Page 1 PROGRAM INFORMATION DOCUMENT (PID) APPRAISAL STAGE Report No.: AB1266 Operation Name Serbia and Montenegro Second Structural Adjustment Credit (Republic of Montenegro) Region EUROPE AND CENTRAL ASIA Sector Financial Sector (25%); Energy Sector (25%); Pension and Health Reform (25%); Public Administration Reform (25%) Project ID P074908 Borrower(s) SERBIA AND MONTENEGRO Implementing Agency REPUBLIC OF MONTENEGRO Date PID Prepared December 12, 2004 Date of Appraisal Authorization March 15, 2004 Date of Board Approval September 16, 2004 1. Country and Sector Background Under the present federal structure of SaM, the two constituent republics —the Republic of Serbia and the Republic of Montenegro—are macroeconomically autonomous and are responsible for nearly all aspects of economic policy. The proposed operation will focus on Montenegro, the smaller of the two republics. The 1990s was a lost decade for SaM. Although the country started the period relatively well integrated with the world economy and with higher standards of living than most other transition economies, the SaM economy was devastated as a result of armed conflicts, international sanctions, and trade shocks stemming from the break-up of the SFRY during the 1990s. By the time of the Federal elections and Serbian parliamentary elections in the last quarter of 2000, which brought to office reform-oriented governments with a mandate to bring greater democracy, modernization and integration with the international economy, Montenegro had already made significant progress in stabilizing the economy and implementing a reform program. In November 1999 the Montenegrin Government declared the German mark (DM) an official parallel currency. One year later the new Central Bank of Montenegro (CBM) declared the DM the sole legal tender in the republic. During 1999 and 2000, the Government of Montenegro financed its budget deficit with substantial foreign grants. The Montenegrin Government has made significant progress in structural reforms since 1998. Montenegro had gradually obtained de facto autonomy in foreign trade, adopted its own customs administration and established a liberal trade regime. By mid-2000, the Government of Montenegro reduced the average tariff to about 3 percent. The Montenegrin Government has also liberalized prices; undertaken a mass privatization program; restructured and privatized nearly all commercial banks; and enhanced the transparency and management of public expenditure. Montenegro’s stabilization efforts succeeded in laying the foundation for economic recovery by curtailing inflation which fell to 25 percent in 2000 from 128 percent in 1999 (and well below the 115 percent recorded in Serbia in 2000). By 2002, inflation in Montenegro had fallen to single digits. Real GDP rebounded from the steep 9 percent decline in 1999 (which reflected the impact of the Kosovo conflict), growing by 4 percent in 2000. Page 2 Nevertheless, subsequent economic performance has been disappointing. While most macroeconomic statistics in Montenegro are either not available or are unreliable, available estimates indicate that GDP growth has been modest in the past 3 years, unemployment has remained high, and job creation has been negligible. In addition, external and fiscal imbalances have remained unsustainably large. While transition reforms have progressed, they are incomplete, were not always planned in an integrated fashion and were introduced with inadequate attention to implementation capacity. The size and scope of Government intervention in the economy remains large and the capacity of public sector institutions to implement reforms remains weak. The reform effort of recent years has improved governance, public sector transparency and financial discipline, but more needs to be done in each of these areas. One of the key challenges the Government now faces is building strong institutions with the capacity and incentives to carry out the recently adopted formal elements of reform. The authorities realize the significance of the satisfactory progress in these policy areas for placing the country on a sustainable growth path and are determined to collaborate with international financial institutions towards successful implementation of their reform agenda. To this end, the Government in cooperation with the IMF and the World Bank has formulated a medium-term stabilization and reform program for 2002-05, which has been supported by a three-year Extended Arrangement approved in May 2002. Attaining sustainable growth and improved living standards, low inflation, and a viable external position constitute the main objectives of the program. As was envisioned in the Transitional Support Strategy agreed with the Government, the proposed operation will focus on key medium-term structural and institutional reforms and complement the macroeconomic program supported by the IMF. 2. Operation Objectives The proposed Second Structural Adjustment Credit (SAC 2) aims to support the Government of the Republic of Montenegro, in the implementation of key structural reforms to promote growth and to support further fiscal consolidation. The program to be supported by the proposed operation intends to achieve these objectives through specific reforms in the areas of: (i) the financial sector; (ii) the energy sector; (iii) pension and health; and (iv) public administration. In the financial sector, the Government program supported by SAC 2 will: (i) begin to resolve the assets carved-out from Montenegrobank and transferred from the failed banks; (ii) divest a majority stake in the remaining large state-owned bank; and (iii) implement measures to further restrict off-shore banking and money laundering activities. In the energy sector, the Government is now focusing on effective implementation of the provisions of the Energy Law and extending the reform of power tariffs to the largest consumer of electricity in Montenegro. The SAC 2 program would: (i) strengthen the financial viability of EPCG; (ii) support EPCG commercialization; and (iii) ensure affordability for poor energy consumers. SAC 2 will support reforms in both the pension and health sectors. The key objectives of the pensions reform are (i) to ensure the effective implementation of the reforms introduced in 2003 aimed at improving the transparency and management of public finances; and (ii) to further lay the ground work for the next stage of pension reform envisaged in the Law on Pension Insurance, through the drafting of new legislation to regulate voluntary pension funds. The Government is also launching reforms in the health sector in accordance with the Montenegro Health Sector Development Strategy adopted in November 2003. This strategy seeks to put in place a framework to strengthen the financial sustainability, efficiency, quality and governance for health insurance and health care. The Page 3 Government’s health reforms would also seek to introduce transparency and improved management of pharmaceutical expenditures. Finally, in public administration, the reforms supported by SAC 2 would (i) depoliticize top level posts and establish a merit-based civil service system; (ii) reform the policy process to control the fiscal cost of the public administration; and (iii) develop the accountability system, by strengthening an independent internal control function in the state administration (administrative accountability), by developing of the administrative court system (judicial accountability) and by improving external oversight through the Ombudsman institution (parliamentary accountability). 3. Rationale for Bank Involvement The Transitional Support Strategy (TSS – Report 22090-YU, June 26, 2001) for the Federal Republic of Yugoslavia (FRY, now the Serbian and Montenegro (SAM)) proposed a broad program of support for FY02-04 focused heavily on policy reform. Up to US$540 million in IDA resources have been allocated over the FY02-FY04 period, with actual lending determined by policy performance. The TSS envisaged up to 80 percent of commitments in the form of adjustment credits to support critical policy reforms. Due to the highly devolved nature of SAM and the different starting points and pace of reforms in the two constituent republics, the reform agenda areas described in the TSS entail differentiated reform programs in each republic. Thus, the TSS Updates of July, 18 2002 and February 18, 2004 confirmed the approach whereby the policy reform program – and the Bank’s planned adjustment lending – is structured to address the specific needs of each republic. This approach envisions credits provided to SAM and on-lent to the republics, to back primarily republic-level reforms. Such a differentiated approach addresses the different starting points, reform challenges and pace of reforms in the two republics and avoids the risk of delaying disbursements to one republic due to a lagged reform effort in the other. Progress in stabilization and structural reform has been substantial in both republics and the Bank has supported the reform agenda through a number of adjustment operations. Consistent with the strategy laid out in the TSS, by end-June 2004 US$315 million for Serbia and US$15 million for Montenegro has been directed toward adjustment credits. These quick disbursing funds have been crucial for closing the financing gap in both republics while facilitating the design and implementation of a critical set of structural reforms. The Bank has supported the reform program in the Republic of Montenegro thus far by a single multi-sector adjustment operation (Montenegro SAC 1). Montenegro SAC 1 closed on January 30, 2004. 4. Financing The operation will be in the amount of around US$18 million equivalent disbursed in two equal tranches. 5. Institutional and Implementation Arrangements As a result of the highly devolved nature of SaM and the different starting points and pace of reforms in the two constituent republics, the proposed operation will focus on the Republic of Montenegro. The Ministry of Finance of Montenegro will serve as the main Government counterpart which will ensure the overall coordination among several other agencies involved in the program: the Ministry of Labor and Social Affairs, the Pension Fund, the Ministry of Economy, the Electric Power Company of Montenegro (EPCG), the Ministry of Health, and the Health Insurance Fund. Reforms to be supported under the Bank operation will be implemented through a variety of mechanisms, including inter-agency working groups. Bank experts will assist the relevant officials and working groups. 6. Benefits and Risks Page 4 SAC 2 builds on and consolidates reforms supported by Montenegro SAC 1. The two-tranche operation, focuses on two broad themes (i) reforms to promote growth and (ii) reforms to support further fiscal consolidation. The financial sector reforms would help to promote growth through increased (and increasingly efficient) financial intermediation. Pension, health and public administration reform would ultimately support ongoing fiscal consolidation. Energy sector reforms would support both growth and fiscal consolidation by overcoming episodes of supply shortfall and ensuring the financial self- sufficiency of energy utilities. Increased institutional transparency and accountability and increased focus on implementation capacity are themes thread through each of the five policy areas. SAC 2 will also provide crucial financing to help clo se Montenegro’s budgetary gap. The proposed SAC 2 also comes with a number of potential risks. Despite recent progress in implementing structural reforms and stabilization policies, the size and scope of Government intervention in the economy remains large while the capacity of public sector institutions to implement an ambitious reform agenda, while much improved over the past few years, remains relatively weak. The process of building strong institutions with the capacity and incentives to carry out the formal elements of reform is a medium-term endeavor. The ability of the Government to stay the course as they implement the reform program will be challenging. The risks involved with the weak policy making capacity are exacerbated by the uncertain political environment. The present constitutional arrangements in the union of Serbia and Montenegro require harmonization of trade, customs, and excise regimes of the two republics. This has proven challenging thus far. The constitutional arrangements also allow either republic the possibility to hold a referendum on opting out of the union. Other potential risks are posed by the lack of reliable macroeconomic statistics including national accounts, balance of payments, monetary, and other statistics needed to guide macroeconomic policy making. Given Montenegro’s exchange rate regime, unforeseen external imbalances would lead to downward pressure on the money supply which could have a deflationary impact. Various external shocks could strain Montenegro’s ability to maintain a sustainable macroeconomic framework. Any interruptions in donor flows would exacerbate the fragility both of the balance of payments and the financing of the budget deficit. On balance, the risks are outweighed by the potential benefits to be derived by continuing to improve the strengthen the economy, by providing needed budgetary support, and by creating a more secure and consistent foundation for other donors to provide similar support. Recovery will remain difficult and will not be possible without adequate and timely support from the Bank and other donors. These benefits will be felt not only in Montenegro and SAM, but also in the wider South East European region, as a more rapid and sustainable recovery in SAM would enhance its ability to become a stabilizing force in the region 7. Poverty and Social Impacts and Environment Aspects The Government’s structural reform program supported by SAC 2 will have an important impact on poverty and will support the goals set out in Montenegro’s recent PRSP. The Government of Montenegro has demonstrated a clear concern for managing any negative social impacts of reforms. In recent years the Government has implemented a number of measures to improve the targeting of social welfare programs. The PRSP process has been a collaborative effort between the Government and NGOs. The authorities are also working with the Bank and other donors to develop the data and analytical capacity required to ground future adjustment operations in a deeper understanding of various policies on the living standards of the poor. One area where Montenegro’s PRSP needs further strengthening is its lack of alignment with the budget process. The implementation of SAC 2 will coincide with Bank assistance in strengthening this alignment. Each of the reform areas to be supported in SAC 2 are included in Montenegro’s PRSP. As the Poverty Assessment emphasized, the shallowness of poverty in Montenegro suggests that even small Page 5 economic shocks can have potentially large effects on poverty. A positive shock, such as sustained economic growth, is likely to result in a disproportional decline in poverty, while a negative shock, such as a recession, is likely to result in a disproportional increase in poverty. The financial sector and energy sector reforms in the SAC 2 program will enhance prospects for growth and thus poverty reduction by improving access to finance and overcoming episodes of energy supply shortfalls. The energy sector, pension and health, and public administration reforms should contribute to a reduction in non-poverty related public expenditure which would should help ensure that the process of fiscal consolidation does not rely on reductions in social transfers to the poor. Successful fiscal consolidation would leave the Government in a better position to mitigate negative external shocks and thus cushion their effects poor. Health reforms should eventually lead to more affordable pharmaceutical prices. Public administration reform should contribute to a more efficient Government increasingly capable of implementing well targeted social welfare programs. The proposed SAC 2 is not expected to result in any negative impact on the environment. Contact point Contact: Bruce J. Courtney Title: Senior Country Economist The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Tel: (202) 458-5242 Fax: (202) 614-7776 Email: Bcourtney@worldbank.org For more information contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Web: http://www.worldbank.org/infoshop