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Unilateral euroization (or dollarization) is a process in which a state gives up on having its own currency and the EUR (or the USD) becomes the legal currency on its territory. So far, only a few countries in the world have decided to choose such a currency regime.
One of them is Montenegro, and for this reason it constitutes a very interesting case for analysis by economists and lawyers, especially considering the fact that unilateral euroization may paradoxically hinder the process of Montenegro’s integration with the European Union and its subsequent entry into the Eurozone. This is due to the fact that the lack of its own currency makes it impossible for Montenegro to fulfil some of the convergence criteria set out in the Maastricht Treaty.
From the dinar (YUM) through the German mark (DM) to the EUR
Montenegro is a very young country, present on the political map of Europe only since 2006. Its economy is very small — measured by GDP, it amounts to only 0.9 per cent of the Polish economy. Montenegro carried out a unilateral euroization in 2002, when it was still a part of the Federal Republic of Yugoslavia together with Serbia. The EUR replaced the DM, which Montenegro had been using since 1999.
The selection of such a monetary regime by Montenegro’s authorities was the result of the exceptional circumstances in which the economy found itself at the turn of the 20th and 21st centuries. In the Balkans, the 1990s was a time of armed conflicts, the disintegration of Yugoslavia and the emergence of new states. The region was ravaged by hyperinflation, as a result of which some economists described the YUM as “the worst currency in the world”.
Due to the fact that Montenegro has never had its own currency, except for a brief period at the beginning of the 20th century, and the fact that it is a very small economy, very open to international trade and tourism, the authorities decided that unilateral euroization would be the best monetary regime for Montenegro.
The costs and the benefits
In retrospect it is clear that Montenegro’s unilateral euroization has brought both benefits and costs. Without a doubt, the most important benefit was that due to the use of a more reliable currency, Montenegro managed to keep inflation at a relatively low and stable level. It was only slightly higher than in the Eurozone, although at the same time it was subject to much greater fluctuations due to the country’s inability to conduct its own monetary policy.
Unilateral euroization also eliminated the exchange rate risk, which has been beneficial for the exporters and importers, foreign investors investing their capital in Montenegro – not only in government bonds and banks, but also, for example, through direct investment in tourism – and for almost two million tourists visiting the country annually.
Besides these benefits, the lack of its own currency also leads to significant challenges for Montenegro’s economic policy. Their nature is very similar to the economic challenges faced by some Eurozone countries such as Greece.
Unilateral euroization means that the Central Bank of Montenegro cannot issue currency and therefore cannot obtain income from seigniorage and cannot conduct an autonomous monetary policy that would be tailored to the country’s current economic situation. Three main problems appear as a result.
Unstable economic conditions
Firstly, the inability to stabilize the economic conditions using monetary policy tools leads to high volatility of economic growth. The current economic situation in Montenegro is very good, and the rate of economic expansion is close to 5 per cent, which is primarily due to the implementation of major infrastructure projects by the government. However, in the past the country experienced very high volatility of the GDP growth rate: during the recent financial crisis the rate of GDP growth fell from 7.2 per cent (in 2008) to -5.8 per cent (in 2009).
Due to the country’s inability to conduct its own monetary policy, fiscal policy becomes the main tool for stabilizing the economic situation. However, the high level of public debt (according to the European Commission’s estimates, it will reach 70 per cent of GDP in 2018) resulting from the expansive fiscal policy pursued for many years, means that Montenegro currently has little room for maneuver when it comes to stimulating the economy in the event of an economic downturn.
In recent years, the increase in Montenegro’s government debt has been largely driven by the USD1.1bn loan granted in 2014 by China’s Exim Bank for the construction of the first section of a motorway that is ultimately supposed to connect the Montenegrin coast with Serbia. Because the loan wasn’t protected against foreign exchange risk and the EUR has markedly weakened against the USD since 2014, Montenegro’s debt arising from this loan has already increased from approx. EUR0.8bn to nearly EUR1bn (these amounts correspond to approximately 20 per cent and 24 per cent of the country’s GDP in 2017).
The increasing public debt creates a risk for the sustainability of Montenegro’s public finances. This is especially true considering that the central bank cannot support the government in a crisis and cannot cause a reduction in bond yields and debt servicing costs through a quantitative easing program (i.e. by purchasing Treasury bonds on the secondary market using newly issued currency). In this situation, the role of the lender of last resort can only be assumed by international institutions. In 2017, due to the difficult condition of its public finances, Montenegro received a guarantee from the World Bank, which allowed it to take out a long-term loan for the amount of EUR250m (i.e. approximately 6.0 per cent of the GDP) from a consortium of international banks.
However, the guarantee provided by the World Bank was conditional on the implementation of reforms, and the interest rate on the loan is equivalent to the EURIBOR rate plus a margin of 2.95 percentage points.
It is therefore worth emphasizing that although Montenegro uses the EUR and there is no foreign exchange risk for investors holding EUR, there is still a significant risk related to the solvency of the borrower. As a result, the interest rate on the debt incurred by Montenegro is much higher than the interest rate on the debt incurred by the Eurozone member states. According to the estimates of the International Monetary Fund (IMF) in 2017 it reached 3.9 per cent on average.
Secondly, the lack of a nominal exchange rate makes it difficult to restore balance in the economy and to absorb shocks. This is because Montenegro cannot depreciate the exchange rate, which would help to restore the competitiveness of the country’s exports.
And Montenegro does have considerable problems with competitiveness, as evidenced by the persistently high current account deficit, which now stands at over 16 per cent of GDP, and especially the deficit in the trade in goods, which reaches almost 45 per cent of GDP. Additionally, the share of Montenegro’s exports in world exports is decreasing, while the share of low-processed goods in the country’s exports is constantly growing.
Although the number of tourists visiting Montenegro increases each year, it is sometimes difficult for them to find local products on the store shelves or in restaurants. The competitiveness of the Montenegrin economy is being undermined by the inefficient labor market (despite a very good economic situation, the unemployment rate currently exceeds 15 per cent) and difficulties in running a business, associated, among others, with very poorly developed infrastructure — which is important considering that Montenegro is a mountainous country — and a large shadow economy.
The persistent current account deficit means that Montenegro’s economy is heavily dependent on foreign financing. Although the current account deficit is financed in large part by the inflow of foreign direct investment — in recent years it accounted for over 10 per cent of GDP on average — an important role in its financing is also played by the inflow of portfolio capital, which can be less stable. According to IMF estimates, as a result of the continued inflow of capital, Montenegro’s overall foreign debt — both private and public — reached nearly 160 per cent of GDP in 2017.
Problems of the banking sector
The third major challenge that a country has to face due to the lack of its own currency is related to the fact that in a situation of a crisis in the banking sector, the central bank has limited room for maneuver as the lender of last resort. This is because it does not have the ability to issue currency in order to provide liquidity support to commercial banks (it can only do so using its own reserves).
Thus, in a crisis situation the role of the lender of last resort for the banking sector would have to be taken over by the government. However, because the public debt is already high, it would need support from international financial institutions.
Although the situation has improved in recent years, just a few years ago Montenegro’s banking sector was experiencing serious problems. Following a credit boom that took place before the financial crisis (from January 2006 to mid-2008 the value of loans granted increased six-fold in nominal terms), in the subsequent years banks had to cope with very high losses and negative profitability.
Every fourth loan became impaired and the lending activity remained stagnant for the next 8 years. This so-called “boom-bust” cycle in the banking sector is well known to economists studying economies that do not have the ability to conduct an autonomous monetary policy, and as a result find it difficult to influence the rate of lending in the economy.
Montenegro’s experience therefore provides a clear example that maintaining competitiveness, as well as macroeconomic and financial stability in a country without its own currency requires rigorous adjustment in fiscal policy, which in many cases can be very costly for the economy (as reflected in a significant loss of GDP) or even outright impossible. In Montenegro, the fiscal authorities have failed to maintain such discipline, which resulted in the emergence of significant and dangerous imbalances.
Problems with joining the Eurozone
However, these are not the only challenges associated with Montenegro’s specific currency regime. Paradoxically, unilateral euroization could in fact hinder the process of Montenegro’s integration with the European Union and its subsequent accession to the Eurozone. Montenegro has formally been a candidate to join the European Union since 2010 and is seen as a leader in the ongoing process of enlargement to the countries of the Western Balkans. The European Commission’s strategy, adopted in early 2018, indicates the year 2025 as an ambitious but achievable date for the accession of the new countries to the EU.
Accession to the EU could be very beneficial for a very small country, also due to the fact that it enables subsequent entry into the monetary regime of the Eurozone. However, for Montenegro entering the Eurozone may be more difficult than for other countries, because the lack of its own currency will make it impossible to fulfil the convergence criteria provided for in the Maastricht Treaty. This especially relates to the criterion of the nominal exchange rate and participation in the so-called ERM II system for at least two years before entry into the Eurozone. During this time, it is necessary to maintain a stable exchange rate of the domestic national currency — which Montenegro doesn’t have — against the EUR.
In 2000, the Economic and Financial Affairs Council of the European Union (ECOFIN) declared that unilateral euroization cannot be treated as a shortcut to Eurozone membership and as a way to circumvent the subsequent stages of adopting the EUR provided for in the Maastricht Treaty.
Additionally, in 2007 the Council of the European Union indicated that Montenegro’s unilateral euroization is not in compliance with the Maastricht Treaty and that the implications of the Treaty for Montenegro’s monetary regime in the context of the accession process will have to be determined at the latest during the accession negotiations. It is possible that these implications will be determined soon, because in June 2018 Montenegro opened a chapter of EU accession negotiations relating to economic and monetary policy (the so-called Chapter 17).
The position taken by the EU Council means that the method used to assess the degree and durability of Montenegro’s convergence before entry to the Eurozone will have to be determined already at the stage of EU accession negotiations. A situation in which Montenegro would become an EU member state using the EUR, but formally remaining outside the Eurozone and unable to meet the criteria for entry, would be unclear and would generate many complications.
Although Montenegro could then be perceived by many as a country belonging to the Eurozone, Montenegrin banks would not have access to operations with the European Central Bank, and the ECB would not be able to act as the lender of last resort to Montenegro. Additionally, the Central Bank of Montenegro would not be a member of the Eurosystem, and therefore would not be able to participate in the decision-making process concerning the monetary policy in the Eurozone, while Montenegro’s Treasury securities would not be included in the asset purchase programs carried out by the ECB.
One potential solution to the problem — which would comply with the literal reading of treaty provisions — would be for Montenegro to replace the EUR with a new national currency for at least two years before joining the Eurozone. Then, after fulfilling all the convergence criteria and making the decision to join the Eurozone, Montenegro would have to switch from that currency back to the EUR. However, such a solution would be risky and expensive, difficult to carry out in terms of logistics, and it would be difficult to find social approval for such a course of action.
For these reasons, during the accession negotiations the European Union and Montenegro may want to look for another way of assessing the degree and durability of Montenegro’s convergence than has been used so far for countries joining the Eurozone. However, it is not clear how this other method should look in practice in order to ensure that the assessment is economically rational, legally possible and politically acceptable at the same time.
Regardless of what solution will ultimately be adopted in relation to Montenegro’s unilateral euroization, the authorities of the European Union will probably try to be very cautious in assessing the degree of the country’s preparedness for full participation in the Economic and Monetary Union. The experience of the recent crisis in the Eurozone has shown that macroeconomic and financial imbalances, even in a small member state of the monetary union, could have significant consequences for the entire currency area. And this in turn will force the European Commission and the Council of the European Union to adopt a very cautious approach to Montenegro’s integration aspirations. For this reason, unilateral euroization may involve not only economic but also political costs.
Piotr Żuk is an expert in the Economic Analysis Department at Poland’s central bank, NBP.
The opinions expressed in the article are private views of the author and are not an expression of the official position of NBP.