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How Emerging Europe Came Through the 2008/09 Crisis

Chapter 24. Montenegro: Riding the Capital Flow Roller Coaster

Bas Bakker, and Christoph Klingen
Published Date:
August 2012
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In its brief history since independence in 2006, Montenegro has been buffeted by strong, and sequentially opposing, external shocks. The postindependence boom, on the back of bold reforms and lofty assessments of the economy’s potential, lacked a broad base, and it aggravated underlying vulnerabilities with unparalleled credit growth and external imbalances. That left this small country of 600,000 fully exposed to the sharp deterioration of the global environment in the fall of 2008. Mitigating domestic policies were largely unavailable in the face of full euroization and depleted buffers in both public finances and the banking system. The economic contraction in 2009 was sharp and on the same order of magnitude as for emerging Europe on average. The legacy of the boom years and an unfinished structural reform agenda make for a weak recovery.


In the final years of the last century, and on the heels of the increasing international isolation of what was then Serbia and Montenegro, Montenegro experienced a dramatic reduction in economic activity: a drop in the standard of living, the evaporation of financial wealth through hyperinflation, large-scale degradation of physical and human capital, loss of traditional markets, and expansion of the underground economy accompanied by a rise in crime and corruption. In 1998, Montenegro started distancing itself from beleaguered Serbia with a bold reform program, focused on economic stabilization through the unilateral adoption of the Deutsche Mark, and later the euro, and through significant fiscal adjustment (Fabris and others, 2004). Structural reform and privatization were also set in motion. International integration was pursued as a political priority, culminating in declaration of independence in June 2006 (Vukotic, 2004).

The Run-Up to the Global Financial Crisis

Because of its considerable potential, which had largely lain dormant in the Yugoslav years, Montenegro quickly found itself in the crosshairs of international investors searching for yield. The shift toward a market-based economy, capital account liberalization, and large-scale privatization encouraged massive capital inflows, especially in real estate, tourism, and financial services. The inflows led to rapid economic gains—the country became the world’s fastest-growing international tourist destination in 2007—but overall these gains were not absorbed in a sustainable fashion.

Given the magnitude of the inflows, Montenegro’s small size, and its economic openness, macroeconomic policy anchors would have had a difficult time in avoiding overheating under the best of circumstances. Making matters worse, domestic policy levers were either not available or insufficiently deployed by the authorities.

Through much of the boom, monetary policy in the euro area had been overly loose for Montenegro’s cyclical position. Lacking an independent monetary policy, the Central Bank of Montenegro could only affect credit conditions by raising reserve requirements or mandating tighter supervisory and prudential standards, thus effectively raising the cost of credit. While the Central Bank of Montenegro undertook these measures, credit growth on aggregate was hardly dented.

This placed the burden of cooling the economy on fiscal policy; however, it was not tightened enough. While surpluses were initially built up, to a large extent they reflected unsustainable tax collections resulting from temporarily high imports (Gagales, 2008). And in any event, accumulated surpluses were placed in the domestic banking system rather than invested abroad, thereby facilitating further procyclical credit extension. Moreover, toward the end of the boom period, buoyant revenues were increasingly used to fund permanent fiscal relaxation, such as tax cuts and public sector wage increases of 30 percent in early 2008. The fiscal stance thus became outright expansionary, further boosting demand.

On the structural side, reforms did occur, but some of them took too long to bear fruit in time. Significant employment protection and a centralized collective bargaining system with little firm-level flexibility did their part in keeping wage growth and the unemployment rate high, thereby limiting the supply-side response of the corporate sector.1 A new labor law, passed in mid-2008, reduced some of the rigidities but still contained substantial employment protection, discouraging job creation and longer-term employment contracts. The otherwise successful privatization program also occurred late compared to the rest of emerging Europe. This limited the interest of the more-experienced multinational companies that had already invested elsewhere. The large industrial sector legacy enterprises, in particular, were sold to investors that were themselves headquartered in emerging markets and would experience a loss of financing when the global crisis escalated.

Accordingly, imbalances built rapidly, largely led by soaring consumption—the share of investment in GDP remained at average levels despite very large foreign investment. The decline in savings was facilitated by wealth effects from booming real estate and other asset prices and extremely rapid credit growth, which topped 100 percent annually in 2006 and 2007. A gaping hole emerged in the current account, which hit a deficit of a stunning 50 percent of GDP in 2008 and was increasingly debt financed. Excessive wage growth—following the public sector pay increase it peaked at 25 percent in August 2008—and the pickup of inflation to 9 percent in 2008 were further evidence of acute overheating.

Impact of the Global Financial Crisis

With these large imbalances and dependence on continued capital inflows, Montenegro was highly exposed to the global financial dislocations that unfolded in the fall of 2008. They were transmitted to the domestic economy through three principal channels:

  • A drastic and severe credit crunch on the heels of contagion and concerns about the robustness of the banking system (Figure 24.1). The initial driving force was massive and broad-based deposit withdrawals, much larger and more persistent than in neighboring countries, that drained liquidity and tested the resilience of the banking system. Important foreign parent banks were also severely stressed, and one (Hypo Alpe Adria) was even nationalized by its home authorities. The owners of domestic banks were often unable to provide sufficient funding to address liquidity and solvency needs. New credit dried up, and banks shrank their loan portfolios for lack of financing and mounting nonperforming loans.
  • Depressed external and domestic demand with strong negative effects on economic activity. Weaker interest by foreign investors in real estate in Montenegro and negative wealth effects—dropping asset prices, weaker balance sheets, and reassessment of growth prospects—triggered a sharp decline in construction activity. Tourism was also affected as the global fallout of the crisis led to a decline in overnight visits.
  • Large negative terms-of-trade shocks. Tumbling international commodity prices undermined the viability of much of the metals-focused industrial sector, such as the large aluminum complex and the steel mill. The drop of the aluminum price below the company’s break-even level prompted severe production cuts and a buildup of arrears and nonperforming loans.

Figure 24.1Montenegro: Development of Bank Deposits and Other Balance Sheet Items

Sources: Central Bank of Montenegro; and IMF staff calculations.

Policy Responses

Initial plans for fiscal stimulus were abandoned. In the fall of 2008, a stimulus package was launched, consisting of bank support and increased public investment, but as the full extent of the global crisis became evident and revenues plummeted, the government reversed course in order to contain budget financing requirements. A midyear revision of the state budget and similar adjustments at the local level ordered large cuts in capital expenditure, goods and services outlays, and the wage bill, all of which were extended into 2010. However, these efforts were met by implementation difficulties, triggering widespread arrears accumulation. Including those, the 2009 deficit came to 6½ percent of GDP, a level at which it has hovered since, partly also driven by the financing of new subsidies and transfers benefiting the industrial sector.2 In addition, the government assumed some state enterprise debt and extended significant loan guarantees to the aluminum and steel plants in order to advance their restructuring and to provide critical working capital. As a result, public and publicly guaranteed debt leapt to some 55 percent of GDP (from 27 percent in 2007).

Despite early, strong, and proactive measures, restoring health to the banking sector proved challenging. Starting in the fall of 2008, the following actions were taken:

  • The government guaranteed all bank private deposits and, on a case-by-case basis, interbank lending until end-2009—a contingent liability of 48 percent of GDP. It used its deposits outside domestic commercial banks for early repayment of bank loans, and it offered to provide banks with loans for up to one year against collateral of shares of at least equal nominal value, to help boost liquidity. In this context, a collateralized loan of €44 million was provided to the largest domestic bank in December 2008.
  • Moreover, the government pledged up to €100 million for bank recapitalization on a case-by-case basis at the request of banks or, in the case of systemically important banks, at the central bank’s request. Loan guarantees to the industrial sector also helped mobilize inflows, while large parts of the 2009 proceeds from the privatization of the electricity company and of the fall 2010 Eurobond proceeds, which were not needed for budget financing, were placed with the banking system.
  • The Central Bank of Montenegro for its part created a small short-term liquidity support facility, enabling solvent banks to borrow against prime collateral for up to 30 days, renewable up to three times. It also allowed banks to borrow up to 50 percent of their required reserves for periods not exceeding seven days in each month and cut required reserves to 10 percent.
  • The Central Bank of Montenegro also engaged in countercyclical regulation, bringing previously more-demanding loan classification requirements back in line with international standards. In a large domestic bank, where the problems were diagnosed to run deeper, the central bank prohibited new lending, demanded the installation of new management, and commissioned an independent external audit.

These measures helped slow deposit withdrawals. In addition, all foreign parent banks supported their subsidiaries with additional funding, thus helping to partially offset the decline in deposits. They also met central bank requests for large recapitalizations to restore solvency. The domestically owned banking sector had a harder time, and central bank sanctions remained in place into 2011.

Faced with the potential shutdown of the industrial sector in the face of the new owners’ financial difficulties, past privatization contracts were reopened to grant more breathing space and incentives for additional investments in exchange for government loan guarantees. The owners of the aluminum complex also returned a significant part of their shares to the government. Still, the success of this strategy remains uncertain, since financial difficulties and poor labor relations persist, both holding up the needed restructuring.

Economic Outcomes 2009–11

Montenegro’s very fast precrisis growth gave way to a severe recession in 2009 and a tepid recovery in 2010–11, reflecting the economy’s many vulnerabilities, its exposure to external developments, and the limited room for countervailing policies.

GDP dropped sharply in 2009, by almost 6 percent, with the contraction particularly pronounced in industry, construction, and financial services. In the industrial sector, the situation deteriorated further, with work stoppages adding to already large output losses. The tourism sector, in contrast, proved much more resilient. In 2010–11, the economy returned to positive growth, albeit at a slow rate of only 2½ percent, below the regional average.

Employment declined substantially, although the true extent of the deterioration was masked by special factors. Throughout much of 2009, headline employment and unemployment statistics depicted a strong labor market. However, this masked underemployment (especially in the metals sector), rising part-time employment, and the substitution of domestic for foreign labor. In effective terms, employment is estimated to have dropped by 14 percent on an annual average basis.

Pressure on inflation and wages eased. Inflation quickly fell below the euro area average, and nominal wages moderated and even declined during 2009—especially in sectors most affected by the downturn—helped by the 2008 tax cuts, which mitigated the effect on net wages. Subsequently, net wages also declined in 2010.

Despite severe pressure on the banking system and the absence of a lender-of-last-resort function, a systemic financial sector crisis was avoided. This owes much to the commitment of foreign parent banks to stand by their subsidiaries in Montenegro. In September 2010, Montenegro returned to international capital markets with a well-received Eurobond issue. Another issue followed in April 2011, although spreads have widened significantly since, reflecting both a more-discerning investor attitude toward sovereigns in general and the very rapid and large take-up of external debt in Montenegro as well.

Challenges Ahead

Montenegro’s economic and financial roller-coaster experience since independence underscores its need to build a more robust economy, one that raises income levels in a sustainable and steady fashion over time. Action is needed on several fronts.

The still-fragile recovery must be strengthened and a relapse into recession avoided. In addition, the needed rebalancing of the economy still has some way to go. Anchoring potential growth on a sustainable path calls for a strategy centered on enabling private sector-led growth, a smaller government, and deregulation, which would all serve to improve competitiveness. In this context, it is critical that further structural reforms get under way.

It is also essential to revitalize the financial sector. The crisis has taught that regulations and buffers must exceed those elsewhere. To the extent the problem areas of the past have not been worked out, that needs to happen urgently. The ultimate challenge will be to right-size the banking system without imperiling new credit flow.

With use of the euro, a highly open economy, and free capital movement, there is only so much that macroeconomic management can achieve. Buffers are therefore needed so that shocks do not knock the economy too far off track. The lack of fiscal space, in particular at the onset of the crisis, severely restricted the authorities’ room for maneuver in dealing with the challenges. The subsequent rapid and large take-up of external public debt has further eroded essential room for maneuver and raised significant new vulnerabilities. Thus, further fiscal consolidation is urgently needed, and the budget should target significant surpluses for a considerable amount of time in order to build up liquid public assets. This challenge could be even greater if large fiscal contingent claims were triggered, for example if some of the extended loan guarantees were to be called.

Montenegro: Principal Economic and Financial Indicators, 2003–11
Real Sector Indicators
GDP (real growth in percent)−
Domestic demand (real growth in percent)−−16.7−1.9−1.1
Net exports (real growth contribution in percent)5.4−0.5−1.0−23.3−20.5−
Exports of goods and services (real growth in percent)−0.350.28.111.312.0−2.2−22.77.416.5
CPI (end-of-period change in percent)
Employment (growth in percent)
Unemployment rate (percent)
Public Finances
Fiscal balance (percent of GDP)1−2.5−1.6−−1.4−6.5−4.7−6.2
Government revenue (percent of GDP)37.537.036.643.447.648.342.341.137.7
Government expenditure (percent of GDP)
Government primary expenditure (percent of GDP)41.638.337.139.339.947.946.844.942.7
Government primary expenditure (real growth in percent)18.4−3.90.815.312.228.3−7.8−1.6−2.6
Public debt (percent of GDP)40.345.338.632.627.531.940.742.446.9
Of which foreign held
External Sector
Current account balance (percent of GDP)−6.7−7.2−8.5−31.3−39.5−50.6−29.6−24.6−19.4
Net capital inflows (percent of GDP)22.215.531.744.937.719.512.55.2
Other investment−1.2−6.710.323.619.5−14.8−4.9−6.2
Exports (percent of GDP)30.642.043.541.043.138.932.835.640.6
Exports (€, growth in percent)51.812.617.531.43.9−18.713.019.9
Global export market share (basis points)0.090.310.320.240.170.18
Remittances (percent of GDP)
Imports (percent of GDP)
Imports (€, growth in percent)36.714.357.937.224.9−
External debt (percent of GDP)37.939.943.947.574.190.893.596.499.9
Gross international reserves (€ billions)
Gross international reserves (percent of GDP)
Reserve coverage (GIR in percent of short-term debt)
Monetary Sector
Broad money (end of period, growth in percent)
Monetary base (end of period, growth in percent)
Private sector credit (end of period, percent of GDP)11.314.617.936.380.387.476.466.955.5
Of which foreign currency denominated
Of which foreign currency indexed
Cross-border loans to nonbanks (Q4, percent of GDP)3.98.912.018.418.620.0
Private sector credit (end of period, real growth in percent)48.237.531.1134.7159.518.1−17.3−9.5−15.4
Financial Sector
Assets (percent of GDP)18.422.030.753.696.798.693.485.577.3
ROA (percent)−0.6−0.6−2.7−0.1
ROE (percent)4.210.6−6.6−6.9−27.0−0.6
CAR (percent of risk-weighted assets)27.921.317.115.015.815.916.5
NPLs (percent of total loans)
Loan-to-deposit ratio
Cross-border claims by foreign banks (all sectors, percent of GDP)6.626.132.841.538.529.7
Financial Markets
Interest rates (end of period, one-year government bond, percent)
CDS spreads (sovereign, end of period, basis points)
EMBIG spread (sovereign, end of period, basis points)
Exchange rate (end of period, domestic currency/€)
NEER (index, 2003 = 100)100.0104.3109.5110.2108.3109.0115.5119.1118.4
REER (CPI-based, 2003 = 100)100.0102.2103.099.597.298.7105.0105.1101.7
REER (ULC-based, 2003 = 100)
Memorandum Items
GDP (nominal, in billions of domestic currency)
GDP (nominal, in billions of €)
Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

The data may differ from those in other published sources owing to conversion to Government Finance Statistics Manual 2001 (GFSM 2001).

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

The data may differ from those in other published sources owing to conversion to Government Finance Statistics Manual 2001 (GFSM 2001).

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

The main author of this chapter is Gerwin Bell.
1Reflecting these rigidities, the tourism industry’s seasonal surges in labor demand were typically met by large inflows of foreign workers despite high unemployment.
2While there is a considerable range of uncertainty surrounding the calculation of structural fiscal balances in Montenegro (Kapsoli, 2010), this deterioration is nevertheless consistent with some fiscal consolidation from 2008.

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