The IMF has raised its forecast for this year's economic growth in Montenegro to 1.5% from a previous 1.2% made in April, according to an Aug 28 statement issued following the Fund's Article IV consultations with the local authorities.

The IMF notes that the economic activity picked up in early 2013, with GDP up 4.3% y/y in Q1, thanks to the more favourable weather conditions and the subsequent sharp increase in hydropower production - after the output contracted in 2012 due to the severe winter and the decline in aluminium firm KAP's production.

The metals sector will, however, continue to drag down the overall economic activity this year as well, especially considering the fact that debt-ridden KAP entered insolvency in early July, the IMF warns. It points out to the significant potential Montenegro has in energy and tourism, adding it could be unlocked via better business climate that would attract greater inflows of foreign investment into these sectors.

The IMF sees the main risk for the Montenegrin economy in the loss of access to global debt markets, considering the recent surge in global risk aversion. In case the planned international bond issue for 2013 does not move forward, Montenegro will be forced to take more expensive bank loans to finance its budget spending - and this would put further upward pressure on interest costs.

"Montenegro has found it very difficult to access external capital markets during several periods over the past 18 months. Eurobond spreads are currently at roughly 520 basis points, but were between 800–1000 basis points for most of 2012. This risk is likely to remain over the medium term as well," the Fund said.

Another substantial risk is related to the possible future government commitment to provide fiscal support to KAP since this would weaken the authorities' ability to deliver the necessary mid-term fiscal adjustments and build up the financing pressures.

"The company is not viable at market  electricity prices, however, and has heavy indebtedness, over employment and large investment needs. Any investor is likely to demand financial assistance to deal with these obstacles," the IMF said.

According to the IMF, moving KAP toward liquidation appears to be the least cost option. Yet, the fiscal support seems inevitable if the company is to operate profitably in its current structure. Still, in times when the government is forced to hike taxes and curb spending, KAP's liquidation (even though costly in the near term) could free the budget from continuous subsidies and let valuable financing resources be employed more productively, including electricity for exports.

The Fund, furthermore, points that the growing financing gap in the pension fund has cramped the fiscal space, and serious front-loaded reforms are needed in this area to allow savings for 2014 and beyond, including, to meet fiscal contingencies.

Another problem in the economy is the enduring high volume of bad loans. The NPL ratio climbed again to 17.6% at end-2012 from 15.5% at end-2011 when it had considerably weakened from its peak of 25.3% reached in mid-2011.

Even though commercial banks sold their non-performing loans to factoring companies, these assets remain mostly unresolved and unrestructured, leaving private balance sheets still impaired. Thus, sluggish private sector demand is contributing to weak economic activity and a further deterioration of asset quality - and as a result, new bank lending remains limited, despite a steady recovery in deposits.