For as long as there is a surplus, there will be a deficit

crnogorski

Author: Esad Krcić

Interview with Jan-Peter Olters, World Bank Representative in Montenegro

Published in CG Ekonomist, “Dok je viška biće i deficita (For as long as there is a surplus, there will be a deficit)”, Vol. 2., No. 12 (February 18, 2008), pages 13–16.

How do you assess the level of development in the banking sector of Montenegro?

The depth of financial intermediation—that is, the use of debt to finance investment in high-quality assets—tends to be a robust leading indicator of long-term economic growth. In assessing the validity and economic viability of business plans, banks—for reasons of prudence and economic self-interest—seek to funnel available funds to the most promising, productivity-enhancing endeavors. For that reason, one finds a strong correlation between a country’s depth of financial intermediation and its overall economic development potential. Montenegro is no exception. With a ratio of private-sector debt to GDP of about 18 percent in 2005, real growth was 4 percent—in 2006 the corresponding figures were 38½ percent and 6½ percent, respectively, and in 2007 97 percent and 7½ percent. But these statistics point to another trend as well, one that could (but does not necessarily have to) be less benign. The growth rates of private-sector credit are very high. With about more than 140 and 180 percent in 2006 and 2007, respectively, these growth rates are higher than anywhere else in the world. In addition, while bank deposits used to be sufficient to finance credits (deposits averaged about 120 percent of private-sector credits in 2005 and 2006), credit expansion exceeded the growth in deposits in 2007, and only a little more than four-fifths of private-sector credits are being financed by deposits. The remainder tends to be bank credits, typically from the respective mother banks. This, of course, raises a number of critical questions, to which the central bank, needs to respond. First, do these numbers pose any macroeconomic risks? Second, can banks monitor the quality of their portfolios effectively? And third, are the banks’ balance sheets sufficiently robust to withstand the effects of an external environment that might turn out less benign than in 2007? Placing the developments in the banking sector within the overall macroeconomic context, I would consider a deceleration in private-sector growth rates in 2008 to be very welcome.

Is the quality of financial reports at a satisfactory level?

Transparent corporate financial reporting represents a key pillar in a policy mix that aims at maintaining the trust in the proper functioning of a market economy. If one looks at the ways companies finance themselves, through the banking sector and the stock markets, it becomes obvious that financial accounts that correctly reflect the financial situation of companies are crucial to preserving existing funding channels, maintaining the current levels of economic growth, and mitigating major financial risks. In late November, the World Bank organized a conference—attended also by Deputy Prime Minister Lazović, Deputy Finance Minister Katnić, and Deputy CBCG Governor Knežević—to summarize the results of a constructive cooperation between our experts and the Montenegrin authorities on means to strengthen financial reporting standards in Montenegro. These are contained in the “Accounting and Auditing Report”. In a series of so-called Reports on Standards and Codes, which are—depending on the particular topic—prepared by the World Bank or the IMF, this document concluded that Montenegro made significant progress in developing financial reporting, while presenting recommendations on how to improve the system further and implement measures needed to bring standards in line with international best practices. The challenges stem from a variety of sources, including the increased financial reporting and auditing requirements used internationally and the alignment with the European Union’s body of law, the acquis communautaire. Financial information provided by enterprises, so the report, often lacked detailed disclosure. Financial reporting standards were not enforced in a systematic manner. Since then, under the leadership of the Finance Ministry, steps have been taken to address remaining challenges, including the creation of a steering committee that has been set up to ensure that the financial reporting standards are strengthened, in line with the recommendations of this—publicly available—report.

Regarding the central bank measures introduced to limit credits, are these justified?

As mentioned earlier, it is the role and function of a central bank to ensure the soundness of the banking system. With the recently introduced measures, the CBCG has focused on prudential and solvency ratios to dampen private-sector credit growth, and I am confident that, in a year’s time, these steps will have proven beneficial to the banking sector as a whole and the financial institutions individually, ensuring they can remain profitable in the Montenegrin market during both calm and stormy days.

Is it possible that, according to statements from within the banking sector, that foreign banks can circumvent the central bank regulations?

I am not best placed to comment on, nor am I willing to suggest, possible ways to circumvent regulations by the Central Bank of Montenegro. While it might be difficult to introduce regulations that are airtight in all circumstances, it is important to stress that mother banks, which have branches here, are being tightly regulated by their respective national central banks and, if headquartered in the euro zone, the ECB. However, if you are willing to speculate that these possibilities existed, two relevant follow-up questions would need to be considered. First, do commission transactions transfer the corresponding portfolio risk out of Montenegro into the books of the mother banks? And second, would these transactions undermine the macroeconomic objectives motivating the central bank’s measures? The answers to these two subquestions define, in my view, the significance of the broader question you have raised.

The Ministry of Finance has prepared the draft banking law. What is your view?

Global financial markets are in a little bit of turmoil these days, and chances are that they will continue to remain unsettled for a little longer. And, as indicated earlier, there are developments within the Montenegrin financial sector that require close monitoring and supervision. It seems to me that the parliamentary debate on the Banking Law has to be seen in this light. It seeks to align the legal framework with the challenges of effective banking supervision and aims at ensuring that the central bank is sufficiently independent and has at its disposal adequate policy instruments to effectively supervise the banking sector.

The ruling DPS wishes, by submitting 28 amendments, to change the substance of the Draft Law on Banks, saying it implies a strengthening of the role of the Central Bank of Montenegro. The part of opposition that has responded to this draft law with 60 of their own amendments claims that DPS amendments are in favor of interests of certain significant players in the financial market in Montenegro. In that particular case, what would be your recommendation?

It is encouraging to see that there is a keen interest among parliamentarians and an active debate on the central bank’s roles and duties. At this point in time, and for the aforementioned reasons, it would be very good, however, to ensure certainty among all players in the financial market as to the overarching legal environment. I note that, on the broad topics surrounding the independence of the central bank, there is agreement. This is good. Over the period of decades, economic research has shown convincingly that economies benefit from central banks that are protected by law from undue influences from fiscal authorities and that have clearly defined policy objectives—stable prices and a sound financial system. Being able to ensure monetary stability lengthens firms’ planning horizons, facilitates investments, and raises an economy’s growth potential.

How do you assess the current growth dynamics in the Montenegrin economy?

The first full post-independence year was exceptional, and many factors played a role that led to growth rates in excess of those prevailing in other countries in the region. Full international support for statehood, an accelerated rate of implementing structural reforms, the policy commitment to the principles of a market economy, a macroeconomic equilibrium with low inflation and budgetary surpluses, and progress in the negotiations with the EU en route to eventual membership—all of these factors contributed to investor interest and very high capital inflows from foreign-direct investments. Together with the banks’ confidence into the ability of Montenegrin enterprises to compete successfully and profitably and to be able to repay their loans, this injected considerable liquidity into the economy and led to high internal demand. As a result, construction boomed, as did the retail sector, telecommunications, and banking. Growth in other sectors of the economy appears to have exceeded initial projections as well. The challenge for policymakers today is, of course, to ensure that similar rates of growth can be maintained in the next years as well, especially in situations in which the external environment becomes less favorable.

Do you support Montenegrin orientation toward development based on small and medium-sized enterprises?

In an annual exercise, the World Bank Group compares the business climate across countries in the world. Last year, Montenegro ranked 81st of 178 countries in the Doing Business survey, down from the 76th rank a year earlier. This survey has shown (1) that other countries, on average, have implemented corresponding reforms at a faster pace and (2) that the main challenges remain in areas that are particularly important for small and medium-sized enterprises—namely, dealing with licenses, paying taxes, or enforcing contracts. In addressing these remaining challenges, Montenegro can take significant steps towards creating an environment that would permit the country to fully make use of its talents and skills. The government has shown interest in undertaking reforms to provide a sufficiently transparent, efficient, confidence-inducing, and inviting environment. This would allow Montenegrins to invest their money in new enterprises and, in so doing, create new opportunities, new jobs, and a continuously dynamic economy. In a number of areas (including business environment, land administration, and cadastre), the World Bank is preparing, together with the government, projects aimed at overcoming key challenges and creating an environment that is conducive for investments at the scale required to increase total factor productivity and, hence, Montenegro’s growth potential.

The trade deficit in Montenegro has become a critical phenomenon. Can it really be justified by the simple explanation that it is a result of development and how can this problem be resolved?

As Montenegro has decided to adopt the euro as its legal tender, large current account deficits have different implications than they would in countries with fixed or flexible exchange rates. Most importantly, external deficits cannot cause financial crises (which would be the principal risk in a country with a fixed exchange rate) or lead to imported inflation (caused by a depreciating exchange rate). Montenegro can currently import more than it exports, because the gap is being financed through the capital account (that is, mainly through foreign direct investments). In short, the current account deficit will exit only for as long as there is a capital account surplus. The impact of any sudden adjustment would be on growth.

The Stabilization and Association Agreement between EU and Montenegro has been enacted. Often it can be heard in the public that the implementation of corresponding SAA-related obligations will be a huge problem.

The signing of the SAA has been a very significant achievement, which would not have happened had the EU any doubts about Montenegro’s capacity to implement related measures and reforms. It is a challenge, not doubt, and it will be difficult. But apart from Montenegro’s integration objective, these reforms—in themselves—will help its economy to be successful in the global market place. Therefore, with or without the SAA, they would have been on the political agenda.

Is the level of cooperation between Montenegro and the World Bank satisfactory and is there a possibility for additional improvements?

Following membership in January 2007, the adoption of the Country Partnership Strategy and the opening of the World Bank Office, both in June 2007, cooperation has intensified considerably. We note with satisfaction that the government has succeeded in tightening the implementation of existing projects and improved project performance. Two projects—in sustainable tourism and energy—have been signed and made effective since. Given the good track record, a number of other projects, for example on issues of land administration, energy efficiency, and agriculture, are being discussed and prepared together with our counterparts in government. I am encouraged.