Report No. 73826-ME Montenegro: Preparing for Prosperity Public Disclosure Authorized Ensuring Sustainability, Connectivity, and Flexibility for Dynamic Growth Country Economic Memorandum Public Disclosure Authorized December 21, 2012 Public Disclosure Authorized Poverty Reduction and Economic Management Unit Europe and Central Asia Region Public Disclosure Authorized Document of the World Bank CURRENCY AND EQUIVALENTS UNITS Currency Unit = EUR (Euro) US$1 = EUR 0.79 (As of November 14, 2012) FISCAL YEAR January 1 – December 31 WEIGHTS AND MEASURES Metric System ACRONYMS AND ABBREVIATIONS Montenegrin Investment Promotion A2A Italian corporate group MIPA Agency Ministry of Interior and Public AAK Advance of Applied Knowledge MIPA Administration Business Environment and BEEPs MoE Ministry of Economic Enterprise Performance surveys Group of countries comprising BRIICS MOF Ministry of Finance Brazil, Russia, India, Indonesia, and Chine Montenegro National Statistics CBCG Central Bank of Montenegro MONSTAT Agency CEAC Central European Aluminum NIS National innovation system Company CEFTA Central European Free Trade NMS New EU member states Agreement CEM NPL Non-Performing Loans Country Economic Memorandum Organization for Economic Co- OECD DB Doing Business (IFC) operation and Development European Bank for Reconstruction OTP Commercial Bank in Hungary EBRD and Development Public Expenditure and Institutional EC Energy consumption PEIR Review ECA Europe and Central Asia PMR Product market regulation EIB European Investment Bank PPP Purchasing Power Parity Electricity company: EPCG PPP Purchasing power parity Elektroprivreda Crne Gore AD Niksic An export basket’s associated EU European Union PRODY productivity level FDI Foreign direct investment PS Product Space FEC Final energy consumption RCA Revealed comparative advantage FMS Family material support SEE South East Europe South East Europe Transport FYR Former Yugoslav Republic of SEETO Observatory Macedonia G-Cloud Government Cloud Computing SME Small and medium-size enterprises GDP Gross domestic product T&D Transmission and distribution GNI Gross national income TEN-Ts Trans-European Transport Network GVA Gross value added TFP Total Factor Productivity HP Hodrick-Prescott filter UK United Kingdom ICA Investment climate assessments USAID U.S. government aid agency ICT Information and Communication VAT Value-added tax Technologies IEA International Energy Agency VET Vocational education and training IFI International Financial Institutions VTB Russia’s Foreign Trade Bank ILO International Labor Organization WDI World Development Indicators IMF International Monetary Fund WEF World Economic Forum IMO International Maritime WTO World Trade Organization Organization ISP Internet Service Provider WTTC World Travel & Tourism Council IXP Internet Exchange Point ZCG Rail entity: Zeljeznice Crne Gore KAP Aluminum company ZICG Railway Infrastructure of Montenegro LLU Local Loop Unbundling ZPCG Railway Transport of Montenegro MICS Montenegro Investment Climate Survey Vice President: Philippe H. Le Houerou, ECSVP Country Director: Jane Armitage, ECCU4 Sector Director: Yvonne Tsikata, ECSPE Sector Manager Satu Kähkönen, ECSPE Team Task Leader: Željko Bogetić, ECSPE Acknowledgements This report was prepared at the request of and in close cooperation with the Government of Montenegro to assist in identifying the development policy agenda now that Montenegro has formally opened negotiations with the EU. The World Bank team would like to express gratitude to all the government agencies, private sector and foreign business associations, civil society, and think tanks that made this study possible by providing data, access to local publications and analysis, discussions, and insights. The team is especially grateful to Finance Minister Milorad Katnić and his team, who coordinated the government’s cooperation with the World Bank, as well as to Governor Radoje Žugić and his team at the Central Bank of Montenegro who were also key counterparts of the Bank CEM missions. Special thanks are also due to Montenegro Chamber of Economy and its president, Velimir Mijušković, and vice president, Ljiljana Filipović, for exemplary cooperation in helping design and conduct the Montenegro Investment Climate Survey (MICS) in the Spring 2012, which served as the basis for analysis of the investment climate. The team would like to express special gratitude and appreciation to the Prime Minister of Montenegro, Igor Lukšić, and Minister Katnić for their kind support, advice, and insights in the course of CEM policy discussions and also for hosting the joint World Bank – Government of Montenegro workshop, which discussed the select preliminary analyses underpinning this report. Jane Armitage (World Bank’s country director for Western Balkans), Yvonne Tsikata (World Bank’s director for poverty reduction and economic management, Europe and Central Asia Region), Satu Kähkönen (World Bank’s sector manager for economic policy for EU11 and Western Balkan countries), and Anabela Abreu (World Bank’s country manager for Montenegro and Bosnia and Herzegovina) provided valuable advice in all stages of this study. This synthesis report was prepared by a team of World Bank economists led by Željko Bogetić, lead economist and country sector coordinator for economic policy for Western Balkans and the main author, who also coordinated the work on export potential and export sophistication, and trust experiments. The following team of authors prepared background papers, notes, and contributions to the synthesis report: Sanja Madžarević Šujster, senior economist, ECSPE (growth convergence and fiscal sustainability; who also coordinated the work of consultants on the investment climate and product market regulation), Arye Hillman, consultant (trade, incentives, entrepreneurship; trust experiments), Yannis Kessides, lead economist, DECRG (energy; infrastructure connectivity), Israel Osorio-Roddarte, consultant (export potential and export sophistication), Martin Melecky, senior economist, ECSPF, and Mike Edwards, lead financial specialist and Country Sector Coordinator, ECSPF (financial sector), Velimir Šonje and Dragan Bagić, consultants (investment climate and firm performance; product market regulation and factors of FDIs), Ken Simler, senior economist, ECSPE (poverty and inequality), Milenko Popović, consultant (sources of growth; trust experiments), Christian Bjørnskov, consultant (trust experiments), Danijela Vukajlović-Grba, consultant (financial discipline), Oleg Petrov, Cecilia Maria Paradi-Guilford, Natalija Gelvanovska (information communication technologies). Naoko Kojo, senior economist, assisted on fiscal sustainability, and Anil Onal, consultant, provided research assistance in the final stage of the report preparation. Maria Andreina Clower (Washington D.C. office) and Dragana Varezić (Podgorica office) provided team assistance with Dragana providing team assistance to all the visiting CEM missions to Montenegro. Jovana Šljivančanin assisted the team with presentations at the workshop in June 2012. The background mission work and field interviews in preparation for this report were conducted by the core mission team consisting of Željko Bogetić (mission team leader), Sanja Madžarević-Šujster, Arye Hillman, Israel Osorio-Rodarte, and Yannis Kessides who presented the preliminary findings of the report at the joint World Bank – Government of Montenegro workshop in July 2012 in Miločer, Montenegro. Table of Contents INTRODUCTION .......................................................................................................................... 1 PART I: SUSTAINABILITY ......................................................................................................... 6 A. Montenegro’s Sources of Growth ........................................................................................................ 6 B. Ensuring Fiscal Sustainability............................................................................................................ 12 C. Ensuring Financial Sustainability ...................................................................................................... 19 D. Towards a New Growth Model ......................................................................................................... 22 E. An Agenda for Sustainable Growth and Income Convergence ......................................................... 24 PART II: CONNECTIVITY ......................................................................................................... 28 A. Why Connectivity Matters ................................................................................................................. 28 B. Expanding and Diversifying Exports ................................................................................................. 30 C. Application of Product Space Analysis to Montenegro ..................................................................... 35 D. Conclusions from Product Space Analysis ........................................................................................ 40 E. From Comparative to Competitive and Locational Advantages ........................................................ 41 E.1. Connectivity via the European Union and South East Europe ................................................... 44 E.2. Connectivity and Infrastructure .................................................................................................. 44 E.3. Transport Connectivity