REPUBLIC OF MONTENEGRO: COUNTRY FINANCING PARAMETERS

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized REPUBLIC OF MONTENEGRO: COUNTRY FINANCING PARAMETERS Date: 15 May 2007 Item Cost Sharing. Limit on the proportion of individual project costs that the Bank may finance Recurrent costjinancing. Any limits that would apply to the overall amount of recurrent expenditures that Bank may finance Local costfinancing. Are the requirements for Bank financing of local expenditures met, namely that: (i) financing requirements for the country s development program would exceed the public sector s own resources (e.g. from taxation and other revenues) and expected domestic borrowing; and (ii) the financing of foreign expenditures alone would not enable the Bank to assist in the financing of individual Droiects Taxes and duties. Are there any taxes and duties that the Bank would not finance? Parameter up to 100 percent No countrylevel limit Yes None Rema &/Ex plana tion Government ownership of project objectives and implementation has been convincingly demonstrated by aligning projects with the objectives of key government policy documents, and the annual budget process, bringing all financing on-budget. The actual cost-sharing shall be determined on a project-by-project basis. The Bank will still encourage cost sharing as a demonstration of ownership. In the aggregate, it is expected that current financing patterns would broadly continue, with the Bank financing around 90 percent of project costs. Recurrent cost financing will not significantly impact debt or fiscal sustainability. No countrylevel limit on recurrent cost financing is proposed. The Bank will continue to monitor fiscal sustainability, the government s commitment to sound fiscal policy management, and sound budget management and execution; and its implications for recurrent cost financing. In determining Bank financing of recurrent costs in individual projects, the Bank will take into account sustainability issues at the sector and project levels. The criteria for Bank s financing of local costs are met. The Bank may finance local and foreign costs in any proportions required in individual projects. The Bank may finance taxes and duties as long as they are reasonable and nondiscriminatory. As of May 2007, there are no taxes or duties that the Bank would not finance. At the project-level, the Bank will consider whether taxes and duties constitute an excessively high share of project costs. The proposed financing of taxes and duties will facilitate efficient project imdementation.

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3 REPUBLIC OF MONTENEGRO COUNTRY FINANCING PARAMETERS Summary 1. This note describes the application of the World Bank s (WB) new policy for expenditure eligibility for Bank-financed activities in Montenegro and sets out the Country Financial Parameters (CFP). The new framework allows the Bank to finance expenditures needed to meet the development objectives of the operations it supports, within an overall framework that addresses risks to fiscal sustainability and the appropriate use of Bank resources, in a way that is consistent with the Articles of Agreement. The new policy is expected to increase the flexibility in the use of Bank loadcredit proceeds to finance a number of expenditures. It rests on three guiding principles: (i) the expenditures financed from the Bank loadcredit proceeds are productive; (ii) the impact of operations financed under such loardcredits on the Borrowing country s fiscal sustainability is acceptable; and (iii) oversight arrangements on the use of Bank funds are acceptable. 2. The new Country Financing Parameters for Montenegro have been prepared following Montenegro s independence in June 2006, and membership of the World Bank Group in January The following sections provide information on political background, relevant aspects of the macroeconomic situation in Montenegro, the objectives of the Bank s FY08-FY 10 Country Partnership Strategy, and how increased flexibility in expenditure eligibility would be used under each of the proposed parameters for Bank financing relevant to Montenegro. This CFP proposal is consistent with the CFPs previously agreed for Serbia and Montenegro in March The Montenegrin Government agrees with the continuation of the CFPs in their current form. Background 3. Montenegro proclaimed independence on June 3, 2006 after a referendum in May 2006, and in line with the 2002 Belgrade Agreement on the future of the Union of Serbia and Montenegro (SaM). Montenegro became a member of the World Bank and the IMF in January In the short period since independence, Montenegro carried out parliamentary and municipal elections (elections were held in 14 out of 21 municipalities). The new Government appointed in November 2006 streamlined the structure of central public authorities, and these changes gave some early indication of the Government s commitment to continue with public institutional reforms. 4. Government priorities are focused on completing the transition to an open, business friendly policy environment, and in moving towards ultimate membership of the European Union. A Stabilization and Association Agreement (SAA) was initialled with European Commission in March This is the first formal step in the EU accession process. 5. For nearly a decade following the breakup of the former Socialist Federal Republic of Yugoslavia, regional conflicts and international isolation crippled the Republic of Montenegro-Country Financing Parameters 1

4 economy and delayed the start of the transition to a market economy. Since 1997, however, Montenegro, with the support of the international community, has been engaged in market-oriented structural reforms. These reforms have re-established macro-economic stability, and provided a foundation for strong recent economic growth. 6. The economy is narrowly based, and heavily dependent on tourism and export of metals. Fiscal retrenchment was supported by an IMF program which helped transform sizeable fiscal deficits (about 8 percent of GDP in 2000) to a surplus of 3 percent of GDP in The fiscal consolidation is approximately equally split between expenditure reducing and revenue increasing measures. The introduction of VAT in 2003 has supported a relatively high revenue-to-gdp ratio while reductions in transfers and interest payments helped lower public expenditures. Current GDP per capita is approximately $3,900. The monetary/exchange rate system remains stable with Euro now used as currency. As a result of the program of macroeconomic stabilization in late 1990s, anchored in the adoption of the Deutsche Mark as sole legal tender, inflation has been reduced from 25 percent at the end of 2000 to about 2.1 percent in In parallel with the currency and fiscal policy reforms, the Government has also implemented a range of structural reforms, including price and trade liberalization, privatization, public administration reform, financial sector reform, pension reform, and labour market and business environment reforms, which have supported modest economic growth and transition. 8. Partly as a result of reforms, recent macroeconomic developments have been highly favorable. Following sluggish growth rates in early 2000 ~~ the Montenegrin economy grew by an average of around 5 percent over with growth accelerating to 6.5 percent in 2006 and an estimated 7.5% in This is driven by FDI in tourism and real estate (Montenegro has the fastest growing tourism market in the world). Growth has been accompanied by significant asset price appreciation and rapid wage rises. 9. One risk is the large current account deficit (now about 28 percent of GDP). Nevertheless, unlike most other countries in the region, Montenegro s current account deficit has been fully funded, and in large part driven by, FDI - which in 2006 was equivalent to 34 percent of GDP. While it is not unusual for small transition countries such as Montenegro to run a high current account deficit to facilitate capital replacement, there is a need for Montenegro to adjust over time to a lower current account deficit, especially in view of a continuing shift to non-concessional loan financing from donors. 10. Montenegro has a reputation for governance issues, and an environment in which there are strong links between key political and business actors. Data is limited: only a small number of Montenegrin firms were included in the World Bank/ EBRD BEEPS anti-corruption survey, and this makes it difficult to draw firm conclusions. Nevertheless, throughout the Western Balkans, state capture remains a concern. While Montenegrin legislation is relatively good, implementation often remains arbitrary. Doing Business suggests that inspections, licensing and permits are main areas for rent seeking behaviour. Republic of Montenegro-Country Financing Parameters 2

5 Bank Strategy 1 1. After its independence Montenegro inherited significant debts to the World Bank: approximately Euro 270 million in IBRD obligations from loans to the previous SFRY, as well as almost SDR 60 million obligations from more recent IDA credits to SaM. Montenegro s total public debt levels have fallen to around 40 percent of GDP, with foreign debt accounting for about three quarters of the total. Debt levels are also moderate, and Montenegro has recently become creditworthy for IBRD lending from the World Bank, while Standard & Poor s also recently upgraded Montenegro s credit rating to BB+. Yet although limited in absolute terms, World Bank debt is equivalent to just under 50 percent of Montenegro s total public debt. On a per capita basis, Bank exposure to Montenegro is among the largest in the world. Montenegro is, however, considering limited prepayments to the Bank of possibly $15-20m in FY Although part of SaM, lending and analytical work for Montenegro has been separately identified since A full three year participatory CAS covering FY05-07, and reflecting separate programs for Serbia and Montenegro, was presented to Board on December 16, The full base case CAS envelope of $42 million is scheduled to be delivered during the CAS period, although with some delays - in part caused by Montenegro s independence in June 2006 and subsequent membership of the Bank in January Nevertheless, Montenegro did not access IBRD, as originally envisaged. The Bank determined in 2007 that Montenegro is creditworthy for IBRD, but the Montenegrin Government s own annual borrowing limits led the Authorities to request that IBRD financing available in FY07 be rolled over to As of May 1, 2007, the Montenegro portfolio consists of 5 investment projects under implementation, with a total value of $29 million. These include investments in education improvement, health sector reform, pension systems reform, energy investments consistent with the Southeast Europe Energy Treaty, and sustainable tourism infrastructure, particularly solid waste and associated environmental investments and planning. All investments except the education reform project were approved prior to the introduction of CFPs for Serbia and Montenegro in There have been significant difficulties with portfolio performance, with all projects except education experiencing implementation difficulties and delays in summer Nevertheless, strong efforts by the Government - supported by the Bank - have been successful in turning around the performance of all projects except for the sustainable tourism investment. This may need to be cancelled. 14. A new Country Partnership Strategy (CPS) for FY08-10 is due to be presented to the Board on June 12,2007. The CPS envisages a shift from IDA to IBRD lending. Given Montenegro s own efforts to manage external debt, as well as Bank exposure, base-case lending will be limited. The CAS is expected at $19 million in IDA funding in FY07 (which will use the last of the IDA made available in the last CAS), and new IBRD financing of $50 million (base case) over three years from FY08 to FY 10. The CPS is structured around the Montenegrin Government s over-arching strategic goal of greater integration with the European Union. Within this framework, the CPS supports the Government three key priorities : Economic Policy of Montenegro for 2007: Government of Montenegro, December Republic of Montenegro-Country Financing Parameters 3

6 (i) enhancing sustainable economic growth, through increasing economic freedoms and strengthening the role of the private sector; (ii) building institutions and the rule of law; and (iii) improving the standard of living of citizens, through efficient education, health and social protection systems. 15. Proposed investments include: (i) energy sector reform: including unbundling generation, transmission and distribution functions and regional transmission investments, as well as improved energy efficiency. This could be complemented by an IFC transaction adviser for energy privatization, as well as possible IFC/ MIGA financing for possible buyers; (ii) tourism inzustructure: including water supply and waste water treatment along the coast, linked to tourism planning and environmental investments (both IBRD and GEF); (iii) EU integration: assisting Montenegro to put in place systems to access EU regional and rural development structural funds once they become a candidate, and environmental investments. This will also particularly benefit the poorer northern municipalities; (iv) Improving the business environment: support for cadastre, as well as streamlining municipal business licensing and permits, and strengthening urban/ spatial planning at the local level. This will be closely integrated with proposed IFC and MIGA analytical work and TA; (v) Social service delively: following-up on current investments to streamline and improve social service delivery (health, education) and pension reform. All investments anticipated in the new CPS will be standard sector investment loans. As a MIC heading toward the EU, IFC and MIGA will become an increasingly central element in WBG engagement in Montenegro. 16. Given Montenegro s strong financing position, the Government is not looking for adjustment lending from the Bank. A potential IMF precautionary SBA offers considerable potential for the Bank to work with the Find to take forward the discussion on critical structural reform issues, including labor market reform and energy sector reform. This will, however, need to be managed carefully. Analytical work will need to be linked, in part, to the support the Bank can provide for an IMF SBA. 17. The Bank is likely to have to take something of a gap filling role. Donor coordination activities in Montenegro are currently led by EC, UNDP and the Bank. There is particular scope to work with the EC on EU integration support, where there are regional models for linking Bank financing for investments with EC TA. Bank investments in cadastre and municipal level spatial planning will need to be linked closely with German and Japanese support. Bank investments in the water sector will also require continuing coordination with the German Government, EIB and EBRD. 18. Montenegro is making steady progress in the development of public financial management and procurement systems and institutions. The last CFAA and CPAR were completed in 2002, although a series of programmatic fiduciary assessments are planned in the forthcoming CPS period, beginning in Financial management and procurement legislation is generally strong. Nevertheless, implementation capacity remains weak and enforcement is variable. A key challenge will be to ensure adequate resources are devoted to oversight and accountability institutions. Republic of Montenegro-Country Financing Parameters 4

7 Cost sharing 19. The previous policy until the development of the SaM CFPs in 2005 (and to which Montenegro would revert without new CFPs) set cost sharing ceilings based on per capita income on a rolling three-year basis (OP 6.30). 20. The policy outlined in these CFPs will continue the practice since the SaM CFPs were approved in 2005 of emphasizing borrower commitment and ownership to the activities supported by the Bank. In addition to the project level per se, the Bank examines such commitment and ownership in the context of the country s overall development program, taking into account factors such as the alignment of Banksupported projects with the country s overall development program, and integration of Bank-financed projects into the budget. Where appropriate, the Bank may finance up to 100 percent of the costs of individual projects 21. Current Bank practice: Montenegro is considered a blend country, although with exceptional access to IDA-only lending, and has been officially classed as such country since arrears to IBRD were cleared. From FY08, however, Montenegro is expected to borrow on IBRD-only terms. Until CFPs for SaM were approved in March 2005, the country was eligible for financing of up to 90 percent of IDA financed investment project costs, net of taxes. Prior to the 2005 adoption of CFPs for SaM, the projected share of Bank funding for individual projects in SaM, based on financing plans set out in a sample of six PADS, has varied from 71 to 86 percent on. the gross cost basis (Le. inclusive of all applicable taxes). Based on the audited project financial statements (or FMRs where audit reports are not available), the actual share of Bank funding for individual projects has varied between 87 and 99 percent of gross expenditures. There are two primary reasons for the variation; (i) the Republican governments have issued exemptions for some taxes that would normally be payable on activities in SaM, thus reducing the overall (gross) cost of the project; and (ii) the Borrower is in arrears to suppliers in respect of counterpart contributions. 22. Since the new CFPs were introduced for SaM in 2005, only one new activity, the education reform project, has been approved and become effective in Montenegro. This project used the flexibility available to provide 100 percent financing by the World Bank, although it was closely integrated into supporting Montenegro s overall education reform program. To date, this has been the only project in the Montenegrin portfolio over the past two years that has not experienced implementation difficulties. 23. Ownership and the Macroeconomic Perspective: Public spending financed from IDA credits, IBRD loans and other sources is compatible with fiscal targets and consistent with the government priorities, as laid out in the Governments two complementary strategies, the Stabilisation and Association Arrangement (SAA) with the EU and the Economic Reform Agenda (which incorporates the PRSP). The Bank s own program of assistance in the CPS is closely aligned to these overall priorities. Country ownership, therefore, is built up through the framework of key policy documents either adopted or agreed with the authorities. 24. The World Bank s own contribution to the public investment program in Montenegro is relatively limited. Capital expenditures from the central Government budget in 2005 and 2006 were equivalent to approximately 4.0 to 4.4 percent of GDP. Republic of Montenegro-Country Financing Parameters 5

8 Of this, foreign financed projects have been equivalent to between 0.8 and 1.3 percent of GDP. World Bank disbursements under investment loans of about $10 million per annum are equivalent to about 0.4 percent of GPO, or about one third to half of total foreign financing to Montenegro over the past few years (figures obviously fluctuate from year to year). In addition, it needs to be noted that capital investments are undertaken within a framework of significant recurrent expenditure, financed predominantly by Government revenues. 25. Government commitment to project objectives and implementation has been demonstrated far more convincingly by aligning projects with the objectives of key government policy documents, and ultimately through the annual budget process, which has been significantly strengthened since 2001, bringing all project financing on-budget. Furthermore all World Bank projects are overseen or implemented by government agencies and the Montenegro authorities participate with Bank staff in regular Joint Portfolio Reviews. Under these circumstances, Government financing contribution to individual projects is not always necessary to demonstrate Montenegro government ownership of such projects. 26. Project prospective: While aimed at raising ownership at the country level, the past cost sharing policy has caused some problems at the project level. The application of cost sharing parameters has often proved administratively difficult to apply since they differentiate not only between goods, works, and consultants, both local and foreign, but also between grants and credits. a 27. Summary: The current Government is a significant contributor to its own public investment program. Commitment and ownership is established through the framework of government owned policy documents and programs, and in active government management of the World Bank financed portfolio. Under the new policy there would be no upper limit on individual project costs to be financed by the Bank. The parameter would, therefore allow Bank financing of up to 100 percent of individual project costs. Recurrent cost financing 28. The previous policy until the development of the SaM CFPs in 2005 (and to which Montenegro would revert without new CFPs) provides for incremental financing of recurrent costs on a declining basis (OMS 1.21). Such financing would normally be on a temporary basis for a transition period until a sustainable financial situation could be achieved. 29. The policy outlined in these CFPs will continue the practice since the SaM CFPs were approved in 2005 would allow financing of recurrent costs if there is a project specific reason for doing so; given that the following strategic criteria at the country level have been met: (i) fiscal sustainability, (ii) demonstrated commitment to sound fiscal management, (iii) sound budget management and execution. 30. Current Bank practice: Currently in Montenegro, the Bank finances recurrent costs consistent with existing policy, on an exceptional basis and on a declining scale. Despite their generally small share in total project (average of 3.3 across a sample of 16 projects across the previous Serbia and Montenegro portfolio as a whole.) Republic of Montenegro-Country Financing Parameters 6

9 recurrent expenditures play a vital role in project implementation. The Bank currently relies on PIUs to implement projects, given generally weak government capacity. Expenditures currently recorded as recurrent cost are largely related to non-salary costs of projects. As PIU staff are generally hired on a consultant basis, these recurrent costs are often reported under consulting services Macroeconomic Perspective: The Montenegro government follows tight fiscal policy and strictly controls expenditures and the fiscal deficit under a macro stabilization program supported by the IMF program. This program helped transform sizeable fiscal deficits (about 8 percent of GDP in 2000) to a surplus of 3 percent of GDP in In addition, to strengthen the efficiency and transparency of public expenditures, the government has also implemented a range of structural reforms, including price and trade liberalization, privatization, public administration reform, financial sector reform, pension reform, and labour market and business environment reforms, which have supported modest economic growth and transition. Given the tight control over total and foreign financed expenditures by the government and transparency of Bank-financed expenditures, Bank financing of recurrent costs per se would not jeopardize overall fiscal and debt sustainability (see Para 5.) 32. Project Perspective: Despite their generally small share in total project costs, recurrent expenditures play a vital role in project implementation. Adequate financing of recurrent expenditures in the PIUs has proved critical to effective project implementation. The Bank is increasingly encouraging the mainstreaming of project implementation activities into government Ministries, and the phasing out of PIUs, (e.g. the Montenegro Education Project, currently under preparation, will rely upon the Ministry of Education s Strategic Planning unit for project implementation; there is no separate PIU). Nevertheless, until such times as the respective line ministries have adequate internal capacity particularly in the areas of financial management and procurement, these activities will continue to be contracted out to ensure the Bank s fiduciary position is adequately safeguarded. Further, as financial controls within the line ministries and the MoF are not risk focused, even the smallest expenditure financed from the Borrower s own resources requires authorisation on several levels. Until such time as the Borrower adopts a more risk focused approach to financial control, the ability to fully fund operating costs, which though typically low in value, represent a high percentage of the total volume of transactions, could significantly reduce the administrative burden associated with implementing a Bank-funded project. Given the low value of such expenditures, both in absolute terms and as a percentage of the cost of each individual project, fully funding them from Bank resources, using streamlined, more risk focused authorisation systems, does not risk undermining the overall sustainability of each project. Indeed, though the Montenegro portfolio is still relatively young (only one investment project has closed to date), there has been no indication, either in supervision reports or mid-term reviews, that fully funding recurrent costs would undermine project sustainability. The inefficiencies in the Borrower s expenditure authorisation systems noted above are better tackled at the country level, not on a project by project basis Le. it would be inappropriate to require the Borrower to amend its Treasury operating procedures to satisfy the requirements of an individual Bank-financed project. 33. It is not envisaged that Bank-financed projects would fund operating costs other than those associated with the operation of a project implementation unit. Republic of Montenegro-Country Financing Parameters 7

10 However, if such a request were received and it could be shown to support the overall project objectives, the country unit would not unreasonably withhold its no-objection. 34. Summary: As envisaged recurrent cost financing will not significantly impact debt or fiscal sustainability. No country-level limit on recurrent cost financing is proposed. The Bank will continue to monitor fiscal sustainability, the government s commitment to sound fiscal policy management, and sound budget management and execution; and its implications for recurrent cost financing. In determining Bank financing of recurrent costs in individual projects, the Bank will take into account sustainability issues at the sector and project levels. Local cost financing 35. The previous policy until the development of the SaM CFPs in 2005 (and to which Montenegro would revert without new CFPs) allows for local costs financing for investment loans only, and under certain specific conditions (OP 6.30). 36. The policy outlined in these CFPs will continue the practice since the SaM CFPs were approved in 2005 allows the Bank to finance local costs if two criteria are met namely that (i) financing requirements for the country s development program would exceed the public sector s own resources (e.g. taxation and other revenues) and expected domestic borrowing; and (ii) the financing of foreign expenditures alone would not enable the Bank to assist in the financing of individual projects. If the two criteria are met, foreign and local expenditures to be treated in the same way with regard to Bank financing. This approach should provide greater flexibility and reduce the administrative burden for project implementation. 37. Current Bank practice: The Bank has generally been financing 100 percent of foreign expenditures for goods, equipment, and materials. In the case of locally procured equipment, goods, and materials, the Bank had previously financed up to percent of costs in Serbia and Montenegro, based on a set of Standard Disbursement Percentages. The result was a complicated series of standard disbursement profiles. Limiting the Bank to financing only foreign exchange costs would limit the project effectiveness. 38. Macroeconomic Perspective: Montenegro has adopted the Euro as its national currency. Montenegro has followed tight fiscal and monetary policies to control inflation. As a result of these policies, the exchange rate has been stable and inflation has been brought under control. 39. Criteria 1: Financing requirements for the country s development program exceed the public sector s own resources Cfrom taxation and other revenues) and expected domestic borrowing. Although the Government managed in 2006 to transform a persistent fiscal deficit into a fiscal surplus, prudent policies will need to be maintained in order to manage an inevitable slowing over the next few years of a rapidly expanding economy. The policy reform agenda also remains large if Montenegro is to set the economy on a higher growth path and narrow the income, productivity and investment gaps with EU members. Investment needs remain large as a result of long neglect of physical infrastructure, especially in the energy sector, and the priority for new transport investments. The EU integration process poses further challenges, as Montenegro will need to undertake significant investments, Republic of Montenegro-Country Financing Parameters 8

11 especially in the environmental and agricultural areas, to move toward European standards. In addition, given the Euroization of the economy, fiscal policy is one of the few instruments to respond to the widening current account deficit, which increased to about 28 percent of GDP in Finally, the fiscal surplus in Montenegro in 2006 is due to both policy measures, but also the operation of automatic fiscal stabilizers given the current upswing in economic performance. Without policy changes, the budget is likely to return to deficit during the cycle. The IMF estimates that, taking into account cyclical adjustments, Montenegro continues to have an underlying structural fiscal deficit (Ih4F Mission Brief, April 2007). 40. Project Perspective: The Bank s flexible approach to financing local costs is expected to have a positive impact on the success of individual projects. This is particularly true for projects that rely on heavy local inputs. Many of the current Bank funded projects are in sectors such as environment, pension reform, finance, water, education, health, etc. that consume a large share of local goods and services rather than foreign. This trend is likely to continue through the next CPS. The added flexibility of local cost financing will also simplify procedures, reduce transaction costs and enhance the implementation efficiency of Bank financed projects Criteria 2: Financing of foreign expenditures alone would not enable the Bank to assist in the financing of individual projects. Financing only foreign expenditures would constrain projects scope and effectiveness. In practice, prior to the introduction of CFPs in Serbia and Montenegro in FY05, the range of local cost financing varied between 0 to 80 percent of total project costs for individual operations, with IDA on average financing approximately half of the local costs of projects in both Serbia and Montenegro over the period from FY99 to FY04, (see table below). Experience with the education reform project, the only investment in Montenegro approved and effective since the introduction of the 2005 CFPs for SaM, demonstrates the benefits that can be gained from a more flexible approach. In this case, over 80 percent of the costs financed by the Bank were local costs. The Bank completely financed critical local costs, including local consultants, training, and textbooks and minor repairs for identified well performing schools, without formal counterpart financing from the authorities. Nevertheless, as this project was well integrated within the Government s overall education reform program, it has proved among the more successful investments in Montenegro in recent years. Serbia and Montenegro: IBRD and IDA Disbursements for Foreign and Local Expenditure FY99 - FY04 (USD Millions) Data Foreign Costs Local Costs Total Costs %Local FY FYOO FYOI FY FY % FY % Cumulative FY % Average FY % Cumulative FYO % Average FYO % Republic of Montenegro-Country Financing Parameters 9

12 42. Summary: The requirements for Bank financing of local cost financing are met. Namely, financing requirements for the country s development program exceed the public sector s own resources, and financing of foreign expenditures alone would significantly limit the Bank s ability to assist in the financing of individual projects. The Bank has traditionally financed local expenditures at a lower percentage than foreign expenditures. Under the new policy, foreign and local expenditures will be treated in the same way with regard to Bank financing. The Bank may finance local costs in the proportion needed in individual projects. This approach should provide greater flexibility and reduce the administrative burden for project implementation. Under the new policy Bank financing up to and including the 100 percent of local costs is now possible. Taxes and duties 43. The previous policy until the development of the SaM CFPs in 2005 (and to which Montenegro would revert without new CFPs) prohibits financing of taxes and duties (General Conditions, OP12.00). 44. The policy outlined in these CFPs will continue the practice since the SaM CFPs were approved in 2005 would allow the Bank to finance the cost of reasonable taxes and duties. Only duties with unreasonably high rates would be excluded from Bank financing. 45. Current Bank practice: Standard Disbursement Percentages were in use in SaM since 2001, although new CFPs since 2005 have allowed the financing of reasonable taxes and duties. SDPs specify rates for procurement of goods, works and services, both internally and externally, and were specific to Montenegro (because of own tax structure). Furthermore, since goods and services financed by grants are accorded different tax treatment than those under loans/credits, different rates must be applied to loans/credits and grants. The application of the SDPs has proven to be administratively cumbersome. 46. Macroeconomic Perspective: From an economic perspective the tax rates in the Montenegro are reasonable. Customs duties average about 3 percent in Montenegro. Montenegro has VAT rate of 18%. Personal income tax rates have ranged from percent, although incomes tax rates are being consolidated at a single rate of 15 percent, which will be further lowered to 9 percent in Corporation tax rates are between percent in Montenegro (on the adjusted tax base). Fiscal revenues equal about 45 percent of GDP. 47. The trade regime is liberal and open, with few restrictions. Most import and export quotas and controls have been eliminated. The average trade tariff is a rate that is generally below that of other transition economies. In 2003 Montenegro introduced the VAT. Fiscal retrenchment was supported by an IMF program to improve Montenegro tax administration and customs administration. The revenue administration reform is underway, and its goal is the improvement of revenue collection. Revenues as a percent of GDP have grown steadily since Summary Taxes and duties in Montenegro are reasonable. The Bank may therefore finance all taxes and duties associated with project expenditures. At the Republic of Montenegro-Country Financing Parameters 10

13 project-level the Bank would consider whether taxes and duties constitute an excessively high level of project costs. The 100 percent financing of local taxes and duties associated with project expenditures would facilitate smoother implementation of projects in Montenegro. Republic of Montenegro-Country Financing Parameters 11