Macroeconomic Framework 2006-2012

After the independence proclamation and the dissolution with Serbia in 2006, Montenegro implemented a new macroeconomic framework aimed at increasing employment and export possibilities and encouraging overall economic growth. This policy discourse was based on considerable investments in the three major economic pillars in the country, namely tourism, agriculture and energy (Ministry of Finance of Montenegro, 2007). Nevertheless, the

fundamental alteration of the system posed several risks to the normal macroeconomic functioning which necessitate further elaboration.

6.1.2.1. Challenges

There were two major structural problems in this period.

Firstly, the underlying barriers of the new framework made the Montenegrin economy unappealing to foreign investments. In order to stimulate the attractiveness of the industry, the government adopted equivalent standards to both domestic and international companies,

with the two groups being treated in the same manner. More specifically, the international corporations were allowed to obtain full ownership of local firms, while they can

unrestrictedly repatriate their profits overseas (World Bank Group, 2017). Moreover, the foreign parties could acquire property on the same basis as the local agents and the government is able to expropriate land only in extreme conditions. However, all of the aforementioned measures imperceptibly enhanced the foreign investments, but mostly on the expense of the domestic production (Marovic, 2016).

Secondly, due to the overreliance on the three industries, the Montenegrin economy was vulnerable to unexpected reduction of economic growth. In general, each of the three pillars was highly dependent on the international demand and as such, a sudden shock in the global market would directly impede the macroeconomic growth of Montenegro (Džankic_{́, 2012).} On the other hand, a universal increase of the prices in the energy sector would largely limit the possibilities of a constant economic development in the former Yugoslav republic. In a similar vein, decreased economic activity of Montenegro would lead to a reduction of foreign direct investments and local production, as well as to a raise of the inflation level (Katnic & Stankovic, 2016).

The exact outcome of these challenges will be illustrated in the subsequent section. 6.1.2.2. General Trends

The implementation of the new macroeconomic framework in Montenegro is characterized with a dubious progression between 2006 and 2012, compared with the previous couple of years. In general, the real economic growth fluctuated from 4 to 8 percent. Additionally, the public surplus represented only 3 percent of the GDP. The large increase in exports and imports, being around 37 and 55 percent respectively, caused a significant raise of trade deficit, which is partly offset by the aroused foreign investments. Based on all that, the real GDP growth gravitated around 8 percentage and was stimulated by the improvement in the infrastructure, as well as by the enlargement of the tourism and the banking sector (Ministry of Finance of Montenegro, 2007). However, as already defined, the new system failed to achieve significant progress in three important macroeconomic aspects, namely inflation rate, unemployment level and financial stability (Rutesic, et al., 2015). As a consequence, it is important to discuss those aspects more in-depth.

The inflation rate was maintained at around 2 percent during 2006, but increased to 6,5 percent in 2007. Correspondingly, the commodity prices were raised with approximately 4 percentage points (Ministry of Finance of Montenegro, 2007). These fluctuations were caused by four different elements. Firstly, the implemented structural modifications of the taxation and property policies, respectively leading to the introduction of a 7 percent VAT rate and a spillover effect of the increased FDI on price levels, generated a 25 percent increase in inflation (Torgler & Schneider, 2009). Secondly, internal factors, signified by a raise in energy charges, and external factors, marked by a global increase in oil prices, also influenced the inflation rate in Montenegro. Thirdly, agnate with the previous point, the new macroeconomic framework established a methodological procedure for computing the imported energy prices, which triggered a 30 percent price growth (Imbs, et al., 2012). Lastly, the economic dependence on the agricultural sector and the high seasonality of the goods stimulated the share of overall inflation by 15 percentage points. Generally, the relative inflation stability prior to 2006 was followed by a sharp increase after the implementation of the policy framework. The monetary experts indicated the sensitivity of the Montenegrin economy to high inflation and the possible risks to the interest rate and credit ratings of the country. However, the government failed to sufficiently monitor inflation rates after 2007, which restricted the fiscal possibilities to address the issue before the end of 2012 (Katnic & Stankovic, 2016).

Unemployment

The structural alternations of the macroeconomic legislation are believed to be the main instigator of the sluggish economic growth, especially compared to the other states in the region. More specifically, the passive privatization, the unfavourable transformation of the service industry and the fundamental reformation of the industrial mechanisms led to

insufficient production capacity (Salahodjaev, 2015). The unemployment decreased from 20 percent in 2005 to 12 in 2007, but the unfavourable conditions diminished the share of local production by 5 percentage points, which had an adverse effect on the employment

possibilities. In broad terms, the slight increase of economic activity had a positive effect on the labour market, signified by an increased number of employed individuals. However, the employees in some of the primary sectors, such as agriculture, transportation and education, decreased significantly from 7 to 12 percent (Drakic-Grgur & Stesevic, 2012).

These aspects prompted the policy-makers to adopt the Law on the Employment of Non- residents in 2009. The basic idea was to enhance the possibilities of local firms by simplifying the employment procedures and tax rates of foreign labourers. Moreover, the health insurance rates represented a major impediment to the establishment of new job possibilities in Montenegro during this period. Hence, the 2009 legislation decreased the employee contribution to healthcare from 80 to 10 euros (Fabris & Mitrovic, 2012. Nevertheless, a series of surveys from the Strategic Studies and Prognoses suggested that despite these fundamental policy transformations, 23 percent of the employed individuals still operated illegally either undeclared or in firms that are not officially registered (Baric & Williams, 2012). This informal structure also constituted the main reason of the inflexibility of the labour market, the inadequate profit maximization and large tax burden of the

companies, as well as the constant fluctuations of the unemployment in the country (Salahodjaev, 2015).

In addition, the inability of the university graduates to complete the transition from higher education to labour market was another major component of the inadequate unemployment rate in Montenegro between 2006 and 2012. This was mainly caused by the lack of structural relationship between the decision-making institutions, the higher education institutions, the employment institutions and the companies. The incapacity of the government to predict the future demands of the labour market resulted in low-quality education which also caused deficiencies in the on-job experience of the graduates (Luksic & Katnic, 2015). The authorities in Montenegro acknowledged the problem and instigated numerous attempts to modernize and promote the educational system, so that the labour market shortages could be eliminated in the long-term (Ministry of Finance of Montenegro, 2007).

In general, however, during the studied period, the unemployment rate in the former

Yugoslav republic remained largely unstable and the legal alternations were unsuccessful in solving the deficiencies on a more permanent basis (European Commission, 2015).

Financial Stability

The volatile economic environment of the global market, provoked the government to strengthen the overall banking control. From 2002 onwards, Montenegro has the Euro as an official currency, without being a member of the Eurozone, which suggests that there are no formal structural arrangements with the EU. This specification largely limits the

macroeconomic authority of the Central Bank, as it is solely responsible for regulating the banking and payment systems and for the monitoring of the fiscal policies (Ministry of Finance of Montenegro, 2007). Despite of the implemented measures, the industrial output decreased on average by 5 percentage points. The aforementioned lack of viable policy instruments of the Central Bank is considered as the main reason causing this decline.

Traditionally, the long-term inflation stability is the basic goal of the Central Banks. As such, in order to guarantee the relative resilience of the currency, those institutions are legally allowed to adopt regular deflation monetary policies (Drakic-Grgur & Stesevic, 2012). Nonetheless, this particular mechanism is not possible when there is a fixed exchange rate and unrestricted capital inflow, which accurately represents the liberal transaction system of Montenegro. In spite of some minor structural improvements, such as the liquidity

maintenance mechanism, the government failed to eliminate the monetary policy restrictions of the Central Bank in this period. Although the amount of similar international institutions which are completely independent in deciding on the fiscal discourse of a country is

negligent, such a drastic decision-making restriction is uncommon (Radovic, et al., 2013). Furthermore, the political authorities in the country also adopted a more countercyclical lending mechanisms. This approach increased the corporate loans by 56 percent and the household loans by 37 percent, while the growth in deposits expanded with 7 percent. In spite of this mostly risky measure for developing countries, the liquidity of the banking sector remained satisfactory, especially due to the fact that it was largely not guaranteed by reserve funds. Next to that, the liquid assets of the Montenegrin banks increased with over 90 percent after the dissolution and the total share gravitated around 35 percent by 2007 (Elgin, 2012). However, the government failed to utilize the full potential of the countercyclical policy measures. A premature debt payment to the World Bank increased the planned expenditures by 25 percent. As a consequence, the public revenues were raised by 5 percent of the GDP (Ibid.). Moreover, instead of financing more important underdeveloped sectors, such as the administrative capacity of the public sector, the budget expenditures were mainly allocated towards improving the infrastructure. In broad terms, the overall service expenditures were raised by 62 percent, while the funds for construction services increased by 35 percentage points. Contrary to the expectations, the issues related to employment and the foreign trade deficit of Montenegro amplified (Fabris & Mitrovic, 2012). This prompted the political authorities to change the policy discourse and to shift from countercyclical to procyclical

measures. The main goal was to simultaneously decrease the costs, as well as to increase the output, aggregate supply and the allocative efficiency regarding the investment inflow (Radovic, et al., 2013).

From one hand, the new macroeconomic framework stimulated the FDI inflow and imports by providing attractive loans to companies and households, but from another, the initial upward trend in economic growth was followed by an evident deterioration, especially in terms of account transactions. The deficit in 2006 was more than 232 percent compared to 2005, while the trade deficit was 1,7 times higher. This vast increase was because of the continuous raise of imports, accounting for 63 percent of the GDP in 2007, relative to exports (Krstevska & Petrovska, 2012). Moreover, the GDP portion of public spending was viewed as a crucial prerequisite for the general economic growth in Montenegro. The decrease of tax rates and the increase of budget expenditures under the Development Fund for Restitution of public spending that was established in 2008 was regarded as a long-term strategy against the account deficit. Nevertheless, the competitiveness of the Montenegrin local products and the export levels remained low, which maintained the import-oriented economic model in the country and the large deficit (Torgler & Schneider, 2009).

In the period 2008-2012, the main objectives of the Montenegrin government were to balance the proportion of public spending by maintaining the degree of infrastructural projects, to complete the banking privatization with the goal of a raise in deposits, and to facilitate the transformation of the macroeconomic system, mainly characterized by a further tax

reduction. Once more, the idea of the policy-making agents in the country was to increase the external competitiveness of the industry and to attract additional FDI by establishing a long- term budgetary control (Penev, 2012). Additionally, the cooperation between the local authorities and the EU institutions intensified. Thus, the financial dialogue reflected in the establishment of the Economic Reform Programme of Montenegro, which was based on strategies towards raising the employment opportunities, quality of education, overall monetary and structural stability, and competitiveness. All of this led to a considerable decrease of state capital, on the expense of an increase in foreign capital in the banks, accounting for almost 80 percent (Radovic, et al., 2013), as well as to other important macroeconomic developments which will be discussed in the subsequent part.