Document of The World Bank FOR OFFICIAL USE ONLY Report No. 57149 -ME INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT COUNTRY PARTNERSHIP STRATEGY FOR MONTENEGRO FOR THE PERIOD FY11­FY14 December 28, 2010 South East Europe Country Unit Europe and Central Asia This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. The last Country Partnership Strategy (CPS) for Montenegro was discussed by the Board of Executive Directors on May 15, 2007. The last CPS Progress Report dated was March 20, 2009. CURRENCY EQUIVALENTS (Exchange Rate Effective August 17, 2010) Currency Unit = Euro (EUR) 1.00 = US$1.2819 US$1.00 = 0.7802 GOVERNMENT'S FISCAL YEAR January 1 ­ December 31 ABBREVIATIONS AND ACRONYMS AAA Analytical and Advisory Activities HIF Health Insurance Fund AF Additional Financing IBRD International Bank for Reconstruction and Development APL Adaptable Program Loan IFC International Finance Corporation BEEPS Business Environment and Enterprise IMF International Monetary Fund Performance Survey BERIS Business Environment Reform and IPA Instrument for Pre-Accession Institutional Strengthening Project CAD Current account deficit IPARD Instrument for Pre-Accession for Rural Development CBCG Central Bank of Montenegro KAP Podgorica Aluminum Plant CEM Country Economic Memorandum LAMP Land Administration and Management Project CPS Country Partnership Strategy LOLR Lender of last resort CPS PR Country Partnership Strategy Progress LRSA Last resort social assistance Report DPL Development Policy Lending MAFWM Ministry of Agriculture, Forestry, and Water Management DPR Directorate of Public Roads MDA Montenegro Drugs Agency Montenegro Institutional DPS Democratic Party of Socialists MIDAS Development and Agricultural Strengthening Project EBRD European Bank for Reconstruction and MIGA Multilateral Investment Guarantee Development Agency EC European Commission MESTAP Montenegro Environmentally Sensitive Tourist Areas Project ECA Europe and Central Asia Region MoES Ministry of Education and Science ECSEE Energy Community of South East MOF Ministry of Finance Europe EIB European Investment Bank MONSTAT Statistical Office of Montenegro EFP Economic and Fiscal Program MOH Ministry of Health EPCG State Electricity Company NGO Non-governmental organization ESW Economic and Sector Work NPI National Program for Integration EU European Union NPL Non-performing loan FDI Foreign direct investment ODIHR Office for Democratic Institutions and Human Rights FSAP Financial Sector Assessment Program OSCE Organization for Security and Cooperation in Europe FY Fiscal Year (July 1­June 30) PPAA Public Procurement Administrative Authority FSDPL Financial Sector Development Policy PPC Public Procurement Commission Loan GDP Gross domestic product PEFA Public Expenditure and Financial Accountability GEF Global Environmental Facility PEIR Public Expenditure and Institutional Review HDI Human Development Index PHC Preventive and primary health care PFM Public finance management PPP Public-private partnership Road to Europe ­ Program of REPARIS Accounting Reform and Institutional Strengthening R&D Research and development ROSC Report on the Observance of Standards and Codes SEE South Eastern Europe SEEC CRIF Southeastern Europe and Caucasus Catastrophe Risk Insurance Facility SME Small and medium-sized enterprises SCG State Union of Serbia and Montenegro TA Technical assistance TBD To be determined TF Trust fund TSU Technical Services Unit UNDP United Nations Development Programme USAID United States Agency for International Development WGI World Governance Indicators y-o-y Year-on-year World Bank Vice President Philippe Le Houérou Country Director Jane Armitage Task Team Leaders Neeta Sirur Jan-Peter Olters WORLD BANK­MONTENEGRO COUNTRY PARTNERSHIP STRATEGY TABLE OF CONTENTS EXECUTIVE SUMMARY .........................................................................................................................I I. INTRODUCTION ......................................................................................................................... 1 II. COUNTRY CONTEXT................................................................................................................. 2 A. Overview .......................................................................................................................................... 2 B. Governance and the Business Climate ............................................................................................. 6 C. Poverty and Welfare ........................................................................................................................ 9 III. COUNTRY CHALLENGES AND GOVERNMENT PROGRAM ........................................ 10 A. The Government's Development Plans ......................................................................................... 10 B. Key Challenges and Government Strategies .................................................................................. 11 IV. THE WORLD BANK GROUP STRATEGY ............................................................................ 19 A. Experience and Lessons Learned ................................................................................................... 19 B. Priorities for the FY11­FY14 CPS ................................................................................................ 24 C. The Lending Program .................................................................................................................... 32 V. RISKS ........................................................................................................................................... 32 Figures: Figure 1: GDP Growth 2005-2007 ................................................................................................. 3 Figure 2: Impact of Global Crisis on Montenegro's Banking Sector ............................................. 5 Figure 3: (a)-(c): Montenegro: Business Climate and Governance Measures ................................ 8 Tables: Table 1 Montenegro: Key Economic Indicators, 2006­12 ............................................................. 5 Table 2 :Western Balkans: Relative Rankings in Institutional, Economic and Social Indicators .. 7 Table 3: Montenegro: Active Portfolio ......................................................................................... 20 Table 4(a): CPS Portfolio and New Lending FY11­FY14 .......................................................... 25 Table 4(b): CPS AAA Country Specific and Regional FY11-14 ................................................. 25 Table 5: Portfolio Consolidation over the CPS period ................................................................. 26 Table 6: Proposed IBRD Lending Program FY11-14 .................................................................. 32 Boxes: Box A: Restructuring the Aluminum Sector ................................................................................... 4 Box B: Country Systems in Public Financial Management and Procurement ............................. 22 Annexes: Annex 1: Draft FY11-14 Results Matrix for the Montenegro Country Partnership Strategy ..................... 34 Annex 2: FY07-FY10 CAS Completion Report ......................................................................................... 38 Annex 3: Gender Profile ............................................................................................................................. 73 Annex 4: Trust Funds.................................................................................................................................. 75 Annex A2: Montenegro at a Glance ........................................................................................................... 76 Annex B2: Selected Indicators of Bank Portfolio Performance and Management .................................... 79 Annex B3: IFC Program ............................................................................................................................. 80 Annex B3: Indicative IBRD Lending Program by Fiscal Year .................................................................. 81 Annex B4: Summary of Non-Lending Service ........................................................................................... 82 Annex B5: Poverty and Social Sector Indicators ........................................................................................ 83 Annex B6: Montenegro Key Economic Indicators 2001 ­ 2012 ................................................................ 84 Annex B7: Key Exposure Indicators .......................................................................................................... 85 Annex B8: Operations Portfolio (IBRD/IDA) ............................................................................................ 86 Annex B9: Operations Portfolio (IFC)........................................................................................................ 87 EXECUTIVE SUMMARY i. Montenegro, the smallest republic in former Yugoslavia, is endowed with a beautiful coastline on the Adriatic Sea, a moderate climate, and close proximity to European and Russian markets. Montenegro's population was estimated in 2010 at 667,000. Montenegro's small, open economy is largely based on activities in the tertiary sector--especially tourism--and agriculture. The energy sector could become an important source of growth and exports, provided that environmental impacts can be adequately contained and investments do not create large negative externalities encroaching on the country's tourism potential. Aluminum and steel production, joint with bauxite and coal mining, remain vital (albeit economically vulnerable) activities, with aluminum products comprising about 40 percent of all merchandise exports. Given a per capita income of nearly US$6,900 in 2009, Montenegro is a higher middle-income economy with relatively low levels of poverty. Trade with the European Union (EU)-- especially with Greece and Italy, Montenegro's second and third-largest export markets (after Serbia)-- underpin most economic activity and international commerce. EU member states and Russia account for a significant proportion of FDI inflows. ii. Since independence in mid-2006, Montenegro has taken important steps towards EU candidate country status. The Government signed and ratified the Stabilization and Association Agreement (SAA) with the European Commission (EC) in late 2007, allowing the interim agreements on trade, visa facilitation, and readmission to become effective by January 2008. For Montenegrin citizens with biometric passports, the EU lifted visa requirements for travel into Schengen countries in December 2009. EU member states completed the process of ratifying Montenegro's SAA in March 2010, allowing the Agreement to formally enter into force in May 2010. In its November 2010 opinion on Montenegro's December 2008 EU membership application, the European Commission (EC) recommended to the European Council to award Montenegro the formal status of EU candidate country. On December 17, 2010 the Council decided to grant Montenegro candidate status. The EU announced that it would open accession talks after Montenegro has complied with Copenhagen political criteria in the areas of public administration and rule of law. The EC has highlighted several key priorities in its opinion, including public-administration and judicial-sector reforms to enhance professionalism and foster de-politicization. iii. The three-year episode of rapid growth was followed by a sharp economic contraction, caused by the combined effects of a busting boom and the effects from the global financial crisis, and signs of a gradual recovery as of mid-/late 2010. During 2006­08, annual GDP growth rates averaged nearly 9 percent, propelled by strong domestic and external demand, rapid credit expansion, and substantial FDI flows, which were largely concentrated in the real-estate, construction, and tourism sectors. The global crisis precipitated a severe credit crunch as (i) the private sector withdrew funds from the banking system; (ii) foreign mother banks limited their exposure to the Montenegrin market; and (iii) domestic banks consolidated their portfolios, resulting in the accumulation of payment arrears within the private sector. Reduced external demand for exports--in conjunction with very large and adverse terms- of-trade shocks--led to the near-collapse of the industrial sector, including the pivotal aluminum industry, partly reflecting the drop in world prices well below the company's break-even point. The combined impact of reduced access to credit and loss of export markets, together with eroding confidence and escalating labor conflicts, led to a severe recession in 2009, with an estimated GDP contraction of 5.7 percent. Tourism (accounting for nearly a quarter of the economy) remained a bright spot during the recession, holding steady in 2009 and showing signs of growth in 2010. FDI flows remained buoyant, partly reflecting the partial privatization of EPCG in 2009 and bank recapitalizations in 2010. Investor confidence in Montenegro seemed to be confirmed by the oversubscription of the country's first international bond issue in 2010, which raised 200 million in 5-year Eurobonds at a rate of 7.875 percent. i iv. The experiences from the post-independence boom-bust cycle, amplified by the global financial crisis, revealed structural weaknesses and heightened the government's responsiveness to the need to adjust the underlying growth model. The implicit susceptibility of Montenegro's small, open economy to changes in the external environment, paired with the pro-cyclicality of its most important sectors and the underlying tax system, has placed an increased premium on reforms aimed at increasing (i) knowledge, productivity, and innovation; (ii) employment, professional perspective, and social inclusion; and (iii) energy efficiency and environmental protection. Given Montenegro's decision in 1999/2000 to adopt the euro as legal tender and the existence of lower--but still large--current account deficits, improving the business climate to be able to maintain substantial inflows of foreign direct investment remains the principal anchor of economic policy-making. Related reforms complement those (to be) introduced in the context of achieving the overarching political objective of EU integration (especially those in the rule-of-law area). The European perspective, together with a strengthened judicial environment and business climate, would help to increase investors' confidence in the inherent profitability of Montenegro's economy as a site for investment and business. v. Against the above background, the CPS seeks both to help the country recover from the 2009 recession and advance longer-term goals. In particular, the CPS supports Montenegro's efforts to (i) strengthen institutions and competitiveness in line with EU accession requirements; and (ii) improve environmental management. Government has requested the Bank to provide support in areas where the Bank has previously been engaged in Montenegro and/or gained applicable regional or global experience. The centerpiece of the Bank's engagement will be two financial-sector development policy loans (about US$105 million, total in FY11 and FY12), which will support a banking-sector strengthening and stabilization program, bring regulations into line with EU norms, and encourage resumption of (healthy) credit growth. New investment lending in roughly the same amount will be very selective, given existing resource constraints under the new exposure framework, the country's limited implementation capacity, and the substantial portfolio of operations under implementation (about US$55 million still to be disbursed). At present, new investment lending is planned for a Higher Education/R&D project (FY12), a small investment to facilitate Montenegrin participation in a regional Catastrophe Risk Insurance Facility (FY12), and an Environmental Clean-up Project (FY13). An additional project could be included for FY14, depending on client demand and timely closure of projects in the existing portfolio. Technical assistance, analytical work, and advisory services will support convergence with EU norms in selected sectors, address key issues of competitiveness, and strengthen governance and public sector institutions. IFC is expected to provide advisory services to help improve the business climate and country competitiveness, and make new investments in private companies as opportunities arise. The expected level of support will be on the order of US$40­50 million over the CPS period. vi. The principal risks to successful implementation of the CPS are fivefold. First, slower-than- expected growth in South-East Europe and the EU could dampen Montenegro's fledgling recovery and exacerbate fiscal vulnerabilities--especially high external debt. Second, ongoing weaknesses in the banking sector could perpetuate a constrained credit environment and choke off private-sector led growth. Third, lack of progress on institutional strengthening and governance improvements--especially in those areas mentioned by the European Commission in its opinion as prior actions for opening membership negotiations--could undermine Montenegro's path towards EU accession and its efforts to continue to attract significant flows of FDI. Fourth, CPS goals of portfolio consolidation could be adversely affected if current efforts to reinforce implementation capacity (especially with respect to procurement and financial management) prove inadequate or ineffective. Finally, much of the country is vulnerable to natural disasters including both droughts and flooding which could impose tremendous hardships for households and businesses in both the coastal and mountain areas. ii I. INTRODUCTION 1. This Country Partnership Strategy for FY11­FY14 builds on the Bank's sustained engagement with Montenegro--both before and after its declaration of independence in mid-2006. The FY02­FY04 Transitional Support Strategy for the Federal Republic of Yugoslavia (FRY) included a discrete program of Bank support for Montenegro, as did the FY05­FY07 CAS for the State Union of Serbia and Montenegro (SCG). The Bank's engagement during the pre-independence period was focused on supporting Montenegro's efforts to build a market economy and re-establish growth after a period of regional conflict and intense instability, both through Analytical and Advisory services (AAA) and new investments especially in energy and water. In mid-2007, the Bank and country authorities developed Montenegro's first post-independence Country Partnership Strategy (CPS) covering FY07­FY10. The CPS deepened the Bank's engagement in infrastructure, the social sectors, and public sector management, as well as marked Montenegro's graduation from IDA into the ranks of middle-income IBRD borrowers. A CPS Progress Report submitted on March 20, 2009 took stock of progress on the FY07­FY10 CPS and made necessary adjustments to the program in view of the evolving economic crisis. Attached as an annex to this report is a CPS Completion Report, which assesses Bank support for Montenegro during FY07­ FY10 and identifies lessons relevant for the Montenegro-Bank partnership over the next years. 2. Following independence, Montenegro grew rapidly, while taking important steps in its European Union (EU) integration process. The Government signed and ratified the Stabilization and Association Agreement (SAA) with the European Commission (EC) in late 2007, allowing the interim agreements on trade, visa facilitation, and readmission to become effective by January 2008. For Montenegrin citizens with biometric passports, the EU lifted visa requirements for travel into Schengen countries in December 2009. Already in 2008, Government approved a National Program for Integration (NPI), a comprehensive plan to reform policies and standards towards the full implementation of the EU acquis communautaire, while EU member states completed the process of ratifying Montenegro's SAA in March 2010, allowing the Agreement to formally enter into force in May 2010. Following Montenegro's formal membership application in December 2008 and its submission of responses to the accompanying--very comprehensive--questionnaire of more than 2,850 questions in late 2009 and early 2010, European Commission (EC) recommended to the European Council to award Montenegro the formal status of EU candidate country. On December 17, 2010 the Council decided to grant Montenegro candidate status. The EU announced that it would open accession talks once Montenegro had complied with Copenhagen political criteria in the areas of public administration and rule of law. The EC has highlighted key priorities in its opinion, including public-administration and judicial-sector reforms to enhance professionalism and foster de-politicization. 3. The current CPS is being prepared at a time when Montenegro is striving to recover from the sharp economic contraction; the CPS thus seeks both to help the country (i) recover from the impact of the financial and economic shock; and (ii) support Government's longer-term objectives of building modern institutions, promoting international competitiveness, and improving environmental management. In this regard, Government has requested the Bank to provide budgetary and investment support (as well as knowledge services) in areas where the Bank has previously been engaged in Montenegro and/or gained regional or global experience applicable to the Montenegrin context. In particular, the CPS supports Montenegro's efforts in addressing some critical developmental challenges, viz., to (i) strengthen institutions and competitiveness in line with EU accession requirements; and (ii) improve environmental management and reduce the cost of environmental problems. The centerpiece of the Bank's engagement will be two financial-sector development policy loans (about US$105 million) which will support a banking-sector strengthening and stabilization program, bring regulations into line with EU norms, and help to put Montenegro back on a positive growth path by encouraging healthy credit 1 growth. New investment lending in roughly the same amount will be very selective, given existing resource constraints under the new exposure framework, the country's limited implementation capacity, and the substantial portfolio of operations under implementation (about US$55 million still to be disbursed). Technical assistance, analytical work, and advisory services will support convergence with EU norms in selected sectors, address key issues of competitiveness, and strengthen governance and public sector institutions. IFC is expected to provide advisory services to help improve the business climate and country competitiveness, and make new investments in private companies as opportunities arise. The expected level of support will be on the order of US$40­50 million over the CPS period. II. COUNTRY CONTEXT A. Overview 4. Montenegro, the smallest republic in former Yugoslavia, is endowed with a beautiful coastline on the Adriatic Sea, a moderate climate, and close proximity to European and Russian markets. Montenegro's population was estimated in 2010 at 667,000. The key sectors of Montenegro's small, open economy include tourism, given its attractive beaches and coastal towns, and agriculture, including production of tobacco, olives, citrus fruits, and livestock. Montenegro's energy sector could also become the engine of growth in the near future, particularly as foreign (principally Italian) investors have shown keen interest in investing in Montenegro's hydro-/thermopower production and its distribution capacity, linking the local grid, via a trans-Adriatic transmission line, to Italy's electricity network. However, careful consideration will need to be given to environmental impacts. Steel and aluminum production, joint with bauxite and coal mining, remain important--albeit economically vulnerable--activities, with aluminum products comprising about 40 percent of all merchandise exports. Given a per capita income of nearly US$6,900 in 2009, Montenegro is a higher middle-income economy with relatively low levels of poverty. Trade with the EU--especially with Greece and Italy, which (after Serbia) are Montenegro's second and third-largest export markets--underpin most economic activity and international commerce. EU member states (together with Russia) account for a significant proportion of FDI inflows. 5. With a 55.5-percent majority in favor of independence, Montenegro ensured full international recognition of its separation from Serbia on June 3, 2006 and has since made good progress in consolidating its political stability and building institutions. Parliament approved a new Constitution in October 2007. Internationally supervised presidential and parliamentary elections have been successfully implemented, with OSCE/ODIHR confirming their compliance with international standards, cementing the pro-independence, pro-EU and pro-business majority assembled by a coalition led by the Democratic Party of Socialists (DPS). Its leader, Milo ukanovi, who was in power for almost two decades (one term as President and six terms as Prime Minister), has prepared and managed the political transition of executive power to a younger generation of politicians, allowing him to retire as Prime Minister on December 21, 2010 and designating his deputy, Finance Minister Igor Luksi, to prepare Montenegro for accession talks and eventual EU membership. Opposition parties, partly ethnically based, have not overcome their fragmentation and proven unsuccessful in presenting the electorate with convincing alternatives. Macroeconomic Performance and Outlook 6. Montenegro's pro-business policies and clear European perspective helped to achieve strong growth up until mid-2008. As shown in the accompanying Figure 1, average 2006­08 GDP growth has been almost 9 percent, propelled by strong domestic and external demand, rapid credit expansion, and substantial foreign direct investment (FDI), particularly in the real estate, construction, 2 and tourism sectors (see November 2008 Public Expenditure and Institutional Review). Credit to the private sector grew from 33 percent of GDP in 2005 to 83 percent by June 2008, and net FDI averaged 19 percent of GDP over 2007 and 2008. At the same time, rapidly increasing imports and falling exports drove the current account deficit (CAD) from 8.5 percent of GDP in 2005 to 51.8 percent in 2008. 7. The post-independence boom had Figure 1: GDP Growth 2005-2007 masked structural weaknesses, and the global financial crisis then amplified effects of the bust that had already started to become visible as of mid-2008, resulting in a notable deterioration of macroeconomic and financial indicators; see Figure 1. The stock-market boom (until mid-2007), the real-estate boom (until mid-2008), private-sector credit growth rates of 140 and 180 percent in 2006 and 2007, respectively, together with very high, FDI- financed current account deficits, symbolized the vulnerability of the small, open economy to exogenous shocks. The global crisis resulted in the economy's acute illiquidity, as the private sector withdrew considerable funds from the banking system, while foreign mother banks stopped their race for market share and, instead, consolidated their investments--leading to more than two years of consistent negative private-sector credit growth rates and, subsequently, the accumulation of payment and wage arrears in the private sector and a significant increase of non-performing loans towards the banking sector. The reduction in external demand for Montenegro's exports, together with very large, adverse terms-of-trade shocks, led to the near collapse of the industrial sector, including the pivotal aluminum industry, where world prices--at the peak of the crisis--had dropped to levels of one-half the company's break-even point (see Box A). The resultant decrease in investments, together with eroding confidence and escalating labor conflicts, led to a severe recession in 2009, with an estimated GDP contraction of 5.7 percent. The tourism sector, representing almost one-quarter of GDP, has held steady in the crisis year 2009 and appears to have rebounded in 2010. 8. Montenegro's fiscal trends were closely linked to the country's growth performance (Table 1). The general government achieved fiscal surpluses in 2006 and 2007 of 3.0 and 6.7 percent, respectively, on the back of increased tax revenues, particularly value-added taxes on imports. These surpluses drove an expansionary fiscal policy, which boosted consolidated expenditures and net lending to 48.9 percent in 2008. Additional outlays covered both capital and recurrent expenditures, including a notable expansion of spending on the wage bill, which reached 12 percent of GDP in 2008. Partly as a reflection of the pro-cyclical nature of the tax regime, Montenegro's fiscal position deteriorated after the crisis. General government revenues and grants dropped 6 points to 42.5 percent of GDP between 2008 and 2009. This decline was driven in part by the large arrears of the state electricity company (EPCG), the aluminum smelter (KAP), and other large companies, which together accounted for tax arrears of almost 3 percent of GDP by October 2009. Owing to the widening deficit, gross public debt grew from 29 percent of GDP in 2008 to 38.2 percent in 2009. External debt--both private and public--rose from 79.4 percent of GDP in 2007 to an estimated 86.1 percent in 2009. The projections included in Table 1, which are IMF staff estimates prepared in November 2010, suggest that the external debt picture could worsen slightly over the medium-term. With ongoing measures to tighten control over government expenditure, the fiscal deficit for 2010 and over the medium-term horizon will fall gradually. When issuing 200 million in Eurobonds in mid-2010, Government reiterated its policy commitment to continuing its fiscal adjustment towards a balanced budget by 2013. The relatively buoyant tourism season in 2009, the partial 3 privatization and recapitalization of the electricity company, together with efforts by Government to tighten control over public expenditures, has led to a overall fiscal deficit in the crisis year 2009 of around 5 percent. Further efforts in this direction, paired with the difficulty that the private sector is experiencing in obtaining credit, would help to contain rapid increases in debt ratios. Box A: Restructuring the Aluminum Sector The aluminum smelter KAP, majority-owned by Oleg Deripaska-owned CEAC (in late 2010, one-half its shares were transferred back to the national authorities), and the Government of Montenegro have joined forces to prevent the company's bankruptcy and address key challenges that have brought the company to the brink of collapse and would have risked widespread social unrest. This situation arose as--following the privatization in late 2005-- KAP's new management was (i) prevented from purchasing the Pljevlja thermo power plant in mid-2007 (which would have given the company direct and secure access to cheaper energy); (ii) obliged to maintain KAP's (partly idle) workforce and, consequently, to finance any modernization investments with credits from international banks; and (iii) affected severely by the negative terms-of-trade shocks that followed the global financial crisis (aluminum prices fell by more than one-half between mid- and end- 2008). Following CEAC's decision to drop a large international arbitration case, the Government accepted one-half of CEAC shares, or 29.4 percent of the aluminum smelter, against an agreement to (i) provide CEAC with 135 million in loan guarantees necessary to restructure its debt; (ii) facilitate and co-finance an agreement on a social program, thereby allowing KAP to reduce its workforce from about 2,800 in 2008 to 1,100 by end-2010; and (iii) subsidize (for a pre-specified) transition period electricity costs at rates below those defined by the regulator. A similar arrangement has been agreed for the affiliated Bauxite mine. These measures--along with additional actions taken by management to modernize and streamline production--have reduced production costs, permitting KAP to take advantage of rising world market prices and plan for an increase of production from less than 60,000 tons in 2009 and 80,000 tons in 2010 back to its full capacity of about 120,000 tons over the medium term. Although the settlement agreement with Government averted KAP's collapse, the industry's long-term economic viability will depend critically on (i) CEAC and the Government honoring their respective commitments in finding a joint solution to address the smelter's energy needs with minimum cost to the budget; (ii) KAP's ability to modernize its operations while managing its large historic debt; and (iii) world market remaining at currently prevailing levels. 9. The 2008­09 global crisis also exacerbated existing vulnerabilities in Montenegro's banking sector. Underpinned by substantial foreign borrowings (typically from foreign mother banks), the growth in domestic banking assets reached 172 percent in 2007, before plummeting sharply by December 2009. Rapid increases in credit of 139 percent in 2006, 176 percent in 2007, and 25 percent in 2008, with heavy exposure to tourism and construction sector, gave way to declining asset quality and an increasing share of non-performing loans (NPLs); see Figure 2 below. The massive, broad-based and persistent withdrawals from Montenegrin banks, which occurred in the wake of the global financial crisis drained liquidity and, coupled with the banks' own efforts to clean up their loan portfolios by tightening credit risk appraisal, led to a severe credit squeeze. Bank-held deposits fell by 31 percent (y-o-y) by June 2009, and improved only slightly with the revenues from the EPCG recapitalization/partial privatization (about 58 percent of related privatization revenues benefited private minority shareholders). Net profits in the banking system as a percent of capital dropped from 6.4 percent in June 2008 to a net loss of 18.4 percent in June 2009, and double this amount by June 2010. 4 10. Given concerns Figure 2: Impact of Global Crisis on Montenegro's Banking Sector about the health of Montenegrin banks, the Government and the Central Bank took steps to restore confidence in the system and make it more resilient to possible future shocks. The emergency law for protection of the banking sector, including the introduction of a temporary blanket deposit guarantee and the possibility of state assistance for vulnerable banks, helped to stop the deposit outflow and to prevent the collapse of the second largest bank in the country. The Central Bank stepped up the supervision of systemically important banks, agreeing with the management and shareholders on supervisory action plans aimed at securing the necessary capital and liquidity support. In parallel, the authorities made progress on the longer term agenda of strengthening the legal framework for supervision and resolution of financial institutions, striving to bring it closer to EU best practice. Working with the World Bank and the IMF, Montenegro prepared amendments to the Law on Banks, the Law on Bank Bankruptcy and Liquidation, and new laws on the Central Bank, Deposit Insurance Fund, and Financial Stability Council. Table 1 Montenegro: Key Economic Indicators, 2006­12 (In percent of GDP; unless otherwise noted) 2006 2007 2008 2009 2010 2011 2012 Real sector Real GDP growth (%) 8.6 10.7 6.9 -5.7 0.3 2.9 3.7 Consumer prices (end-period, %) 2.0 7.7 7.2 1.5 0.8 1.0 2.0 Gross national savings 1.4 -5.6 -11.2 -3.1 -1.1 0.7 2.3 Gross investment 25.4 33.8 40.7 28.3 26.0 26.0 26.0 Fiscal sector Revenues and grants 43.4 47.6 48.6 42.5 41.2 41.0 40.9 Expenditures 40.4 40.9 48.9 47.7 45.7 43.9 42.9 Overall balance 3.0 6.7 -0.3 -5.2 -4.5 -2.9 -2.0 Primary balance 4.2 7.4 1.3 -3.4 -4.0 -1.1 0.0 Public debt (gross) 33.0 27.5 29.0 38.2 48.4 48.1 47.8 External debt (public and private, end-period) 56.8 79.4 95.1 99.9 120.1 116.5 120.0 of which: private sector 33.0 62.1 79.4 76.5 74.2 79.1 81.4 External sector Current account balance (excl. grants) -24.1 -39.5 -51.9 -30.3 -27.1 -25.3 -23.7 Foreign direct investment (net) 21.7 19.6 18.4 30.6 15.9 16.9 15.9 Source: IMF estimates, November 2010. 5 11. To contain the widening fiscal deficit, the Government undertook politically difficult expenditure cuts to consolidate government and expenditure growth, including by privatizing selected state assets and awarding concessions. The Government implemented a first round of expenditure cuts in early 2009 and a budget revision in July 2009 to account for lower growth under the crisis. The revision included the postponement of capital expenditures into future budgets and moderation of the wage bill, and led to a general government deficit of around 5 percent in 2009--an outcome that was a vast improvement over the 8 percent deficit that had been projected for a non-revised budget. In addition, the Government privatized state-owned enterprises and explored options for public private partnerships (PPPs) to lessen strain on public revenues. The state electricity company EPCG was unbundled in 2009 into a transmission company and entity overseeing generation and distribution with the support of Italian investors. Further, the legal framework was updated to facilitate concessions in infrastructure, particularly transport. Besides improving fiscal conditions, private investment in infrastructure is expected to reduce the CAD significantly over the medium-term. In light of these reforms and the good performance of some key economic sectors, Montenegro moderated its economic contraction to 5.7 in 2009 and is expected to resume growth at about 3-4 percent during 2011­12. 12. There have recently been clearer signs that--with foreign investor confidence having remained relatively strong--the Montenegrin economy is recovering from the recession. Preliminary estimates suggest that, after a continued contraction during the first half of 2010, a trend reversal occurred during the third quarter, following (i) an unexpectedly strong tourist season during the crucial summer months (January­August 2010 was up by 7 percent over the same period last year); (ii) the bottoming-out of problems in the metal industry (August 2010 was 12 percent higher than August 2009); (iii) consistent growth rates in mining (January­August figures are up by 36 percent); and (iv) strong growth in the energy sector (+39 percent during January­August). These trends foreshadow an overall growth rate for 2010 at slightly above 0 percent, with external imbalances narrowing and fiscal deficits remaining below last year's level. Prices have remained stable, with year-on-year inflation being only ­ 0.1 percent at end-August. In general, Government has anchored economic policies in the objective of providing an environment attractive to private investors. The still-buoyant inflow of FDI--including substantial PPPs in tourism, energy and transport--both in 2009 and 2010, seems to validate this approach. B. Governance and the Business Climate 13. Since independence, Montenegro has made steady progress on a number of institutional, economic, and social indicators. The Government has implemented diverse reforms linked to the EU accession agenda and the relevant Copenhagen Criteria addressing democracy, rule of law, human rights, and protection of minorities. These and other reforms have, inter alia, improved public administration, strengthened the judicial framework, enhanced the role of Parliament, and fostered cooperation on EU integration issues across government agencies. Government has also demonstrated commitment to human rights protections and civil liberties by ratifying key international treaties and developing a strategy for cooperation with NGOs in 2009. Moreover, some progress was achieved in strengthening the rights of women and minorities, e.g., through initiating reforms under Montenegro's 2008­12 Action Plan for Gender Equality. Nonetheless, more progress is needed in some areas to satisfy EU requirements and unlock additional financial support, including strengthening local government and the civil service, promoting judicial independence and enforcing anti-corruption legislation. politicization. 6 14. The strong pace of Montenegro's reforms has translated into substantial gains in key international indicators measuring governance and political and economic performance (see Table 2). Montenegro has advanced significantly between 2006 and 2009 on all six of the composite Worldwide Governance Indicators (WGIs) published by the World Bank Institute (WBI). Notable gains were achieved on political stability, regulatory quality, rule of law, and government effectiveness (See Figure 3a). The indicator that shows the least progress is control of corruption. Montenegro's ranking in Transparency International's Corruption Perception Index rose from 85th in 2008 to 69th in 2010, and Freedom House upgraded its rating of Montenegro to Free in 2010 from Partially Free in 2007. Key international indicators for Montenegro and neighboring states are presented in Table 2 above, which demonstrate Montenegro's strong overall gains and good performance relative to its SEE neighbors. Figures 3(b-c) show that Montenegro's formal regulatory framework and implementation practices are fully in line with the expectation for a country at its income level. Table 2 :Western Balkans: Relative Rankings in Institutional, Economic and Social Indicators (+ indicates improvement) MNE ALB BIH MKD SRB World Economic Forum, Rank* 49 88 102 79 96 International Competitiveness +16 +20 +5 +10 -11 Change** Transparency International, Rank* 69 87 91 62 78 Corruption Perception Change** +16 -2 +1 +10 +7 Rank* 66 82 110 38 89 World Bank, Doing Business Change** +11 +7 +9 +31 +1 United Nations Dev. Programme, Rank* 49 64 68 71 60 Human Development Change** +16 +6 +8 +1 +7 *Latest Ranking: WEF (2010); TI (2010); WB (2011); UNDP (2009); **Change in rank relative to: WEF (2008); TI (2008); WB (2009); UNDP (2008) 15. Montenegro continued to make significant progress in improving the business climate. Montenegro's ranking in the Ease of Doing Business in the World Bank's Doing Business Reports improved from 85 out of 178 countries in 2009 to 66 out of 183 countries in 2011. The biggest gains were reported for ease of trading across borders, starting a business and getting credit. Montenegro's ranking under the World Economic Forum Global Competitiveness Index also rose significantly from 82 in 2007/08 to 49 in 2010/11. Though allegations of high-level corruption remain a concern among EU and domestic observers, survey findings suggest that crime and corruption are not frequent obstacles to business operations and business development in Montenegro. In the 2008 Business Environment and Enterprise Performance Surveys (BEEPS), 65 and 70 percent of Montenegrin businesses indicated, respectively, that corruption and crime, theft, and disorder were not business impediments--representing a substantially better outcome compared to either the SEE or ECA averages. 7 Figure 3: (a)-(c): Montenegro: Business Climate and Governance Measures (a) World Governance Indicators ­ Montenegro Control of Corruption Rule of Law Regulatory Quality Government Effectiveness Political Stability Voice and Accountability 1.5 1 0.5 0 0.5 1 1.5 2006 2009 (b) GDP per capita and formal regulation (c) GDP per capita and implementation practices K DN S WE E C H I FN T AU G BR D NL Georgia K D N S I L I R L U D E GB R R I L R F A I S L L BE I FN Slovenia S WE T ES E C H T P R L BE P E S T ES U DE E CZ U LT Macedonia, FYR A LV T A U 80 D NL R FA Azerbaijan N HU 80 Armenia Bulgaria KG Z K SV SV K GR C A LV U L T N H U P OL RomaniaSlovenia T PR Croatia T I A L BR U TR P ES Bulgaria Z K A 60 Georgia Montenegro Doing Business 60 Montenegro TR U P OL CZ E Romania Albania I A T Macedonia, FYR Armenia WGI Serbia Moldova Serbia B&H Albania Croatia 40 40 GR C B&H S RU Moldova Ukraine S R U Azerbaijan Z KA Ukraine 20 B UZ 20 TK J B UZ KG Z J TK R BL 0 0 5 6 7 8 9 10 5 6 7 8 9 10 Log GDP per capita (PPP) Log GDP per capita (PPP) 8 16. The prior actions for EU membership negotiations, as spelt out in the EC's opinion, define current rule-of-law reform priorities. The EU stated that membership negotiations could commence once the country had achieved the necessary degree of compliance with, in particular, the Copenhagen political criteria "requiring the stability of institutions guaranteeing notably the rule of law", pointing inter alia to public-administration and judiciary-sector reforms aimed at enhancing professionalization, and fostering de-politicization. The authorities have taken on this challenge. Immediately following the EU's awarding of candidate status, the Government underwent a process of rejuvenation (including the transfer of premiership to the pragmatic and reform-minded former Finance Minister), with a view to strengthening public institutions in those critical areas impacting the country's EU integration perspective. A critical subset of rule-of-law challenges is congruent with structural reforms required to strengthen Montenegro's relative attractiveness as a destination for direct investment--areas in which the Bank has already provided considerable support, and proposes to continue to do so under the current CPS. Bank financed operations (for land administration and the financial sector) aim to improve the functioning of relevant public institutions, and bolster Montenegro's business environment. AAA/ESW provides overarching policy advice on challenges related to public administration, fiscal policy priorities, public financial management and procurement, statistics, and financial reporting. C. Poverty and Welfare 17. Strong growth in Montenegro since independence has increased living standards and reduced poverty, although some groups remain more vulnerable than others. As a result of rapid GDP growth, per capita GDP rose rapidly from about 3,582 in 2006 to 5,143 in 2008 and unemployment fell from 22.3 percent in 2004 to an estimated 10.7 percent in 2008. The national poverty rate dropped commensurately, from 11.3 percent in 2006 to 8 percent in 2007. However, a relatively higher proportion of the population, 18.2 percent, was classified as being "at risk" of falling into poverty, given average consumption of less than 25 percent more than the poverty line. Spatial differences in poverty and welfare are also a concern: households in the mountainous north are six times more likely to be poor than their southern compatriots. In 2008, about 14 percent of northern households were poor versus only 2.2 percent of households living in the south. Poverty among the marginalized Roma, Ashkalia, and Egyptian (RAE) population is also high (36 percent) but this group comprises less than 2 percent of the Montenegrin population. Finally it is worth noting that, unlike in many comparable countries, gender equality and empowerment appear to be relatively high in Montenegro, with very little difference apparent between overall and gender-specific development indices (see annex 3 on gender). 18. Although social data are limited, available information suggests good progress and relatively high human capital achievements relative to comparable neighboring countries. Montenegro's rating on the Human Development Index (HDI), climbed from 0.775 in 2000 to 0.828 in 2007, placing it 65th among 182 countries and exceeding recent ratings in Albania, FRY Macedonia, and Bosnia and Herzegovina. Inflows of poorer migrant workers to central and southern regions and slower development in northern areas has, however, increased inequality, as reflected by a rise in the Gini Coefficient from 0.29 in 2004 to 0.35 in 2008. Available data on MDGs show that good gains have been made in boosting access to education, reducing infant and child mortality, and combating tuberculosis. 9 19. The dramatic economic downturn in the wake of the global economic crisis likely had a detrimental impact on the most vulnerable Montenegrin households. The contraction in growth (2009) is likely to have slowed or even reversed some of the gains on social indicators and poverty rates, given that nearly a fifth of Montenegrins were deemed to be "at-risk" of poverty. A Bank-supported rapid living standards assessment undertaken in 2009 indicates that almost a quarter of all Montenegrins were affected by deteriorating labor market conditions in 2009, including 10 percent that experienced wage arrears and another 10 percent suffering salary reductions. About 30 percent of crisis-impacted households increased their supply of labor, either by having a non-working member find work, or having working members seek additional employment. However, the analysis suggests that some poor Montenegrin households adopted risky coping strategies that could increase their vulnerability to shocks in the future. For example, nearly a quarter of crisis-affected households in the bottom income quintile cancelled health insurance or reduced visits to health facilities for preventive care. To the extent, however, that there has been a shift to positive growth (and clearance of wage arrears in key industries) in the second half of 2010, there is likely to be a commensurately positive impact on poverty. III. COUNTRY CHALLENGES AND GOVERNMENT PROGRAM A. The Government's Development Plans 20. The National Program for Integration (NPI), outlining the reform agenda required for eventual EU membership, defines Montenegro's overarching policy objectives. Approved in 2007, the NPI is an implementation plan of Montenegro's Stabilization and Association Process that lays out a comprehensive set of political, economic, and sector reforms to harmonize domestic legislation and practices with European law--known as the acquis communautaire. The NPI aims at consolidating the rule of law and democracy, promoting human rights, and enhancing commitments to regional initiatives. It also proposes wide-reaching structural reforms to, inter alia, promote a market economy, strengthen public financial management, upgrade commercial laws, enhance environmental and agriculture standards, and improve the performance of the energy, transport, and infrastructure sectors. 21. The 2009­12 Economic and Fiscal Program (EFP) summarizes macro-fiscal policies aimed at fostering sustainable growth and employment by improving economic management, the business climate, and labor market skills. This plan calls for prudent fiscal policies with a balanced budget as of 2012, and an efficient state administration, including strategic use of public private partnerships (PPPs) to reduce the State's fiscal burden. Reforms to the business climate, together with policies and programs aimed at supporting SME growth, are identified to attract investments, reduce import dependence, and generate employment. To encourage long-term competitiveness, the EFP calls for further modernization of the (higher) education system, including through increased alignment with EU standards and business needs, as well as greater entrepreneurship and innovation. 22. Implementation of these plans, along with a number of ministerial-level strategies in key sectors, is already under way. Objectives established in the NPI have been further developed and implemented through medium-term sectoral plans supporting agriculture, the environment, tourism, and energy. The EU has been an active and supportive partner, intensified through the establishment of a-- now significant--presence in Podgorica in 2007. The EU Delegation is managing over 100 million in assistance to Montenegro under its Instrument for Pre-Accession Assistance (IPA), an instrument that supports the approximation of (potential) candidates to EU standards and their abilities to meet the obligations spelt out in the respective SAAs. Other important donors and development partners include the bilateral, European, and multilateral institutions. 10 B. Key Challenges and Government Strategies Strengthening Macroeconomic Stability (i) Strengthening public finances 23. Montenegro seeks to contain current expenditure both for reasons of post-crisis fiscal policy consolidation and to carve out budgetary space for ambitious investment projects. The EFP comprises a comprehensive--if ambitious--program of gradual fiscal consolidation, while addressing domestic and exogenous risks to the economy. The consolidation is anchored in the objective of a balanced budget by 2012, with the brunt of the adjustment being borne by current expenditures. Key to the Government's success is the containment of the public-sector wage bill, which the Government has begun in 2009 by (i) imposing a hiring freeze; and (ii) increasing social-security contributions so as to reduce net public-sector salaries by 3­7 percent. Further reductions are expected through improvements in transparency and accuracy, following the centralization of the payroll system and the impact of a new law on civil servant wages that will regulate recruitment and introduce part-time work with a reduction in salary of 30 percent. It is the Government's intention to protect capital expenditures--to the extent possible--from the effects of the overall fiscal consolidation. The rebalanced composition in the 2010 budget of capital-to-current expenditures, to the detriment of the latter, reflects this policy commitment. Contrary to previous years, the fiscal strategy includes a "pessimistic" scenario based on the assumption of a deeper, more prolonged recession, foreseeing additional adjustments in the wage bill, discretionary spending (including in the capital budget), welfare benefits, and--possibly--tax policy. Improvement of efficiency of tax administration and increased tax compliance will also further the strengthen revenue collection and balance public expenditure efforts. These measures are complemented by efforts to improve further public-debt management, with a focus on currency structure and interest rates. (ii) Increasing financial sector stability and liquidity 24. The crisis revealed the importance of strengthened private-sector confidence in the banking system and a reinforced set of policy instruments for the Central Bank of Montenegro (CBCG) to ensure the sector's increasing resilience to future shocks. To this end, Montenegro enacted a set of (organic) financial-sector laws--on the CBCG, banks, bank bankruptcy and liquidation, deposit insurance fund, and the financial stability council--that has strengthened operational central bank independence. Benefiting from input from the Bank and the Fund, the new legislation--as adopted by Parliament--is broadly consistent with best international and EU practice, but implementation remains difficult. Above all, the Central Bank will need to use its improved mandate to enforce the prudential norms, encourage the creation of enhanced capital buffers, and take appropriate supervisory measures for banks of special concern. It is important that the regulator's actions are fully coordinated with, and supported by, the Government without jeopardizing the CBCG's operational independence. 25. A sound financial sector remains a key ingredient to ensuring dynamic and sustainable rates of economic growth. Unsustainable rates of credit expansion during the boom period, a high level of private-sector indebtedness, and the post-crisis consolidation of bank balance sheets has resulted in tight liquidity, an extended credit crunch, and the resultant increase in NPLs. A good tourist season, continuously buoyant foreign investments, the return to positive rates of economic growth, together with the impact from bank recapitalizations, should help to ease the credit squeeze and normalize the situation in the banking sector. For this to happen, it is imperative that the authorities and the banks collaborate to improve the quality of credit portfolios and ensure the health of the entire financial sector. The CBCG needs to expand the use of risk-based supervision instruments and gradually harmonize its prudential and accounting requirements with prevailing international practice. Given the ownership structure of the Montenegrin banking sector, cooperation with supervisory authorities in parent banks' jurisdictions is 11 important. Consolidated supervision of financial groups will become more relevant, given the sector's increasing complexity and diversification. Finally, the cost of credit can be brought down by improving the quality and range of services provided by credit and collateral registers. Improving Competitiveness and the Business Climate 26. As a euroized economy with large current account deficits, Montenegro has no alternative but to implement reforms aimed at increasing international competitiveness, including by ensuring a business-friendly (tax) policy environment, good infrastructure, upgraded standards for agriculture, strong labor force skills, and mechanisms to encourage innovation. Rather than through currency depreciations, innovation and increased productivity are the principal means of growing exports and attracting direct investment. To this end, the Government recently passed a competition law to ensure a level playing field for all investors and is currently developing the subordinate regulations. (i) Addressing infrastructure bottlenecks--especially in transport and energy 27. Addressing gaps in infrastructure in an environmentally sustainable manner is a crucial element of Montenegro's drive to reignite growth. Montenegro has paid insufficient attention to modernizing and maintaining infrastructure and financing new investments amid growing supply constraints and outdated facilities, particularly in energy and transport. A growing energy deficit and an increasingly congested and deficient road network, with road safety becoming an increasingly urgent challenge, are undermining efforts to promote economic growth, EU-oriented trade, and the full development of Montenegro's tourism market. Institutional capacity and management must be upgraded to improve investment planning and operations, particularly given limited fiscal resources for capital expenditures. The Government approved a concessions law in 2009 to promote PPPs for infrastructure investments too costly to be financed with budgetary revenues. 28. The large-scale energy sector investments and PPPs represent a key engine for growth in Montenegro. In recent years, Montenegro has imported up to one-third of its electricity consumption, roughly equivalent to the demands from the aluminum company KAP. Government recognizes considerable untapped sources of energy production and considerable inefficiencies in energy distribution and consumption. To address these challenges, the Government has developed an energy strategy, covering the period up until 2025 and calling for massive investments in the construction of new facilities in hydro, thermo, and renewable sources of energy (1.5 billion) and the rehabilitation of existing energy infrastructure (0.3 billion). At present, the Government is developing a PPP project for the development of a multi-dam hydropower facility on the Moraca River--upstream from Podgorica--that could, on average, generate 721 GW/h annually. However, environmental and seismic risk considerations will need to be carefully thought through in the development of concrete proposals1. Authorities are also in dialogue with foreign investors on possibly leveraging new investments in production capacity into energy exports and a source of economic growth. In line with its obligations under the 2005 Energy Community of Southeast Europe (ECSEE) treaty, Montenegro has already prioritized market liberalization and enhanced transmission connections with neighboring countries in the SEE market, which will increase opportunities for cost-effective trade as well as the reliability of the energy supply. In parallel, the Government is continuing to address operational and financial constraints in EPCG, such as an inefficient tariff structure, overly high subsidies, low collection rates, and weak governance and financial management, which led to persistent deficits until recently. Recent reforms to introduce automatic metering, reduce subsidies to KAP, which consumes about a third of the Montenegro's electricity, and unbundle EPCG into separate generation, transmission, and distribution lines have improved outcomes. 1 The Bank carried out a Strategic Environmental Analysis in FY07 on the Government's National Spatial Plan that highlights environmental issues associated with hydropower development, including the Moraca project. 12 29. Allocating additional funds to road maintenance and new investments in motorways, regional and secondary roads will be a critical factor in facilitating trade links domestically, regionally, and internationally. Connecting Montenegro's road network to the trans-European Corridors would ensure producers' access to markets and increase the value of the Port of Bar as point of entry. At the same time, social and economic costs of high incidence rates of road accidents are considerable. Although road densities in Montenegro and its SEE neighbors are roughly equal, nearly half of Montenegro's roads are in poor or very poor condition. The quality and extent of Montenegro's regional highways are also insufficient, particularly when compared to requirements of SEE and EU transport plans. Road user taxes in Montenegro contribute three times the amount of road expenditures, but road maintenance is underfunded. The level of recurrent expenditure to maintain the main and secondary road network in "steady-state" condition is typically 60percent more than what is currently allocated. The Government has prioritized increasing funds for road maintenance and developed a plan to invest substantially in new road investments between 2008 and 2015, including in major regional connections, such as the Bar­Boljare and Adriatic­Ionian highways, the former with a link to the trans-European Corridor X.2 However, the scale of these investments will require substantial fiscal resources despite the increased employment of PPP approaches, which, in turn, implies careful budget planning. At present, the Government is considering a number of PPP approaches in the transport sector, including output and performance based contracting, and is working with the IFC to structure a PPP for the Bar­Boljare highway. Further work is ongoing to strengthen the legal and institutional framework for PPPs in the transport sector and mainstream their use in operations. Moreover, the Government is working to improve planning and budgeting processes and the institutional capacity of key transport agencies, including the Directorate of Public Roads (DPR). Finally, an IFC Investment Climate Advisory Services regional Southeast Europe Trade Logistics project, expected to start in FY11 with funding from European Commission IPA funds, will work to reduce administrative barriers to trade in both road corridor transport and air transport. 30. Montenegro's rapid growth in the 2000s was accompanied by an increase in vehicular ownership and road accidents, underscoring the need for a comprehensive program to improve road safety. Between 2004 and 2007, Montenegro experienced a 40 percent increase in road accidents and associated personal damages. The economic cost of traffic accidents in Montenegro is estimated to exceed 2 percent of GDP--a half point higher than in most middle-income countries. Authorities have prioritized upgrading road safety equipment and practices in line with EU standards, and are taking steps to upgrade relevant signage and infrastructure. However, assistance is needed to build the technical and institutional capacity of relevant road agencies and implement investments and pilot projects. (ii) Further enhancing the business climate, focusing on property rights, red tape reduction and support to SMEs 31. Montenegro has made progress in improving its business climate, but more needs to be done at both the central and local levels to streamline business procedures, lessen the regulatory burden, and increase labor market flexibility. In line with the NPI and Montenegro's EU aspirations, the Government has approved new laws on land use planning and licensing and a five-year work plan for streamlining the real estate cadastre to help reduce red-tape and speed up business registration--a key 2 Government has made the PPP for the construction of the Bar­Boljare motorway a priority--as an instrument for regional development in the poorer Northern regions of the country, to increase the development potential of the port of Bar and the hydro energy potential along the Moraca River, and to ensure that Montenegro's road transport infrastructure does not remain unconnected to the pan-European road corridors. Contrary to Albania (Corridor VIII), Bosnia and Herzegovina (Corridor V), Croatia (Corridors V and X), FYR Macedonia (Corridors VIII and X), and Serbia (Corridor VII and X), who are all well-connected to Europe's main road corridors, Montenegro--without the investment into the Bar­Boljare motorway--would remain cut off from all major road transport routes in Europe, thereby placing its economy at a comparative disadvantage. 13 factor in increasing competitiveness. The Government of Montenegro is currently undergoing a regulatory guillotine to eliminate unnecessary business regulations; the Government has initiated the development of a Regulatory Impact Assessment model that will be put in place in 2011. Reforms have started to take root, as suggested by Montenegro's relative improvements in key rankings of competitiveness and business climate (Table 2). To realize further gains, authorities must address several challenges, such as limited capacity for innovation, weak technical and administrative skills, continued fragmentation of business services, slow construction licensing by municipalities and lack of clarity on government responsibilities amid an ongoing program to decentralize service delivery to municipal governments. 32. Promoting entrepreneurship and SME growth requires complementary measures to promote growth and employment, building on the significant gains achieved between 2006 and 2008. Government's principal goals for SME support include increasing the contribution to GDP of SMEs to reach 60 percent, increasing the export orientation of SMEs and increasing employment in SMEs by 20 percent. Active policy measures to support the achievement of these goals focus on ensuring access to credit (including through strengthening the banking system generally as well as the establishment of special SME credit lines) and provision of institutional support. Thus far, the latter effort has focused on establishing and strengthening regional and local business centers, incubators and technology parks. Moreover, Government has put in place a market information service aimed at providing SMEs with statistics and other relevant data for increasing their export orientation. Finally, there is an ongoing effort to increase access to business studies for young Montenegrins with an initial focus on six secondary schools and an education program for "young managers". (iii) Strengthening agricultural productivity and standards to capitalize on EU market opportunities 33. Upgrading agricultural production processes and food-safety standards to conform with EU requirements can increase export earnings considerably and help to raise living standards, especially in the poorer rural regions of the country's mountainous North. Agriculture accounts for about 10percent of GDP and 70 percent of rural incomes, and over half of the poorest Montenegrin households live in rural areas. Despite having abundant water resources, significant agricultural land, a favorable climate, and strong demand for agricultural products, Montenegro confronts structural and institutional challenges that undermine further growth of the sector. Farming is dominated by small-scale operations that produce limited yields owing to insufficient knowledge, outdated technologies, and weak supply chains. Investment capital and government extension services are limited, and agriculture institutions and practices lack compliance with EU and international standards. Montenegro has significant potential for diversifying agricultural activities, particularly to support agri-environmental initiatives and eco-tourism in northern regions, which would result in considerable improvements in socio-economic and poverty indicators, but such activities require the adoption of new practices and improved alignment with EU programs. 34. On an institutional level, Montenegro also needs to improve its capacity to deliver, manage, and monitor agricultural assistance, particularly to access grant funding under the EU's Instrument for Pre-accession for Rural Development (IPARD). Montenegro has substantial scope for improving the composition and quality of expenditure in the agriculture sector, as well as the technical and implementation capacity of the Ministry of Agriculture, Forestry and Water Management (MAFWM) and other key institutions. In particular, the government aims at upgrading institutions to allow access to funding under the IPARD mechanism, which is expected to provide Montenegro with 2.6-6.7 million in annual grants once the country becomes an official EU candidate. IPARD grants are expected to help to modernize agriculture holdings, improve the rural environment, and support a diversified rural economy, while providing targeted support to the EU pre-accession agenda. The Government, with support from the 14 Bank and other donors, is strengthening relevant institutional capacity, including establishing a Management Authority within MAFWM, creating an IPARD Payment Agency; and developing systems and databases to track IPARD payments. In parallel, the Government is strengthening extension services to better reflect the demands and needs of producers. Investing in Human Capital (i) Strengthen education by increasing efficiency and effectiveness of the public education system 35. In recognizing that Montenegro's competitiveness is highly dependent on the skills of its workforce, the Government is seeking to anchor its (higher) education policies into existing European frameworks and standards. As a small economy that lacks the ability to excel in all fields, regional and Europe-wide exchanges are critical. This, however, can only be achieved if the quality of all levels of education is assured--independently, externally, and consistently--so as to ensure that academic degrees are recognized internationally. Without fostering the exchange of students and researchers, Montenegro's education system would not be able to meet the demands of the labor market. Already, there is a mismatch of skills and a shortage of highly skilled employees that constrains growth and holds back socio-economic development. 36. The coverage of secondary and higher education is insufficient and quality improvements are needed at all levels. Primary school attendance in Montenegro in 2005 was nearly universal at 98 percent, and differences were negligible between genders and regions. However, secondary school attendance was significantly lower at 84 percent, and only 67 percent of children from poor households attended secondary schools. Secondary enrollment was also lower than the national average among Bosnian and Muslim groups and in central and northern regions. The Government has embarked on a comprehensive program to improve the quality of primary and secondary education, including revising curriculums and textbooks, providing teacher training, and improving standardized testing, such as Montenegro's recent participation in the Programme for International Student Assessment (PISA). Authorities are also working to expand access by renovating and building schools, especially in the poorer, mountainous north where coverage issues are most apparent. Authorities have also focused on strengthening planning and budgeting in the education sector, successfully eliminating education deficits in recent years. 37. Higher education is critical to cultivating advanced labor skills and competitive businesses, but the national system faces funding and institutional constraints, and reforms are needed to align practices to EU standards. Montenegro's higher education system suffers from comparatively high drop- out and low completion rates and deficiencies in quality and management. The funding model needs a significant overhaul to reward high quality teaching and research, and the institutional structure needs to be upgraded, especially to build capacity in the Ministry of Education and Science (MoES) and to improve management of the University of Montenegro. Academic infrastructure must be modernized and instruction standards upgraded in line with the Bologna Accords, which aim to standardize degree and quality assurance programs across European universities. Stronger alliances with neighboring countries in research, post-graduate training, and quality assurance are also required to ensure Montenegrin students and faculty can access internationally relevant instruction and new educational opportunities. 15 (ii) Increase capacity for research and development (R&D) in a few niche areas relevant for economic growth 38. A key goal established by Government to further growth and competitiveness relates to developing and implementing a strategy on R&D to support economic growth within the framework of a Western Balkans regional cooperation strategy. Expenditures on R&D in Montenegro amount to less than 0.16 percent of GDP, significantly trailing the EU25 average of 1.86 percent. The Government plans to clearly delineate national research priorities while allocating more funding for research infrastructure in these areas. Priority areas might include tourism, environmental issues and research in agriculture such as organic farming. Some other factors inhibiting innovation and R&D in Montenegro as well as other Western Balkan countries include deficiencies in the quality of higher education, and poor linkages between higher education institutions, R&D centers and private businesses. In addition, small country size, inhibits the achievement of minimum efficient size levels required for cost-effective implementation of innovation-related activities (e.g., venture capital, agricultural research). In light of these challenges, the Montenegrin government has developed a two-pronged strategy for strengthening capacity for innovation and R&D, namely: (i) participate in a regional initiative to enable economies of scale and increased productivity of local research through enhanced cooperation and specialization at country level; (ii) invest domestically in significantly strengthening the quality of higher education and the creation of R&D systems to serve as a bridge between businesses and universities in a few areas. Montenegro is already a participant in the Western Balkan initiative on R&D launched in Sarajevo in the spring of 2009. (iii) Reform and expand access to quality health care 37. Montenegro needs to continue comprehensive reform of health care to improve its sustainability and access to care in underserved areas. Thus far, and in part with Bank support under an ongoing project, the Government has significantly improved the financial performance of its healthcare system by improving controls on pharmaceutical costs and upgrading the legal framework and operations of the national Health Insurance Fund (HIF). These and other reforms resulted in a significant decrease in the pharmaceutical budget, and the elimination of operating deficits in the HIF in 2008. In addition, responding to an inadequate focus on preventive and primary health care (PHC), authorities significantly improved PHC services, including revising the PHC benefit package, introducing the concept of choosing a PHC doctor, and expanding infrastructure, leading to increased patient satisfaction and a gain in PHC utilization rates in Podgorica from 11percent of the population in 2004 to 35percent in 2008. However, scope exists for additional improvements in the financial management, capacity, and operations of the HIF and key institutions, and expansion of PHC, particularly in rural and northern regions which are currently underserved. Montenegro also needs to improve the quality and coverage of secondary and tertiary care to complement the expansion of PHC, but the institutional and operational framework is relatively deficient. The state's role in financing secondary and tertiary care needs to be defined along with clinical guidelines and standards. In addition, Montenegro must develop contracting arrangements between providers and insurers and models of public-private cooperation to support delivery of secondary and tertiary care. 38. Two key priorities going forward include strengthening quality assurance programs and institutional capacity of the HIF, Ministry of Health (MOH), and the Montenegro Drugs Agency (MDA). The MOH's capabilities in quality assurance are inadequate, and a national strategy needs to be developed to improve quality assurance programs at the central and local levels. As part of this effort, information channels for financial and medical information need to be strengthened, particularly between hospitals and public health facilities and the HIF. Despite undergoing recent capacity building, the MOH, HIF, and Institute of Public Health still have insufficient technical and management capacity to scale-up ongoing reforms. In particular, the MDA, which is responsible for oversight and regulation of the national pharmaceutical market, lacks adequate controls over imported drugs, and its oversight of prescription and 16 consumption practices is insufficient, which continues to undermine cost containment. On a broader level, mechanisms need to be developed to permit private doctors and informal providers to enter into payment and service contracts with the HIF, which would significantly broaden access to affordable healthcare. Improving Environmental Management and Reducing the Cost of Environmental Problems (i) Strengthening water supply, sanitation and solid waste management in coastal areas 39. Increased tourism and rapid economic growth in Montenegro's attractive coastal areas have underlined the need for significant improvement in water and solid waste services. Facing threats of water shortages from rapid development, the Government and municipalities have invested in a regional pipeline network that supplies major coastal municipalities with water from Lake Skadar, a key watershed and tourist site bordering Albania about twenty kilometers from the Adriatic Coast. This network and complementary investments have significantly improved water connections and the region's water security, though the network may need to be expanded to other less served coastal areas commensurate with growth. Inadequate sanitation services and unsanitary disposal in coastal areas have led the Government and municipalities to upgrade sanitation infrastructure and strengthen the regulation, enforcement, and delivery of solid waste services. Authorities have developed new regional solid waste companies, invested in trucks and equipment, and worked to close unsanitary waste sites and increase landfill capacity. As a result of these efforts, the percent of solid waste collected and properly disposed of in certain major coastal towns increased from 0 percent in 2004 to 65 percent in 2010. 40. Though water services have improved in coastal areas, ensuring the sound management of Lake Skadar remains a key challenge to protect its water quality and the development of sustainable tourism in the lake valley. Pollution from recent unchecked development around Lake Skadar and industrial waste from a nearby aluminum plant pose increasing threats to the lake's water quality and the natural beauty of the region. Overfishing is also a key concern. Given these threats, the Government and Albanian authorities have prioritized effective cross-border management of growth, pollution, and commercial uses of Lake Skadar. To date, a Lake Commission has been established along with working groups on fisheries, hydrology, and other key subjects, and efforts to improve waste disposal of KAP and other polluters are ongoing. Providing for strong management of the Lake will be critical to maintaining its ecological importance and attractiveness as a vacation destination. (ii) Reducing environmental and public health risks associated with industrial pollution 41. Poorly regulated growth in Montenegro over several of the last decades has left a legacy of industrial pollution, often in close proximity to population (including tourism) centers. Many disposal sites associated with heavy industries such as energy plants, aluminum and steel factories, and shipyards have become heavily polluted with ash, lead, chemical, and hazardous waste. Environmental regulations on industrial pollution are weak, and disposal and treatment practices are below EU and international standards. Existing pollution at these sites, and in some cases the continued unregulated operation of polluting industries, poses risks not just to the immediate environment, but to the public and environmental health of surrounding communities, including through groundwater contamination and other pathways. Montenegro has prioritized remediating the most-heavily polluted sites and strengthening regulations and capacity to manage hazardous waste. Montenegro has prepared an extensive list of sites for remediation, which typically involve, depending of the findings of site-specific plans, closure and capping for sites, water management measures, and/or removal of hazardous waste. The Government aims to develop and enforce regulations on separation of hazardous waste and waste categories, and the segregated disposal of these waste streams in line with EU directives. Recognizing that disposal options for some hazardous waste are limited, the Government is also seeking to construct a new hazardous waste 17 facility in an environmentally suitable location. The establishment of such a facility will require development of operational arrangements, including for ownership, tariffs, and overall financial sustainability. It will also involve extensive consultation and negotiations with municipal governments, citizen groups and other stakeholders in order to proceed in an efficient manner. (iii) Insuring against the costs of natural disasters 42. Montenegro is vulnerable to natural and human induced disasters that could cause significant suffering and monetary damages, including risks of abrupt climatic shifts. Key natural threats include forest fires, flooding, and earthquakes. The Pazicko Polje and the Lim River Valley have experienced major flooding events, with two record-breaking floods in January and December 2010, and flooding could become more frequent and widespread under predicted climatic shifts. Montenegro is also vulnerable to low and medium-intensity earthquakes (Montenegro's seismological observatory registered more than 200 earthquakes in 2009), and occasional major earthquakes with devastating geological impacts such as mud and rock slides (such as the one in 1979, which measured 7.0 on the Richter scale). The coast and the Zeta-Skadar region are among the areas with the highest seismic activity. In addition, Montenegro is exposed to risks of environmental disasters associated with mining and industrial activities, including poorly regulated industrial pollution. Climate change is a major concern. Bank estimates indicate that by 2100, the Southeast European countries will undergo a mean annual temperature increase of 1.8 degrees, and a decrease in precipitation of between 5 and 20 percent. Droughts and fires could also become more widespread and intense as the climate grows hotter. Though overall precipitation is expected to drop, scientists expect flooding to worsen given more intensive precipitation and flash floods. 43. Given increasing disaster and climatic risks, Montenegro is working to upgrade its capacity in disaster management and risk reduction, including increasing access to emergency liquidity. The Ministry of Interior has developed a broad framework for handling emergency situations, and disaster risk management plans were incorporated into the 2006 National Spatial Plan. Montenegro is also pursuing comprehensive reforms in disaster management and risk reduction in line EU standards and the Hyogo Framework for Action. Montenegro participates in key regional initiatives, including the SEE Disaster Risk Mitigation and Adaptation Program, designed to strengthen regional cooperation on, inter alia, risk assessment, disaster preparedness, and upgrades to codes, regulations, and legislation. Country-specific challenges include, among others, increasing trans-boundary coordination, building municipal capacity in disaster mitigation and response, and strengthening legislation on land-use planning and building codes. Increasing capacity in firefighting and flood control is also needed, particularly in rural areas. Given the potentially dire economic impacts of disasters, the Government also seeks to enhance access of individuals and small businesses to insurance, as the current commercial market does not provide adequate options. Improving the coverage and efficiency of social transfer programs 44. The impact of the crisis and the high share of Montenegrins who are "at risk" of poverty emphasize the importance of a strong social safety net, but social assistance in Montenegro has limited coverage and certain program designs are inefficient. Montenegro spends about 1percent of GDP on social assistance, which is lower than most of its neighbors, including Kosovo, Albania, Serbia, and Bosnia and Herzegovina. Categorical benefit programs, which tend to be more susceptible to targeting errors, receive roughly the same share of expenditure as means-tested programs in Montenegro. Other Western Balkan countries except FYR Macedonia spend greater shares of overall expenditure on categorical benefits. The Central Government is responsible for designing, planning, and monitoring 18 social assistance, but local governments implement programs. Last resort social assistance (LRSA) programs transfer more than half of their benefits to the poorest quintile, which is on par with Albania and FYR Macedonia, but Serbia and Kosovo manage to transfer 70 percent. Coverage of the poorest quintile by LRSA programs is relatively low at 15 percent, mainly as inefficient designs channel multiple social benefits to the same individuals and families. LRSA programs provide generous benefits in Montenegro compared to programs in neighboring states. However, this generosity combined with poor designs and strict exclusionary filters may provide disincentives for able bodied adults to work. Further improvements in social assistance may require reforms to, inter alia, increase spending on well tested means-tested programs, modifying eligibility criteria to remove perverse exclusionary filters, and streamline benefit administration. 45. Reform of the public pension system which amounts to 11.8 percent of GDP (2009) is another important priority for Montenegro, especially in light of the impact of the 2009 recession on both public finances and vulnerable households (many of whom are elderly). While the pension system, as currently designed, does a reasonably good job of protecting the elderly against poverty and maintaining strong linkages between contributions and benefits, revenues from contributions consistently fall below expenditure on benefits. Curtailing the fiscal costs of the system will necessarily involve parametric adjustments including constraining entry benefit levels, benefit indexation and, to some extent, the inflow of new beneficiaries. Government is fully conscious of the fiscal burden associated with the current structure of the pension system and, as a first step, has taken action to channel pension financial flows through Treasury as a means of increasing the transparency of inflows and outflows of funds. Going forward, it plans to analyze (and eventually implement) various reform options that could help contain costs and lessen pressures on the national budget. 46. The preceding discussion of Montenegro's challenges in key sectors and the strategies that Government has developed to address them provides the contextual underpinning for the discussion of the program of Bank support under this CPS. The Bank Group's strategy, developed in close coordination with the Montenegrin Government and other stakeholders is laid out in Chapter IV. It includes a detailed discussion of expected CPS outcomes and activities following a description of the existing portfolio and lessons learned from implementation of the previous CPS. IV. THE WORLD BANK GROUP STRATEGY A. Experience and Lessons Learned 47. Current Portfolio. Ongoing Bank assistance under the FY07-10 CPS provided selective support to three key country priorities: (i) enhancing sustainable macroeconomic growth; (ii) building institutions and strengthening the rule of law; and (iii) improving the standard of living for citizens. The committed portfolio has grown from five lending operations totaling US$34 million in 2007 to eight operations at present, six financed by Bank loans or credits amounting to US$77.2 million and two GEF financed-programs totaling US$6.6 million. About 70 percent of these commitments remain to be disbursed, as shown in Table 3 below. Investment operations are focused principally on supporting programs in the sustainable development and human development sectors. 19 Table 3: Montenegro: Active Portfolio Comm. $ GEF % Project Age in Latest Latest Project name Board Closing million disb. ratio years IP DO Health System June 2004 Dec 2012 14.2 66.9 6.6 MS S Solid Waste in Tourist Areas Sep 2003 June 2012 12.7 19.2 7.3 MU MS [AF 5.7 m] Energy (APL3) July 2007 March 2012 9.0 55.1 3.5 S S Energy Efficiency Dec 2008 Dec 2012 9.4 18.8 2 S S Land Administration Dec 2008 April 2014 16.2 4.3 2 MU MS Agriculture Institutional Dev April 2009 June 2014 15.7 19.6 1.8 MS S Agriculture Institutional Dev April 2009 June 2014 4.0 7.5 1.8 MS MS (GEF) Lake Skadar/Shkodër (GEF) May 2008 Sep 2012 2.6 24.0 2.7 MS MS 77.2 6.6 28.2 3.4 48. Portfolio performance has been generally satisfactory, although disbursements fell in FY10, largely due to a disruption in implementation support to ongoing operations and the slow start-up of new projects. The disbursement ratio in the first three years of the CPS was strong and well above the ECA average of 17.8 percent, peaking at 41 percent in FY09, due to strong disbursement ratios in several projects before their closure. The disbursement ratio fell to 11.8 percent in FY10, largely due to a temporary disruption of project implementation support, following the en bloc resignation3 in 2009 of staff in the "Technical Services Unit" (TSU) in the Ministry of Finance, which handles procurement and financial management for most Bank- supported operations. The slow--but ultimately successful--re-establishment of the TSU reflected relevant skills shortage in this area (in itself a consequence of the fact that, up until independence in mid-2006, related activities for donor-financed projects had mostly been provided by Belgrade-based institutions). Bank fiduciary experts based in the region will provide significant guidance and training to ensure that the new procurement and financial management staff in the TSU can effectively handle the demands of portfolio implementation. Most lending interventions maintained satisfactory ratings in Implementation Progress (IP) and Development Objective (DO) throughout the CPS period, reflecting both concerted efforts by Project Implementation Units (PIUs) to overcome implementation hurdles, as well as the strong ownership by Government of the projects themselves. Overall performance was affected by 3 At the time, TSU staff had sought to exploit the scarcity of procurement and financial management (FM) skills in the local labor market and requested that personal salaries be paid as function of the number of projects served. Both Government and Bank teams rejected this demand. Against the backdrop of more than a year and a half of interim arrangements to ensure fiduciary support for the Bank financed projects, alternative arrangements were discussed, but, in the end, the Government decided to retain the "centralized" procurement and FM architecture within the Ministry of Finance as the most effective setup to (i) assure, under existing constraints of procurement and FM expertise, high quality support to Bank-financed projects; (ii) develop local expertise in these areas, including by allowing for high impact training to be provided by the Bank; and (iii) reflect the portfolio's average maturity and the expected trend decline in the number of Bank-financed projects. In the re-established TSU, it has been agreed that the Senior Procurement Officer serves also as head of unit, who will communicate directly and regularly with the Deputy Minister of Finance and, as such, address potential obstacles and delays in a pre-emptive manner. 20 lower ratings for some projects which had a slow start up and the designation of one project--the Montenegro Environment in Sensitive Tourist Areas Project (MESTAP)--as a problem project, due to delays in resolving stakeholder issues at a sanitary landfill, now planned for the Mozura area. The issues surrounding the landfill were recently resolved and a small additional financing (AF) operation was processed to complete its construction. Lessons from the CPS Completion Report 49. The FY07­10 CPS Completion Report identified a number of lessons related to the overall strategy, project implementation, and Bank and borrower performance that are helping to guide the new CPS program. Key lessons are noted below: The CPS's provision of selective, mutually reinforcing interventions supporting Montenegro's own goals produced solid results, while maximizing the impact of the Bank's scarce resources. Other development partners in Montenegro, such as the EBRD and EIB, have scaled up successful Bank financed projects with proven development impacts in, e.g., energy (metering) and solid waste management (landfills), while the Government has used scarce budgetary resources to complete successfully the regional water supply system, which was initiated with Bank support. As a result, the development challenges posed by power outages and interrupted water supply (including in the main tourist centers during high season) are being overcome. The portfolio's knowledge products, technical assistance, lending programs, and regional grant programs leveraged synergies among World Bank Group institutions (i.e., IBRD and IFC), donors, and domestic stakeholders. Analytical products such as the FY07 FSAP and ROSC were particularly valuable in diagnosing challenges and developing follow-up TA as well as the proposed development policy lending for FY11 and FY12. The Bank's suite of ESW and analytical reports covering economic and fiscal matters were critically important in identifying needed reforms in a newly-independent country, and the acquired knowledge helped to identify key areas for follow-up work. The analysis in the FY07 ROSC, FY09 PEIR, and FY09 PEFA helped to illuminate key challenges and policy recommendations, which led to deeper engagement with the Bank on public expenditure management and a Government request for follow-up technical assistance. The increase in the number of (relatively small) projects in the Bank's portfolio by the end of the last CPS period have strained Montenegro's scarce implementation capacity as well as limited the Bank's ability to maintain a robust country-specific AAA program given the need to allocate scarce resources to project supervision. Going forward, the Bank should seek to consolidate the portfolio focusing on fewer, larger lending interventions. A robust program of AAA will also be essential to help build capacity and provide specialized analytical support in key areas. Leveraging regional experiences and programs is important, particularly in a small country with limited Bank engagement. To some extent, the Bank's success in Montenegro was facilitated by framing country needs within a regional context, and by leveraging solutions and products that had been tested and proven successful in neighboring countries. For example, the Land Administration, Energy Efficiency and Agriculture Institutions projects were all modeled on successful IBRD operations in neighboring countries. Similarly, the Government's decision to retain IFC as an advisor on the Bar-Boljare motorway and the Moraca Hydropower project was partly motivated by IFC's success in the energy sector in Albania. The Bank and IFC should continue to leverage regional programs and experiences whenever possible. Careful assessment and monitoring of the interests of government agencies and local stakeholders are critical during project preparation and implementation, particularly when operations involve different levels of government. Complications in MSTDP and MESTAP were partly driven by the Bank's underassessment of diverging views on project goals among 21 municipalities, stakeholders, and central government. Close monitoring of interests and open communications between the Bank and stakeholders at all levels of government are crucial to avert project implementation issues downstream. Though the continued use of the Technical Services Unit (TSU)--a central unit providing financial management and procurement services to most Bank-financed operations--reflects the extreme shortage of these implementation skills in Montenegro. Improved oversight of its operations is needed to avoid project delays. The use of a central TSU entails some risks deriving from the TSU's isolation from line ministries and PIUs, the difficulties of prioritizing among competing demands from "client" projects, and the risk of paralysis across several projects in the event of a major staff turnover as occurred in mid-2009. To mitigate these issues, the government and the Bank are trying to improve the stability and operations of the TSU through introducing periodic workload and staffing assessments, and improving communications between the TSU and project beneficiaries. Box B: Country Systems in Public Financial Management and Procurement Montenegro has made progress in establishing an effective and transparent public financial management (PFM) system. Montenegro's introduction of a single treasury account in 2002 greatly improved budget and cash management, and clear gains have been made in budget planning and the transparency and accuracy of budget documentation. Internal controls are being strengthened in line with EU standards, notably by establishing a Central Harmonization Unit within the MOF and improving the internal audit capability of spending units. Montenegro has established the State Audit Institution (DRI) and provided for enhanced Parliamentary oversight of public expenditure via its Budget and Finance Committee. However, there is scope for further improvement across many areas of public financial management including comprehensiveness of the budget, multi-year budgeting, commitment control, cash and debt management, internal financial reporting, internal audit and financial management control, external audit coverage and legislative scrutiny of DRI reports. Notable advances were also made in public procurement. Montenegro enacted a new public procurement law in 2006 that harmonizes key practices with EU directives. In line with this law, two agencies were established: a Public Procurement Administrative Authority (PPAA), which sets regulations and issues tenders; and a Public Procurement Commission (PPC), which hears complaints and appeals. This law more clearly defines responsibilities and procedures, requires publication of contract awards on the web, and incorporates new regulations on anti-corruption and conflicts of interest. However, supplementary regulations and bidding documents still need to be updated in line with best practice, and capacity of the PPC needs strengthening to better manage the complaints process. Internal and external audits also need to be expanded to strengthen the overall control framework. Training of contracting staff and capacity building of contracting institutions will also be needed Complementing these gains, Montenegro has taken steps to reduce the risk of corruption in the public sector. The Government established an Anti-corruption Agency in 2001, which was renamed the Directorate for Anti- corruption Initiatives in 2003. In 2006, the Government finalized an Anti-corruption Action Plan that calls for, inter alia, studies on the scope of corruption, improved monitoring of anti-corruption activities, and whistle- blowing. In 2010, Montenegro adopted an Action Plan for Fighting Corruption and Organized Crime aligned with EU standards. Anti-corruption efforts have focused mainly on the financial sector. Montenegro stands to reap considerable wins in anti-corruption by improving the enforcement of existing laws. Montenegro's progress on strengthening PFM and procurement systems, may permit consideration of piloting the use of some aspects of country systems for Bank projects during the next CPS period. A 2007 study indicated that Montenegro fully met only one of six key prerequisites for use of country systems: establishment of an efficient treasury system. However, the 2009 PEFA suggests that Montenegro has continued to make progress, particularly in external auditing. If country capacity continues to increase, the Bank will consider piloting the use of some aspects of country systems during the FY11-14 CPS period. However, efforts to pilot country system will be gradual, with due attention to advancements in internal controls and the availability for adequately skilled staff for financial management and procurement. In the meantime, the Bank will continue to strengthen the capacity of the reconstituted TSU to help ensure smooth implementation of Bank-financed operations. 22 Partnerships and Consultations 50. Donor assistance in Montenegro has been dominated by funding from European institutions, including assistance through the EU IPA mechanism, though other international and bilateral donors also provide support in specific areas. In 2009, the EIB approved contracts of 111 million to Montenegro to strengthen transport and solid waste infrastructure and provide credit lines for SME growth. The EBRD supports an active portfolio of 206 million through 21 projects, mainly in energy and transport infrastructure. Montenegro's funding from IPA and EC sources equaled nearly US$60 million in 2008, and assistance was directed at virtually all development sectors. The Bank remains an important player with annual disbursements averaging US$7.7 million during FY07­FY09 as discussed above. More modest funding is provided from other international institutions, including the United Nations Development Program (UNDP), which supports projects in health, infrastructure, and the environment. The Global Fund to Fight AIDS, Tuberculosis, and Malaria has also been active in Montenegro, providing US$1.5 million in 2008. Key bilateral donors include, inter alia, Germany, France, and the United States, have also engaged in a number of sectors including infrastructure, water and sanitation, health, school construction loan guarantees for infrastructure investments, and social protection. 51. Montenegro is also benefiting from a number of TFs managed by the Bank, and which are fully aligned with the country partnership program. There are two GEF grants, one which complements the Bank's Agriculture Institutional Development Project (US$4.00 million) and another for the environmental management of Lake Skadar, which is supportive of the CPS program for improvement of water supply in the coastal zone. In addition, several multi-donor TFs have been made available in support of Western Balkan regional analytic work which will benefit Montenegro in a number of areas: (i) land rights and access for women; (ii) science, R&D and innovation; and (iii) accounting standards in the private and public sectors; (iv) public financial management; and (iv) Catastrophe Risk Insurance Facility. The work supported by these TFs will continue during the FY11-14 CPS period and is fully integrated with the CPS program as shown in the description of CPS-supported activities described later in this chapter. Details of each of the TFs and the amounts allocated are included in Annex 4. Grant funding is also being sought from the Russia Public Expenditure Management TF to support Montenegro's ongoing effort to increase the efficiency and impact of public expenditures in a resource constrained environment. 52. Going forward, as Montenegro has been granted candidate status, the EU's presence can be expected to become even stronger, making it imperative that the Bank and other donors coordinate their programs more systematically with the EU and the EU accession agenda. Substantial EU pre- accession funds will be available to Montenegro as the country's institutions become stronger and are able to absorb the funds in an effective manner. The Bank has coordinated closely and aligned its activities with the EU (agriculture and education), the EIB (solid waste), EBRD (energy), and Germany's GtZ (energy efficiency) but not jointly implemented projects or engaged in fee-for-service activities. The expected gradual increase in the availability of EU funds (once its institutions will have been placed into a position to absorb these funds), joint with a concomitant (gradual) withdrawal of bilateral donors, will place the Bank in a more central role as provider of technical expertise and financial support in areas that are complementary to EU accession priorities. As a result, the draft CPS priorities have been discussed with both, domestic counterparts and development partners, as well as with the Delegation of the EU in Montenegro and the European Commission, with a view to assessing, to which degree the programming and implementation of support can be aligned across institutions, thereby increasing the degree of results orientation and development impact. 23 B. Priorities for the FY11­FY14 CPS Areas of Engagement 53. The FY11­FY14 CPS is client driven and reflects Montenegro's status as an upper middle income client with well-defined development priorities. Based on the outcome of extensive consultations with the Montenegrin Government, other domestic stakeholders and external partners, the focus of Bank interventions under the CPS will fall under two main priority areas as follows: Priority 1: Strengthen institutions and competitiveness in line with EU accession requirements Priority 2: Improving environmental management, including reducing the costs of environmental problems To the extent that the CPS is being prepared at a time when Montenegro is striving to recover from the deep recession it suffered following the global financial crisis, activities under priority 1 will aim to address both immediate issues related to restoring macro balances and medium-term issues related to putting in place stronger, EU-aligned institutions and sharpening Montenegro's competitive advantages in the integrated EU market. At Government's request the Bank will focus its support in areas where the Bank has previously been engaged in Montenegro and/or gained applicable regional or global experience. The centerpiece of the Bank's engagement will be two financial-sector development policy loans (about US$105 million, total in FY11 and FY12) which will support a banking sector strengthening and stabilization program, bring regulations into line with EU norms, and encourage resumption of (healthy) credit growth. New investment lending in roughly the same amount will be very selective, given existing resource constraints under the new exposure framework, the country's limited implementation capacity, and the substantial portfolio of operations under implementation (about US$55 million still to be disbursed)4. At present, new investment lending is planned for a Higher Education/ R&D project (FY12), a small investment to facilitate Montenegrin participation in a Regional Catastrophe Risk Insurance Facility (FY12), and a Hazardous Waste Clean-up and Management Project (FY13). An additional project could be included for FY14 depending on client demand and timely closure of projects in the existing portfolio (see Table 5). IFC is expected to provide advisory services to help improve the business climate and country competitiveness, and make new investments in private companies as opportunities arise. The expected level of support will be on the order of US$40­50 million over the CPS period. 54. The Bank's interventions will contribute to specific development outcomes that are integral to Government's broader development program. For much of the CPS period, contributions towards these outcomes will come mainly from the existing portfolio of projects, all of which are fully supportive of the two priorities identified above. Of the new lending proposed under this CPS, outcomes associated with development policy lending or DPLs and most TA and analytical work should also be fully achieved during the CPS period. However, the full impact of proposed new investment operations cannot realistically be achieved within the CPS time frame and will become apparent only in the next CPS period. Table 4a below provides a breakdown of ongoing and planned lending operations. Knowledge and advisory activities for the FY11­FY14 CPS are shown in Table 4b. 4 . While there is no new Bank-financed project that is explicitly designed to address gender issues (see Annex 3),several ongoing operations monitor and seek to increase women's access to health care, education, pension benefits, and land titles. The latter issue, included in the Land Administration and Management Project, is particularly important as land titles represent the principal collateral for bank loans and, as such, would open the doors for increased female entrepreneurship. 24 Table 4(a): CPS Portfolio and New Lending FY11­FY14 (b): CPS AAA Country Specific and Regional FY11-14 Ongoing Operations FY11-14 Support EU Integration through Strengthening Improve Environmental Management Institutions and Competitiveness Ongoing investment projects (closing date) - SEE Energy Market FY12 - Solid Waste in Env. Sensitive Tourist Areas* FY12 - Health Sys. Improvement FY13 - Energy Efficiency FY13 - Land Administration FY14 - Lake Skadar GEF FY13 - Institutional Dev & Agric Strength. FY14 - Institutional Dev & Agric Str. GEF FY14 New Operations FY11-13 (delivery date) - Fin Sector DPL I FY11 - Regional Catastrophe Risk Insurance FY12 - Fin Sector DPL II FY12 FY12 (CRIF) - Higher Ed/Sci/Innov. FY12 - Hazardous Waste Clean-up and FY13 Management (b): CPS AAA Country Specific and Regional FY11-14 Montenegro Specific AAA Regional AAA - Public Exp. and Inv. Review FY11 - Western Balkans REPARIS FY11-FY14 - Pension Reform TA FY12 - Western Balkans Public Financial FY11-12 - CEM Growth and Competitiveness FY13 Management - Public Sector Institutions FY13 - Western Balkans Programmatic FY11-FY14 &Fiduciary Rev Financial Sector Dev - Agriculture Assessment FY14 - Western Balkans Study on Science, FY11-13 - Statistical Cap. Bldg. and Pov. FY11-FY14 R&D and Innovation Monitoring - Western Balkans Programmatic Gender FY12-14 Monitoring - Doing Business Reform Advisory (IFC- FY11-12 World Bank) - Southeast Europe Trade Logistics FY12-14 Project (planned, IFC) - Southeast Europe Regional Tax FY12-14 Improvement Project (pipeline, IFC) - Insolvency Advisory Services (pipeline, FY12-13 IFC) * Includes AF approved in December 2010. 55. Planned lending during the CPS period is underpinned by AAA activities carried out over the past 2-3 years and new AAA activities (both country-specific and regional) are targeted to key CPS areas with the aim of supplementing the lending program in the effort to achieve specified CPS outcomes. Design of each of the major lending activities foreseen for the CPS period builds on recently- completed or ongoing AAA activities. For example, the FY08 FSAP and follow-up knowledge and advisory services in FYs 10-11 have helped shape the FSDPLs. Regional analytical work on higher 25 education (FY08), as well as the education-sector policy dialogue established in the context of the FY05- 09 Education Reform Project, and ongoing TA support to the Western Balkans initiative on Science, R&D and Innovation underpin the planned Higher Education/R&D project. Similarly, the Environmental "Hot-Spots" Clean-up Project is informed by analytical work and feasibility studies undertaken under the Lake Skadar GEF operation which is currently ongoing. New country-specific and regional AAA planned under the CPS is targeted to improved public expenditure management and institutional development in key areas related to EU integration. Regional AAA also serves to help nurture and promote regional integration in sectors where Western Balkan Governments have themselves spearheaded regional initiatives, and where regional approaches are more cost effective and/or successful implementation requires regional cooperation. Table 5: Portfolio Consolidation over the CPS period FY11 FY12 FY13 FY14 Existing portfolio Agriculture Institutional Agriculture Institutional Agriculture Institutional Agriculture Institutional Land Administration Land Administration Land Administration Land Administration* Health System Health System Health System* Energy Efficiency Energy Efficiency Energy Efficiency* Energy (APL3) Energy (APL3)* Solid Waste + AF Solid Waste AF* Pension Administration* New Operation under CPS FY11-14 Financial Sector DPL I* Financial Sector DPL II* Higher Ed, R&D and Innov Higher Ed, R&D and Innov Higher Ed, R&D and Innov CRIF CRIF CRIF Hot Spots Clean Up Hot Spots Clean Up Additional project tbd *Closes during FY. 26 Strategic Objectives and Results Priority 1: Support EU accession through strengthening institutions and competitiveness 56. In support of Government's overarching objective of full integration with the EU within a medium-term time horizon, the Bank expects to concentrate its support on the achievement of stronger, "EU-compatible" institutions in areas central to Montenegro's longer-term competitiveness in the integrated EU market. In this regard, the Bank Group's interventions are aimed at achieving key outcomes in seven areas as follows: (i) financial (especially banking) sector strengthening; (ii) improve public expenditure management; (iii) business climate enhancement including simplification of trade and tax procedures; (iv) overhauling of agriculture support capacity; (v) strengthening higher education and capacity for R&D and innovation; (vi) strengthening of the health system; and (vii) increased efficiency in the use of energy and accelerated integration into the SEE market. The extent of Bank involvement with respect to each of these seven outcome areas is not planned to be uniform ­ e.g., the Bank's support for financial sector strengthening or higher education/R&D/innovation is expected to be relatively comprehensive, while support for solid waste will be--as currently conceived--considerably more focused. The following paragraphs provide more detail about the specific results that the CPS program will influence and about the instruments through which Bank support will be provided. 57. CPS Outcome: A stronger banking system governed by a modern regulatory framework and central institutions, which is more resilient to future shocks. The centerpiece of the Bank's engagement under the CPS is a program of two Financial Sector Development Policy Loans (FSDPLs) -- for $85 million and $20 million in FY11 and FY12 respectively -- that would support measures to strengthen the banking sector, with a view to mitigating the impact of the global financial crisis and increasing the resilience of the sector to future shocks. On a general level, the FSDPLs will also support the Government's aims to maintain a stable macroeconomic framework over the short to medium-term, including sustainable deficit and debt levels. Design of the FSDPLs is underpinned by a joint IBRD-IMF FSAP report and intensive policy dialogue, advisory services and TA in support of both the MOF and Central Bank authorities. Specific outcomes associated with the two FSDPLs are detailed below given that the program constitutes over half the CPS lending envelope along with key reforms linked to disbursement: Enhanced market confidence. The proposed FSDPLs would help reverse a decline in deposits precipitated by eroding confidence in Montenegrin banks during the economic crisis, and to restore lending to the private sector. The proposed operations will support the transition from the blanket deposit guarantee to an increased ceiling for mandatory coverage which is fiscally and economically viable. Assistance will also help to strengthen the liquidity of Deposit Protection Fund in the event of a crisis by, inter alia, establishing a legal framework for mobilizing external resources, and improving its capacity to execute deposit payouts. A strengthened bank liquidity framework. To reduce risks of financial destabilization due to low bank liquidity, the FSDPLs aim to boost liquidity in the banking sector mainly by strengthening the Central Bank's (CB) independence and role as a Lender of Last Resort (LOLR). Specific reforms include diversifying instruments for LOLR operations; expanding the sources of funding available to the CB; and augmenting the collateral to be used by CBCG for liquidity support. Stronger capacity for bank supervision. The FSDPLs will build capacity to assess the health of banks and supervise financial institutions with a view to pro-actively reducing systemic risks. Previous Bank- supported examinations of Montenegrin banks will be complemented by stress-testing of the banking 27 system as a whole, taking into account baseline and worst-case scenarios. The CB will use the results of these tests to develop and implement appropriate supervisory responses for individual banks and a contingency plan for the banking sector. Supervision capacity will be strengthened in line with EU standards, and improved supervision is expected promote improvements in key banking indicators, such as ratios of liquidity and capital adequacy. A modern regulatory framework consistent with EU norms. The FSDPLs will support regulatory improvements to strengthen the CB's ability to conduct the risk-based supervision and resolution of problem banks. The proposed operations will, inter alia, support amendments to the Law on Banks that strengthen the CB's capacity to impose remedial actions, establish statutory protection for the CB, and better define the scope of courts' powers on arbitration. In addition, the amendments to the Law on Bank Bankruptcy and Liquidation will enhance the CB's ability to undertake timely enforcement measures vis-à-vis problem banks. Adequate resolution of problem banks. The recent crisis exposed the extreme vulnerability of at least one domestic bank of systemic importance. The FSDPLs will support the design and implementation of a least cost restructuring strategy for this bank. The large fiscal risks presented by the bank's heavy reliance on deposits from state and state-controlled entities will also be addressed. 58. Further support to the strengthening and deepening of the financial sector will be provided through Bank advisory services for the financial sector which will complement the DPL program and through IFC's regional programs in the SEE. Within the context of the programmatic Western Balkans Financial Sector Development AAA (FY11­FY14) the Bank will provide assistance in identifying and addressing remaining financial system vulnerabilities and removing obstacles to the expansion of financial markets. Specifically, support will be provided: (i) to the central bank in drafting regulations to implement the newly-amended Banking Law in areas of bank supervision and problem bank resolution; (ii) to the Deposit Protection Fund in implementing the new Law on Deposit Insurance, including training of staff and drafting of internal regulations; and (iii) to review Prva restructuring strategy to be prepared jointly by CBM and MoF. IFC may provide targeted financial assistance to raise bank liquidity, as well as advisory services to banks and financial institutions to help restore credit to the private sector with a special focus on SMEs. 59. CPS Outcome: Improved public expenditure management. As discussed in Chapters II and III, the recent recession, from which Montenegro is just beginning to recover, led to a severe contraction in public revenues and a substantial deterioration in the country's budget deficit and public sector indebtedness in 2009. To reverse this situation, Government has developed a medium-term framework for strengthening public finances involving actions to gradually curb spending (particularly recurrent expenditures) and improve the management of public debt. To help support this effort, the Government has requested that the CPS program include a Public Expenditure and Investment Review (PEIR) for completion in FY11 to help identify areas for achieving savings through efficiency improvements in transfer programs (pensions, social assistance) and social services (education, health). This PEIR follows an earlier expenditure review (FY09) which concentrated on reviewing expenditures in the infrastructure sector. The FY11 social sectors PEIR will be followed in FY12 by TA to improve management of the pension system, which represents a major fiscal burden as previously discussed. [Grant funding is also being sought from the Russia Public Expenditure Management TF to support Montenegro's ongoing effort to increase the efficiency and impact of public expenditures in a resource constrained environment]. In addition, an assessment of selected public sector institutions and fiduciary practices would be undertaken in FY13 with the aim of identifying means of further increasing the transparency and efficiency of public financial management and procurement. The study will follow an ongoing AAA for improving public financial management in the Western Balkans financed by an EC trust fund. Finally, to support improved targeting of public expenditures and strengthen policy decisions the Bank will also help 28 strengthen the statistical capacity of the Montenegrin Government with a particular emphasis on monitoring poverty, living standards and gender. 60. CPS Outcome: Creating an enhanced climate for business investment. Montenegro's overall economic policy stance is strongly pro-business but there are a number of bottlenecks (regulatory and institutional) on a practical level that need to be addressed to further encourage investment, including in the SME sector. Bank Group support under the FY11-14 CPS will assist Government's efforts to address them in a few selected areas. First, financial support and TA under the FY09 Land Administration Project (LAMP) will help provide clarity around land use and property registration through development of updated national and base maps in the Real Estate Administration Department (READ), and completion of detailed urban maps in Montenegro's municipalities. The maps are critically important to strengthening land management and planning for sustainable growth, especially the development of sustainable tourism markets. Second, support from LAMP and the IFC's Investment Climate Advisory Services and Doing Business Reports will help to identify opportunities for reducing red tape for businesses and assist in simplifying procedures for construction permits, administrative procedures, and business permits including initiation of a Regulatory Impact Assessment. Third, technical advisory services from the regional Road to Europe Program of Accounting Reform and Institutional Strengthening (REPARIS) will assist Montenegro and other countries in the region set and implement standards to upgrade key business accounting practices to EU standards. A Country Economic Memorandum (CEM) is planned for FY13 that will take a more comprehensive approach to identifying and analyzing factors affecting business growth and competitiveness in the evolving post-crisis environment and recommend appropriate policy responses for Government's consideration. Finally, IFC Investment Climate Advisory Services will explore the potential of working in Montenegro on tax administration simplification and insolvency. 61. CPS Outcome: Enhanced institutional capacity to support adoption of EU standards in agricultural production and increased agricultural exports to the EU. Progress towards this outcome is being supported by the Bank via the FY09 Montenegro Institutional Development and Agriculture Strengthening (MIDAS) Project, which will remain under implementation throughout the FY11-14 CPS period. The MIDAS project and an associated GEF program were designed to improve compliance with EU agricultural standards as well as strengthen institutional capacity to provide agro-environmental services to Montenegrin farmers, thus enabling them to access EU grant funds to improve their operations. Thus far, steps have been taken toward establishing an IPARD-compatible payment agency, and accreditation and capacity building activities are in progress for agencies and laboratories concerned with food safety, veterinary care, and enforcement of phyto-sanitary standards. In addition, specialists are being hired to increase the coverage of extension and advisory services in agro-environmental issues. Going forward, MIDAS will also help authorities to improve the effectiveness of extension services, raise agriculture and food safety standards to those of the EU, and diversify agriculture activities, including agri-environmental measures in northern regions. The project has also supported implementation of Montenegro's first Agricultural Census in 40 years, which will underpin future development of the national rural development program. A proposed Bank analytical report assessing the agriculture sector (FY14) will also help review progress and define recommendations for future sectoral development. 62. CPS Outcome: Higher education quality has been strengthened and made more cost effective and capacity for R&D and innovation in cooperation with the private sector has been established in a few niche areas relevant for Montenegro's growth. Developing higher-level labor force skills and targeted capacity for R&D is a key government goal in view of Montenegro's need to compete effectively in the sophisticated EU market. Building on analytical work on higher education in the Balkans (FY08) and an ongoing policy dialogue and conference program on higher education, the Montenegrin Government and the Bank are beginning to develop a Higher Education and R&D project ($20 million) for Board presentation in FY12. The proposed project will strengthen quality assurance in higher education in line with the Bologna Process, and increase the financial sustainability of tertiary 29 education. In addition, it will seek to strengthen R & D and increase its links to private business in areas such as tourism, agriculture and environmental science where Montenegro has clear comparative advantages. While the project is still at an early concept stage, possible activities on the education side would include reform of curricula to incorporate Bologna standards, reform of incentives to reward high quality teaching and instruction and improved management of higher education by the Ministry of Education and Science (MoES). With respect to strengthening R&D capacity linked to areas of Montenegro's established comparative advantage, the project will build on strategies identified via an ongoing Western Balkan initiative to cooperate across the region on business-relevant R&D. This regional initiative, in which Montenegro is already an active participant, is receiving ongoing Bank support through a TF-financed AAA initiative to help countries arrive at a common regional strategy for R&D and innovation through a program of meetings, learning visits to relevant countries and TA for policy development and implementation. 63. CPS Outcome: Creation of a more sustainable health care system and improvements in the quality of, and access to, health care. Bank support under the FY04 Health Systems Improvement Project (HSIP) has helped to rationalize expenditures and improve the financial status of the HIF. A new primary health care benefit package was introduced and overall patient satisfaction with PHC services has dramatically improved. An AF was approved in FY10, which will continue to identify cost savings and improve financial management, especially by improving pharmaceutical management, while expanding PHC reforms and services in underserved northern regions. The AF will also support a needed expansion of secondary and tertiary care. 64. CPS Outcome: Enhanced cross-border energy trade and more regular energy supply within Montenegro. The FY08 ongoing ECSEE Adaptable Program Loan 3 will influence achievement of the above outcome by investing in an optical ground wire connection with Serbia to better manage the cross- border energy trade and strengthen the energy system's resilience to power interruptions. The project will also support the completion of infrastructure investment activities supporting improved operations of the Peruica hydropower plant, with a view to decreasing power losses and thereby helping to increase the regularity of power supplies. In addition, IFC, which is providing advisory services in relation to the structuring of a PPP project for a major hydropower investment on the Moraca river will continue to explore the viability of attracting private investment in EPCG (the state-owned electricity company) and developing PPPs for existing energy sector operations, which could help improve service quality as well as alleviate the high fiscal burden of the utility's operations. The Bank undertook a Strategic Environmental Assessment (FY07) of Montenegro's National Spatial Plan which points to a number of environmental considerations which will need to be taken into account in the development of hydro power and other energy investments. Priority 2: Improving environmental management and reducing the costs of environmental problems 65. The second priority area for which the Government is seeking Bank Group support under the FY11-14 CPS concerns improved environmental management. Specific outcomes to be supported through CPS activities focus on four main areas: (i) efficient solid waste management and disposal; (ii) remediation of toxic industrial waste dumps; (iii) provision of insurance against risk associated with natural disasters; and (iv) energy efficiency. These outcomes and the associated CPS instruments are described below. 66. CPS outcome: improved solid waste collection and disposal in heavily populated and economically-important coastal areas. Ongoing and planned IBRD lending and IFC investments in municipal sanitation projects will continue to improve solid waste management and disposal services in coastal areas to respond to rapid growth. The FY04 MESTAP project and the FY11 Additional Financing 30 project ($5.7 million) supports the development of a regional sanitary landfill serving the major coastal cities of Bar and Ulcinj as well as the operations of a new regional sanitation company. This assistance from the World Bank Group, together with a parallel EIB project supporting a regional landfill for Korot, Tivat, and Budva, is expected to improve sanitary waste collection and disposal in coastal areas. This, in turn, will enhance the quality of life for coastal residents and enable the further expansion of tourism in the covered municipalities. 67. CPS Outcome: improved trans-boundary cooperation on shared environmental issues and strengthened institutions to allow the development of sustainable tourism in the lake valley. The ongoing Lake Skadar project, financed through a GEF grant of $4.6 million (of which $2.6 million is allocated to Montenegro), is helping the Governments of Montenegro and Albania to improve the management of Lake Skadar to halt and reverse some of the effects of pollution derived from industrial waste associated with a nearby aluminum plant (KAP). The project is also helping to strengthen Montenegro's capacity to prepare for the requirements of the EU Industrial Pollution Prevention and Control Directive using the KAP site as a pilot area. The project will also help assess the feasibility of rural wastewater treatment through constructed wetlands. 68. CPS outcome: environmental risks have been reduced at about 3-4 major industrial waste disposal sites and the capacity to manage hazardous waste has been enhanced. Through a proposed FY13 Hazardous Waste Clean-up and Management Project (US$60 million), the Bank will help to reduce the environmental and public health risks associated with Montenegro's legacy of industrial pollution, mainly by remediating industrial waste disposal sites and increasing capacity to manage hazardous waste. Building on analytic work undertaken under the Lake Skadar GEF project, this proposed project will support remediation of the most heavily polluted sites prioritized by the Government, particularly in the energy and metal sectors, which may involve closure and capping of polluted sites, water management measures, and removal of hazardous waste. In this regard, a key focus will be addressing issues of red sludge associated with waste from the KAP aluminum plant. The project will also support the development a national hazardous waste disposal facility and associated regulations on segregating waste disposal streams in line with EU directives. TA and capacity building will help to define arrangements for managing the hazardous waste disposal facility, including institutional parameters such as its ownership, management structure, and tariff schedule. 69. CPS outcome: better insurance coverage for Montenegrin businesses and households in the event of a natural or climatic disaster. The Bank plans to provide investment support to facilitate Montenegro's participation in the Regional Southeastern Europe and Caucasus Catastrophe Risk Insurance Facility (SEEC CRIF). The objective of the SEEC CRIF is to increase access to financial protection for the Government as well as homeowners, farmers and small and medium enterprises (SMEs) from losses due to weather extremes caused by climate change and relevant geo-hazards, such as earthquakes, landslides, droughts, floods, etc. The Government has requested the Bank to provide a small (US$5 million) loan to finance Montenegro's participation in this regional facility. 70. CPS outcome: reduced energy wastage in public buildings and better environment for users of the facilities. Through the ongoing FY09 Energy Efficiency Project, the CPS will support improved energy efficiency in public sector buildings through energy-saving retrofits. Recognizing that the carbon footprint and energy costs associated with public sector facilities were high, the Government has worked with the Bank to retrofit select public schools and hospitals. Project-supported retrofits, which generally target insulation and other aspects of building envelopes, also help to improve the ambient environment of buildings, thereby enhancing overall living conditions. 31 C. The Lending Program 71. The proposed lending program for CPS FY11-14 is summarized below. As previously mentioned, projects in the outer years have not been specified at this stage to allow flexibility to adapt the program to emerging needs. Up to two additional operations may be included at Government's request within the general priority areas laid out in this CPS. If such requests are made, the rationale for any new operation(s) and the amounts would be laid out in detail in the CPS Progress Report to be prepared in early FY13. Table 6: Proposed IBRD Lending Program FY11-14 FY11 US$m Financial Sector DPL I* 85 Solid Waste AF 5.7 FY11 Total 90.7 FY 12 Financial Sector DPL II 20 Higher Education, R&D, Innovation 20 CRIF (Disaster Management) 5 FY12 Total 45 FY13 Env. Hot-Spots Clean Up 60 FY13 Total 60 FY14 Possible project (tbd) 20 FY14 Total 20 Overall Total 215.7 *Macro situation is subject to risk which could prevent moving ahead with the DPL, in which case loan amounts would be transferred to investment projects as appropriate and the Board would be updated via the CPS PR. V. RISKS 72. Implementation of the CPS program identified in the previous chapter is subject to five main risks as follows: Slower than expected growth in the SEE and the EU could dampen Montenegro's economic recovery and exacerbate fiscal vulnerabilities. As a small, open economy, Montenegro's growth hinges strongly on resuming strong exports and maintaining FDI flows--with promising signs in both areas to date. However, although economic growth in 2011 is expected to reach 1.8 percent in EU economies and between 2.5 to 4.0 percent in SEE countries, the fiscal strain of country stimulus packages, increasing sovereign debt, weak regional financial performance, and lower-than-expected global growth could negatively affect foreign investment and demand for Montenegrin exports. In turn, this could thwart recovery, reduce fiscal revenues, and increase Montenegro's already-high debt. To partially mitigate these risks, the CPS proposes several analyses, studies and advisory services (e.g., FY11 PEIR, FY13 CEM) to support the Government in its efforts to address evolving economic and fiscal risks and design and implement effective policy responses. Further, the proposed FY11 and FY12 FDPLs support maintenance of a viable macroeconomic framework. 32 Ongoing weaknesses in the banking sector could increase financial instability and constrain credit just as Montenegro seeks to reignite private sector-led growth. Montenegro took steps to protect its banking system during and after the economic crisis by, inter alia, enhancing deposit protections and the role and independence of the Central Bank. However, continued high shares of non-performing loans and the fragile state of financial institutions, particularly Prva Bank, underline solvency risks while reducing the capacity of banks to lend to the private sector. Though foreign owned banks have injected new capital into many Montenegrin subsidiaries, portfolio quality is still an issue and banks remain vulnerable to external shocks. The proposed FY11 and FY12 DPLs support policy measures to mitigate key risks, mainly by strengthening the liquidity framework, developing instruments to resolve problem banks, and improving banking sector regulations. Lack of progress on institutional strengthening and governance improvements could undermine Montenegro's path toward EU Accession and its efforts to attract increasing FDI flows. EU and domestic observers have raised concerns about possible links between some senior public officials and organized crime. Perceptions among EU and international investors that Montenegro is not fully tackling these issues could stall progress on EU integration, thereby reducing the country's attractiveness as an investment and tourist destination. The EC's set of prior actions to be completed before opening EU membership negotiations has sought to reflect these concerns, with clear signs from the Government that related reform priorities would be addressed. The Bank can offer some assistance in diagnosing and addressing broader governance-related issues, which will be provided through AAA activities, such as the PEIR, the proposed advisory services in the business environment and the institutional and fiduciary assessment. The quality of the portfolio could be impaired by deficiencies in country implementation capacity. The 2009 breakdown of the TSU highlighted risks that unexpected personnel shifts or other organizational deficiencies could interrupt procurement or implementation support for Bank projects, leading to delays on project outputs and outcomes. In addition, the relative inexperience of certain line ministries in processing Bank projects could negatively affect project execution. To ensure adequate fiduciary support, the Bank has significantly strengthened its oversight of the TSU, including by undertaking annual assessments of the TSU workload and staffing, and strengthening communications between TSU staff and project beneficiaries. The Bank has also enhanced its engagement with PIUs in line ministries to ensure the transfer of adequate knowledge on Bank standards and procedures. Montenegro is vulnerable to natural disasters, including, increasingly, severe climate pressures. A significant proportion of Montenegro's land area and population are vulnerable to multiple natural hazards associated with climate change pressures. The prevalence of both floods and droughts is expected to increase with detrimental impacts on households and possible negative effects on tourism and agriculture, and hence, economic growth. To help mitigate the impact of such natural phenomena on the Montenegrin population and businesses, the Bank will support the country's participation in the regional Catastrophic Risk Insurance Facility. 33 ANNEX 1: DRAFT FY11-14 RESULTS MATRIX FOR THE MONTENEGRO COUNTRY PARTNERSHIP STRATEGY Country Outcomes the Bank Program is Devt. Goals Issues and Obstacles Expected to Influence Milestones WBG Program Pillar I: Support EU Accession Through Strengthening Institutions and Competitiveness Creating a The Central Bank's limited Strengthen the Central Bank's capacity to provide New Law on the Central Bank implemented FY11 Financial & stronger capacity to ensure liquidity in the liquidity as a Lender of Last Resort (LOLR), as upholding the independence of the Central Bank Private Sector banking system banking sector, particularly given indicated by: and expanding its role as a LOLR. Development Policy Euro monetization, enhances risks - Liquidity ratio in the banking sector remains Loan of a crisis and its potentially compliant with CBM's prudential norms Facility established providing emergency 90-day negative impacts. - liquidity to solvent banks. FY12 Financial & Private Sector Development Policy Though the Government Enhance public confidence in the health of the New Law on Deposit Insurance Fund Loan introduced anti-crisis measures to banking sector, as indicated by: implemented. protect the banking system, - Stabilization of the decline in bank deposits additional legislative and (baseline: -31% percent y-y decline in June 2009; AAA/ESW: institutional changes are needed target: decline halted) to enhance public confidence. - Resumption of growth in credit (baseline: 15% FY11-14 Programmatic y-y contraction in credit in Dec. 09) Balkan FSD/TA Facility Montenegrin banks remain Improve the capitalization of Montenegrin banks and Stress-tests of systemic banks completed and undercapitalized and burdened their resilience to shocks, as indicated by: supervisory action plans for banks implemented. IFC: with large portfolios of non- - Average Capital Adequacy ratio of the banking Advisory Services to performing loans in the aftermath system remains above prudential norm mandated Amended Law on Banks implemented. Deepen Credit Reach of the economic crisis. by CBM The financial crisis highlighted Strengthen Montenegro's capacity to resolve Amendments to the Law on Bank Bankruptcy and inadequate capacity to address problem banks and financial institutions. Liquidation implemented. and resolve troubled financial institutions, and the near-failure A problematic, systemically important bank in full of at least one systemically compliance with minimum requirements (or, important bank. failing such, de-licensed). Enhance macro- Increases in debt to above 40% of Improve public expenditure management as 2011 budget adopted that is consistent with an FY11 Public and economic GDP and strain from the global indicated by decreasing trend in the deficit and debt adequate medium-term fiscal framework. Institutional stability and economic crisis require prudent levels (2010 projected baselines: general government Expenditure Review improve public budget and economic planning deficit of 4.5 % of GDP; gross public debt 48.4% of expenditure and fiscal restraint. GDP). FY12 Public management Institutions Review and Fiduciary Assessment FY13 Pension TA FY11-14 Statistical Capacity Building 34 Country Outcomes the Bank Program is Devt. Goals Issues and Obstacles Expected to Influence Milestones WBG Program Strengthen the Advances have recently been Improve the quality and coverage of PHC services in Increase in health facilities constructed, renovated, FY10 Health Systems health system to made in reforming PHC benefits and outside Podgorica, as indicated by: or equipped (baseline: 5 in 2010; target: 8 in Improvement improve and expanding PHC coverage, but - Increase in PHC utilization rates (baseline: 37% 2012) Additional Financing coverage, health management systems need of general population report visiting general quality and to be further strengthened to practitioner in 2009; target: 40% by 2012) Decrease in waiting time (arrival to consultation) financing improve quality of care and scale- - Increase in client satisfaction with PHC services for PHC services: mechanisms up programs, particularly outside (baselines: 66% of population in Podgorica totally - In Podgorica (baseline: 57% reported 21 or Podgorica. satisfied in 2008; target: 70% in 2012; 61% of more minutes in 2008; target: 30% by 2012) population outside Podgorica satisfied in 2008; - Outside Podgorica (baseline: 15% reported 21 target: 66% in 2012) or more minutes in 2009; target: 11%) Recent reforms to the HIF and Improve the financial sustainability of the health Increase in the share of pharmaceuticals on the pharmaceutical management have sector, as indicated by: market registered by the Drugs Agency (baseline: improved financial performance - HIF maintains a zero deficit in 2012 (baseline: 8% in 2009; target: 15% in 2012) of the health system, but there is small projected deficits in 2009). scope for further reform and Share of HIF expenditures spent on drugs kept at regulation of drug purchases to or below 18% through 2012 (baseline: 16.3% in curb costs and overall 2008). sustainability. Creating an Registering property and business Streamline property registration and business Increase in number of municipalities with FY09 Land enhanced licensing remain key impediments permitting, as indicated by: completed spatial plans (baseline: 2 in 2010; Administration Project climate for to business growth, largely due to - Increase in real estate transfer tax (baseline: target: 8 in 2014) business weak cadastre services, poor 41m in revenue in 2007; target: 121m in 2014) AAA/ESW: investment municipal spatial planning, and - Decrease in time to receive a construction permit Increase in share of customers satisfied with real complicated procedures. (baseline: 6 months in 2008; target: 2 months in estate registration and permitting (baseline: TBD FY13 CEM: 2014) based on survey in 2010; target: 20% Competitiveness and improvement) Productivity IFC: [Investment Climate Corporate financial reporting has Strengthen the transparency of corporate financial Progress noted in Annual Progress Report of EC Advisory Services on improved but lags behind EU reporting in line with EU standards. Professional body; admitted to International Regulatory Reform, practices. Federation of Accountants (IFAC). regional Trade Logistics, Tax Administration simplification] FY11-14 Regional REPARIS 35 Country Outcomes the Bank Program is Devt. Goals Issues and Obstacles Expected to Influence Milestones WBG Program Strengthen Limited capacity to deliver rural Strengthen government capacity to deliver System established for monitoring and evaluating FY09 Montenegro agricultural development assistance and agricultural assistance and upgrade agricultural rural development funds in compliance with EU Institutional productivity, inadequate agricultural standards practices to EU standards, as indicated by: IPARD requirements. Development and particularly to below those of the EU curtail - Rural development measures compatible with Strengthening Project capitalize on EU export potential and impede EU IPARD integrated into MAFWM programs Annual monitoring of food processing plants market economic growth in rural areas. - Food safety labs accredited to EU standards introduced and plants in compliance with EU opportunities (baseline: 0 labs accredited in 2010; target: 100 standards % accredited by 2014) Strengthen land and natural resource management Agro-environmental extension services introduced focusing on Montenegro's northern regions, as and regularly provided by MAFWM. FY09 MIDAS GEF Unsustainable land use and low indicated by: coverage of agri-envrionmental - Increase in agri-environmental measures adopted activities, particularly in northern by targeted households (baseline: 0; target: regions, pose threats to ecological measures adopted by 20% of households) resources and eco-tourism opportunities. Strengthen the Montenegro's competitiveness Improve the quality, management and financing of Reforms to the higher education curriculum and FY12 Higher quality of and hinges on developing a skilled higher education in Montenegro in line with EU mobility tools completed in line with the Bologna Ed/SCI/Innov access to higher workforce, but the national higher developments and Bologna agreements. Process. education education system has high drop- out and low completion rates, Capacity building provided to the MoES and the AAA/ESW: funding models are inadequate, University of Montenegro, in particular to and efforts are needed to strengthen Science and Technology Education FY11-14 Western implement the Bologna Accords Balkans Study on as relevance of degrees and At least one Center of Excellence has been put in Science, R&D and quality of instruction are place to promote cooperation between the private Innovation insufficient. sector and the University on R&D. Note: the above milestones will be defined more explicitly during project preparation Improve Montenegro's energy security is Improve the security and reliability of Montenegro's Optical ground wire connection to manage cross- FY08 Energy Montenegro's undermined by inadequate energy sector, as indicated by: border trade completed with Serbia. Community of energy security facilities for regional trade and - EPCG integrated into the UCTE telecom Southeast Europe with a view to aging transmission and generation highway (baseline: partial integration in 2010; [any remaining milestone for the activities in APL 3 ensuring long- infrastructure. Power target: full integration by 2011) Andrijavica and Mojkova, other than measuring term growth interruptions are increasing risks, - Reduction in power interruptions in the data?] IFC: particularly as Montenegro Andrijavica and Mojkova regions (baseline: 381 PPP and Private imports 33% of its electricity. and 369 MW, respectively, in 2006; target: 191 Electricity losses at the Perucica Hydropower Investment: Energy and 185 MW by 2011) Plant reduced from installation of a project- financed turbine runner (baseline: 40 gwh loss in 2006; target: 38 gwh by 2011) 36 Country Outcomes the Bank Program is Devt. Goals Issues and Obstacles Expected to Influence Milestones WBG Program Pillar II: Improving Environmental Management Improved solid Pollution and inadequate solid Strengthen solid waste management services in Bar Regional landfill constructed at Mozura and a FY11 Additional waste waste services in Bar and Ulcinj and Ulcinj, as indicated by: waste management company in operation serving Financing for MESTAP management threaten the quality of life in these - Increase in the percent of solid waste collected Bar and Ulcinj. coastal cities and their potential as and disposed of in proper facilities (baseline: tourist sites. 65% in 2010; target: 90% in 2011) Reduce Lake Skadar, a critical watershed Strengthen the environmental management of Lake Agreement on a site remediation solution to the [FY08] Lake Skadar environmental and tourism site near the Adriatic Skadar in cooperation with Albanian authorities, as KAP waste dump site. GEF risks associated coast, faces increased risks from indicated by: joint action on shared environmental with industrial pollution, overfishing, and challenges concerning fisheries management, Financially sustaining the Joint lake Commission. FY13 Montenegro pollution development pressures that wastewater, tourism, and industrial pollution. Hazardous Waste threaten its sustainability. Clean-up and Reduce the environmental and public health risks of National facility for the disposal of hazardous Management Project Instances of poorly managed polluted industrial disposal sites, as indicated by waste developed and operational. growth in Montenegro have led to - Environmental remediation completed of five polluted industrial disposal sites industrial disposal sites (KAP in Podgorica; Site risk reduction measures agreed and with hazardous waste that poses lignite thermal power plant in Pljevlja; lead-zinc underway. risks to human health and the tailings pond in Pljevlja; steel mills in Niksic; environment. and the Bijela shipyard) National regulations developed on institutional arrangements for the transfer of hazardous waste. Insuring against The Government and Improve access of the Government and households Shareholders Agreement of the CRIF signed by FY12 CRIF costs of natural Montenegrin households have to low-cost catastrophe insurance products as the Montenegrin Government. disasters inadequate access to diversified, indicated by: low-cost insurance covering the - Increase in share of households covered against impacts of natural and climate- climate-related and geo-perils from participation related disasters. in CRIF (baseline: 0% in 2010; 10% by 2014) Increase the Montenegro's energy Enhance the efficiency of energy use in targeted Detailed energy audits completed for 18 public FY09 Montenegro efficiency of consumption greatly exceeds EU public schools and hospitals, as indicated by : facilities (baseline: 2 schools and 3 hospitals in Energy Efficiency energy use in averages, but the awareness and - Decrease in energy use attributable to retrofits of 2009; target: 18 facilities in 2012) Project the public implementation of policies targeted buildings (baselines & targets: see sector promoting energy efficiency in project document) Energy-saving retrofits of 18 public schools and the public sector is limited. hospitals installed (baseline: 0 completed in 2010; target: 18 completed by 2013) 37 Montenegro FY07-10 Country Partnership Strategy (CPS) ANNEX 2: FY07-FY10 CAS COMPLETION REPORT Date of Original CPS: May 15, 2007 Date of CPS Progress Report: March 20, 2009 1. This Country Partnership Strategy Completion Report (CPSCR) takes stock of the effectiveness and impact of the World Bank's assistance to Montenegro during FY07-10. The CPSCR assesses the extent to which the Bank has helped in the achievement of country goals and the appropriateness of the approaches adopted by the Bank. It also identifies lessons for future Bank partnership and programs in Montenegro. To undertake this review, the assessment team: Reviewed progress on Montenegro's principal long-term and medium-term goals Examined the alignment between Montenegro's development goals and the CPS, including the appropriateness of the CPS design Assessed the extent of CPS achievements against the CPS pillars and Bank-influenced country outcomes Analyzed Bank and borrower performance over the CPS period related to portfolio quality, preparation, and supervision (including the effectiveness of responses to problems) Reviewed the impact of country aid dialogue and donor coordination Derived lessons for future Bank assistance to the country 2. Numerous sources were consulted to assess achievements and portfolio effectiveness. An in- country visit was undertaken to meet with ministry and project officials, consult with donors and other stakeholders and, as feasible, obtain feedback from beneficiaries with regard to the effectiveness of Bank support to Montenegro. Within the Bank, interviews with the Country Manager and Country Office Staff as well as the Country Sector Coordinators provided important insights into the effectiveness of CPS activities, including the broad policy dialogue and donor coordination on a national and sectoral basis. Finally, on a project level, the team reviewed implementation status reports (ISRs) and supervisory and monitoring documentation, and interviewed task team leaders (TTLs) to review achievements and trends in project quality and performance. A. Progress on Country Development Outcomes 3. Following independence in mid-2006, Montenegro developed its National Program of Integration (NPI) which established three medium-term development goals for its small, open economy--(i) accelerating sustainable, private sector-led economic growth, (ii) strengthening institutions and the rule of law, and (iii) improving the population's living standards--within an overarching long-term vision of integration with the European Union. The Bank's CPS, which was prepared shortly after independence, fully mirrored these country goals and sought to selectively support the Government's efforts in mutually-agreed areas. The following paragraphs provide a general assessment of Montenegro's progress with respect to each of the above national goals. Sections B and C of this report subsequently focus on the specific outcomes associated with Bank support for Montenegro and determines the extent to which these were met over the CPS period as well as the role that the Bank played in helping to achieve them. 38 Montenegro FY07-10 Country Partnership Strategy (CPS) Progress on EU Integration 4. Montenegro has made significant progress toward achieving its overarching country objective: integration with the European Union (EU). The Government signed and ratified a Stabilization and Association Agreement (SAA) with the Council of the EU in late 2007, and the interim agreements on trade, visa facilitation and readmission became effective in January 2008. In mid-2008, Montenegro approved its ambitious NPI, which established sector objectives and benchmarks for compliance with EU standards, and in December 2008 submitted an official application for EU membership. Following completion by Montenegro of an extensive questionnaire related to compliance with EU standards, Montenegro's SAA was ratified by all EU member states in late March 2010, thus allowing the Agreement to formally enter into force. The European Commission is currently preparing its opinion, to be published in early November 2010, on whether Montenegro is ready for the opening of accession talks with the EU. Economic Performance 5. Montenegro's pro-business policies and clear European perspective helped to achieve strong growth from independence in mid-2006 through late 2008, but its small, open economy was hard hit by the global crisis, leading to a sharp deterioration in growth as well as macroeconomic and financial sector indicators. GDP growth between 2006 and 2008 averaged 9%, propelled by strong domestic and external demand, rapid credit expansion, and substantial foreign direct investment (FDI), particularly in the real estate, construction, and tourism sectors. Credit to the private sector (y-o-y) grew from 33% of GDP in 2005 to 83% by June 2008, and net FDI averaged 19% of GDP over 2007 and 2008. However, rapidly increasing imports and falling exports drove the current account deficit (CAD) from 8.5% of GDP in 2005 to 51.8% in 2008. Montenegro's economy was overheated until mid-2008 and would likely have returned to lower growth rates over time, but the onset of the global crisis meant a very sharp, painful reduction in growth, in turn caused by contagion and concerns about the banking system which led to persistent withdrawals and a credit crunch, stagnation in tourism (including a decline in critically-important overnight visitors) and reduced external demand. Combined with drops in investment and eroded confidence, these factors led to a recession in 2009 and a contraction of GDP of close to 6%. 6. Montenegro's fiscal trends were closely linked to its growth performance. The Government achieved fiscal surpluses in 2006 and 2007, on the back of increased tax revenues, particularly value- added taxes on imports. These surpluses drove an expansionary fiscal policy, which boosted consolidated expenditures and net lending to 48.8% in 2008. Additional outlays covered both capital and recurrent expenditures, including a notable expansion of spending on the wage bill, which reached 10% of GDP in 2008. Reflecting the pro-cyclical nature of the tax regime, Montenegro's fiscal position deteriorated after the crisis. General government revenues as a percent of GDP dropped 5.5 points to 42.9% between 2008 and 2009. This decline was driven in part by the large arrears of the state electricity company (EPCG), KAP, and other large companies, which together accounted for tax arrears of almost 3% of GDP by October 2009. Owing to the widening deficit, gross public debt grew from 29% of GDP in 2008 to an estimated 38.8% in 2009. External debt rose from 79.4% of GDP in 2007 to an expected 98.2% in 2009. 7. The crisis exacerbated existing vulnerabilities in Montenegro's banking and financial sectors and prompted Government to undertake significant reforms to bolster the stability of the system. Growth (y-o-y) in domestic banking assets reached 172% in 2007 before plummeting sharply by December 2009. Increases in credit (y-o-y) of 139% in 2006, 176% in 2007, and 25% in 2008 was underpinned by substantial foreign borrowings but was also associated with declining asset quality and an increasing share of non-performing loans (NPLs). The massive, broad-based and persistent withdrawals from Montenegrin banks which occurred in the wake of the global financial crisis drained liquidity and, coupled with the banks' own efforts to clean up their loan portfolios by tightening credit risk, led to a 39 Montenegro FY07-10 Country Partnership Strategy (CPS) severe credit crunch. In this context, Montenegro embarked on a major reform of its financial system and regulatory framework to mitigate challenges linked to the economic crisis and increase conformity with EU standards. Working with the WB and the IMF, Montenegro upgraded instruments to improve supervision of banks, including preparing amendments to the Law on Banks to enhance enforcement powers of the Central Bank of Montenegro (CBCG), improve corporate governance, and strengthen procedures for resolving troubled institutions. In large measure, the reforms undertaken followed the recommendations of the joint Bank-Fund FSAP which had been undertaken in 2006. 8. To respond to the crisis and contain the widening fiscal deficit, the Government also undertook politically-difficult expenditure cuts to consolidate government and expenditure growth, including by privatizing selected state assets and concessions. The Government implemented a first round of expenditure cuts in early 2009 and a budget revision in July 2009 to account for lower growth under the crisis (assuming zero real GDP growth and 3% annual inflation). The revision included cuts in capital spending and moderation of the wage bill, and led to a moderated central government deficit of around 3% in 2009 ­ an outcome that was a vast improvement over the 8% deficit that had been projected for a non-revised budget and underscored Government's commitment to a prudent fiscal stance. In addition, the Government privatized state owned enterprises and explored options for public private partnerships (PPPs) to lessen strain on public revenues. EPCG was unbundled in 2009 into a transmission company and entity overseeing generation and distribution with the support of Italian investors. Further, the legal framework was updated to facilitate concessions in infrastructure, particularly transport. Besides improving fiscal conditions, private investment in infrastructure is expected to reduce the CAD significantly over the medium-term. In light of these reforms and continued good outlook for tourism, Montenegro is expected to moderate its economic contraction to only 1.8% in 2009 and achieve growth of 5.5% of GDP in 2011. Strengthening Institutions and the Rule of Law 9. Both prior to and after the onset of the global crisis, Montenegro continued its efforts to strengthen public institutions and upgrade standards and legal frameworks to comply with EU requirements, focusing especially on the business climate. Montenegro's overall ranking in the World Bank's Doing Business Reports improved from 81 out of 178 countries in 2008 to 71 out of 183 countries in 2010.5 Rankings improved in trading across borders, employing workers, getting credit, and starting a business (see Chart 2). Rankings were largely static in enforcing contracts and closing a business. However, rankings deteriorated in paying taxes, registering property, and dealing with licensing. Surprisingly, the paying taxes ranking worsened despite a decrease in the tax rate for small and medium enterprises, which forms a component of this indicator. The registering property ranking fell due to an increase in property transaction costs, though there was no change to the number of procedures and days to complete a transaction. Doing Business's dealing with licensing ranking is based on the days, costs, and procedures for building a proxy warehouse. In Montenegro, these costs and procedures decreased, but the days to receive a construction permit increased from 197 to 230 days. Despite these setbacks, the Government is supporting measures to improve property systems and business permitting, including by adopting a new spatial planning law in 2008 and instituting reforms to cadastral and other property services, but strong gains in the these areas are not expected until a few years after implementation. 5 Data sets for Doing Business reports originate from June of the previous year (e.g., data for Doing Business 2010 cover June 2009). The methodologies for calculating certain indicators were subject to modest revisions over 2008- 2010 as documented at http://www.doingbusiness.org/MethodologySurveys/ 40 Montenegro FY07-10 Country Partnership Strategy (CPS) Improving living standards 10. Available data suggest that unemployment and poverty fell throughout the CPS period, though the recession triggered by the global crisis now risks reversing trends unless growth picks up rapidly. Montenegro's unemployment rate dropped significantly from 22.3% in 2004 to a projected 10.7% in 2008. In 2009, headline unemployment and employment data continued to suggest a strong labor market. However, this data obscured underemployment, particularly in KAP, rising part-time employment, and substitution of domestic for foreign labor. In effective terms, employment is projected by the IMF to have dropped 14%, and further decreases are possible given the possible restructuring of KAP. According to an analysis of 2007 Household Budget Survey Data, the national poverty rate fell from 11.2% in 2005 to 8% in 2007, with rural poverty more than double the rate in urban areas. Though the overall pattern is favorable, projected contractions in GDP in 2009 and 2010 will likely reverse this trend, particularly as 18.2% of Montenegrins are "at risk" of poverty with average consumption less than 25 percent above the poverty line. Indeed, poverty simulations assuming three-year annual average growth rates of between -1% to -2%, which encompass the forecasted -1.3% average contraction between 2009 to 2011, suggest a modest increase in the national poverty rate to between 8.9% and 9.5%. B. Government's Strategic Goals and CPS Design 11. As mentioned above, The FY07-10 CPS was designed to support Montenegro's EU aspiration as well as its specific medium-term development goals. The proposed portfolio reflected the priorities of Montenegro's SAA and the Government's 2007 to 2011 Economic Reform Program. At Government's request, the CPS integrated EU accession requirements into planned activities wherever possible, including supporting the development of institutions and mechanisms that would help Montenegro tap into the EU's Instrument for Pre-Accession financing (e.g., in rural development). Within the framework of EU integration, the World Bank adopted the Government's three major policy priorities as CPS pillars: (i) Enhance sustainable economic growth, through increasing economic freedoms and strengthening the role of the private sector; (ii) Build institutions and the rule of law; and (iii) Improve the standard of living of citizens, through efficient education, health and social protection systems. 41 Montenegro FY07-10 Country Partnership Strategy (CPS) 12. Selective lending assistance and knowledge services were designed to be coordinated and mutually reinforcing, while capitalizing on the World Bank Group's comparative advantages. Investments and analytical work were selected to exploit synergies between IBRD and the International Finance Corporation (IFC), though IFC's activities would undoubtedly be opportunistic, depending on actual demand from the private sector. Achieving effective donor coordination was also a key aim of the CPS. Proposed interventions took account of activities of the International Monetary Fund (IMF) and diverse multilateral organizations, including the EC, European Investment Bank (EIB), European Bank for Reconstruction and Development (EBRD) and the United Nations Development Programme (UNDP). In addition, the CPS coordinated its activities with several bilateral donors, such as the development arms of Germany, Japan, Canada, Japan, Finland, and the United States. 13. The CPS was aligned to Montenegro's political cycle to ensure country ownership and effective interventions, and included base and high case scenarios linked to policy performance. The CPS supported policy priorities of the Government expected to be in office until 2010. A new CPS in early FY11 was projected based on discussions with newly elected officials following Parliamentary elections in late 2010. Base case assistance was to include US$19 million from IDA (FY07) and US$50 million from IBRD (FY08-10) channeled through seven projects, complemented by select technical assistance (TA), economic and social work (ESW), and GEF support. The high case was to include an additional US$20 million from IBRD in FY10. IDA financing was limited to FY07, reflecting residual uncommitted IDA funds from the FY05-FY07 CAS for Serbia and Montenegro, followed by a transition to IBRD financing given Montenegro's middle-income status. Under the base case, the CPS was expected to reduce the number of annual investment projects from two to one given concerns about implementation and absorptive capacity. Design Changes at CPS Mid-Term 14. The CPS Progress Report (CPSPR) in March 2009 affirmed good progress on the CPS's base and high case triggers, but reaffirmed the base case given uncertainties about Montenegro's creditworthiness and the economic climate. As Annex 1 illustrates, most base and high case indicators were satisfied at the end of the CPS, though performance on fiscal and economic indicators involving debt and balance of payments remained mixed. 15. The CPSPR introduced a number of programmatic changes. Though most lending and AAA programs were on track, the proposed FY10 Improved Social Services Project was dropped as the Government expressed support for other priorities, such as additional financing for the FY04 Montenegro Health information Project (MSHIP). In addition, the CPSPR expanded options for a possible high case project beyond the proposed FY10 Transport Project. Contingent on fiscal and economic performance, the CPSPR noted possibilities for an investment project in higher education or environmental mediation, or development policy lending (DPL) if economic conditions deteriorated significantly. 16. Finally, the CPSPR introduced a revised results matrix to reflect emerging best practice in Bank monitoring and evaluation (M&E). The original CPS results matrix had an excessive number of indicators and milestones relative to the portfolio's size. In addition, certain indicators were weakly constructed, and some results chains overestimated the influence of Bank interventions (e.g., attributing Montenegro's satisfactory macroeconomic performance to limited ESW activities). The revised matrix, which serves as the benchmark for this Completion Report, permitted a more realistic portrayal and assessment of WB activities and achievements over FY07-10. 42 Montenegro FY07-10 Country Partnership Strategy (CPS) C. CAS Results Assessment 17. This section takes stock of the contribution of the World Bank Group to the achievement of results under the three pillars of the Montenegro CPS. The results matrix in Annex 2 summarizes the results achieved and lessons learned. The presentation follows the pillars of the CPS noted above, and discusses progress on Bank-influenced outcomes. Pillar I. Enhance Sustainable Economic Growth Country Priority: Sustain Macroeconomic Stability and Maintain Sustainable Economic Growth 18. CPS goals under this Priority included strengthening government capacity to manage macroeconomic and fiscal challenges, and improving public financial management and fiduciary controls. Though these outcomes were largely achieved, measuring the degree to which they can be attributed to the Bank is difficult. The Government's fiscal management has clearly strengthened considerably, particularly in the wake of the 2009 recession. Quick government action contained the 2009 deficit from a projected 8% to a much more manageable 3.2% of GDP, including making politically- difficult cuts in wages and pushing forward with privatization in key areas. Notable progress was also made in strengthening financial controls, budget planning, and fiduciary systems to improve the effectiveness and transparency of public financial management (PFM). The Government collaborated with many donors to achieve these objectives, including the WB and the IMF, and pursued comprehensive fiduciary reform, which is laying the foundation for e-procurement. 19. Technical assistance, advisory services, and ESW provided by the Bank helped to strengthen government capacity in these areas. A comprehensive Public Expenditure and Institutional Review (PEIR) was completed in 2008 and its recommendations on fiscal strategies were welcome by authorities. In 2009, the Bank completed a Public Expenditure and Financial Accountability Assessment (PEFA) that benchmarked financial management practices and led to strategies to improve financial controls, budget planning, and public procurement in line with EU standards. Testifying to the quality of these studies, the Government requested follow-up TA on the PEIR and the PEFA for FY10 and FY11 to respond to post- crisis needs and propose additional measures to facilitate compliance with EU requirements. These reports and TA have guided dialogue on a proposed program of development policy lending under the next CPS. Moreover, it is worth noting that Government requested the Bank to undertake an additional follow-up Public Expenditure Review (PER)--currently nearing completion--focused on ways to better manage social spending, suggesting that the analysis has been useful for policy design and fiscal management. 20. The CPS also aimed to strengthen the institutional framework for managing transport and infrastructure services, particularly through public private partnerships (PPPs), and to improve capacity in road safety management. Montenegro faced critical needs to upgrade and build roads and other transport infrastructure to improve its competitiveness, but the Government's fiscal space was limited, and the institutional framework for harnessing PPPs was inadequate along with the understanding of how to tailor PPPs to transport projects. To begin addressing these issues, authorities developed and approved a new, comprehensive framework law for Concessions that supported outsourcing public infrastructure services without increasing pressure on public finances. In addition, high rates of accidents and weak overall safety on public roadways prompted authorities to prioritize upgrading road safety standards and the capacity of relevant agencies. 21. Good progress on these outcomes was achieved with the support of Bank-managed trust funds and IFC advisory services. Bank TA and analyses funded by the Public-Private Infrastructure Advisory Facility (PPIAF) provided inputs to develop the draft Concessions Law, and supported 43 Montenegro FY07-10 Country Partnership Strategy (CPS) feasibility studies on key transport corridors that could be developed through PPPs. Under the PEP-SE Infrastructure program, IFC helped authorities to structure a PPP transaction to finance, construct, and operate 170 km of motorway between Bar and Boljare, which is designed to connect Montenegro's coastal areas with its northern region and Serbia (the preferred bidder for this project is currently seeking financing). In addition, PPIAF funded a study on national capacity in managing road safety as well as two pilot demonstration projects. Moreover, all relevant milestones in the CPS result framework were achieved through these interventions. 22. The final outcome under this priority was to improve coordination and capacity in poverty analysis and measurement. At the outset of the CPS, government capacity in poverty measurement and social assistance evaluation was limited, and associated services were fragmented across the Statistical Office of Montenegro (MONSTAT), the Ministry of Labor, and the Ministry of Finance. The Government sought to improve institutional coordination to heighten programmatic efficiency while improving the methodology for poverty measurement and the accuracy of projections. With Bank support, solid gains were made in strengthening coordination and capacity in poverty analysis. The FY07 Programmatic Poverty Assessment and follow-up TA helped MONSTAT to enhance its use of Household Budget Survey (HBS) data to develop poverty profiles for 2005 and 2006, and to strengthen its coordination with other ministries on poverty statistics. The Bank's collaboration led to development of a joint discussion note on HBS data, and--testifying to the Bank's success in transferring knowledge-- MONSTAT developed its own note on employing HBS data in 2009 with the World Bank serving as solely a peer reviewer. In addition, the Bank supported a regional study on social safety nets that benchmarked Montenegro's performance in targeting and covering the poor through social assistance programs, particularly "last-resort" social assistance, while proposing reforms to enhance coverage, strengthen eligibility requirements, reduce work disincentives, and improve benefit administration. Country Priority: Strengthen Environmental Management and Tourism Planning 23. The CPS strove to influence three outcomes under this priority: (i) strengthen water and solid waste services in coastal municipalities facing development pressures from tourism; (ii) establish a protected area in the Bojana Delta; and (iii) strengthen environmental management of Lake Skadar-- a key watershed. These objectives reflected concerns about the rapid recent growth in coastal areas including the Bojana Delta, and concomitant pressures on natural resources and the region's increasingly inadequate water and sanitation infrastructure. Authorities recognized the need to carefully manage the growth and the natural endowment of the coastal region given its importance as major tourist destination and source of revenue. Simultaneously, authorities aimed to improve the management of Lake Skadar, the largest lake in the Balkans situated between Albania and Montenegro seven kilometers from the Adriatic Sea, as it was facing threats to its pristine beauty and value as a tourist site from overfishing, pollution, and poorly managed development. 24. Two bank operations supported the outcomes related to water and sanitation and protection of the Bojana Delta: the FY07 Montenegro Sustainable Tourism Development Project (MSTDP), and the F04 Montenegro Environmentally Sensitive Tourist Areas Project (MESTAP). MSTDP supported government efforts to construct a Regional Water Supply (RWS) pipeline network to channel water from Lake Skadar to coastal cities, particularly the pipeline segment between Lake Skadar and Bar. As MSTDP was designed to promote "integrated coastal management," the project linked support for water infrastructure to the establishment of a protected area on the Bojana Delta. In turn, MESTAP was designed to help major coastal cities, including Bar, Ulcinj, Kotor, Tivat, and Budva, address critical and growing problems in the solid waste sector, including unsanitary waste disposal, insufficient landfill capacity, limited coverage of waste services, and inadequate institutional management. 44 Montenegro FY07-10 Country Partnership Strategy (CPS) 25. With support from the MSTDP, the Government successfully completed the RWS network and increased 24-hour water connections in coastal areas. However, MSTDP's overall contributions were less than expected as the project was cancelled in FY09 owing to a lack of progress on establishing a protected area on the Bojana Delta. Buttressed by strong local support, MSTDP investments in regional water supply infrastructure made good gains from the project's outset. However, unexpected disagreements among stakeholders on what constituted adequate protection of the Delta stalled progress on this project component, thereby undermining MSTDP's aims to promote sustainable tourism and integrated coastal management. MSTDP supported a background study on the protection of the Delta in 2008, but stakeholder disagreements impeded its approval, even as its water infrastructure components progressed satisfactorily and the Bank team considered additional financing to support a second segment of the RWS to Ulcinj and Velika Plaza. The Bank entered dialogue with stakeholders to attempt to resolve disagreements, but a consensus was not reached, and in late 2009 the Ministry of Spatial Planning and Environmental Protection informed the Bank that the Government did not intend to establish a protected area. Given the fundamental importance of this component to the project, and the fact that the project had fully disbursed on the RWS component, the Bank chose to cancel the project in January 2010. MSTDP's investment in water infrastructure, which accounted for only 20% of the total cost of the RWS, were on track when the project closed, having supported construction of 60% of the RWS segment to Bar. However, some delays had occurred due to seasonal weather and technical design issues related to the underwater segment in Lake Skadar. Since the project closed in early 2010, the Government tapped other financing sources to complete the RWS, but data on improved household water connections, a key indicator of the CPS, are not yet available. 26. Government efforts to strengthen solid waste services in coastal areas were mixed. Though certain CPS milestones were achieved under MESTAP, progress was uneven and planned landfill investments were impeded by stakeholder disagreements and a funding shortfall linked to the economic crisis. Given concerns about pollution and weak solid waste services along the coast, the Government prioritized closing unsanitary disposal sites, increasing landfill capacity, and strengthening solid waste institutions and services. Legislation was also approved in 2008 requiring coastal cities to properly dispose of waste in sanitary landfills or face penalties. To support these goals, MESTAP funded the closure of two unsanitary disposal sites; financed new trucks, containers and waste equipment for Kotor, Tivat, and Budva; and successfully rehabilitated a waste disposal site into a regional sanitary landfill serving the these cities, which was operated by a regional waste management company established through the project. However, this landfill, which originally operated under a temporary license issued by the Municipality of Kotor, closed in 2008 after the Kotor declined to renew its license and use as a long-term landfill, apparently due to `not in my backyard (NIMBY)' concerns about its location. Plans are now in place to construct as second regional landfill for these cities at another location under a possible project financed by the EIB. The construction of a second regional landfill under MESTAP serving Bar and Ulcinj and the creation of a second landfill company were also delayed due to disagreements among stakeholders on the landfill's location, and later due to a shortfall in government co- financing linked to a fiscal deterioration under the crisis. Given these delays, MESTAP's IP rating dropped to unsatisfactory between June 2007 and March 2008 pending agreement on a suitable site, though its rating was upgraded to moderately unsatisfactory after all parties agreed on a site at Mozura. Further improvements in MESTAP's rating are contingent on procuring adequate funds to cover the approximately 4.5 million financing gap for the landfill's construction. Ongoing consultations with the Government and EIB, a key donor in the sector, have led to the development of an additional financing proposal to cover this gap. This proposal, which is expected to be submitted to the Executive Board in fall 2010, would restructure the project and direct funding solely on constructing the new Mozura landfill, while shifting to EIB the financing of outstanding activities relating to closure of two additional waste disposal sites originally under MESTAP. 45 Montenegro FY07-10 Country Partnership Strategy (CPS) 27. Despite MESTAP's complications, significant progress was achieved on the primary CPS outcome of strengthening solid waste services in coastal areas, though only modest progress can be attributed to the Bank. Over the project period, significant advances were achieved in increasing recycling and the frequency of waste collection. More specifically, the percent of solid waste in targeted coastal cities collected and disposed of in proper facilities increased from 0% in 2004 to 65% in 2010. Some of this increase can be attributed to MESTAP's financing trucks and equipment and the creation of a working regional model for waste collection, including the establishment of a functioning waste management company serving Kotor, Budva, and Tivat. However, most gains in proper collection and disposal are due to coastal cities inefficiently transporting their waste to a sanitary landfill in Podgorica to comply with the waste management legislation, and not, as intended, increased access to viable long-term regional landfills. This variance is particularly pronounced in Bar and Ulcinj, where MESTAP did not finance waste disposal equipment and where the planned regional waste management company is not yet in operation pending completion of the second regional landfill. 28. No significant progress was expected in the CPS on strengthening the environmental management of Lake Skadar, as the associated FY08 GEF program is just getting underway. However, work has begun on drafting a Lake Management Plan, the completion of which was a CPS milestone. In addition, a Lake Commission was established, contracting is underway to support a hydrological study, and working groups on fisheries, water management, and other subjects were established and are meeting regularly. The project has also hired an advisor on environmental issues and tendering is underway for studies on solid waste categorization for KAP, a major polluter in the area. This project is noteworthy for its effective involvement of Albania under a joint-Lake management plan, and is expected to make strong gains in the next CPS period. 29. IFC's engagement in tourism and environmental management was modest given the impact of the global crisis, which reduced the appetite of private investors for new investments. Nonetheless, IFC participated in a joint mini-diagnostic of the investment climate focusing on tourism. In addition, IFC's Balkan Hotel Market Access Program remains active and is contributing to opening Montenegro's lucrative travelers' market. Through the PEP-SE Infrastructure program, IFC is currently engaged with the municipalities of Berane, Rozaje, Plav and Andrijevica, which comprise about 80,000 inhabitants and generate about 35,000 tons of solid waste annually, to attract a private partner to invest 14 million in developing and operating a new regional landfill. The project is expected to significantly improve waste management services and improve the environment in project areas in later years. 30. The mixed progress in the MSTDP and MESTAP operations illuminate important lessons: Though the strategic goal of complex projects--such as the aim of MSTDP to promote "sustainable tourism development"--may reasonably entail linking relatively straightforward investments to politically sensitive or difficult outcomes, the Bank is advised to carefully assess the realism of such linkages and consider alternative designs to confirm government commitment. The underlying philosophy of MSTDP to facilitate integrated coastal management and sustainable development in coastal areas by linking water infrastructure investments to establishing a protected area on the Bojana Delta was reasonable given increasing shares of uncontrolled construction and the clear need to "incentivize" improved growth management. However, the Central Government's expressed commitment to establishing a protected area during project preparation proved untenable during execution owing to unexpected disagreements among local municipalities and stakeholders. In future similarly designed operations, the Bank should undertake a more comprehensive assessment of stakeholder interests in achieving potentially controversial outcomes, and consider mandating: 1) more tangible evidence of government commitment toward the politically more sensitive component before project approval; and/or 2) demonstration of substantial progress on the more controversial component before any 46 Montenegro FY07-10 Country Partnership Strategy (CPS) disbursements on the less controversial component. In some cases, it may also be wise to separate the more straightforward and politically charged investments into two separate projects, while conceding that this runs the risk of altering the nature of the program. More broadly, it is recommended that the Bank perform greater due diligence when operations involve multiple stakeholders and levels of government. Disagreements and conflicts among central government, municipalities, and stakeholders over project activities impaired achievement of outcomes in solid waste management and natural resource protection under MESTAP and MSTDP. The execution of both of these projects might have been improved had the Bank undertaken a more comprehensive evaluation of the views of the municipalities and stakeholders involved in project outcomes, particularly to identify perspectives that are different from those of the central government. By more clearly identifying the interests and balance of power among the stakeholders, such an assessment might also have led to more effective project leadership, possibly by identifying "champion" agencies that could have more strongly supported the projects' goals. Country Priority: Improve the efficiency and sustainability of the energy sector 31. CPS outcomes under this Priority included strengthening communication linkages with SEE utilities to better manage the regional energy trade, and improving the quality of energy supplies in two regions (Mojkovac and Andrijevica). The first outcome was linked to government efforts to integrate Montenegro into the SEE and EU electricity markets, which is expected to enhance the country's long-term energy security given Montenegro's high share of electricity imports. As part of this overall plan, authorities also supported investments in EPCG, Montenegro's energy utility, to improve its operational efficiency, including unbundling its assets to reduce its fiscal burden on the state. Increasing private sector participation in power generation was also identified as mechanism to ensure fiscally sustainable solutions to growing power needs. In the Mojkovac and Andrijevica regions, authorities aimed to reduce the frequency of power outages through investments in additional transmission infrastructure. 32. Significant progress was made on these outcomes, though data is not yet available on reduced power outages in these two regions. Under the FY08 Montenegro Energy Community of Southeast Europe (ECSEE) Adjustment Program Loan (APL) 3, optical ground wire communication lines enabling better management of the cross-border power trade were completed with Bosnia & Herzegovina, and contracts are underway for a line with Serbia. Completion of these lines was the sole CPS milestone linked to the improving communication linkages with the SEE utilities. As envisaged under the CPS, additional transmission line circuits were completed for the Mojkovac and Andrijevica substations, which are expected to reduce regional blackouts. However, data on power interruptions will not be available until late 2010. While not addressed in the CPS results framework, the ECSEE APL3 also improved the operational reliability of the Perucica Hydropower Plant by installing new trash rack designed to reduce power failures, which is expected to decrease energy production losses by 5% by 2011 (data on losses not yet available). In line with the government plan, authorities proceeded in March 2009 to unbundle EPCG into a new transmission company and an entity overseeing power generation and distribution. This unbundling led to a restructuring of the APL's activities in late 2009, which proceeded well, though dialogue with the PIU was required to ensure tracking of project components linked to the new transmission company. Overall, progress on this project has been in line with expectations. 33. An additional CPS outcome to improve energy efficiency in the public sector was not achieved, mainly due to delays in the associated Bank project, though planned energy-saving retrofits of targeted public buildings are being installed. Recognizing increasing demand for energy and concerns 47 Montenegro FY07-10 Country Partnership Strategy (CPS) about the impacts of energy generation on climate change, the Government prioritized promoting energy efficiency in the public sector by retrofitting public buildings with energy-saving materials and technologies. In support of this priority, the FY09 Montenegro Energy Efficiency Project (MEEP) aims to improve energy efficiency in select public schools and hospitals through energy-saving retrofits, with a view to providing a model for energy efficiency that can be replicated nationally. Under MEEP, detailed energy audits have been completed for several facilities, and retrofits of two schools are underway, which include improvements to windows, insulation, roofs, and other aspects of building envelopes. MEEP also entered a contract to retrofit a hospital, and by end-2010, it is expected to have completed retrofits of this facility and three schools. However, MEEP, like other projects in the portfolio, was delayed by the dissolution of the Technical Services Unit (TSU)--an agency set up in the Ministry of Finance (MOF) in 2005 to handle project fiduciary responsibilities given limited country capacity. Though the TSU initially provided efficient services to MEEP and other projects, a salary dispute in 2009 led to the resignation of staff for several months, leaving several projects without adequate support (see paragraph 61). In MEEP's case, the subsequent need to hire a procurement specialist and enhance capacity within the PIU slowed activities and required greater project supervision. MEEP was also delayed by the Government's failure to include the project in its FY09 budget, and the Bank's underestimation of the time to complete energy audits. On the positive side, the Project Coordinator for MEEP has been a strong leader, which has helped to mitigate problems and put the project back on track. 34. IFC complemented Bank support by promoting private sector participation in energy operations and power generation. IFC engaged in ongoing dialogue with authorities on assessing further options for privatizing the EPCG, including reviewing potential investors. Through the PEP-SE Infrastructure program, IFC is advising the Government on structuring a PPP transaction to finance construction and operation of a cascade of hydropower plants on the Moraca River. The associated investment, which could exceed 500 million for construction of four dams with an annual generation capacity of 721 GWh, would respond to Montenegro's growing energy needs while tapping into a renewable, low-carbon resource. IFC finalized the legal, financial and technical due diligence of this project and assisted the government in completing the prequalification process, which resulted in qualification of four renowned investors to submit project proposals. Following IFC's recommendations, authorities made preliminary structuring decisions in May 2010, and IFC is now preparing tender and contractual documentation. Submission of proposals from qualified investors is planned for spring 2011. 35. A few lessons can be derived from the Bank's engagement in the energy sector. Although the APL3 has progressed well, there was some concern about resettlement issues concerning site locations for the transmission line circuits. In retrospect, it may have been better to cite arrangements for siting such towers in the project agreement. On the positive side, the decision under MEEP to enter into individual contracts for retrofitting each institution was likely a good design feature, as lumping retrofits into on contract risks slowing all project activities in the event of one serious procurement issue (as has apparently been the case in other countries). In addition, it will be critical over the next CPS period to ensure that the staff in the TSU is committed to their positions, and that any additional project involving audits be mindful to allocate sufficient time to their completion. Pillar II. Build institutions and the rule of law Country Priority: Improved regulatory environment for businesses, including land registration and improve property rights 36. Broadly speaking, the CPS strove to improve Montenegro's business climate by diagnosing key challenges and strengthening land administration systems, with a view to fulfilling the sole CPS outcome: streamlined land registration and business permitting procedures. Montenegro's high pace of economic activity in 2007 and the resultant slowdown from the economic crisis focused attention on 48 Montenegro FY07-10 Country Partnership Strategy (CPS) barriers to doing business, particularly constraints in transacting property and fostering businesses growth. In response, the Government initiated steps to develop the real estate cadastre, strengthen spatial planning, and streamline permitting procedures. Authorities also prioritized enhancing access to finance among small and medium enterprises (SMEs), and upgrading business practices to international standards to ensure the country's growth and competitiveness. 37. The Bank's Doing Business TA program funded by FIAS provided strong insight into key business hurdles, satisfying a milestone of Bank assistance. The FIAS-funded program shed light on regulatory and policy hurdles to doing business, and subsequent dialogue and TA led to the development of a government reform strategy and the establishment of a Council on Eliminating Business Barriers. Based on these diagnostics, the Government has undertaken reforms in 2009 and 2010 to improve business start-up, trade logistics, and paying taxes. 38. Assistance under the ongoing FY09 Land Administration and Management Project (LAMP), which aims to improve property registration and permitting procedures, has made satisfactory progress on its key outputs and CPS milestones. As expected under the CPS, strategies were devised to develop an automated system for the real estate cadastre, and development and testing of such a system is underway. LAMP also supported the completion of urban spatial plans for two municipalities, and tendering is underway for urban plans focused on six northern municipalities. LAMP activities have significantly improved the efficiency of municipal cadastre offices in Podgorica, Budva, and Zabljak, as measured by a reduction in the percent of pending cases. In addition to these achievements, LAMP has supported the roll-out of an information system facilitating ministerial approval of local spatial plans, and implementation of an extensive training program for staff at the national and municipal level. 39. However, LAMP has not realized reportable progress on its key project outcomes, partly due to the impacts of the crisis and project delays. Reforms supported by LAMP were designed to increase real estate transactions, and the project adopted an increase in the real estate transfer tax as an associated proxy indicator. Though good progress was made on systemic reforms, real estate taxes fell about 50% in 2009 as property sales plummeted under the economic crisis. Further, Doing Business reports no change in the days (86) to register property between 2008 and 2010, and an increase in the days to issue construction permits. Even under optimal circumstances, LAMP might not have made much progress at this early stage on its key outcome indicators, and the Bank may have been overzealous in including reductions in the time to register property and issue construction permits in the CPS result matrix. However, it is noteworthy that the original approval date of the project slipped six months to December 2009 owing to protracted negotiations on the extent of safeguards for its land management components, particularly given enhanced scrutiny of safeguards linked to an Inspection Panel case of an Albania project involving demolitions. The implementation of certain project activities was also slowed by the inexperience of implementing agencies in executing Bank-financed projects, as well as the dissolution of the TSU, which required the project to engage specialized fiduciary consultants. Despite these hurdles, it is expected that good progress on the outputs detailed in the preceding paragraph will translate into strong gains in the next CPS period. 40. IFC provided complementary investment and advisory services to support competitiveness and business development through country-specific and regional programs. Between FY07 and FY10, IFC invested about US$30 million in two country projects: the development in Podgorica of a mixed-used shopping mall that introduced new retail standards, and an investment in a foreign bank to support programs promoting growth of SMEs. IFC invested US$190 million in regional projects supporting SMEs, commercial property development, and growth sectors. The largest Montenegrin portion of these regional investments was the micro-finance regional fund (EFSE), which now has 59.6 million exposed in five Montenegrin lending partners that are providing finance to commercial enterprises. IFC provided successful advisory services, including the International Standards and 49 Montenegro FY07-10 Country Partnership Strategy (CPS) Technical Regulations Program, which has trained more than 30 local consultants and 130 companies on implementing international regulations to increase commercial sales, exports, and investments. Under the Sub-national Competitiveness Project, IFC supported streamlined and transparent business regulations in Bar, Bijelo Polje and Niksi, which enabled businesses in these areas to save over 3 million annually. In addition, IFC worked with the Ministry of Justice to open a second Mediation Center in Podgorica focusing on commercial disputes. Under this program, judges were trained and 110 cases with legal claims totaling 4.5 million were successfully resolved. Country Priority: Strengthen and deepen the financial sector 41. Bank assistance over the CPS sought to address critical vulnerabilities in the financial sector, including structural weaknesses underlying unsustainable credit growth and weak banking regulation. Specific outcomes included reducing the economic risks of rapid credit growth by supporting implementation of recommendations identified in the Bank-IMF FY06 Financial Sector Adjustment Program (FSAP) report, and harmonizing financial sector legislation to EU standards. In addition, the Bank aimed to enhance government capacity to assess banking sector risks and propose remedial actions, and to update corporate and financial reporting requirements aligned with EU directives. 42. Amid increasing pressure for reform during the economic crisis, the Government made substantial progress on implementing FSAP recommendations and harmonizing financial legislation with the EU. The immediate impact of the crisis was contained through the prompt passage in late 2008 of a temporary Law on Measures for Protection of the Banking System. At the same time, the Central Bank strengthened regulations on bank provisioning, capital requirements, and risk weighting to slow the unsustainable pace of credit growth. In the past year, the authorities, with support of extensive TA from WB and IMF, have worked on a comprehensive review of financial sector legislation to align it with EU best practices. This work culminated in the passage, in mid-2010, of amendments to the Law on Banks and the Law on Bank Bankruptcy and Liquidation, and approval of a new Law on the Deposit Protection Fund, the Central Bank Law, and the Financial Stability Council Law. 43. With the support of the Financial Sector Reform and Strengthening (FIRST) Initiative, analytical activities, and TA under the proposed DPL series, Montenegro also made good progress on strengthening capacity to assess banking sector risks, as well as upgrading corporate and financial reporting standards. An FY09 Early Warning Toolkit grant funded by FIRST helped to develop and test new methodologies for on-site Bank examinations and stress-testing of credit risk models. The Bank subsequently advised the Central Bank on conducting in-depth on-site examinations and stress-testing systemic banks, which served as an analytical foundation for developing bank-specific supervisory action plans. Finally, the Bank was closely involved in assisting the Montenegrin authorities in designing the least-cost resolution strategies for problem banks. With respect to corporate and financial reporting, an FY07 Report on Observance of Standards and Codes (ROSC) analyzed Montenegro's financial and auditing standards and identified needed reforms to legislation. Complementing this diagnostic work, an FY10 grant from FIRST has supported the development and adoption of a Country Strategy and Action Plan to enhance the quality of corporate sector financial reporting to comply with EU standards. In addition, TA supported amendments to Montenegro's Law on Accounting and Auditing to ensure alignment with EU directives. 44. Bank-country collaboration in the financial sector was strong, and all milestones in the CPS results framework were eventually achieved. The Bank achieved important synergies by supporting complementary studies and TA and working closely with the IMF and donors. The diagnostic work under the FSAP and the ROSC generated constructive dialogue and recommendations on financial sector challenges, particularly related to EU accession, and underpinned TA and the reform program of proposed 50 Montenegro FY07-10 Country Partnership Strategy (CPS) DPL. However, it is worth noting that, as in many other countries in Southeast Europe, the crisis was a factor in securing support for necessary reforms which could have been delayed absent such pressure. Pillar III. Improving the Standard of Living for Citizens Country Priority: Enhance Opportunities for Rural and Regional Development 45. Bank interventions in this priority area were designed to upgrade rural development and agriculture practices in line with EU standards, improve institutional capacity to manage rural development assistance from the EU, and strengthen the capacity of extension services to introduce agro-environmental measures. As noted, agriculture is important for employment and poverty reduction in Montenegro, particularly as over half of the poorest fifth of the population lives in rural areas. However, the quality and productivity of agriculture has been undermined by limited capital, inadequate extension services, and underdeveloped standards in agriculture and food safety. In this context, Montenegro prioritized upgrading agriculture practices, particularly standards in food and environmental safety, to align practices to those of the EU and permit access to financial assistance under the Instrument for Pre-Accession for Rural Development (IPARD). Montenegro also sought to build capacity in agro- environmental extension to mainstream sustainable resource practices while tapping into eco-tourism opportunities, particularly in its pristine northern regions. 46. Assistance under the CPS was channeled through the FY09 Montenegro Institutional Development and Agriculture Strengthening (MIDAS) project. This project and an associated GEF program were designed to improve compliance with EU agricultural standards as well as capacity to implement assistance under the IPARD system and agro-environmental services. Both the IBRD and GEF operations became effective in July 2009 and have initiated activities that have made some progress toward the achievement of CPS milestones. With Bank support, Montenegro has completed its first Agricultural Census in 40 years, which will underpin further development of the national rural development program. Steps have been taken toward establishing an IPARD compatible payment agency, and accreditation and capacity building activities targeting food safety, veterinary, and phyto-sanitary agencies and laboratories are in progress. In addition, specialists are being hired to increase the capacity of extension and advisory services in agro-environmental issues. 47. However, outcomes are less than expected under the CPS due to project delays. MIDAS was the first Bank project under the Ministry of Agriculture, Forestry, and Water Management (MAFWM), and MAFWM was slow to hire a project manager. The dissolution of the TSU delayed procurement supporting some activities, such as the noted Agricultural Census, which was postponed from fall 2009 to spring 2010. As a result, many expected milestones in the CPS results matrix have not yet been fully accomplished, such as development of a Code of Good Agriculture Practices, the full establishment of the IPARD compatible payment unit, and trainings on agro-environmental issues within Montenegro's Extension Service. Procurement activities should accelerate now that new personnel occupy the TSU, but this project again highlights the importance of sufficient fiduciary support to ensure timely and effective project execution. Country Priority: Improve quality and efficiency of education services 48. The World Bank provided assistance before and during the CPS period to improve the quality of teaching and learning, renovate schools to improve academic environments, and strengthen the management and efficiency of education expenditure. The Government prioritized these objectives as educational approaches were outdated and below EU standards, and academic infrastructure was inadequate, with some of Montenegro's 600 plus schools in disrepair or operating in multiple shifts. These efforts were linked to the Government's comprehensive education reform begun in 51 Montenegro FY07-10 Country Partnership Strategy (CPS) 1999, which aimed to apply updated curriculums in primary and secondary education. In parallel, the Government sought to address deficiencies in sector planning and budgeting, which had led to significant arrears in education budget of 10% in 2005. Specific CPS outcomes sought to improve education quality in the government's "reform" schools and improve the use of budgetary resources in the education sector. 49. The FY05 Montenegro Education Reform Project (MERP), which closed in December 2009, provided successful and widely praised support to address these challenges. The project expanded the government's reform program to 50 additional schools, and supported professional development of teachers, renovations of 42 schools, and development and distribution of textbooks, particularly in minority languages. At the end of the project, 75% of teachers in supported schools were observed employing new skills and knowledge in the classroom, which, as a proxy indicator, represented the accomplishment of the first CPS outcome related to education quality. The share of textbooks arriving at the start of the academic year also increased from 17% in 2005 to 100% in 2009, and 98% of students were observed using project-supported textbooks in class. To lay the groundwork for more systematic assessment of education quality, MERP facilitated Montenegro's participation in the Programme for International Student Assessment (PISA), and development of a standardized exit exam for secondary school. In addition, MERP provided capacity building to the MOES and BES to improve their planning and budgeting in line with the Government's medium-term expenditure framework, which helped these institutions to provide on-time annual budgets to the MOF. MERP supported development of a plan to eliminate arrears, which was achieved in 2009, satisfying the CPS outcome on use of budgetary resources. Strengthened financial performance also led to an increase in non-salary current expenditure from 5.4% of the total state primary and secondary budget in 2005 to 15% in 2009. Given these successes, MERP received the Improving Lives of People in ECA Award. In particular, the Montenegrin model of teacher training is now considered "good practice" and a model for replication. 50. In addition, the Bank provided selected capacity building activities to support higher education. Swiss Trust funds supported TA on higher education financing (FY07), higher education quality assurance (FY08), and implementation of the Bologna European Credit Transfer and Accumulation System (ECTS) (FY08). The first activity included a high level workshop and the second and third hands-on workshops. All three activities led to reports that were well received by ministry and university officials, and that provide excellent bases for possible future assistance. 51. The Bank's engagement in the education sector offers lessons concerning program design, monitoring, and education assessment. MERP's success was partially driven by strong country ownership a good design that accounted for the needs of different demographics. For example, grouping the schools into "reform cohorts" allowed the project to tailor support to specific areas, such as small schools in mountainous regions. The establishment of a project steering committee (PSC) comprising stakeholders and donors provided a highly effective mechanism for strategic planning, donor coordination, and monitoring of sector performance. Recognizing the PSC's value, the Government continued the PSC after the MERP closed. Establishing a common understanding on M&E mechanisms and the use of monitoring data was crucial to project success, and M&E workshops for government and other actors should be considered for future projects early during project execution. Finally, international assessments such as the PISA can be important tools in countries without baseline data, as similar countries can be used as comparators. Country Priority: Improve quality efficiency and patient satisfaction of health services 52. World Bank assistance over the CPS aimed to improve the efficiency and quality of primary health care (PHC) services and to strengthen the management and financial performance of the national health insurance system. These goals were designed to address deficiencies in health care 52 Montenegro FY07-10 Country Partnership Strategy (CPS) coverage, particularly inadequate access to preventative care, weak and fragmented coordination of health services, and low patient satisfaction. In addition, the financial sustainability of the healthcare system was undermined by deficits in the national Health Insurance Fund (HIF), which were attributable to weak revenue collection, high expenditures relative to economic circumstances, notably on pharmaceuticals and an overly generous benefit package, and fragmented regulatory and monitoring systems that impeded effective management of the sector. 53. The FY04 Montenegro Health Systems Improvement Project (MHSIP) made substantial progress on its key objectives and CPS outcomes, though more efforts are now needed to expand primary health care services outside the Capitol city. The MHSIP, which strongly oriented its investments toward Podgorica, provided assistance to define a new primary care benefit package, train hundreds of healthcare personnel [in primary care], construct or renovate five health facilities, and introduce a more efficient model of care based on choosing a primary care doctor. As a result of MHSIP- supported reforms and other activities, PHC utilization rates in Podgorica rose from 11.4% in 2004 to nearly 35% in 2008, with solid gains among the marginalized Roma population. Consultation and waiting times for PHC services also fell dramatically, and patients expressing complete or partial satisfaction with PHC services rose from 82% in 2004 to 97% in 2008. In addition, MHSIP supported the development and adoption of bylaws and policies to improve pharmaceutical management, the delivery of care, and the operations of the HIF. To improve management of the sector, a new information system was developed sharing critical performance data between the HIF, healthcare providers, and the pharmaceutical supply chain, though the integration of this system with hospitals is pending. Owing to these and other activities, the HIF decreased the share of expenditures on pharmaceuticals from 19.2% in 2004 to 16.3% in 2008. More to the point, operating deficits within the HIF were eliminated in 2006 and 2007, and a surplus of a 10.9 million was achieved in 2008. In light of the project's successes, the Government requested in late 2009 additional financing of $7.1 million to, inter alia, expand PHC services outside Podgorica, and continue strengthening health sector institutions, particularly information systems and quality assurance programs. 54. A few lessons can be drawn from implementation of the MHSIP. As with other projects, some activities of MSHIP were delayed by the dissolution of the TSU, which again highlights the critical role of adequate fiduciary support to project execution. Difficulties coordinating aspects of the PHC reforms among myriad agencies suggest that identifying a single champion agency with adequate clout to promote project objectives is a wise tactic (whenever possible). In addition, MSHIP highlights the benefits of building flexibility into project design. During project execution, certain agencies within Podgorica expressed a higher degree of resistance to implementation of reforms. The project's reorientation, particularly in its proposed additional financing, toward supporting PHC services outside the capitol illustrates a flexible approach that has facilitated project success. Country Priority: Improve the fiscal sustainability of the pension system 55. The Government requested World Bank support over the CPS to improve the financial sustainability, effectiveness, and efficiency of Montenegro's pension system. Linked to the 2003 Pension and Disability Law, these priorities entailed building relevant capacity and operational linkages among the key institutions of the pension system, including the Directorate of Public Revenues (DPR), the Pension and Disability Fund (PIO), and the Ministry of Labor and Social Affairs (MOLSA). Given weak collection of pension revenue and fragmented management of data and benefits among pension agencies, the CPS aimed to strengthen pension administration and the collection of PIT and social contributions. Given inadequate capacity in actuarial analysis and projections, which risked undermining the efficiency of pension programs, the CPS sought to strengthen capacity in pension monitoring, analysis, and identification of reform options. Finally, the CPS prioritized establishing a "third pillar" 53 Montenegro FY07-10 Country Partnership Strategy (CPS) framework providing options for voluntary private pensions, with a view to broadening the scope of pension offerings to meet public demand. 56. Substantial advances in all these outcomes were achieved with the support of the FY04 Pension System Administration Investment Project (PSAIP). Capacity building provided by PSAIP helped to significantly improve pension administration, leading to a reduction in the days required to process pension registrations in the DPR from 5 days in 2004 to 3 in 2010. In line with expectations under the CPS, new IT equipment and software were introduced in the PIO and DPR to build an integrated contribution and collections system, and most software modules are operational in the PIO (however, some additional work remains to link the DPR's system to Montenegro's social funds, and to permit tracking of individual and not just aggregated pension data in new organizations). Most importantly, these and other reforms helped to improve the financial solvency of the pension system by increasing collections from 106 million in 2004 to 218 million in 2010. Assistance under PSAIP significantly increased capacity in pension design and analysis within MOLSA. PSAIP supported the development of an actuarial model for the pension system, and 13 staff members were trained in employing the model in pension analysis and forecasting. As expected, Montenegro approved a "third pillar" law supporting voluntary pensions and enacted 11 related bylaws, and PSAIP trained staff in the Securities Commission on supervising private pension funds. 57. However, a few lessons can be distilled from PSAIP concerning the importance of government ownership, fiduciary support, and skilful project leadership. The efforts to build a unified contribution and collection system were slowed by insufficient cooperation among the implementing agencies (DPR, MIO, MOLSA), particularly in linking the system to Montenegro's social funds. More broadly, these agencies' relatively separate operations and lack of previous experience working together rendered cooperation throughout the project more difficult than originally envisaged. Looking forward, careful assessment of the commitment of implementing agencies is indicated, particularly when multiple actors are involved in project outcomes. As in other projects, understaffing in the TSU slowed procurement of key purchases, such as IT equipment, and necessitated hiring separate procurement officers. On the positive side, PSAIP was headed by a strong and skilled project director (the current Minister of Finance). His able leadership and substantial clout partially mitigated delays and helped to accelerate data sharing among agencies and inter-agency cooperation. His role also highlights the importance of high-level leadership to project success when an operation involves multiple layers of government. Of note, PSAIP's closing date was extended from March 31 to September 30, 2010 to allow for the procurement of delayed IT equipment and the testing and functionality of the integrated contribution and collection system. D. Bank Performance Portfolio Assessment 58. With a few exceptions, lending over FY07-10 generally adhered to the original CPS plan. The CPS supported four ongoing lending operations from the previous CAS period, including the FY02 Emergency Stabilization of Electricity Supply Project (ESESP), which closed in FY07, and the MESTAP, MHSIP, PSAIP, and MERP. New investment loans in the energy, tourism, and agriculture sectors were approved as originally programmed (see Annex 3), along with a GEF program in FY08 supporting management of Lake Skadar. However, the LAMP, originally planned for FY08, was approved in FY09 as additional dialogue was needed on safeguards issues related to its land management components. Additional financing for MSTDP in FY08 was dropped due to uncertainties on the Government's commitment to protection on the Bojana Delta, as was the GEF Tara Lim operation, though parts of the former were subsumed into MIDAS. 54 Montenegro FY07-10 Country Partnership Strategy (CPS) 59. Key portfolio indicators were generally sound, though disbursements fell dramatically in FY10 due to an interruption in implementation support and the slow start-up of new projects, and overall performance was weakened by one problem project: MESTAP. The portfolio fluctuated from 5 lending projects totaling US$34 million in commitments in 2007 to 8 projects totaling US$80.5 million. The disbursement ratio in the first three years of the CPS was strong and well above the ECA average of 17.8%, peaking at 41% in FY09 due to strong disbursement in several projects before their closure. For example, MERP had a 40% disbursement ratio in FY09 and MSTDP a 90% ratio before its cancellation, mainly due to high disbursements on its regional water supply component. The disbursement ratio plummeted in FY10 to 11.8% owing to the dissolution and slow re-establishment of the TSU, the inexperience of new line ministry and PIU staff in processing Bank projects, and, to some extent, inadequate responsiveness from the Bank. In addition, MESTAP was classified as a problem project and an "at-risk" commitment throughout the CPS because of problems in finding politically acceptable sites for the landfill components. As the lending portfolio expanded, overall commitments at risk declined from about 20% in FY07 to 9% in FY10. Proactivity was 100% in FY07 and FY08, but dropped to 0% in FY09 and FY10 given continuing problems in resolving local political issues concerning location of the landfills. Average project supervision and preparation costs from FY07 to FY10 were below ECA averages. Table 1. Key Lending Portfolio Indicators FY07-10 2007 2008 2009 2010 No. of Projects 5 6 9 8 Net Commitment Amount $34m $43m $88.3m $80.5m Number of Problem Projects 1 1 1 1 Percent "At Risk" 20.6% 16.3% 7.8% 8.7% Percent "Proactivity" 100% 100% 0% 0% Commitments at-risk $7m $7m $7m $7m Disbursement ratio 21.5 18.5 41 11.8 Total Undisbursed at Start of FY $22.7m $26.8m $27.3m $61.2m Disbursed in FY $7.6m $7.9m $11.2m $6.1m Quality 60. The quality of most lending operations was generally high, though, as noted, the performance of a few operations deteriorated owing due to fiduciary hurdles and difficulties managing the interests of relevant stakeholders. Most lending interventions maintained satisfactory ratings in Implementation Progress (IP) and Development Objective (DO) throughout the CPS period, which reflected the timeliness and relevance of the Bank's interventions and the mostly effective operations of PIUs. However, ratings dropped below satisfactory in certain projects. The PSAIP's DO rating has fallen to moderately satisfactory due to delays in procuring IT equipment associated with the TSU's dissolution. MESTAP's IP and DO ratings have dropped to moderately unsatisfactory and moderately satisfactory, respectively, due to the complications on its landfill components mostly attributable to stakeholder disagreements. MSTDP faced significant performance problems and ultimately cancellation given the aforementioned halt in progress on establishing a protected area on the Bojana Delta amid diverging stakeholder interests. 61. As discussed in the section on CPS results, the dissolution of the TSU clearly impacted the implementation and performance of the portfolio; nonetheless, its continued operation is justified 55 Montenegro FY07-10 Country Partnership Strategy (CPS) given limitations in local fiduciary capacity. The MOF created the TSU in 2005 as cost-effective and pragmatic means of addressing inadequate fiduciary capacity and providing effective and centralized management of credit proceeds. Initially established for the MHSIP, the TSU was expected to help Montenegro grow a talented pool of fiduciary specialists who could be retained after the closure of Bank- financed projects, rather than hiring temporary, costly, and often foreign consultants to support individual projects. The TSU provided effective support to Bank projects through 2008. In February 2009, the MOF sought to renew the expiring contracts of the original three staff and add additional specialist(s) given a predicted increase in workload after the approval of new Bank projects. However, the original staff requested a near doubling of their original salaries, claiming that they could handle the increased work without necessarily expanding the unit. Viewing these demands as untenable, the MOF allowed the contracts of the original staff to expire and opted to open recruitment in April 2009 for all four positions, a process which took several months as qualified local candidates were in short supply, in turn impeding the processing of several Bank projects including MHSIP, MEEP, PSAIP, LAMP, and MIDAS. Even when fully operational, the TSU does have drawbacks, namely a degree of isolation from individual PIUs and risks that staff turnover and inadequate coordination might affect its services. However, given a clear shortage of appropriately skilled staff in line ministries and the need to ensure effective project management, the continued operation of the TSU is warranted, though close oversight from the Bank and the MOF is indicated. 62. To some degree, project implementation delays can also be attributed to counterparts' inexperience in implementing Bank projects and select instances of inadequate responsiveness from the Bank. LAMP, MIDAS, and MEEP--all of which were approved in FY09--are being implemented by Ministries and PIU staff with limited or no experience with Bank projects. Lack of experience and familiarity with Bank procedures has at times led to unexpected delays in the delivery of documents from government agencies, and instances where the Bank needed to request more information to ensure documents align to Bank standards. The responsiveness of the Bank to client requests and project supervision across the portfolio have also at times fallen short. In some cases, aide-memoires (AM) for supervision missions have not been completed, or were delayed past associated "action plan" deadlines. Further, Implementation Status Reports (ISRs) have not always been completed on time, and the Bank has sometimes taken too long to acknowledge client requests. Supervision from the Bank has improved under new AM and ISR policies, but, taken together, these factors have partly contributed to slow implementation and disbursement and reveal areas for continued improvement over the next CPS period. 63. No formal QAG reviews were undertaken of Montenegro projects, but two project implementation status reports (ISRs) were subject to a review by ECA Quality, and IEG reviewed the Implementation Completion Report (ICR) of the FY03 Emergency Stabilization of Electricity Supply Project (ESESP). According to ECA Quality's review in December 2009, the ISRs for the ECSEE APL3 and MERP scored generally average on overall quality: 2.8 and 2.4, respectively, on a 5 point scale. However, areas for improvement included better defining project indicators and ensuring links to PDOs, and enhancing the realism in project ratings. The FY03 ESESP, which focused on strengthening the financial management of the EPCG and improving power distribution by, inter alia, installing automatic electric meters, closed in June 2007 a month after the publication of the CPS. IEG's ratings of ESESP were the same as those in ICR. IEG remarked that the ICR was clear and contained all the needed elements to evaluate the project. Recommendations for improvement concerned minutiae, such as more clearly labeling the costs of the project components in the ICR. 64. The quality and design of the Bank's knowledge products were strong. The Bank supported a strong package of demand-driven ESW and TA programs, particularly to diagnose and respond to fiscal and economic challenges before and after the crisis, build capacity in poverty measurement and in banking supervision, and analyze the potential for transport and energy investments using public-private partnerships. No formal quality reviews were undertaken of these products, but interviews with Bank 56 Montenegro FY07-10 Country Partnership Strategy (CPS) teams suggest that the products were useful to government authorities and used to shape policies. Evidence of the quality of Bank interventions included government requests for follow-up TA after delivery of ESW, notably for the FY08 PEIR and FY09 PEFA. However, changing government priorities before and after the crisis led to a few products planned in the CPS and CPSPR being dropped, including an FY10 Country Economic Memorandum, as well as the addition of new products in the business environment and financial sector. 65. Though small, the CPS's trust fund portfolio provided valuable assistance to complement lending and grant-financed operations, mainly to support outcomes in agriculture, finance, infrastructure, and education. Total commitments of Recipient-executed TFs over FY07-10 reached US$8.1 million, dominated by a US$4 million GEF operation supporting agro-environmental activities under MIDAS. Bank-executed TF commitments reached US$1.5, and included the two FIRST initiatives supporting corporate financial reporting and risk assessment in the banking sector, and operations funded by the Public Private Infrastructure Advisory Facility (PPIAF) analyzing opportunities for public-private partnerships in the transport sector. Small grants from Canada and Switzerland supported, respectively, [analysis of the health sector], and dialogue on higher education financing and quality assurance. Amid changing government priorities, some expected TF programs, such as a planned GEF program supporting the Tara and Lim river basin watershed, were cancelled. Disbursements of TF activities were [add trend]. In general, the use of TFs enabled the CPS to harness additional resources and targeted expertise in key areas beyond those available through traditional channels, and continued selective use of TFs is indicated for the next CPS. Country Dialogue and Aid Coordination 66. The Bank opened a country office in June 2007 and worked with Montenegro during its post- independence state-building phase. The Bank confronted a number of challenges related to portfolio implementation, including: (i) insufficient ownership for projects inherited from the state union of Serbia and Montenegro; (ii) the lack of established lines of communication between the Central Government and municipalities, initially worsened by the implementation of the Law on Local Self-Government; and (iii) administrative constraints and a lack of knowledge and experience in collaborating with Bank teams. The successful establishment of close, day-to-day contacts with key counterparts in the Finance and line ministries and intensive dialogue on operational issues--such in the Montenegro Environmentally Sensitive Tourist Areas Project--significantly allayed these constraints while laying the groundwork for possibly scaling up support. The client perceives the Bank as competent (albeit cumbersome and complicated) counterpart, which is sought for guidance and advice in difficult situations. Despite its resource constraints, the Country Office succeeded in establishing a field presence capable of placing project support into a broader perspective, contributing to the increased ownership of the current project portfolio. 67. The coordination between the Government and the donor community--or among donors-- has been sporadic (except possibly on SAA and defense-related challenges, which are both outside the direct Bank mandate). The Government has not taken the initiative to organize regular donor meetings on political levels. Most bilateral and multilateral representations have focused on establishing their own presence, and not pushed the donor coordination agenda. However, donor coordination on a project level has worked well and proven effective, such as in the MIDAS project. Bilateral coordination among donors largely hinges on personal relations between the heads of offices. 57 Montenegro FY07-10 Country Partnership Strategy (CPS) D. Lessons Learned 68. The FY07­10 CPS Completion Report identified a number of lessons related to the overall strategy, project implementation, and Bank and borrower performance that are helping to guide the new CPS program. Key lessons are noted below: The CPS's provision of selective, mutually reinforcing interventions supporting Montenegro's own goals produced solid results, while maximizing the impact of the Bank's scarce resources. The portfolio's knowledge products, technical assistance, lending programs, and regional grant programs leveraged synergies among World Bank Group institutions (i.e, IBRD and IFC), donors, and domestic stakeholders. Analytical products such as the FY07 FSAP and ROSC and FY08 PEIR were particularly valuable in diagnosing challenges and developing follow-up TA as well as the proposed development policy lending for FY11 and FY12. The Bank's suite of ESW and analytical reports covering economic and fiscal matters were critically important in identifying needed reforms in a newly-independent country, and the acquired knowledge helped to identify key areas for follow-up work. The analysis in the FY07 ROSC, FY09 PEIR, and FY09 PEFA helped to illuminate key challenges and policy recommendations, which led to deeper engagement with the Bank on public expenditure management and a Government request for follow-up technical assistance. The increase in the number of (relatively small) projects in the Bank's portfolio by the end of the last CPS period may have strained Montenegro's scarce implementation capacity as well as limited the Bank's ability to maintain a robust country-specific AAA program given the need to allocate scarce resources to project supervision. Going forward, the Bank should seek to consolidate the portfolio focusing on fewer, larger lending interventions. A robust program of AAA will also be essential to help build capacity and provide specialized analytical support in key areas. Leveraging regional experiences and programs is important, particularly in a small country with limited Bank engagement. To some extent, the Bank's success in Montenegro was facilitated by framing country needs within a regional context, and by leveraging solutions and products that had been tested and proven successful in neighboring countries. For example, the Land Administration, Energy Efficiency and Agriculture Institutions projects were all modeled on successful IBRD operations in neighboring countries. Similarly, the Government's decision to retain IFC as an advisor on the Bar-Boljare motorway and the Moraca Hydropower project was partly motivated by IFC's success in the energy sector in Albania. The Bank and IFC should continue to leverage regional programs and experiences whenever possible. Careful assessment and monitoring of the interests of government agencies and local stakeholders are critical during project preparation and implementation, particularly when operations involve different levels of government. Complications in MSTDP and MESTAP were partly driven by the Bank's underassessment of diverging views on project goals among municipalities, stakeholders, and central government. Close monitoring of interests and open communications between the Bank and stakeholders at all levels of government are crucial to avert project implementation issues downstream. Though the continued use of the Technical Services Unit (TSU)--a central unit providing financial management and procurement services to most Bank-financed operations -- is perhaps unavoidable given the extreme shortage of these implementation skills in Montenegro, improved oversight of its operations is needed to avoid project delays. The use of a central TSU entails some 58 Montenegro FY07-10 Country Partnership Strategy (CPS) risks deriving from the TSU's isolation from line ministries and PIUs, the difficulties of prioritizing among competing demands from "client" projects, and the risk of paralysis across several projects in the event of a major staff turnover as occurred in mid-2009. To mitigate these issues, the government and the Bank are trying to improve the stability and operations of the TSU through introducing periodic workload and staffing assessments, and improving communications between the TSU and project beneficiaries. 69. Though Montenegro became an IFC member only in 2006, a few preliminary conclusions and lessons can be drawn from its engagement: Though IFC's overall engagement was strong, the global economic crisis and to some degree a lack of diversified instruments reduced involvement in the tourism sector. IFC achieved significant results in Montenegro, particularly in promoting retail commerce, building awareness of international business standards, and attracting private sector capital in infrastructure. However, proposed investments in sustainable tourism failed to materialize due to lowered interest from foreign investors during the economic crisis, and IFC's lack of tailored and regional products supporting tourism. As in many small countries, IFC's success in Montenegro was facilitated by framing country needs in a regional context and leveraging solutions and products that had been tested and proven successful in neighboring countries. For example, the Government's decision to retain IFC as an advisor on the Bar-Boljare motorway and the Moraca Hydropower project was partly motivated by IFC's success in the energy sector in Albania. In addition, IFC tapped into a regional approach for investments, such as supporting a regional microfinance fund that promoted small business growth in the country. 59 Montenegro FY07-10 Country Partnership Strategy (CPS) ATTACHMENT TABLES Annex 1: Status: Base and High Case Lending Indicators Annex 2: CAS Results Summary Annex 3: Planned Lending Program and Actual Deliveries Annex 4: Planned Grant and AAA Programs and Actual Deliveries 60 Montenegro FY07-10 Country Partnership Strategy (CPS) Annex 1: Final Status: Base and High Case Lending Indicators Base Case Lending Indicators Status High Case Lending Indicators Status Continued satisfactory macroeconomic Improvement in overall performance creditworthiness, as indicated by, inter - Continued moderate public debt to Achieved alia: Almost GDP - Measures to reduce public debt to Achieved ratio. Achieved 30% of GDP by 2012 remaining on Not Ach. - Contain inflation to EU average Achieved track. Achieved range. - Continued fiscal surpluses. - Maintain prudent fiscal policies. Achieved - Strengthened fiscal oversight of SOEs and municipalities with major SOEs Continued implementation of FSAP obliged to carryout audits of their 2006 recommendations balance sheets by internationally Achieved reputable auditors and local Achieved Continued energy sector reform governments required to produce - The unbundling of EPCG completed Achieved consolidated 2006 balance sheets. Not Ach. in line with ECSEE Treaty - Satisfactory resolution of restitution requirements Achieved debt. Not Ach. - Continued implementation of phased - Improvements in overall BOP tariff Achieved performance, with the CAD moving to increases for KAP, as agreed in SAC 2. Achieved more sustainable levels and remaining Achieved - A restructuring and privatization fully funded by FDI. plan for - External debt indicators continue to the energy sector agreed. improve. - Further improvements in collections. - Social program to offset tariff Achieved Continued satisfactory portfolio Achieved increases for performance low-income households agreed. - No more than 1 unsatisfactory Underway Achieved operation. Pension system continues to be put on more sustainable footing Implementation of a robust and - Overall pension expenditures as a Achieved efficient framework for handling share of GDP continue to decline from private provision of infrastructure baseline of 10.4%. through PPPs/concessions - Increase in collections of pension - Adoption of revised PPP legislation contributions and introduction of Partly in accordance with international best integrated collection scheme. Achieved practice. - Voluntary "Third pillar" scheme - Completion of independent feasibility introduced in 2007 to supplement studies for major highway corridors. retirement savings. Continued strengthening of environmental and tourism planning 61 Montenegro FY07-10 Country Partnership Strategy (CPS) Annex 2: CPS Results Summary Longer-term Strategic Goals Strategic Goal Status at CAS Design Status at Completion Lessons Learned Continue path to Montenegro signed a Stabilization and EU Accession Agenda on track and The Bank's analytical work helped EU Integration Association Agreement with the EU in 2007; benchmarks achieved. Montenegro submitted the government to diagnose and interim agreements on trade and visa an application for EU membership in respond to challenges. Lending facilitation became effective in early 2008. December 2008 and completed an EU projects, such as MIDAS, are questionnaire in late 2009, as well as an helping to boost standards in line additional set of questions in early 2010. The with EU requirements. Bank support questionnaire's score confirmed good progress on governance may be warranted in on EU benchmarks, though governance, crime, the next CPS. and corruption remain key concerns. Enhance In 2007, GDP growth reached 10.7% and the The economic crisis and weak external The extent of the crisis and its sustainable government achieved a fiscal surplus of 5%. demand led to a 6.6% contraction of GDP and contagion on Montenegro was economic growth Strong credit growth, high investment, and a fiscal deficit in 2008 and 2009. Credit faces unexpected and uncertain. In a substantial activity in the tourism and real negative growth and banks are vulnerable from deteriorated fiscal climate, DPL estate sectors drove robust economic activity. weak assets and declining liquidity. Negative support may be warranted to help growth is expected in2010 followed by around reestablish growth and fiscal health. 5% growth through 2012. Doing Business ranked Montenegro 81st of Montenegro's ease of doing business ranking The Bank's engagement under the Build institutions 178 countries in the ease of doing business in improved ten places to 71st. The Government FSAP and knowledge activities and the rule of 2008. The Government identified policy significantly strengthened regulation and provided targeted and highly useful law, including priorities and reforms to strengthen the supervision of the financial sector, including support to diagnose and respond to strengthening the financial sector with support of the joint amending the Law on Banks and approving deficiencies in the business climate business climate Bank/IMF FY06 Financial Sector laws to strengthen the Central Bank, protect and financial sector. and the financial Adjustment Program (FSAP). deposits, and resolve troubled financial sector institutions. The economic crisis is expected to Improved Montenegro's poverty rate was 14.5% in The most recent available data indicate that have a negative impact on poverty standards of living 2006. Unemployment reached 14.5% in July poverty fell to 8% in 2007 and unemployment and employment, though for citizens 2008. to 13.2% in July 2009. However, contraction Montenegro's ongoing steps to of GDP under the economic crisis is expected improve education, health, and to lead to an uptick in the poverty rate, social services are expected to possibly to between 9.5-13.9%. improve competitiveness over the medium-term. 62 Montenegro FY07-10 Country Partnership Strategy (CPS) CPS Outcomes CAS Outcomes Status at CAS Design Status at Completion Lessons Learned Pillar 1. Enhance Sustainable Economic Growth Strengthened Montenegro had limited capacity to address Government capacity in fiscal and economic The Bank's analytical assistance was government fiscal and macroeconomic challenges given affairs was strengthened; the Bank enhanced particularly valuable to a new capacity to address its recent independence. capacity by completing a PEIR and CEM and country environment and to macroeconomic presenting recommendations on growth and catalyzing other engagement. and fiscal fiscal reforms to government. challenges Montenegro's capacity in poverty The Statistical Office of Montenegro The Bank's approach of combining Improved measurement and social assistance (MONSAT) enhanced its use of HBS data and targeted trainings on poverty coordination and evaluation was weak and fragmented across developed HBS-based poverty profiles for measurement with appropriate capacity in poverty multiple organizations. 2005 and 2006. MONSAT's coordination with documentation was successful. analysis and the MOF and Ministry of Labor was Montenegro now needs to develop a measurement strengthened. A regional study was undertaken national poverty line and upgrade of social safety nets in Western Balkan the quality of HBS data. countries, including Montenegro. Strategies Montenegro faced structural inefficiencies in Assessments undertaken of PFM and fiduciary developed to PFM related to financial controls, budget controls, and recommendations developed and improve public planning, and public procurement, but shared with authorities. financial authorities had an unclear path for reform. management and fiduciary controls Analytical and advisory assistance Montenegro had high investments needs in The legal and institutional framework for PPPs from PPIAF and IFC enhanced Strengthened the transport and infrastructure sectors, but in infrastructure was upgraded, including Montenegro's capability to structure institutional fiscal space was tight and the legal and adoption of a new Concessions Law. PPPs and public concessions. IFC framework for institutional framework for PPPs and Independent feasibility studies were completed will continue work in these areas in managing transport concessions was underdeveloped. for major transport corridors that considered the next CPS. and infrastructure PPPs. Use of PPPs was increased, such as for services the Bar-Boljare motorway and energy generation. Montenegro had high accident rates on Improved highways and standards for road safety were Management capacity to improve road safety understanding and inadequate. was enhanced by developing an analytical capacity to improve study and sector recommendations; two pilot road safety mngt. demonstration projects in road safety were The unexpected closure of the first 63 Montenegro FY07-10 Country Partnership Strategy (CPS) Strengthened solid Coastal areas had deficient solid waste implemented. landfill and slow progress on the the waste and water services. Some waste from Kotor, Budva, Two unsanitary landfills were closed and a second landfill serving Bar and services in coastal Tivat, Bar, and Ulcinj was being improperly new sanitary landfill and waste management Ulcinj were largely due to municipal areas disposed, sometimes at unsanitary dumping company were established serving Kotor, conflicts on site locations, which sites. Budva, and Tivat (though this landfill was highlight the need to consider closed after a short period of operations after country ownership and political Kotor failed to license its use as a long-term factors in project design and landfill). The construction of a second sanitary execution. Most of the gain in waste landfill serving Bar and Ulcinj is expected in disposal was due to new legislation the next CPS period. The percent of solid requiring cities to dispose of waste waste in targeted coastal cities disposed of in sanitarily, and cities transporting proper facilities increased from 0% in 2004 to waste to landfills in Podgorica. 65% in 2010. Good progress on the RWS, though Water connections in coastal areas were its construction was modestly insufficient to support growth and 60% of a new regional water supply (RWS) delayed by seasonal weather and development of tourism; certain targeted scheme was completed serving coastal technical issues with underwater coastal areas had only 12-hour water municipalities, and several thousand sections in Lake Skadar. services. households were connected to piped water and improved water sources. Upon completion, the RWS is expected to provide 24 hour water supply service. Protected area When dealing with project outcomes status established that are politically controversial for the Bojana Pressures from growth, tourism, and and/or subject to multiple Delta development on the Bojana Delta threatened Background study completed on protection of stakeholders, it is critical that the environmental and natural resources, the Bojana Delta. Diverging viewpoints among Bank accurately assess the degree of emphasizing the need for improved municipalities, stakeholders and government realism in achieving outcomes, and management and protection. on the extent of environmental protection consider mandating evidence of stalled progress on establishing a protected commitment beyond simple area. declarations or inclusion in the project agreements. In MSTDP's case, the government agreed to protection of the Bojana Delta at the outset of the operation, but the on- the-ground reality proved untenable to realizing this outcome. Strengthened The ECSEE APL3 progressed well, 64 Montenegro FY07-10 Country Partnership Strategy (CPS) communication though there was some concern linkages between Communication linkages between about resettlement issues at sites for EPCG and SEE Montenegro's energy utility (EPCG) and Communication linkages were significantly transmission line circuits. In utilities regional utilities were inadequate to manage enhanced; optical groundwire connections retrospect, citing arrangements for power loads and cross-border trade of were established with power utilities in Bosnia siting in the project agreement may Improved quality of energy. (connections pending with Serbia). have smoothed project electricity supply in implementation. Mojkovac and Andreijevica Residents and businesses in the Mojkovac Construction of additional transmission line and Andreijevica regions experienced circuits for the Mojkovac and Andreijevica Improved energy frequent power cuts and disruptions owing to substations completed (data on reduced power efficiency in the weak capacity in electricity transmission. disruptions expected in late 2010). MEEP's use of individual contracts public sector for retrofitting was a good design Public sector facilities had inefficient energy Detailed energy audits completed for several feature, as lumping all retrofits into a use and failed to harness energy-saving public facilities and retrofitting of two schools single contract risks slowing project retrofits that could reduce consumption. underway; 5-6 public facilities expected to be activities if a serious procurement retrofitted by end-2010. issue arises. Pillar 2. Build Institutions and the Rule of Law Streamlined land In 2008, 86 days were needed to register In 2010, 86 days needed to register property LAMP was postponed until FY09 registration and property and 6 months to issue construction (no change) and 230 days needed to issue a and has not yet made significant business licensing permits. Ease of doing business ranking was construction permit (deterioration). Ease of gains. Outcomes related to 81 of 178 countries according to the Doing doing business ranking was 71 of 183 construction permitting and real Business reports. countries. estate registration are expected in the next CPS period. Reduced economic risks associated Credit grew explosively in 2006 and 2007 by Economic crisis of 2008/09 magnified The crisis underlined with urgency with rapid credit 139% and 176%, respectively, underpinned imbalances and credit contracted by 15% by of rapid adoption of measures to growth by substantial foreign borrowings. FSAP December 2009 (y-y). In line with the FSAP strengthen the banking sector amid identified risks associated with credit growth and to respond to the crisis, the government increasing shares of non-performing and proposed reforms to mitigate proposed and approved reforms on bank loans, liquidity problems, banking imbalances. Public holdings in the financial provisioning and capital requirements, and losses, and drops in deposits. sector risked inefficiencies and conflicts of improved banking supervision and oversight interest. from the Central Bank. The government also divested public holdings in the financial sector. 65 Montenegro FY07-10 Country Partnership Strategy (CPS) Enhanced capacity Montenegro has significantly greater capacity ESW and trust-funded programs to assess banking Montenegro suffered from limited capacity to assess systemic risks in the banking sector; provided instrumental and sector risks and within the Central Bank to assess risks and Bank credit risk model was developed and complementary support. The Bank propose remedial develop responses. tested on selected banks. and the IMF's joint work on the actions FY07 FSAP helped to identify areas Financial sector regulations were upgraded, for reform in the financial sector, Financial sector Regulations in the financial sector lacked including adopting laws on protection of the including follow-up Bank TA. The legislation harmonization with EU standards. Banking System and amending the Law on FY07 ROSC diagnosed critical harmonized with Accounting and Auditing to align with EU challenges in financial and auditing EU standards directives. standards and led to a FIRST- supported program to develop the An Action Plan to enhance the quality of noted action plan on corporate Corporate auditing The quality of corporate auditing and corporate financial sector reporting has been financial reporting. FIRST also and financial financial reporting practices was weak. developed and the government is supported a successful grant to build reporting implementing reforms. capacity in risk assessment in the requirements banking sector. This body of work updated. has led to a proposed new DPL program for the next CPS period. Pillar 3. Improve the Standard of Living for Citizen, Improved Agricultural standards and practices lacked Government developed and adopted a code of The FY09 MIDAS/GEF project is in compliance with harmonization with EU standards. good practices and has taken initial steps to its early stages and most outcomes EU standards for upgrade food and phytos-sanitary standards, related to rural development are agriculture and such as accrediting veterinary labs. expected in the next CPS period. rural development Montenegro capacity to manage EU Preparatory work to establish an IPARD Improved capacity assistance in the rural sector was limited, compatible Rural Development Unit to harness particularly under the EU's IPARD underway. development mechanism. assistance under the IPARD system Montenegro lacked a diversified agricultural Efforts to increase support for agro- Improved capacity base, with particularly shortages of skills in environmental measures underway; of extension agro-forestry and agro-environment consultants being hired to implement agro- services to activities, which could help protect environmental trainings in Montenegro's introduce agro- environmental sustainability and encourage Extension Service and Rural Development 66 Montenegro FY07-10 Country Partnership Strategy (CPS) environment eco-tourism. Unit. measures Improved Teaching and instruction methods were Percentage of teachers in reform schools Engagement under MERP was education quality outdated, and inadequate infrastructure and observed using new skills in classroom buoyed by strong country ownership in reform schools classroom materials impeded learning. 17% reached 75% in 2009, surpassing the 70% EOP and a design that grouped schools of textbooks arrived at the start of the value. Infrastructure in 42 reform schools was into "reform cohorts" that tailored academic year. upgraded. 100% of textbooks arrived at the support to specific areas, such as start of the academic year in 2009. mountainous regions. MERP's project steering committee was an Improved use of effective mechanism for strategic budgetary Weak planning in the MOES and BES and Capacity building was provided to MOES and planning, donor coordination, and resources in the high expenditures and arrears in the primary BES to improve planning and budgeting in line monitoring. Establishing a common education sector and secondary education budget reduced the with the government's MTEF. Arrears in the understanding on M&E was crucial efficiency of resource use and threatened the education sector were eliminated by 2009. to project success. MERP received system's financial sustainability. Non-salary current expenditure within the total the Improving Lives of People in state primary and secondary budget rose from ECA Award, and its model of 5.4% in 2005 to 15% in 2009. teacher training is "good practice." Strengthened Coverage and use of PHC services was New PHC benefit package was defined and a The FY04 MSHIP made good gains, efficiency and limited and quality of care was inadequate. system introduced allowing patients to choose but project execution was slowed by quality of primary In 2004, the primary health care (PHC) a PHC doctor. In 2008, PHC utilization rates in the dissolution of the TSU. The health care utilization rate in Podgorica was 11.4%. 57% Podgorica rose to nearly 35%, with good gains reorientation of MSHIP to areas services of patients in Podgorica expressed waiting among the Roma. Consultation and waiting outside Podgorica, particularly under times for PHC of 21 or more minutes. Only times for PHC services fell dramatically, with its proposed additional financing, 82% of patients in Podgorica expressed only 34% of patients claiming wait times of 21 was a flexible project design feature complete or partial satisfaction with PHC or more minutes. 97% of patients expressed that allowed it to contend with less services. complete or partial satisfaction with PHC responsiveness to reforms among services 80% of targeted populations in Podgorica-based agencies. Podgorica now have a chosen primary care Sustainability of the national health care doctor. Strengthened system was threatened by rising HIF's operating deficits were eliminated in management and pharmaceutical costs and weak regulatory, 2006 and 2007, and the share of HIF's financial management, and monitoring tools. In 2004, expenditures on pharmaceuticals fell to 16.3% performance of the the HIF ran an operating deficit, and in 2008. national insurance allocated a high 19.2% of its expenditures on system pharmaceuticals. 67 Montenegro FY07-10 Country Partnership Strategy (CPS) Strengthened Financial sustainability of the pension A unified collection system was developed and Dissolution of the TSU slowed pension system was undermined by administrative linked to key agencies, such as the Directorate execution of the PSAIP and administration and deficiencies, limited inter-agency of Public Revenues (DPR) and the Pension and procurement of IT equipment in collection of PIT cooperation, and weak collection and Disability Fund (PIO). The system is partially 2009. Lack of active cooperation and social compliance. Pension revenue from operational, though some IT equipment among the key implementing contributions contributions reached only 106 million in remains to be purchased for the DPR. The days agencies (DPR, PIO, MOLSA) in 2004. to process pension registrations in the DPR fell linking the unified collection system, from 5 in 2004 to 3 in 2010. Improved pension particularly to social funds slowed administration helped to boost pension progress, though a strong project contribution revenue to 218 million in 2010. director helped to keep momentum, mainly by monitoring milestones to A new actuarial model for pension system was achieve before a proposed extension developed; 13 staff members were trained in of the project closing date. This Strengthened The capacity of staff within the Ministry of forecasting and pension analysis in the project worked with numerous capacity in pension Labor and Social Affairs (MOLSA) was Ministry of Labor and Social Affairs. agencies that lacked familiarity with policy monitoring, limited in monitoring and analyzing pension Bank procedures, and underlined the analysis, and policies, and identifying needed reforms. importance of striving to identify identification of lead agencies with strong reform options commitment and authority. Third pillar law enacted establishing voluntary pension funds. Staff trained in the Securities Third pillar Limited options for harnessing private Commission on supervision of pensions and framework savings for retirement left un-served a voluntary regimes. established segment of the pension market. providing options for voluntary pensions. 68 Montenegro FY07-10 Country Partnership Strategy (CPS) Annex 3: Planned Lending Program and Actual Deliveries Planned at CPS (May 15, 2007) Actual at CPS Completion Report (2010) US$ Millions US$ Millions FY Project IDA IBRD TF Project IDA IBRD TF FY07 ECSEE APL 3 9.0 Actual 9.0 MSDTP 10.0 Actual 10.0 Total 19.0 Total 19.0 FY08 MSTDP Add. Financing 5.0 Moved to FY11 (new CPS) Land Administration 10.0 Moved to FY09 GEF Lake Skadar 2.6 Actual 2.6 Total 15.0 2.6 Total 2.6 FY09 MEEP 10.0 Actual 9.4 MIDAS (Rural Devt.) 15.0 Actual 15.7 4.0 GEF Tara Lim 5.0 Dropped Additional Actual Project: a. Land Administration 16.2 Total 25.0 5.0 41.3 4.0 Total FY10 Improved Social Services 10.0 Dropped Transport Infrastructure 20.0 Dropped (High Case) Additional Actual Projects: a. Health Systems--Add. Financing 7.1 [85.0] b. [Programmatic Financial and Private Sector DPL] Total 30.0 [92.1] Total TOTALS 19.0 70.0 7.6 19.0 [133.4] 6.6 69 Montenegro FY07-10 Country Partnership Strategy (CPS) Annex 4: Planned Grant and AAA Services and Actual Deliveries CPS Plans CPS Progress Report (May 15, 2007) (March 20, 2009) Product Status FY07 Public Expenditure Review [Dropped] Additional Actual Products: Debt Sustainability Analysis ROSC Poverty Update FSAP FY08 Programmatic PEIR Actual Policy Notes: Labor Market [Dropped] PPIAF: Highways [Actual] Programmatic Fiduciary [Dropped] Programmatic Poverty/Poverty Update Actual Additional Actual Products: Business Environment TA (FIAS) Quality Assurance/ETCS (Swiss TF) SBA Policy Engagement FY09 Country Economic Memorandum [Dropped] Programmatic Poverty Actual Programmatic Fiduciary [Dropped] Additional Actual Products: Public Expenditure and Institutional Review Public Expenditure and Financial Accountability Assessment CPS Progress Report Plans CPS Completion Report (March 20, 2009) (2010) Residual Early Warning Toolkit for Assessing Forwarded to FY10 FY09 Bank Risk Profiles (FIRST) Health System (CIDA) Actual Central Bank Controls (IDF) [Dropped] Additional Actual Products: Road Safety Management Review (GRSF) FY10 Country Economic Memorandum Dropped Programmatic Poverty Assessment [Dropped] Economic Policy Notes [Dropped] PPP Options in Electricity Generation Actual Road Safety Management Review Moved to FY09 (GRSF) ROSC Action Plan Actual 70 Montenegro FY07-10 Country Partnership Strategy (CPS) Podgorica Water and Sewage TA [Actual] (PPIAF) Power Sector Generation [Actual] (PPIAF/ESMAP) Additional Actual Products: PEIR Follow-up TA Early Warning Toolkit for Assessing Bank Risk Profiles (FIRST) Transport Sector Work a/ Actual, Dropped, or Forwarded to a different year. 71 Montenegro FY07-10 Country Partnership Strategy (CPS) Annex 5: IFC Historical and Active Commitments Montenegro Historical Commitments - FY07 to FY10 (in US$ millions) Commitments 2007 2008 2009 2010 NLB - - 14.10 - CGF Montenegro Total CGF - - 14.10 - CGM GINTASMONT - 15.68 - - Total CGM - 15.68 - - Total Commitments - 15.68 14.10 - Montenegro Committed Portfolio (in US$ millions) As of July 31, 2010 Equity- Loan- Committed - IFC EQ GR Total NLB - 12.29 CGF Montenegro 12.29 Total CGF - 12.29 12.29 GINTASMONT - 12.29 CGM 12.29 Gov - 6.91 Montenegero1 6.91 Gov - 0.95 Montenegro 2 0.95 - 20.15 Total CGM 20.15 Total Committed Portfolio - 32.44 32.44 72 ANNEX 3: GENDER PROFILE Figure 1 below presents selected indicators of gender achievement, benchmarking Montenegro (in yellow) against the Western Balkans (in blue) and the ECA region (in red).6 As all figures are standardized to the ECA average it is easy to see the areas where Montenegro and the Western Balkans perform very differently from the rest of the region. Figure 1 Selected Gender Indicators: Montenegro vs. Western Balkans vs.ECA Countries (latest year, 2005-2009) Births attended by skilled health staff (% of total) 350.00% 300.00% Unemployment, female (% 250.00% Fertility rate, total (births of female labor force) 200.00% per woman) 150.00% 100.00% 50.00% 0.00% Share of women employed in the nonagricultural Maternal mortality ratio sector (% of total (modeled estimate, per nonagricultural 100,000 live births) employment) Proportion of seats held by Mortality rate, adult, female women in national parliaments (%) (per 1,000 female adults) Montenegro relative to ECA ECA Western Balkans relative to ECA Health related indicators show Montenegro performing in line with other countries in the Western Balkans and more generally in ECA. While fertility is slightly higher than the regional average, almost all births are attended by skilled health staff as in the rest of the region. Female mortality overall is higher than in other Western Balkans countries but similar to mortality in the region. Interestingly as in Montenegro also male mortality (not shown) is lower than the ECA average, this indicator shows less gender disparities (advantage in this case) than in the rest of the region, in line with the rest of the Western Balkans. Maternal mortality stands out as particularly low with respect to neighboring countries and the region as a whole. On other dimensions of gender achievement, Montenegro performs in line with other countries in the region and in the Western Balkans, such as in terms of the share of women employed in the non- 6 The indicators presented are limited by data availability. For the sake of comparability the indicators refer to the latest year for which the indicators are available for the majority of the countries being compared. The data referred to in this figure, therefore, might not be the most updated for Montenegro. 73 agricultural sector. A large share of the female labor force (and almost 3.5 times of the ECA average) is however unemployed. Data from the latest enterprise survey (2009) complement this picture, showing the extent to which women face different challenges than men. While, for example, women represent more than 50 percent of the full time workers ­ a higher percentage than in the ECA region or in upper middle income countries overall ­ this is because they are more likely to be represented particularly in small firms and in firms in the service sector. Female participation in ownership remains however more limited than in those other groups of countries, and it trails behind particularly for large firms (4 percent, 35 percentage points behind the ECA average). Education data show that while in the past women had lower educational opportunities than men (more than four fifths of the illiterate population are women), currently there are no reported differences in primary completion rates for female to male enrollment in primary and secondary education. The ratio of female students in universities is high, 43 percent in 2005, with ratios exceeding 50 percent in key faculties (economics, law, medicine, biology, and philosophy). This suggests that at least some of the barriers that have been holding behind women in the labor force are currently being addressed, though continued disparities in land tenure, property ownership and inheritance practices may contribute to perpetuate gender disparities. 74 ANNEX 4: TRUST FUNDS Ongoing Trust Funds US$ Trust Fund Closing FY Donor 000s GEF - Agriculture Institutional Development FY14 4,000 MDTF GEF - Lake Skadar FY13 2,600 MDTF Assessing Land Administration FY11 46 MDTF Trust Funds under Preparation FY11-14 Trust Fund Donor Western Balkans Study on Science, R&D FY11-14 and Innovation* EU Improving Public Financial Management* FY11-12 EC Regional REPARIS* FY11-14 MDTF *This is a Regional TF from which Montenegro benefits. 75 ANNEX A2: MONTENEGRO AT A GLANCE 76 77 78 ANNEX B2: SELECTED INDICATORS OF BANK PORTFOLIO PERFORMANCE AND MANAGEMENT 79 ANNEX B3: IFC PROGRAM 80 ANNEX B3: INDICATIVE IBRD LENDING PROGRAM BY FISCAL YEAR Fiscal year Proj ID US$(M) Strategic Rewards b Implementation b (H/M/L) Risks (H/M/L) 2011 Financial Sector DPL I 85 H L Solid Waste AF 5.7 H M FY11 Total 90.7 2012 Financial Sector DPL II 20 H L Higher Education, R&D, Innovation 20 H L CRIF (Disaster Management) 5 H L FY12 Total 45 2013 Env. Hot-Spots Clean Up 60 H M FY13 Total 60 2014 An additional possible projects (tbd) 20 FY14 Total 20 81 ANNEX B4: SUMMARY OF NON-LENDING SERVICE 82 ANNEX B5: POVERTY AND SOCIAL SECTOR INDICATORS 83 ANNEX B6: MONTENEGRO KEY ECONOMIC INDICATORS 2001 ­ 2012 84 ANNEX B7: KEY EXPOSURE INDICATORS 85 ANNEX B8: OPERATIONS PORTFOLIO (IBRD/IDA) 86 ANNEX B9: OPERATIONS PORTFOLIO (IFC) Committed Disbursed Outstanding **Quasi Partici **Quasi Partici FY Approval Company Loan Equity Equity *GT/RM pant Loan Equity Equity *GT/RM pant 2008 Gintasmont 6.51 0 6.51 0 0 6.51 0 6.51 0 0 1982/87 Gov montenegero1 6.48 0 0 0 0 6.48 0 0 0 0 0 Gov montenegro 2 0.89 0 0 0 0 0.89 0 0 0 0 2009 Nlb montenegro 13.02 0 0 0 0 13.02 0 0 0 0 Total Portfolio: 26.9 0 6.51 0 0 26.9 0 6.51 0 0 * Denotes Guarantee and Risk Management Products. ** Quasi Equity includes both loan and equity types. 87 IBRD 34825R 19°E BOSNIA AND M O N TE N E GRO HERZEGOVINA SELECTED CITIES AND TOWNS NATIONAL CAPITAL RIVERS a in MAIN ROADS Dr To RAILROADS Priboj Cehotin OPSTINA (MUNICIPALITY) BOUNDARIES To a To Priboj Foca Gradac INTERNATIONAL BOUNDARIES Pljevlja Ljubisnja 20°E (2238 m) Du Bioc rm v Zabljak (2396 m) ito r ´ Durdevica SERBIA Tara San Rudinice dzak To Goransko Kom v Foca Tomasevo ari Ta Bijelo Polje Bajovo a Sin ra nc Polje jaj 43°N evi Savnik na Mojkovac To Vucitrn To Mostar Zeta v Rozaje Gvozd v Ivangrad Kapa Kolasin Velimlje Moracka v Petrovi ´ Petrovici ` Niksic (2227 m) v Matesevo Vilusi v Andrijevica Morakovo Medurijecje To Komovi To Dubrovnik (2656 m) Dakovica Grahovo Lijeva Rijeka Murino ca Ze M o ra ta a Pelev Plav Crkvice Danilovgrad To Dubrovnik v Gusinje KOSOVO Risan Spuz v Perast Bioce Herceg- Novi Tivat Kotor PODGORICA Radovi´ci vn a ije Cetinje Tuzi C Plavnica ALBANIA Sveti Budva Stefan Virpazar Petrovac Lake A dr ia t ic Scutari Stari Bar Sea Bar Shkodër 42°N a un To -B Kukes a 0 5 10 15 20 Kilometers MONTENEGRO Bojan Ulcinj 0 5 10 15 20 Miles Sveti Nikola To This map was produced by the Map Design Unit of The World Bank. Tirane The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any endorsement or acceptance of such boundaries. 19°E JULY 2009