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Systematic country diagnostic: Montenegro

Montenegro Economy

Montenegro is a small and open upper middle-income transition economy that gained independence in 2006 and is negotiating accession to the European Union. Montenegro has a population of 622,000 and a GNI per capita of $7,320. It started negotiations with the European Union in June 2012 and strives to join the EU ahead of the other countries in the Western Balkans. In the negotiation process so far, 3 chapters have been provisionally closed.

Montenegro has gone through a period of economic boom and poverty reduction followed by one of economic bust, stagnation, and an increase in poverty. The economic boom, from 2000 to 2008, was triggered by a large inflow of capital that stimulated aggregate demand and led to a steady increase in the rate of growth, and a fall in the rate of unemployment. During the boom, there was a steady decline in the percentage of households below the poverty line and an increase in the income of households in the bottom 40 percent. The period of economic bust and stagnation, from 2009 to 2014, was triggered by an initial sudden stop in capital inflows—prompted by the international financial crisis, while falling aggregate demand reduced output and the demand for labor, resulting in a partial reversal of the earlier gains in poverty reduction.

Montenegro has no currency of its own, which puts large emphasis on sound fiscal policy and the country’s competitiveness. Montenegro unilaterally adopted the euro in 2002 without officially joining the euro zone, which means economic adjustments to meet the convergence criteria might be required as part of the European Union accession process. While using an external currency provides price stability following earlier problems with hyperinflation, the tradeoff is that fiscal policy is therefore the main economic management policy instrument available. Countercyclical fiscal policy can require significant discretionary spending, yet the budget of Montenegro is characterized by the predominance of non-discretionary spending, namely pensions and public sector wages. System-wide solvency and liquidity indicators in the banking sector appear broadly sound, but significant pockets of vulnerabilities exist among domestically-owned banks. In this context, the absence of a policy interest rate and the significant litations to its lender of last resort function reduce the central bank’s ability to influence bank lending.

Montenegro’s economic growth cycle follows closely the business cycle in Europe. The correspondence between the path of Montenegro and Europe’s GDP illustrates the vulnerability of the economy to the vagaries of the business cycle in a region that has not yet stabilized from the turmoil prompted by the financial crisis of 2008-10 and the subsequent sovereign debt crisis in some euro area countries.

Cyclical vulnerabilities are occurring in the context of an unfinished transition from command and control to a market economy. The transition to market rules has been accompanied by high and protracted unemployment and low levels of capacity utilization of machinery, equipment and physical infrastructure in all countries in the region. In the Balkans, the complexities inherent to this process were exacerbated by conflict and political uncertainty. The high unemployment rate even at the peak of the economic cycle in 2008 (at above 17 percent) suggests that the roots underlying low potential growth in Montenegro and other countries in the Balkans are way deeper than the business cycle and can be traced to the legacy of socialism and a unfinished reform agenda.

The development challenges facing Montenegro are a combination of cyclical and structural factors and require a two-pronged approach. The cyclical factors are the state of the economies in Europe, Russia and South Eastern Europe (SEE)—the short- to medium-term prospects of these economies; and the country’s macro-fiscal situation. The main structural factors are the level of regional integration, the level and quality of human and physical capital, the legacy of a socialist past, and the weak development of the private sector. The legacy of socialism is visible in the still large influence of the public sector and in the weight of the pension system and public administration cost in overall government expenditure. The weakness of the private sector is evident in the state of the financial sector, the high number of companies literally being insolvent with accounts blocked for years, the development of private firms, and the limited trade links between Montenegro and the rest of the world.

The Systematic County Diagnostics is organized into six parts.

  1. The first part presents a brief overview of the country’s recent socio-political and economic context.
  2. The second part examines the links between poverty, income distribution and economic growth, through the labor market, against the background of large changes in international capital flows and the unfinished structural reform agenda.
  3. The third part, examines the sustainability and vulnerability of the current growth model.
  4. The fourth part examines the structural constraints to sustainable and inclusive growth and poverty reduction.
  5. The fifth part reviews the governance and the rule of law foundations. The assessment of each constraint is followed by a description of what the Government of Montenegro (GoM) is doing to address the issue.
  6. The sixth part examines priorities and opportunities.