Steering clear of fiscal cliffs

Availabile in: Montenegrin

Author: Jan-Peter Olters, World Bank Representative in Montenegro

Published in Monitor, Vol. 19, No. 947 (December 12, 2008),

“Ploviti mimo fiskalnih stijena,” pp. 32–33.

If one does not know to which port one is sailing, no wind is favorable.

—Roman philosopher Seneca

Of all the reasons given to make the Bar–Boljare motorway Montenegro’s number 1 investment priority, “salvaging the struggling construction industry”—and, with it, other critical sectors of the economy—has not been among them. With effects from the global financial crisis starting to creep into the real economy, the €2 billion project has been given an additional economic justification. However, the deteriorating environment has added to the already significant difficulty in attracting considerable amounts of private-sector co-financing and Government is likely left with a larger fiscal burden to carry.

This road will shape and constrain fiscal policies for years, if not decades. The current debate on budgetary priorities, already laden with a long list of worries, needs to extend to periods far beyond the fiscal year 2009. The realization of an infrastructure project of this magnitude, with projected costs equivalent to about two-thirds of this year’s GDP, will span over several business and electoral cycles. Fiscal space will have to be created, including by finding ways to control the growth in current expenditure. To be able to design and commit to growth-enabling fiscal policies over a long-term horizon, Government might want to consider following the example of other countries that have—on the whole successfully—experimented with establishing principles to guide and constrain fiscal policies.

While today’s government cannot speak for its successors, it can, however, seek a national consensus not only on the road per se (which it seems to have achieved) but also on adequate fiscal rules needed to secure the availability of sufficient resources in future budgets. For other reasons as well, fiscal pressures are rising, and there are too many competing demands that could easily lead to a premature end to the ambitious investment plans. With every day, it becomes clearer that the budget will not be able to finance large increases to both current and capital expenditures. To prevent being seduced by tactical political gains at the expense of strategic economic considerations, as reflected in Montenegro’s commitment to the Bar–Boljare motorway, policymakers need to convince market participants of their sincerity to adhere to such a long-term policy framework.

Following the decision to euroize, made almost a decade ago, fiscal policy has become the principal instrument of macroeconomic management, and it will increasingly have to play a double function. Next to the socio-economic development objectives to be achieved by the successful implementation of its high-impact infrastructure investments, the budget needs to counter strong pro-cyclical tendencies prevalent in Montenegro’s economy (caused, in particular, by credit-financed investments and a tax regime that is increasingly reliant on imports as a source of fiscal revenue).

Any fiscal framework designed to achieve the stated goals needs to ensure fiscal discipline over the medium term (as, otherwise, the public infrastructure investments cannot be implemented) and provide policymakers with a sufficient degree of flexibility to be able to react to economic shocks of the type currently experienced. Against this background, a recent World Bank report (entitled “Beyond the Peak: Growth Policies and Fiscal Constraints”) derived a set of suggestions that could lead to a sustainable fiscal framework—one, which would add some counter-cyclical elements and protects those budgetary elements that are most effective in advancing socio-economic development objectives.

The Finance Minister’s “hard” constraints are posed by the Stability and Growth Pact, a direct consequence of the unilateral euroization decision. As Montenegro seeks to join the EU and eventually formalize the use of the euro as the country’s legal tender, policymakers are bound—implicitly, at least—by the fiscal-policy constraints applicable to the members of the euro zone. These aim at achieving a balanced budget over the span of a business cycle. For any given fiscal year, the fiscal criteria limit the overall budget deficit of general government to 3 percent of GDP and public debt to 60 percent of GDP. Since 2004, fiscal policies have remained consistently within the fiscal limits. However, if the overall economic situation worldwide worsens more dramatically than currently foreseen, Government might find itself in a situation next year, in which it will have to curtail public investments as well to stay within the deficit limit.

In addition, tax revenues (net of those derived from temporary factors) need to be able to finance public expenditures (net of public investments). Such a rule removes cyclical factors during periods of high growth, while allowing Government, during economic downturns, to borrow—but only to finance investments. This “modified golden rule” is intended to prevent policymakers from committing to recurrent expenditures during boom periods that they cannot be maintain during economic downturns. Fiscal policies since 2005 have been consistent with this principle.

Finally, some mechanism needs to be established to keep growth rates in current expenditure below nominal GDP growth rates. If it were possible to adjust recurrent spending, which increased as a share of GDP in 2008, only to (expected) inflation rates, this would allow for a gradual increase in the available fiscal space for public investments. Given existing pressures for increased expenditure on the wage bill and on goods and services, this principle appears to be the most difficult to attain (and maintain), even more so in an electoral year. During 2006–08, the ratio of recurrent expenditure to GDP has increased.

If adopted, such a framework would allow fiscal policy to play its double role, by combining (moderately) counter-cyclical elements (within well-defined overall constraints) with efforts to overcome existing bottlenecks in public infrastructure. Implementing some form of a multi-year capital budget helps to guarantee the large-scale public investments retain sufficient financing, thereby facilitating planning and implementation and, subsequently, increasing the overall quality of realized public investments. Apart from building the budgetary foundation for the ultimately successful highway link between the Montenegro’s Adriatic harbor, its Serbian neighbor, and the trans-European road network, the corresponding fiscal framework should help policymakers to combine these investment efforts with financial ones, aimed at ensuring the gradual decline of sovereign risk premia and an improvement in the grades conferred to Montenegro by international credit rating agencies (which would help to lower the budget’s debt-service obligations and improve the country’s reputation vis-à-vis foreign investors). With the destination clearly defined, even headwinds cannot prevent ships from beating and moving forwards.