Montenegro 'B+/B' Ratings Affirmed; Outlook Stable


  • We estimate that Montenegro's economy grew by 4.7% last year, exceeding our previous forecast.
  • However, this pace should moderate in the medium term as fiscal adjustment advances and eurozone economic growth decelerates.
  • The debt-financed construction of a public highway, alongside persistently high current spending, has contributed to the rapid accumulation of net general government debt, which we expect will peak at 63% of GDP in 2020.
  • We are affirming our 'B+/B' ratings on Montenegro.
  • The outlook is stable.
RATING ACTION
On March 15, 2019, S&P Global Ratings affirmed its 'B+/B' long- and short-term 
foreign and local currency sovereign credit ratings on Montenegro. The outlook 
on the long-term ratings remains stable.


RATIONALE
Montenegro's high net general government debt burden--which we expect will 
peak at 63% of GDP in 2020--constrains our ratings on the sovereign. This is 
especially pertinent given the country's unilateral adoption of the euro, 
which leaves almost no room for monetary policy flexibility. Montenegro also 
remains vulnerable to balance-of-payment risks, with a large net external 
liability position and persistent historical current account deficits.

Montenegro's favorable growth potential, stemming from the possibilities for 
further development of tourism and the energy sector, continues to support the 
ratings. The country's comparatively strong institutional settings in a 
regional context, as well as upside potential from structural reforms that the 
government will need to implement for Montenegro to become an EU member, also 
support the ratings.

Institutional and economic profile: Growth exceeded our projections last year, 
reaching an estimated 4.7%, but it is set to moderate
  • Despite the wide-ranging demands, we expect any immediate implications of recent public protests to be contained.
  • We estimate that economic growth will moderate after strong 4.7% expansion in 2018.
  • The country's long-term potential remains favorable, stemming from opportunities in the tourism and energy sectors.
Several public protests have taken place in Montenegro in recent weeks, but we 
do not expect any immediate implications, despite the wide-ranging demands. 
The participants opposed corruption, demanding the resignations of the 
government and President Milo Djukanovic--a long-standing veteran of 
Montenegrin politics. Revelations exposing several government officials appear 
to have fanned the protests. The authorities could heed some of the calls, but 
the resignations of the government or the President seem unlikely. Although 
the current coalition government between Djukanovic's Democratic Party of 
Socialists (DPS) and several ethnic minority parties commands a narrow 
majority, opposition so far appears disunited. We also note that Djukanovic 
and the DPS have weathered periods of public discontent in the past. 

More broadly, we think recent developments underscore the evolving nature of 
Montenegro's institutional arrangements, which are characterized by several 
shortcomings typical of the countries in the West Balkan region. These include 
high levels of perceived corruption, media freedom limitations, and judicial 
weaknesses. To this end, we note that several local journalists have been 
attacked in the past year. Risks were also highlighted by the developments 
around the 2016 general election, when an alleged coup took place. Multiple 
opposition members have faced allegations in the aftermath with opposition 
parties boycotting Parliament. 

Montenegro remains an EU candidate country, and we view positively the 
potential for the early implementation of reforms that will align it with the 
EU's Acquis Communautaire. That said, the process will likely be only gradual. 
Unlike NATO membership, which appears to be a divisive topic among the 
population, there is broader support for integration with the EU; however, we 
consider the announced possible accession date of 2025 as optimistic. Further 
progress could be hampered by both domestic developments and rising 
euroscepticism among the existing member states, which--under EU rules--will 
ultimately have to unanimously approve Montenegro's membership bid. That said, 
we think the ongoing EU accession negotiations strengthen Montenegro's policy 
frameworks and we view the country's institutional settings favorably in a 
regional context. 

Positively, occasional political volatility does not appear to have harmed the 
economy in recent years. We estimate that last year's growth reached 4.7%, 
exceeding our previous forecast of 3.5%. Montenegro's economy is primarily 
driven by tourism and related activities, and strong visitor growth has 
contributed to broader economic dynamics.

We note that the public-financed, ongoing construction of a new highway has 
also underpinned Montenegro's growth. Upon completion, the government expects 
the highway to link the coastal port of Bar with the Serbian border, 
connecting remote regions and improving road safety. Only the first section, a 
41 kilometer segment north of the capital, Podgorica, is so far under 
construction. Because of difficult terrain, the cost of the first section is 
high, estimated at close to 20% of 2018 GDP and largely financed by a U.S. 
dollar-denominated loan from China. The first section of the highway was 
originally scheduled to be finalized this year, but it is currently facing 
delays and potential cost overruns. 

Aside from political considerations, the direct net economic benefits from the 
highway are uncertain. We believe that its construction has led to a notable 
accumulation of debt and erosion of fiscal headroom. This is particularly 
pertinent because budgetary policy is the government's main lever to influence 
domestic economic conditions, given that Montenegro's unilateral euro adoption 
means it has no independent monetary policy.

To curb the increase in debt from the highway construction, in mid-2017 the 
government announced a fiscal consolidation strategy aimed at reducing the 
non-highway deficit. Consequently, we expect some moderation of growth rates 
to below 3%, as fiscal consolidation advances and the first highway section is 
completed in 2020, later than originally planned. The weaker outlook for the 
European economy will also likely contribute to a softening of growth in 
Montenegro. 

We continue to view Montenegro's long-term economic prospects as favorable. 
This primarily stems from the multiple opportunities that exist in the tourism 
sector. A number of hospitality projects are currently under way, including 
several high-end coastal resorts. We also understand that there is untapped 
potential in mountain ski tourism and energy generation. 

Flexibility and performance profile: Elevated net general government debt is 
projected to peak at 63% of GDP in 2020
  • We expect net general government debt to start declining from a peak of 63% of GDP in 2020, as the first section of the highway is completed.
  • Balance-of-payments vulnerabilities remain elevated, given the recurrent historical current account deficits and the resulting large net external liability position, which we estimate at close to 200% of GDP.
  • Montenegro has no monetary policy flexibility because it has unilaterally adopted the euro while not being part of the eurozone.
  • Two small domestic banks have run into trouble but we do not expect any material spillover to the rest of the financial system.
Montenegro has historically posted recurring fiscal deficits, which have led 
to a substantial accumulation of public debt and reduced the available fiscal 
space. This is particularly important given the lack of independent monetary 
policy. The shortfalls have been a result of high social spending and 
transfers, as well as the substantial shadow economy, which eludes taxation. 
More recently, deficits have widened as a result of the implementation of the 
highway project.

Despite originally being scheduled for completion in 2019, the first section 
of the highway project is facing delays and we now expect it to be completed 
by the end of 2020. There will also likely be a cost overrun. We understand 
that, under the contract with Chinese Road and Bridge Corporation, the 
government of Montenegro is responsible for financing any extra costs of up to 
10% of the originally agreed amount, while the Chinese contractor will bear 
any overhead on top of that. As such, extra budgetary burden is unlikely to 
exceed €80 million--about 1.5% of 2019 GDP--which we do not think will 
materially affect Montenegro's fiscal position.

That said, substantial fiscal risks remain. Primarily, the government may 
decide to implement further sections of the highway, financed by 
debt--northward to the border with Serbia, and another section linking 
Podgorica with the coastline. In our view, further leverage would weaken 
Montenegro's already vulnerable fiscal position. We understand that the 
government is alternatively considering implementing the remaining sections 
via the Public Private Partnership (PPP) mechanism, without incurring extra 
debt directly. Nevertheless, a PPP arrangement could still be risky because 
such contracts typically include either a debt assumption clause or a minimum 
usage guarantee, de facto exposing the budget to debt-type risks. 

To control the upward public debt trajectory in recent years, the government 
embarked on a fiscal consolidation strategy announced in mid-2017. The 
strategy included a number of revenue and expenditure items, such as raising 
the VAT rates and excise taxes, as well as controlling public employment 
levels and spending efficiency. 

We have previously outlined that the fiscal targets in the consolidation 
strategy are overly optimistic and unlikely to be achieved. Under the fiscal 
strategy, the government planned to reduce the general government deficit to 
1.8% of GDP in 2018 before turning to a surplus from 2019 onward. According to 
government estimates, general government deficit amounted to 3.7% of GDP in 
2018, only slightly better than our previous forecast of 4% of GDP. We 
understand that several developments have contributed to this outcome. These 
have included the difficulty in implementing the higher excise taxes adopted 
at the beginning of the year because tax evasion has intensified. As a result, 
the authorities had to revert to a more gradual rise of excise levels in 
steps. Salaries have also been adjusted upward for some public sector 
employees, while weaknesses in budgeting and planning, primarily on the local 
government level, led to a repayment of some extra arrears--amounting to 1.5% 
of GDP--from the previous periods. The latter has been a recurrent problem in 
Montenegro in the past.

In addition to weaker headline fiscal performance, the government made a 
one-off payment of about €70 million (1.5% of 2018 GDP) to Italian utility 
company A2A. The payment relates to A2A's option that allowed it to exit its 
stake in Montenegrin majority state-owned electricity company EPCG and receive 
compensation from the government. We have not included this one-off 
expenditure within the 2018 general government deficit but instead accounted 
for it below the line. The increase in net general government debt in 2018 is 
therefore higher than the headline deficit implies. The government will make 
an additional €40 million (1% of GDP) budgetary payment this year to A2A with 
the rest of the obligations to A2A covered using EPCG's cash buffers and 
profits.

We currently forecast that budget deficits would narrow over the next four 
years, averaging 2% of GDP as fiscal adjustment advances and the first section 
of the highway is completed in 2020. Nevertheless, we consider that the 
government's projected surplus for 2020 is unattainable, given the possible 
cost overruns related to the highway construction and likely pressures to 
increase spending ahead of the general elections that will take place in the 
latter half of 2020.

Given our base-line forecast of continued gradual fiscal consolidation, we 
expect net general government debt will peak at 63% of GDP in 2020 and reduce 
thereafter. Positively, refinancing risks have reduced, in our view. 
Montenegro previously faced Eurobond redemptions totaling a substantial €1.1 
billion over 2019-2021. In April 2018, the government issued a €500 million 
Eurobond that was partly used to buy back €360 million of debt maturing over 
2019-2021. Moreover, in May 2018, the authorities secured a World Bank 
guarantee-supported syndicated loan of €250 million. In 2019-2020, the 
Montenegrin government plans to use the proceeds of the loan to meet debt 
redemptions coming due in May 2019 and in later years. We understand the 
authorities are exploring the possibility of attracting a second similar 
arrangement to manage the refinancing risks in the future. 

More broadly, Montenegro primarily finances fiscal shortfalls on the foreign 
markets, and nonresidents hold close to 70% of commercial debt. We expect this 
to remain the case in the future, which exposes the country to risks of 
European Central Bank (ECB) tightening monetary policy.

Montenegro's weak balance-of-payments position remains a key ratings 
constraint. The country has consistently posted double-digit current account 
deficits and we estimate the net external liability position totaled close to 
200% of GDP at the end of 2018. Positively, Montenegro has seen substantial 
amounts of inbound foreign direct investment, averaging more than 10% of GDP 
over the past five years. These investments are concentrated in real estate, 
tourism, and energy sector projects, and tend to be import-intensive. As such, 
the investments cause the current account to be in a recurrent deficit, rather 
than the other way around. That said, risks remain because the economy could 
be hit if foreign direct investment unexpectedly dries up.

Montenegro's external accounts show persistent and positive errors and 
omissions, which--following recent data revisions--average 3% of GDP over the 
past five years. These discrepancies may reflect unrecorded tourism export 
revenues and the underestimation of remittances from the large Montenegrin 
diaspora, among other factors. This could mean that the current account 
deficit may be lower than the reported data indicate. We understand that the 
authorities are in the final stages of producing comprehensive International 
Investment Position statistics, which they aim to publish this year, as 
opposed to the original plan to do so in 2018. The work to improve external 
statistics is ongoing; we note that net errors and omissions previously 
amounted to a more substantial average of 5% of GDP compared with the current 
3%.

Montenegro's unilateral adoption of the euro prevents the Central Bank of 
Montenegro from setting interest rates and controlling the money supply, and 
restricts its ability to act as a lender of last resort. Although the central 
bank has some options to provide liquidity support to banks, its inability to 
create the currency needed in a stress scenario effectively prevents it from 
fulfilling a lender of last resort function, in our view. Unilateral euro 
adoption also makes the country's economy highly sensitive to cross-border 
capital movements.

We consider that there are pockets of risk in Montenegro's financial system:
  • Two domestic Montenegrin banks have been under stress in recent months--Invest Banka Montenegro (IBM) and Atlas Bank. The regulator has taken the decision to close down IBM; the fate of Atlas remains uncertain as the bank tries to attract extra capital from external sources after the existing owners failed to provide resources. In our view, the developments in the two banks potentially highlight the regulatory shortcomings, given that some transactions went undetected and later negatively and substantially affected the capitalization level of Atlas Bank. Importantly, there has not been any negative spillover effect on the rest of the system so far, and we do not expect any to materialize, given that the two banks combined amount to about 6% of the system. According to the authorities, the Deposit Protection Fund currently has enough resources to pay out the insured depositors, should Atlas be liquidated, without the need for any budgetary support.
  • The government-owned Investment Development Fund (IDF) has been expanding at an accelerating pace in recent years, focused on financing SMEs at favorable interest rates. We understand that its balance sheet amounts to about 7% of GDP and that the institution benefits from a sovereign guarantee on its liabilities. Therefore, if IDF's asset quality were to deteriorate, the government may have to bear some of the cost via the guarantee exposures.
Apart from the aforementioned institutions, Montenegro's banking system 
appears broadly stable and liquid. Nonperforming loans have declined to about 
5% of the total, compared to 20% in 2013. We still view the government's 
contingent liabilities from the banking system as limited, because we think 
the government would provide only minimal support--that is, to cover the 
insured deposits--in the event of a bank default. 

In our view, the financial system is potentially overbanked, given the 
existence of more than 10 institutions for a country with a small population. 
We expect this number to reduce not only because some banks could close down 
but also due to the orderly consolidation of the sector. To this end, we note 
that Societe Generale is exiting its investment in Montenegro, with its 
operations taken over by another domestic bank, owned by Hungary's OTP group. 
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