Proposal for a COUNCIL DECISION providing exceptional financial assistance for Montenegro

(presented by the Commission)

EXPLANATORY MEMORANDUM

Introduction

Montenegro is a constituent republic of the Federal Republic of Yugoslavia (FRY) of some 600,000 inhabitants. Montenegro's macroeconomic situation deteriorated steadily during a decade of gradual dissolution of the Socialist Federal Republic of Yugoslavia, disruption of trade patterns, wars in the region and economic decline in the large Serbian market. The outbreak of the Kosovo crisis and the large influx of refugees from Kosovo led to a further sharp deterioration of the economic situation in the Republic. In addition to this, over recent years the Serbian and Montenegrin republics have drifted apart in both political and economic terms.

The Serbian/federal government on the one hand and the Montenegrin government on the other are increasingly pursuing different political approaches to the challenges facing the Federal Republic of Yugoslavia. The Montenegrin government is committed to democratic principles and pursues a policy of openness towards the EU and reforms towards a well-functioning market economy. The policies conducted at federal level, notably monetary policy, are from the Montenegrin government's point of view not supportive of its reform efforts and accordingly Montenegro has taken steps to unravelling itself from the impact of those political decisions.

In recognition of the difficult situation of the democratic government of Montenegro and the severe economic crisis afflicting the population, the Community has provided substantial economic assistance for Montenegro. The support (humanitarian, OBNOVA, Food Security Programme assistance and other) in 1998-1999 amounts to more than EUR 60 million, of which some two thirds has been executed at this stage. This included substantial humanitarian and exceptional budgetary assistance to cover expenditure linked to the substantial influx of refugees.

On 23-24 March 2000, the European Council in Lisbon underlined "...the urgent need for substantial assistance to Montenegro in order to ensure the survival of democratic government and to avoid another serious crisis in the region." Furthermore, the European Council asked "...the competent institutions to take without delay the necessary decisions on the funding [..] of projects, programmes and other forms of assistance which would help to alleviate the immediate financial needs of Montenegro, if necessary by resorting to EU budgetary reserves, as well as macro-economic assistance."

Against this background, it is proposed to provide exceptional financial assistance to Montenegro, which is in addition to the assistance already envisaged by the Community for 2000 under the OBNOVA Regulation (20 MEUR) and the Food Security Programme (10 - 12 MEUR).

The Macroeconomic situation in Montenegro

It is very difficult to obtain precise statistical information on Montenegro's economy. According to conservative estimates, GDP is approximately EUR500 million (DM 1 billion). Figures by the Ministry of Finance of Montenegro underlying its budgetary projections suggest that the Montenegrin nominal GDP, expressed in DM, fell by some 13.3% in 1999 after a 3.8% drop in 1998. For 2000, nominal growth of 5.0% is expected.

According to available statistics, living standards are poor: the minimum wage is 50 DM/month and the average wage is 160-170 DM/month. However, this does not capture income generated from activities in the substantial informal economy nor remittances from the important number of Montenegrins working abroad. As regards the labour market, 116.000 persons are employed (of which 35.000 in the government sector and 81.000 in the private sector) and 73.000 are unemployed. Accordingly, an official unemployment rate of 39% can be computed which, however, does not take into account the employment in the informal sector. There are 82.000 pensioners in the Republic, which is quite a high number compared with the number of employed persons.

Official foreign trade and balance of payments data for Montenegro cover only transactions over Montenegro's external borders (i.e. not over the border with Serbia). However, trade with Serbia appeared to have come to virtual standstill by early 2000. In 1999, exports over the external borders amounted to USD 123 million while imports amounted to USD 358 million. Thus, a "trade deficit" of USD 235 million was recorded. Due to non-registered re-export of goods, however, this trade deficit may be significantly overestimated. For 1999, an overall balance of payments deficit of some 50-70 Mio DM (about 5-7% of GDP) is expected by the Monetary Council of Montenegro.

The Monetary Regime

During the autumn of 1999, the National Bank of Yugoslavia (NBY) increased the money supply of YUD by some 40%, which led to a sharp depreciation in the black market YUD exchange rate and a significant acceleration in inflation. Data published by the federal statistical agency show that consumer price inflation in FRY (in YUD) increased in September by 12.4% (month-on-month) and by 9.1% in October, after just 3.8% in August. According to the Montenegrin authorities, this provided the immediate economic reason for introducing the DM/Euro as parallel currency on 2 November, the plans to transform the Montenegro branch of the NBY into the National Bank of Montenegro (NBM; a move not yet completed due inter alia to constitutional difficulties), and to create a Monetary Council charged with deciding on monetary policy. The changeover was facilitated by the fact that the DM already circulated illegally (mainly for saving purposes and large ticket transactions such as real estate transactions).

The introduction of the parallel use of the DM in Montenegro was accompanied by the injection of some DM 14 million into the Montenegrin payment system as the government paid this amount in wages and pensions to accounts held at the official payments institute (ZOP). Since then, the share of DM in the transactions in Montenegro has increased considerably. By February 2000, it represented around 2/3 of registered transactions in the Republic. However, earlier expectations that the dinar could be completely out of circulation by March 2000 have not been fulfilled. This can be partly explained by the fact that the Yugoslav army present in Montenegro continues to be paid in dinars and dinars continue to be widely accepted in the Northern part of the Republic.

Moreover, in reaction to the Montenegrin decision to adopt the DM as a parallel currency, the federal authorities took steps early on to restrict payments in YUD from Montenegro to Serbia and payments in DM to Montenegrin companies, thus disrupting the normal payments pattern. Together with measures relating to the border control between the two republics, this has implied that trade between Montenegro and Serbia has almost ceased.

Montenegro has been quite dependent on imports of foodstuffs from Serbia. After the virtual elimination of trade between the two republics, Montenegro has been forced to import food from other countries at higher prices. Therefore, after the introduction of the dual currency system inflationary pressures did not abate in Montenegro, as foodstuff prices increased strongly. Thus, in December 1999 inflation in FRY increased by just 0.8% month-on-month (50.1% year-on-year) while in Montenegro prices in YUD of a monitored basket of foodstuffs increased by 20.8% month-on-month (128.4% year-on-year).

The Budgetary situation in Montenegro

Besides the FRY federal budget, each constituent republic has its own republican budget and a number of other budget entities such as extra-budgetary funds. The federal budget is normally charged with funding tasks of a federal nature such as military and war veteran pensions. As a result of the tense political situation between Serbia/FRY and Montenegro, the normal financial relations between the Montenegrin republican budget and the federal budget are presently cut. Thus, on the one hand Montenegro does not receive transfers from the federal budget to pay for war veteran pensions while on the other hand the Montenegrin customs authorities do not transfer customs revenue to the federal budget. The net effect of the cut-off of financial ties with the federal budget has been a deterioration of the Montenegrin budget.

After being approximately in balance in recent years, Montenegro's consolidated general government budget is estimated to have been in deficit at around DM 66 million (approximately 6.5% of GDP). Moreover, according to the Ministry of Finance, arrears in pension payments were accumulated and certain pension payments are now reported to be some two months behind schedule, equivalent to about DM 25 million.

In order to encourage tax payments in DM, the government in November 1999 adopted a regulation obliging companies that obtain their earnings in foreign currency to pay their taxes in DM and offering other companies and individuals tax rebates of between 15% and 30% for settling their taxes in DM. Whereas this regulation did support the DM denominated tax revenue in the short term, the fiscal cost of the measure might further weaken the government's budgetary position in the longer run.

As required by law, the 2000 republican budget is presently balanced. It amounts to DM 394 million based on a 5 % nominal GDP growth assumption. Yet, serious downside risks exist. First the balanced budget is based on the explicit assumption of foreign financial assistance of 2-3% of GDP. Second, a 5% nominal GDP (in DM terms) growth may turn out to be excessively optimistic. Third, the 2000 budget appears to overestimate somewhat revenue and underestimate expenditure, when compared with the numbers in 1999. This implies that actual needs may turn out to be significantly higher than foreseen. Therefore, it appears reasonable to expect budget support requirements to be at least in the same order of magnitude as in 1999, even without counting the need to clear the arrears, notably in the pension fund.

On the whole, it is difficult to obtain a precise picture of the external financing needs of Montenegro. One major reason is the absence of a detailed assessment and economic programme by the IMF and the World Bank, of which Montenegro is not a member. However, there are clear indications that the economic situation in Montenegro is difficult and that the needs are likely to be of a macroeconomic nature.

Possible Community Exceptional financial assistance for Montenegro

Given the unfavourable circumstances affecting the Republic of Montenegro over the last decade, and particularly in recent months, it would be important for the Republic of Montenegro to obtain external support at this crucial moment. Such assistance would support a rebound of the economy, thereby improving the standard of living. Moreover, it would help to ensure that basic administrative functions continue to be provided while steps are taken to improve the revenue situation. This should in turn support the recent fragile progress to provide in the Republic of Montenegro and more generally in the Balkan region, economic, social and political stability.

The Republic of Montenegro is not eligible for membership of the Bretton Woods Institutions. As a consequence, the Republic of Montenegro may not benefit from conventional IMF or World Bank arrangements in support of an economic programme.

A number of bilateral donors have already announced their intentions to support Montenegro. EU Member States have indicated that they will provide financial assistance in favour of Montenegro of some EUR 4.5 million, in addition to an expected EUR 45 million in the form of guarantees. The US is expected to provide some EUR 30 million of grant assistance.

To complement these efforts and in addition to the Community assistance of EUR 30-32 million envisaged under OBNOVA and the Food Security Programme, the Commission is putting forward a proposal for exceptional financial assistance of up to EUR 20 million in the form of straight grants. Before submitting its proposal, the Commission has consulted the Economic and Financial Committee, which endorsed the initiative.

The release of the grant would be implemented in at least two tranches and would be subject to appropriate macro-economic and structural adjustment conditionality. For example, this could include measures to enhance the transparency of the budgetary sphere and to improve revenue collection, and it could also include the requirement to reduce the amount of pension arrears.

Given the absence of official monitoring by the Bretton Woods institutions in the Republic, it is the intention of the Commission to devote particular attention to the proper implementation and monitoring of this assistance. All related preparation, implementation and monitoring costs shall be covered by the assistance. It is expected that the total amount of these costs would be in the order of EUR 1 million.

In light of the above considerations, the Council after hearing the opinion of the European Parliament is requested to approve the attached Proposal for a Council Decision providing exceptional financial assistance for Montenegro.

2000/0114 (CNS)

Proposal for a COUNCIL DECISION providing exceptional financial assistance for Montenegro

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community, and in particular Article 308 thereof,

Having regard to the proposal from the Commission [1],

[1] OJ C , , p. .

Having regard to the opinion of the European Parliament [2],

[2] OJ C , , p. .

Having regard to the following:

(1) The Commission has consulted the Economic and Financial Committee before submitting its proposal;

(2) The Montenegrin government pursues a policy of openness towards the EU and reforms towards a well-functioning market economy;

(3) Montenegro's overall economic situation has deteriorated during recent years and the Republic's budget suffered a substantial deterioration in 1999;

(4) In recognition of the difficult situation of the democratic government of Montenegro and of the severe economic crisis afflicting the population, the Community has provided strong support for Montenegro in 1998-1999;

(5) Montenegro's budgetary needs are expected to remain substantial in 2000;

(6) The external support in the year 2000 required from international donors is expected to be substantial, also in view of the need to clear the arrears, notably in the pensions fund;

(7) The Republic of Montenegro is not in a position to obtain long-term borrowing either domestically or abroad;

(8) The Republic of Montenegro is not eligible for membership of the Bretton Woods Institutions. As a consequence, the Republic of Montenegro may not benefit from conventional IMF- or World Bank arrangements in support of an economic programme;

(9) On 23-24 March 2000, the European Council in Lisbon underlined "...the urgent need for substantial assistance to Montenegro in order to ensure the survival of democratic government and to avoid another serious crisis in the region." Furthermore, the European Council asked "...the competent institutions to take without delay the necessary decisions on the funding [..] of projects, programmes and other forms of assistance which would help to alleviate the immediate financial needs of Montenegro, if necessary by resorting to EU budgetary reserves, as well as macro-economic assistance";

(10) Exceptional financial assistance from the Community in the form of straight grants to be made available to the Republic of Montenegro would ease the Republic's financial constraints in the current difficult circumstances;

(11) In the absence of macroeconomic monitoring and financial support from the IMF and the World Bank to the Republic of Montenegro particular attention should be devoted to the proper implementation and monitoring of this assistance; all related preparation, implementation and monitoring costs shall be covered by the assistance;

(12) The exceptional financial assistance should be managed by the European Commission;

(13) The Treaty does not provide, for the adoption of this decision, powers other than those of Article 308

HAS ADOPTED THIS DECISION:

Article 1

1. The Community shall make available to the Republic of Montenegro exceptional financial assistance in the form of straight grants of up to EUR 20 million, with a view to alleviating the Republic's external financing needs .

2. This assistance shall be managed by the Commission in close consultation with the Economic and Financial Committee.

Article 2

1. The Commission is empowered to agree with the Republic of Montenegro, after consultation with the Economic and Financial Committee, the economic conditions attached to this assistance.

2. The Commission shall verify at regular intervals, in consultation with the Economic and Financial Committee, that economic policies in the Republic of Montenegro respect the objectives and economic policy conditions of this assistance.

Article 3

1. The grant assistance shall be made available to the Republic of Montenegro in at least two instalments on the basis of a successful completion of the economic policy conditions referred to in Article 2(1). The second tranche shall not be released before two months after the release of the first tranche.

2. All related preparation, implementation and monitoring costs shall also be covered by this assistance.

3. The funds shall be made available to the budget of the Republic of Montenegro.

Article 4

The Commission shall address to the European Parliament and to the Council an annual report, which will include an evaluation on the implementation of this Decision

Done at Brussels,

For the Council

The President

FINANCIAL STATEMENT

1. Title of operation

Exceptional financial assistance to the Republic of Montenegro.

2. Budget heading(s) involved

B7-532 macroeconomic assistance for the countries of the Western Balkans.

3. Legal basis

The forthcoming Council Decision based on Article 308 of the Treaty.

4. Description of operation

4.1 General objective

Provision of an exceptional financial assistance in the form of straight grants of up to EUR 20 million to support Montenegro's budget.

4.2 Period covered and arrangements for renewal

Until the end of 2000.

5. Classification of expenditure or revenue

5.1 Non-compulsory expenditure

5.2 Differentiated appropriations

6. Type of expenditure or revenue

Up to EUR 20 million of straight grant assistance (100% subsidy), which would be released in at least two successive instalments. All related preparation, implementation and monitoring costs shall also be covered by this assistance.

7. Financial impact

7.1 Method of calculating total cost of operation (relation between individual and total costs)

In the absence of an economic programme assessed by the Bretton Woods Institutions and unreliable statistical data, it is very difficult to precisely estimate the needs for external assistance. Estimates of the required international assistance in 2000 vary considerably depending on the sources. Nevertheless, it appears reasonable to expect budget support requirements to be at least in the same order of magnitude as in 1999 (estimated at some DM 66 million), even without counting the need to clear the arrears, notably in the pension fund, which are estimated at some DM 25 million. A Community contribution of up to EUR 20 million is proposed in order to cover a substantial part of these needs. The difference is expected to be pledged by other bilateral donors.

7.2 Itemised breakdown of cost - Schedule of commitment and payment appropriations

EUR million (at current prices)

>TABLE POSITION>

It is expected to undertake the first commitment and payment appropriation before the end of August 2000 while the second tranche could be undertaken before the end of December 2000.

8. Fraud prevention measures

The funds will be paid directly to the Republic of Montenegro's Ministry of Finance, only after verification by the Commission Services, in consultation of the Economic and Financial Committee, that the economic policy implemented in the Republic of Montenegro is satisfactory and that the specific conditions attached to this assistance are fulfilled. This could include efforts to enhance budget transparency which will also help prevent fraud.

All related preparation, implementation and monitoring costs shall also be covered by this assistance. Therefore, a minor share of the grant assistance will be provided in the form of support to back the preparation, implementation and monitoring of the grant assistance. This element of the assistance will enhance transparency and facilitate fraud prevention.

The assistance will be subject to verification, control and auditing procedures under the responsibility of the European Court of Auditors and the European Antifraud Office (OLAF).

9. Elements of cost-effectiveness analysis

9.1 Grounds for the operation

By supporting the efforts to organise economic reconstruction and development and to establish a well functioning market economy this assistance would improve the Republic of Montenegro's prospects of economic recovery and future growth, would help it face the severe economic and social consequences of the current economic crisis in the country and for the medium and longer term would lower its dependence on external financing.

Furthermore, the assistance will provide a signal of political support for the Republic at a critical moment.

9.2 Monitoring and evaluation of the operation

This assistance is of exceptional nature. It will be made available to the Republic of Montenegro's Ministry of Finance only after verification by the Commission Services that the implementation of economic policy conditions by the Republic of Montenegro is satisfactory.

The Commission Services will monitor and evaluate the action. To this end, the Commission services will evaluate reports prepared by the Montenegrin authorities and by experts financed under by the technical support element of the assistance.

The assistance will be subject to verification, control and auditing procedures under the responsibility of the European Court of Auditors and the European Antifraud Office (OLAF).

10. Administrative expenditure (Section III, Part A of the budget)

This action is exceptional in nature and will not involve an increase in the number of Commission staff.