoming o f emphasizing the supply side over the demand side. Agriculture sector policies recognize that targeting niche markets represents the main prospect for agricultural development in Montenegro. In-country tourism must be recognized as an important niche market, and the Government can play a facilitative role inhelping producers capture it. Public investment in infrastructure 5.18 Despite the recent progress, expenditure on tourism infrastructure and services in Montenegro is relatively low in comparison with the country's competitors. Montenegro currently ranks at only fifty-eight out o f 174 rated countries worldwide inthis measure o f government and private sector commitment to tourism development. The TSA estimates total capital investment (combining private and public sectors) in tourism infrastructure, plant and equipment at 33.89 97Including the "Strategic Framework for Development o f Sustainable Tourism inNorthern and Central Montenegro: Roadmap for Development o f Wild Beauty" prepared through UNDP; the Regional Plan for the Mountain Regions prepared by the International Institute o f Tourism-Slovenia; and a strategy for the Bjelasica regionbeing developed by the Austrian Office o f Technical Cooperation. 98Economic statistics are given for both the "Travel and Tourism Industry" and the broader "Travel and Tourism Economy." 84 million in 2004, showing a steady increase from 24.6 since 2000. They project that capital investment in the tourism sector as a percentage o f total capital investment will grow at 7.4 percent annually through 2014. This compares favorably with the projected rate o f 3.2 percent annually across the EU and 4.2 percent worldwide, but the record over the past few years throws some doubt on this projection (see Figure 5.8). 5.19 The Government should focus Figure5.8. CapitalInvestment inTourism(Public and on addressing the environment-related public Private), 2000-2005 infrastructure constraints-- in particular waste water treatment, c T 5 and waste management- to ensure sustainability of coastal tourism' development. The TMP emphasizes improved infrastructure o j -m as a major element in increasing tourism numbers and quality. The - Government has numerous I initiatives inthis area and has shown - ~~ progress in recent years, mostly in ACapitalInvestment,bonil1 RealCapdal Investment Growth (percent) , cooperation with international -+-Capital Investment, % GDP i donors, but the scale remains small L~~ compared to the need. Source: OEF for WTTC 2005 (Satellite Accounts). Water: The linkage between water shortages in the coastal municipalities and maintaining and increasing tourism levels has been clearly demonstrated. While there i s considerable scope for improving the efficiency and financial viability o f existing water distribution and use through rehabilitating the existing infrastructure, stopping illegal connections and improving fee collection, and generally putting water supply on a sound commercial basis, the existing data indicates that there i s still the need for a bulk water supply system to supplement local sources. At the request o f the Government, the Bank i s investigating the feasibility o f a regional scheme in the proposed Tourism Development Project. The feasibility assessment will be based on field measurements o f all key sources in the system, which are being carried out over the dry summer period. The Government is drafting a new Law on Water, but more attention i s neededto enforcing the existing laws. 0 Transportation: Government policy emphasizes road rehabilitation, particularly for access to the coast and between major cities. However, despite recent improvements, actual investment levels remain low and, more substantial longer term commitments will be needed to achieve lasting improvement. The Government should also develop a strategy for using road and other transport infrastructure to steer tourism development to new areas. Air transport i s increasingly important as Montenegro targets a wider international market. The two airports are functional but give a poor first impression, as they have received only small investment since 1976. EBRD funds have recently been obtained for airport upgrading. Montenegro has become more open to foreign carriers over the past few years, with about 20 scheduled and charter airlines operating during the peak tourist season. However, Government policy still limits foreign carriers to a few landings a week, presumably as a measure to protect the national airline. This policy i s likely to be a barrier to the growth of international tourism in the future, as air travel worldwide i s increasingly shifting to the rapidly growing segment o f discount air carriers. 85 Solid Waste and Wastewater Management: Everyone agrees that inadequate solid waste management i s a major challenge for maintaining the environmental sustainability coastal tourism and for attracting more international visitors. A waste management master plan at the Republic level was adopted by the Government in January 2005. Also, the Draft Law on Waste Management i s soon to be considered for approval at a session o f the Assembly o f the Republic o f Montenegro.. One temporary landfill was constructed with World Bank funding, and a few more are being undertaken." Similar small investments inwastewater management are being made under other donor-funded projects (e.g., USAID, European Agency for Reconstruction). The 2004 "Keep it Clean Campaign" proposed a wide range o f actions, but the implementation was focused mainly on education and media promotion, while little was achieved in relation the elimination o f illegal dumpsites or stricter controls on vehicles carrying waste materials. A survey o f dumping sites was undertaken, but no other direct measures for roadside clean-up appear to have been implemented. The M o T M A received 35,000 euros from the Government for contracting with municipality service companies for this purpose, but the funds went unclaimed. For 2005, the multi-sectoral Tourism Coordination Commission has proposed a different approach: a public employment program for roadside clean-up o f tourism sites. Considering the harm that this problem does to Montenegro's competitiveness as an international destination, a more intensive effort to combat the problem will be required. As in the case o f illegal construction, strict and consistent enforcement o f anti-dumping laws i s at least as important as capital investment in landfills (people who are inthe habit o f dumping trash over a nearby cliff will not necessarily take the trash to a landfill several miles away just because it i s available). This could be combined with such incentives as national recognition and awards for the cleanest towns. In addition, educational campaigns must be greatly expanded and more effectively targeted (e.g., to schoolchildren). 5.20 The Government needs to play a coordinating role in areas where donor infrastructure investments are ongoing, and a complementary role o f filling the investment gap inthe context o f its comprehensive public investment program that rigorously screens public infrastructure investment for their economic and social returns in tourism. 5.21 The Government's Tourism Master Plan (TMP) needs to be provided with concrete budgetsandinterimimplementationtargets (see Box 5.1. for an assessment o fthe Plan). As noted in Chapter 3, and budget allocations to support the TMP are uncertain from year to year, and have been cut by as much as 20 percent in recent years. Some short-term planning i s being carried out, in the form o f annual plans for preparation for the forthcoming summer seasons (there are two such plans to date, for 2004 and 2005). However, these annual plans are a mixture o f specific and general goals and short-term and long-term undertakmgs without prioritization, annual targets or costing. Thus, the Action Plan for Preparation for the 2005 Summer Season contains nearly 170 separate items under 32 headings. Some are concrete actions that could conceivably be completed inone year (e.g., works on the third lane from the Mojkovac via Krstac saddle towards Bijelo Bolje). Others will take several years to complete, assuming that the funding i s available, and there i s no indication o f how much i s expected to be completed in the coming year (e.g., modernization o f the railroad infrastructure-construction o f new tracks and reconstruction o f tunnels and bridges). Many are simply general statements o f intent or policy (e.g., for improving water supply infrastructure: 99Atpresent, an ecologically sound closing of illegal dumpsites-including covering the dumps, constructing drainage systems, gas emissions and fencing-- is being undertaken in Kotor, Tivat, Budva, Bar and Ulcinj through World Bank funding (Montenegro Environmental Infrastructure Project, and Montenegro Environmentally SensitiveTourist Areas Project). 86 "continuation o f activities on realization o f sub-projects, internal measures, intervention measures, optimization o f existing sources and new ones;" and for privatizing tourism enterprises: "resolve the issues o f land ownership between the state, private owners and economy [sic]). Box 5.1. Merits and Limitations of Montenegro's Tourism Master Plan (TMP) Montenegro does not have a tourismpolicy, but a "Tourism Master Plan" (TMP) was preparedin 2001, with technical assistance from the German Investment and Development Company (DEG). The TMP calls for both a large overall increase in tourism arrivals and overnights (up to 15.68 million overnights in all categories in 2010 and 25.85 million in 2020), but also a substantial shift from a mainly lowerimedium end domestic market to a mainly mid-to-high end international market. Its two strategic pillars are: (i) upgrading the coastal tourism product (accommodation and services); and (ii)diversifying the tourism product (lengthening the season, developing niche sectors such as adventureinature tourism). One key element i s to gradually eliminate 1- and 2-star accommodations* mainly by upgrading them to 3-star or better through privately financed renovation and stricter regulation. There i s also strong emphasis o n reducing the "grey economy" in the tourism sector, including, for example, putting in place regulation and flat rate taxation of private apartments that are rented out for tourism purposes. Some merits of the TMP, and of measuresbeingtaken to implementit, are: The recognition o f the cross-sectoral nature o f tourism development. A multi-sectoral Tourism Coordination Commission, established in 2004, is responsible for developing annual plans o f action to prepare for the forthcoming summer seasons and then reporting to the Government on their implementation. A "Keep it Clean Campaign" (aimed at reducing and cleaning up solid waste) has been developed and mounted by a working group comprised o f the Ministries o f Environment, Tourism, Health, Interior, Education and Science, Transport and Maritime Affairs, and Justice. The Government's remarkable openness. Nearly all Ministry o f Tourism documents are available o n the Internet. The Government is also very open to privatizing state properties and inviting international technical assistance. Some limitationsof the TMP are: It fails to recognize the inherent limitations o f Montenegro's coastal tourism product, seeming to work or the assumption that increasing high quality accommodation at the coast i s the key to a very substantia: increase inmarket share (inreality, quality accommodation i s a necessity but is not in itself an attraction). Diversification into other types o f tourism i s identified as a general objective, but with little detail and nc concrete strategies or targets for achieving this. While the TMP is itself multi-sectoral and multi-level, it i s not clear to what extent it i s integrated wit1 other planning instruments(e.g., National Spatial Plan, urban development plans). Furthermore,some important strategic objectivesof the TMP are not reflected in the annual plans. Fol example, the TMP indicates that Central and Western European countries will be targeted as the key source markets, but in 2005 action plan, the section on "Promotional Activities Nationally and Internationally" i s very general and gives no indication o f targeting any particular geographic source area or market segment. The plan calls for the opening o f Tourism Agencies only inBelgrade, Kosovo, and "abroad." Source: Bank Staff assessment. *By 2020, reduce 1- and 2-star hotel beds from 64 percent o f total to 25 percent o f total; increase 3-star beds from 33 percent to 40 percent. PrivateSector Investment,Regulation, and Finance 5.22 The immediate physical rehabilitation and upgrading of hotels through privatization, while a step inthe right direction, should be complemented by the knowledge and experience to create a facility that will attract an upscale, international clientele. The Government would thus need to pay attention not just to the price offered by bidders but also to their knowledge and experience to create high-end value. Inthe initial round o f hotel privatizations some o f the properties 87 were bought by speculators who did not make significant rehabilitation and upgrading o f services. Later tenders addressed this problem by stiffening investment requirements. By 2004, 19 hotels had been privatized for a total sale price o f about 35 million euros, involving a total investment commitment o f about 85 million euros, and a total actual and pending investment o f over 200 million euros. A few renovated hotels have reopened (e.g., Maestral, Mediteran). A detailed assessment o f hotel privatizations to date, focusing not only on the amount o f money invested but on the nature o f the buyers and the quality o f rehabilitation and the subsequent operation o f the property, could provide important insights.In future it may be necessary to give greater consideration to prospective buyers' experience in operating international standard tourism accommodations. In addition, experienced and capable tourism investors are concerned not only with the potential o f a particular property but with the overall context, including the Government's commitment to provide essential public infrastructure and services and to control negative influences such as unplanned and illegal development. Finally, because Montenegro i s currently relatively unknown in many prospective tourism markets, high priority should be placed on attracting a few highquality "flagship" operators whose presence can help provide the reassurance that many travelers need in order to try out a new destination. 5.23 Legislation and regulation are needed, but must be supportive, not oppressive. In the tourism sector, as in other areas o f business, the Government has placed considerable emphasis on enacting new legislation and regulations and creating institutions to implement them. In addition to the Law on Tourism (currently being amended), there i s a new Law on Tourism Organizations (February, 2004) which established a Commission for Categorization o f Tourism Resorts,100and contains various regulations, guidelines and obligatory standards recently enacted or under preparation for the licensing, classification and categorization o f accommodations and catering establishments, development o f nautical tourism, the development o f mountain tourism, etc. The Ministry o f Tourism regards such regulations as a main mechanism for stimulating the upgrading of tourism facilities in the country. For example, it has proposed that in the future licenses should be issued only to 3- to 5- star quality accommodations. A classification system i s important to give confidence to international travelers, but it must be accurate and reliable in order to serve this purpose. The Commission (which includes an international expert) and the MOTconsider that the standards now beingapplied in Montenegro are equivalent to international standards."' Furthermore, as noted in Chapter 4, the proliferation o f laws and regulations, particularly when combined with a high degree o f discretion on the part of inspectors, can lead to confusion and to opportunities for official rent-seeking, and can discourage business owners from joining the formal (regulated) sector. The stated objective o f the new wave o f regulations is to ensure that accommodation and services are brought up to international standards, but in some cases the level o f prescriptive detail seems excessive."* One action listed in the 2005 plan i s the unification o f all laws and by-laws in the tourism sector, but little information i s provided regarding how this will be carried out. It i s clear, however, that the process should include a thorough review o f the body o f regulations, to identify loo Categorization refers to the type o f facility (e.g. hotel, small hotel, apartment hotel, bistro, etc.). Classification refers to quality within that category, such as 1-star (budget) to 5-star (luxury). About 180 enterprises have been categorized and classified to date. lo' However, some experts do not agree. For example, the authors o f the MPSDC benchmarking study consider the Government categorizations higher (more generous) than international standards, particularly for the 4-and 5-star categories. lo* For example, inthe "Obligatory h Qualitative Standardsfor Private Tourist Rentals -Rooms, Apartments, Houses" the minimumrequirements for all classification levels include (inaddition to reasonable items such as clean sheets, curtains and adequate lighting) a requirement that clothes hangers inbedrooms may not be made o f wire, an iron and vacuum cleaner be available on request, and there be one reserved parking space for each apartment. For restaurants, it is apparently required that a copy o f the price list-stamped by the Minister o f Tourism-be displayed on the wall (personal communication with, M.Yanofsky). 88 those that are required for maintaining basic standards (health, safety, environment, etc.) and protecting consumers' interests, and those to aspects that would be better left to market-based mechanisms. 5.24 Land use planning, the strengthening of property rights and the control of illegal construction are essential and urgent. The TMP recognizes inadequate planning, uncertain property rights and proliferating illegal construction as important constraints to private sector investment, including investment in Ulcinj, which represents a major portion o f the projected growth in international tourism at the coast. The Government has taken some important actions, such as preparing the Ulcinj Development Plan (including an environmental assessment), establishing the Coastal Zone Management Agency, embarking on an integrated coastal zone planning program, and preparing a L a w on Restitution. However, these institutional instruments will succeed only ifthere is a strong Government commitment to support and enforce them. The 2005 plan lists intended responses (e.g., defining a list o f locations in the Marine Zone o f particular importance for the development o f tourism and establishing a way o f prohibiting their being used for other purposes; defining the legal framework for managing tourist destinations; ensuring more efficient implementation o f regulations related to unlicensed construction). However, it lacks concrete mechanisms, commitments and targets. The Government needs to make a genuine commitment to addressing this crucial issue of property rights and associated lack o f control o f illegal construction, particularly in the few remaining high-potential sites (e.g. Ulcinj, and inland areas close to national parks and other natural attractions). This issue represents one o f the greatest threats to the future prospects o f Montenegro's tourism. Concrete measures such as improving cadastral data and implementing the Law on Restitution are urgently needed. 5.25 Affordable financing and incentives are key to private sector investment in tourism. The main incentive offered to the private sector i s the opportunity to purchase properties for renovation, presumably at attractive prices. In 2004 the Government also put in place a program to subsidize credit for small and medium tourism enterprises. Demand for the loans was fairly high, but the impact has not yet been evaluated. Ad hoc initiatives cannot make up for the overall problem of the lack o f affordable, medium-term credit (see Chapter 4). The resulting high degree o f dependence on internally generated cash flows means that much o f the tourism development that takes place i s likely to be in the form o f individuals and firms that are in other businesses and are simply "trying their hand" at a tourism enterprise. This contributes to lack o f professionalismand inconsistent quality in the sector. The development o f a competitive tourism sector will require greater access to medium- term and longer-term credit at feasible rates, provided to investors with the demonstrated professional and financial capacity and commitment to develop and operate high quality tourism enterprises. Other fiscal policies should also be reviewed in relation to their impact on tourism profitability and competitiveness. For example, unlike many countries, Montenegro does not give an exemption on the 17 percent VAT to tourism, as it does to other export goods and services.'03 It i s important for the Government to view tourism as a long-term source o f economic growth and employment generation, rather than as a short-term revenue generator. I O 3Most European countries have one or even two reduced rates for VAT. As o f 2004, 10 out of 15 EU Member States and 9 out of 10Accession countries applied reduced rates on accommodation services; 13 of the 25 areiwill apply reduced VAT rate on restaurant services (SCEPP, 2004). 89 Box 5.2. Sustainable CoastalTourismDevelopment: Some Lessons of Experience An extremely difficult challenge in tourism development is to balance four major considerations: (i) profits for developers and other commercial interests; (ii) visitors who wish to return; (iii) satisfied improved quality o f life and voice for residents; and, (iv) environmental sustainability for the enjoyment o f future generations. Montenegro faces all o f these challenges at the moment, including attracting private investment for coastal development. However, achieving sustainable coastal tourism development is probably the biggest challenge over the long-term. The experiences o f Caribbean islands with small population and specializing in sea-based tourism--in particular that o f Antigua-- illustrates what not to do. On the other hand, the experience o f US Virgin Islands in coastal management practices illustrates good practice o f how to achieve coastal management and sustainable tourism development. Failure to protect coastal capital i s often the most important threat for sustainable coastal tourism development. This arises due to environmental neglect, a n d or aggressive promotion l o w value-added mass tourism. Antigua represents an example where there has been loss o f coastal capital and lack o f sustainability. Between 1975-1980, total tourist visits doubled, and it doubled again between 1980-1990. During these years more mangrove swamps and offshore reefs were damaged or killed than in all previous island history (Coram, 1993). Subsequent to these asset losses, the number o f overnight visitors has dropped and still not recovered (WTO, 2002). This policy failure derived from a legacy o f environmental neglect, the poor performance 01 non-tourist diversification into manufacturing and other economic sectors, marginal citizen participation in decision-making, and the authorities' persistent preference for short-term economic gain over long-tern sustainable natural resource planning and management. Montenegro may need to avoid all o f these ills. However, coastal capital depletion can be avoided. The Virgin Islands Coastal Zone Management Program (VICZMP) provides a best practice example o f how coastal assets can be protected while realizing tourisr development. The program was enacted by the U S Virgin Island Legislature in 1978 to protect, maintain and where feasible, enhance the overall quality o f the coastal zone environment for the benefit o f residents anc visitors alike. A Commission, headed by a cabinet level position and made up o f 15 private citizens/ staff, was appointed by the Governor and approved by the Legislature to regulate activity and development in the coasta zone through major and minor permit processes. In the case o f a major permit for a large resort, the proces. involves an Environmental Assessment Report (EAR), review by the Commission staff and appropriate agencies, public noticesihearings for citizen input, and a final decision by the Commission. Public participation-in particular the thorough permit vetting process--institutionalizes expert input from Commission staff and from technicians in related local public agencies. Commission staff i s also charged under the law with identifying any illegal coastal zone activities undertaken without valid permits. The lessons are that sustainable coastal tourism development can be achieved through: (i)a basic integrative understanding from public planners, resource users, and managers and developers o f how terrestrial and marine ecosystems interact to preserve overall ecological stability; (ii)the establishment o f an effective regulatory framework supportive o f coastal stability based on such understanding; and, (iii) an institutionalized citizen participation in coastal resource management and conflict resolution. The VICZMP is recognized as a model for other governments and for other island governments inthe Caribbean incoastal tourism management. Source: Based on: Jerome L. McElroy, "Sustainable Tourism Coastal Development: Some Policy Suggestions", Paper presented to the Workshop on Coastal Tourism Policy, Simon Fraser University, Vancouver, British Columbia (December 6-7.2002) Labor Market and Skills Development 5.26 Human resources development is key to upgrading tourism and reaping its benefits. Tourism i s one of the most labor-intensive export industries, and employment generation i s usually an important economic benefit of tourism development. However, the extent and quality of the 90 employment benefits varies depending on the type o f tourism, on labor market policies, and on the level o f investment in human resources development. In Montenegro the potential employment benefits are not being captured. Local employment in the tourism sector i s relatively low and i s projected to grow at only a modest rate (1.7 percent in 2005; average 4.5 percent per year over the next decade:) (OEFNTTC, 2005). Montenegro currently ranks eighty-sixth among 174 countries worldwide with respect to employment in the tourism and travel economy (TTE) as a percentage of total employment, while it ranks sixteenthinthe contribution o fTTE to total GDP. This suggests that the rate o f tourism sector job creation is below what would be expected (it shouldbe noted, however, that these figures reflect only registered jobs, while a substantial proportion o f tourism workers are likely to be unregi~tered''~). 5.27 The WTTC (2004) identified a severe shortage of skilled labor, and inadequate training facilities (especially at the higher levels), as major constraints to developing a vibrant and competitive industry in Montenegro. Certainly, a better trained workforce will be essential for improving Montenegro's competitiveness inthis industrywhere service i s everything, and for making tourism an attractive career for young Montenegrins. However, the TMP barely makes a general reference to this as an area where international assistance i s needed (mainly in relation to improving catering and service skills), and includes no comprehensive strategy or targets. The National Employment Agency strategy appears to focus on training and increasing employment at the unskilled and low-skilled levels, with no strategy to absorb or mobilize the substantial population o f young, educated, unemployed people. An EU-funded project for providing school leavers with practical job skills i s initially targeting the tourism and wood industries, and provides training as waiters and waitresses. While better skills at the service level are urgently needed to improve quality and competitiveness in the existing facilities, the future development o f a modem tourism sector will require higher level professional training in a wide range o f skills and with an emphasis on modem information technology, management, and flexibility and "multi-tasking." The existing faculty of Tourism and Hotel Management at the University o f Montenegro i s not in a position to perform this function. The first private faculty o f tourism, management and trade, established in 2004 by Atlas Mont Bank inBar, holds out promise, but i s at a very early stage and little information i s available on it. 5.28 Finally, Montenegro needs to continue to take a regional perspective on tourism development. The Government's tourism development strategy, as reflected in the TMP, i s focused mainly on Montenegro in isolation from its neighbors. In reality, Montenegro i s a small part o f a region which includes some countries with well-established tourism industries (e.g., Croatia) and several others that are targeting tourism as a major area for investment and economic growth. While these countries represent competition, in today's highly mobile market (thanks to inexpensive long- haul air travel), physical proximity i s not a major factor inthis regard. The real challenge i s to entice international tourists to come to the western Balkans inthe first place, rather than to other comparable destinations such as the Mediterranean, the Caribbean, etc. Caribbean and southern African countries have recognized the advantages o f cooperating with one another to sell themselves collectively as world class destination with each country identifyingits own particular niche and benefiting from the appeal o f multi-country circuits. Their strategies include joint marketing and promotion and the facilitation o f inter-countrymovement through measures such as reducing border formalities, building complimentary infrastructure, and using o f common signage. Smaller, less known countries benefit from their larger and more advanced neighbors through an "overflow" effect, while the latter have an `04The Labor Agency reported 3,000 newjobs filled inthe tourism sector in2004, but the majority o f these are jobs that existed previously inthe informal sector and moved into the formal sector as a result o f a legalization campaign. Estimates are that one-half to one-third of tourism jobs are held by expatriate seasonal workers. (Wieland, pers. comm.) 91 incentive to assist the former to develop to a high standard in order to raise the overall reputation o f the region. 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Brussels. 97 ANNEXES ANNEX1.MONTENEGRO--CHRONOLOGY OFMAJOR EVENTS, 2002-2004 Month MainEvent January -- Introductiono f euro and replacement o f Deutsche Mark as legal tender A new company law was adopted (minimal capital requirement significantly - reduced for LLC - to one euro. Several important laws adopted: Customs Law and L a w o n customs administration, Employment Law, Enterprise Insolvency Law, Law o n Courts and Accounting Law. February - The Central Bank decided to introduce compulsory management inJugobanka - The Agreement o n the Redefinition o f the Relations between the two Yugoslav republics was signed. March - The Government o f Montenegro makes decision to freeze the debt and the old foreign reserves on balance sheet o fMontenegro Banka. This decision was made to rehabilitate and re-capitalize the bank. - EIB approved loan for railways sector o f 15 millioneuros. April - Euro becomes the only official currency, 115 thousands persons inMNconverted -- currencies o f counties from euro zone to euros (approximately 920 millionDM) The government adopted Economic policy, Parliament o f Montenegro adopts Agreement on Redefinition o f Relations ---- between Montenegro and Serbia. License for work granted for Montenegro Banka, Bankruptcy process started in Jugobanka. The new three-year arrangement with IMF started, No confidence for the republican government voted inthe Parliament. June - Initial tender for privatization o f Telecom o f Montenegro, Minimumcapital requirement for commercial banks raised to 5 million euros Central Bank's initiative for the process for closing the offshore banks started. July Signed agreement with Greece on bilateral assistance to Serbia and Montenegro August ----- WB emergency energy project started, privatizationo f Jugopetrol started by issuing tender September - A USAID sponsored commercialbank -Opportunity Bank-- started operations. October - Elections for the Republican Parliament, 39 out o f total 75 mandates, won "Democratic list for European Montenegro - M i l o Djukanovic". "Coalition for changes" won 30 mandates, "Liberal Committee" 4, and "Albanians Together" 2 - mandates. Jugopetrol, largest oil retailer, privatized. The new owner i s Greek oil retailer - Hellenic Petroleum. Signed contract o n concession o f largest Montenegrin port - Port o f Bar container terminal (concessionaire i s Panama's company Eberhard International Distributors). November -- Repayment o f frozen foreign exchange savings started, Set o f laws o n education andbreeding passed. The Parliament o f Montenegro passed General L a w o n Education and Breeding, L a w o f Pre-school Education, Primary Education, L a w on Gymnasium and Law o n Professional Education o f adults. December - Parliament approved budget for 2003 (expenditures will be 43lmillions euros, 25 percent more than previous year) - Securities Commission adopted the regulation for trade inshares from mass - voucher privatization. Presidential elections failed (about 46 percent o f Montenegrin citizens came to the polls), 98 - Privatization o f Niksic's Ironworks initiated. 2003 January -- The new government is formed -Mr.Djukanovic i s the Prime Minister, Parliament o f the Republic o f Montenegro adopted the Constitutional Charter o f the State Unionbetween Serbia and Montenegro and Law for Constitutional Charter Implementation. February I - Second round o f presidential elections failed, with turnout o f only 47.7 percent o f - Montenegrin citizens at the polls EuropeanBank for Reconstruction and Developmentbecame shareholder inthe Euromarket Bank March -- The government adopted an Agenda o f economic reforms, Council o f the Central Bank o f Montenegro reduced requiredreserves for commercial banks from 50 percent to 23 percent. April - Introduction o f VAT M a y - Montenegro Banka privatized through sale to Slovenian Nova Ljubljanska Banka. June - Joint customs office o f Serbia and Montenegro established. July Parliament adopted supplementary budget. August -- Action plan for harmonization o f economic systems o f Serbia ad Montenegro adopted. September -- Reform o f pension system started with adoption o f the new pension insurance law. Two additional laws adopted: anti money laundering law and law o n repayment o f frozen foreign currency deposits to citizens o f Montenegro. October I Privatization o f hotels continued November I ---- Government o f Montenegro adopted PRSP. Donors' meeting inBrussels Free Trade Agreements between Serbia and Montenegro and Albania, Bulgaria and Moldova signed inRome. December - The new Labor Law adopted inthe Parliament, -- Budget for 2004 adopted. Collective agreement between Chamber o f Commerce and trade union signed. 2004 January -- Transfer o f the public payment system (ZOP) to commercial banks. The Government o f Montenegro and six Montenegrin commercial banks signed contracts for micro-credits scheme worth 13 million euros. This credit line is designed to stimulate employment and to finance projects inagriculture and tourism. February - Privatizationcontinued with the sale o f Hotel Splendid, and issuing o f tenders for - the factories Beranka, Niksic Still mill, Changes inthe positions o f ministers o f finance and international economic - relations. The government signed the protocol on establishingjoint maritime company with Norwegian Th. Jacobsen. March - The Parliament o f Montenegro adopted several new laws: law o n railways, law on political parties, law on restitution o f disposedproperty rights and repatriation, - law on civil procedure, and law on executive procedure. EUadoptedplan for technical andfinancial assistance to SEE -CARDS (Community Assistance for Reconstruction, Development and Stabilization), o f April - The initial results o f the Decree on Tax Relief for N e w Employees was that - - - around 40,000 new employees were registered, Adopted L a w on Tax o n the use o f passenger vehicles, L a w o n supreme auditing institution, Foreign trade law, Law on civil servants salaries, L a w o n tax o f - insurance premiums, Implementation o f FTA with Bosnia started. May - Supplementary budget adopted. 99 - The Parliament o f the Unionwas established and MPs voted for the establishment -- o f the last missing institution o f the State Union- the State Union Court. Announced Tender for the sale o f a part o f the company Radoje Dakic. Government adopted decree which allows reduced tax on wage bill by 5 percentage points on July lst,additional 5 percentage points inDecember. and June - Control share package o f the Niksic Ironwork, i.e. 59.27 percent o f the share - capital, was sold to the company "Midland," World Bank approved credit o f seven million dollars for health reformand five - million dollars for pension system reform The government adopted the Decree o n Foreign Exchange Currency Savings -- Conversion into Bonds. Nominal value o f issued bonds is EUR 150 million, The agreement o n succession o f former SFRY came into force, Adopted Law on Changes inLaw o f Privatization o f the Montenegrin Economy, L a w on prevention o f conflict o f interests, Law o n tax free zones and Law on roads. July - Severalnew laws adopted: Law on Mortgage, Law o n Investment Funds, -- amendments on the Law on Pension and Invalid Insurance. Montenegrin maritime company bought the first ship. The first installment o fthe repayment scheme for frozen foreign currency deposits - was paid to persons European Commissionrepresentatives handled the document: European Partnership with Serbia and Montenegro to the state union council o f ministers. August - Privatization continued: company "Jakic" from Pljevlja was sold to the American company PrimPacific, and preliminary Tender for sale o f the Aluminum Mill from Podgorica was announced. Norwegian company Telenor, one o f the owners o f mobile lines operator "Pro Monte", bought the rest o f the shares (55.9 percent) thus becamethe only owner. The new law on game o f chance started to be implemented September -- Shares and portions o f property o f the companies Cmagoraput, Zitoprodukt, - Lovcen and Centrojadran were offered for privatization through public auction. The Board o f Directors o f the World Bank approved SAC2 inthe amount o f US$ - 18 million. The Government decided to establish the fund for the refund o f the nationalized property. October -- Tender for sale o f 51percent o f shares inTelekom Cme Gore was issued. The government has increased temporary customs on flour (to 30 percent) due to requests from the local suppliers. November - Closing date for the tender opened for the privatization o f K A P has been - prolonged to January 20. Serbia and Montenegro signed an agreement with Russia on settling the old debt innon-convertible currencies (amount ofUS$306.8 million). December -- Tax on wages reduced by further 5 percentage points. The newbudget for 2005 has beenadopted. It envisages total government - expenditure o f 492 million euros. Several laws adopted: Law on protection on the work, amendments on the law on social insurance, law on labor, employment law and law on pension insurance. 100 ANNEX2. MONTENEGRO--STATISTICAL TABLES Table A.l. Montenegro-Key Macroeconomic Indicators Indicator 2000 2001 2002 2003 2004 Real sector developments GDP, mlnEUR 1,022.2 1,244.8 1,301.5 1,433.0 1,535.0 GDP, mlnUSD 944.1 1,114.9 1230.2 1621.0 1909.4 GDP real growth 3.1 -0.2 1.7 2.3 3.7 Industrial production growth (y-0-y) 3.3 -2.0 0.6 2.4 13.8 Agriculture growth, (y-0-y) -5.O 7.0 6.6 1.o 3.5 Public finances Central governmentrevenues, % GDP 28.7 23.3 26.7 25.7 27.3 Central governmentexpenditures,% GDP 37.0 26.3 30.8 29.9 31.3 Budget deficit before grants, % GDP -8.3 -3.O -4.1 -4.2 -4.0 General governmentrevenues, % GDP na 38.0 35.1 34.8 36.5 General governmentexpenditures, YOGDP na 42.3 38.6 37.6 37.7 General governmentdeficit after.grants, na -1.6 -1.8 -4.0 -3.1 %GDP Privatization revenues, EUR mln 0.0 0.0 66.4 15.8 7.7 Privatization revenues, % GDP 0.0 0.0 5.1 1.1 0.5 Debt service, EUR mln na 59.5 48.9 55.7 52.0 Prices Inflation(CPI, eop) 24.8 24.0 9.4 6.7 4.3 Inflation(CPI, average) 24.7 22.9 17.5 7.0 3.4 Costs of living (eop) 22.4 26.6 9.5 6.2 1.5 Foreign Trade Export of goods, mlnUSD 161.3 210.8 305.1 304.9 474.1 Import of goods, mlnUSD 354.5 647.4 706.7 713.4 1014.3 Trade deficit, mlnUSD -193.2 -436.6 -401.6 -408.6 -540.2 Export of goods, mlnEUR 174.7 235.3 320.8 270.6 381.6 Import of goods, mlnEUR 383.9 726.3 742.8 629.9 812.5 Trade deficit, mlnEUR -209.2 -491.0 -422.0 -359.3 -430.9 Export of goods inEUR, as %GDP 17.1 18.9 24.7 18.8 24.9 Import of goods inEUR, as %GDP 37.6 58.3 57.1 43.7 53.0 Trade deficit, as %GDP -20.5 -39.4 -32.4 -24.9 -28.1 101 Indicator 2000 2001 2002 2003 2004 CAD before grants, mlnUSD na -307.5 -247.9 -154.0 -189.3 CAD,as %GDP na -27.6 -20.1 -10.7 -12.3 CAD after grants, mlnUSD na -175.0 -161.1 -102.0 -143.0 CAD after grants, as %GDP na -15.7 -13.1 -7.1 -9.3 Gross official reserves, mlnEUR na 34.5 43.0 38.5 53.5 FDI, mlnEUR na 10.6 86.9 43.8 51.8 FDI, mlnUSD na 9.5 84.3 50.5 62.0 Tourism income, mlnUSD na 94.9 144.0 151.2 179.7 Monetary M 1 na na 402.0 386.1 429.6 M2, mlnEUR na na 496.0 460.8 536.1 M2,as %GDP na na 38.1 32.2 34.9 Wages Average net wage inEUR 96.4 108.0 142.2** 174.0 195.9 Average pension, EUR 84.0 98.4 108.7 112.0 123.0 Employment Average employment (official), 000 140.8 141.1 140.1 142.7 143.5 Registered unemployment, average in000 84.1 81.6 80.9 71.7 65.0 LFS unemployment rate 23.2 24.6 24.5 26.9 27.7 Indebtedness Public external debt, EUR mln 671.0 674.4 893.6 461.5 488.3 Public external debt, %GDP 65.6 54.2 68.7 32.2 31.8 Public debt, EUR mln na na 1149.2 711.2 742.4 Public debt, %GDP na na 88.3 49.6 48.4 Memorandum items: Population 611,122 613,328 615,534 617,740 620.145 USDper 1 EUR,period average 0.924 0.896 0.946 1.131 1.244 ***- - in dinars averagefor 1-6/2002 and 7-12/2002. Source: MONSTAT; Central Bank o f Montenegro; Montenegrin Ministry o f Finance. 102 Table A.2. Montenegro:Balanceof Payments,2001-2004 (EURthousands) 2001 2002 2003 2004 Trade balance -491,012.8 -421,950.2 -359,330.0 -430,900.0 Exports f.0.b. 235,310.8 320,823.2 270,574.0 381,607.0 Exports f.o.b., excluding export to Serbia 209,792.0 219,388.0 177,575.0 259,553.0 olw aluminum 157,644.0 165,365.O 109,726.0 158,069.0 Imports c.i.f. -726,323.6 -742,773.4 -629,904.0 -812,507.0 Imports c.i.f., excluding import from Serbia -611,473.2 -564,967.4 -413,091.O -566,7 16.0 olw electricity -37,326.2 -48,923.4 -46,526.0 -48,777.0 Services (non-factor services, net) 97,355.0 101,796.8 111,733.0 139,879.0 Receipts 150,738.0 176,094.4 191,395.O 241,123.0 Expenditure -53,382.9 -74,297.6 -79,662.0 -101,244.0 Net factor income -5,138.0 -8,846.0 -20,802.0 -39,231.0 Of which: Net interest -1,o 12.0 -649.0 -11,991.0 -23,983.0 Earnings 1,623.0 1,122.0 580.0 586.0 Payments -6,761.0 -9,968.0 -21,382.0 -39,8 17.0 olw interest 2,465.0 1,601.0 12,568.0 24,524.0 Private remittances, net 52,652.5 71,321.0 114,376.0 140,906.0 Inflows 96,849.5 114,793.0 127,945.0 160,704.0 outflows -44,197.0 -43,472.0 -13,569.0 -19,798.0 Current account balance, before grants -346,143.2 -257,678.4 -154,023.0 -189,346.0 (In percent of GDP) -27.8 -19.8 -10.7 -12.3 Official grants 147,108.5 91,521.5 52,037.0 46,378.0 (In percent of GDP) 11.8 7.0 3.6 3.0 Current Account Balance, after grants -199,034.8 -166,156.8 -101,986.0 -142,968.0 (In percent of GDP) -16.0 -12.8 -7.1 -9.3 Foreign direct investment, net 10,636.5 87,327.0 38,725.0 50,O 15.O Foreign loans, net -6,052.0 4,411.0 47,047.0 98,170.0 Medium and long term, net -6,052.0 4,411.0 47,047.0 98,170.0 Disbursements 2,916.0 23,679.0 114,597.0 176,103.0 Amortization -8,968.0 -19,268.0 -67,550.0 -77,933.0 Short term, net 0.0 0.0 0.0 0.0 Other capital inflows -13.0 -174.0 942.0 5,524.0 Commercial banks, net 3,305.0 10,007.0 45,759.0 32,237.0 Capital account balance 7,876.5 101,571.O 132,473.0 185,946.0 Errors and omissions 191,158.3 60,619.8 -31,044.0 -27,937.0 Overall balance 0.0 -3,966.0 -557.0 15,041.0 Financing 0.0 3,966.0 557.0 -15,041.0 Net foreign assets (increase, -) 0.0 3,966.0 557.0 Central Bank, net 0.0 3,966.0 557.0 --1$04 1.O 15,041.O Gross foreign reserves (increase, -) 0.0 3,966.0 557.0 -15,041.O Ofwhich; IMF purchases 0.0 0.0 0.0 0.0 Gross foreign liabilities (increase +) 0.0 0.0 0.0 0.0 IMFrepayment 0.0 0.0 0.0 0.0 Arrears (reduction, -) 0.0 0.0 0.0 0.0 Memo items: GDP inEUR 1,244,800.0 1,301,500.0 1,433,000.0 1,535,000.0 USD per 1 EUR 0.8956 0.9449 1.1309 1.2439 Source: Central Bank o f Montenegro 103 Table A.3. Montenegro: EmploymentandUnemployment,1997-2004 (average per year in thousands) 1997 1998 1999 2000 2001 2002 2003 2004 Employment Employment (LFS) 178.6 180.4 184.8 181.7 176.6 177.6 168.5 187.3 Employment (official) 147.1 147.2 145.6 140.8 141.1 140.1 142.7 143.5 Unemployment Unemployment (LFS) 57.3 50.7 53.3 54.9 57.5 57.7 62.1 71.8 Unemployment (official data) 64 68.3 75.3 84.1 81.5 80.9 71.7 65.0 Source: Labor Force Survey, MONSTAT; Employment Fund for official data. 104 Table A.4. Montenegro:ConsolidatedFiscalOperations,2001-2005, YOof GDP" 2001 2002 2003 2004 2005" Total revenue 38.0 35.1 34.8 36.5 36.3 Current revenue 38.0 35.1 34.8 36.2 36.3 Tax revenue 32.9 32.8 32.6 34.5 34.7 Personalincome tax 5.4 4.4 4.4 4.2 4.2 Social security contributions 10.8 11.5 10.6 11.2 10.3 Corporate income tax 0.6 1.o 0.9 1.1 1.4 Retail sales tax / VAT 1/ 7.1 8.3 9.7 10.3 10.7 Excises 4.4 4.3 4.0 4.0 4.2 Taxes on international trade 4.3 3.0 2.7 2.4 2.6 Other taxes 0.4 0.4 0.2 1.3 1.3 Nontax revenue 5.1 2.3 2.2 1.7 1.5 Capital revenue 0.0 0.0 0.1 0.2 0.0 Total Expenditure and net lending 42.3 38.6 37.6 37.7 36.4 Current Expenditure 38.6 35.5 34.0 34.0 32.4 Net wages, salaries and allowances 9.9 10.0 8.9 9.5 9.1 Payroll Tax 1.6 1.1 1.5 1.7 1.4 Purchases o f goods and services 5.9 3.7 4.2 3.5 3.4 Interest payment 0.1 1.o 1.o 1.6 0.9 Subsidies and other current transfers 20.7 19.0 17.9 16.9 17.2 Subsidies to enterprises 1.2 1.9 1.o 0.6 0.4 Transfers to households 19.5 17.1 16.9 16.4 16.8 Other non-interest current expenditure 0.5 0.6 0.5 0.7 0.4 Capital expenditure 2.0 1.5 1.6 2.0 2.8 Foreign financed project spending 0.0 0.6 0.6 1.2 1.1 General reserves 0.6 1.o 0.6 0.7 0.7 Net Lending 1.1 0.7 1.4 1.o 0.5 Transfer to the Union Budget 0.0 0.0 2.2 2.3 2.6 Overall balance before grants -4.7 -3.8 -4.9 -3.6 -2.7 Overall balance before grants and -4.7 -3.3 -4.4 -2.4 -1.6 foreign-financed project loans Foreign grants 3.1 2.1 0.9 0.5 0.2 Overall balance including grants -1.6 -1.8 -4.0 -3.1 -2.4 Financing 1.6 1.8 4.0 3.1 2.4 Domestic financing 1.6 -3.7 1.7 0.6 -9.5 Bank financing 0.8 -3.4 1.1 -0.8 -9.0 Nonbank financing 0.8 -0.3 0.6 1.4 -0.5 Of which: repayment of FFCDs 0.0 -0.3 0.0 -0.3 -0.5 Net ForeignFinancing 0.0 0.6 1.3 2.0 1.9 Program 0.0 0.0 0.8 0.9 0.9 Project 0.0 0.6 0.6 1.2 1.1 Amortisation 0.0 0.0 0.0 -0.1 -0.1 Privatization receipts 0.0 4.9 1.o 0.5 10.0 * IMFProjections. Source: IMF;MontenegrinMinistryo fFinance 105 Table A.5. Montenegro: ConsolidatedGeneralGovernmentExpenditure by Function,2002-04" 2002 2003 2004 Yo GDP General Government Services 11.57 16.05 14.93 General public services 7.53 11.8 8.97 Defense 0 0 2.08 Public Order and Safety 4.04 4.25 3.87 Community and Social Services 28.21 29.09 27.06 Education 4.52 5.62 5.4 Health 7.25 6.98 6.28 Social Welfare and Protection 5.13 15.33 14.59 Housing and Community Amenities 0.13 0.14 0.09 Sport, Recreation and Religion 1.18 1.02 0.7 Economic Services 2.52 2.35 2.34 Energy and Fuel 0.35 0.08 0 Agriculture, Forestry and Fishing 0.57 0.64 0.61 Mining and Mineral Resources 0.04 0.02 0.04 Transportation and communications 0.79 0.44 0.81 Other economic activities 0.77 1.16 0.89 Other Expenditures 0.1 0.1 0.04 Memo Item 2: GDP (mill euro) 1301.5 1433.0 1535.0 Source:Montenegrin Ministry o f Finance * Datadoes not include municipalities (local governments). 106