Outlook for 2011-12

The Democratic Party of Socialists (DPS) is set to remain the dominant political force over the forecast period, following its victories in the parliamentary election in March 2009 and the local elections in May 2010. The new prime minister, Igor Luksic, will rely on the support of his predecessor, the DPS leader, Milo Djukanovic, to establish his authority. EU integration will remain the priority of foreign policy, and-given sufficient progress in reforms-Montenegro could start EU accession talks in 2012. After a contraction of 5.7% in real GDP in 2009 the Economist Intelligence Unit estimates a rebound of 0.5% in economic growth in 2010, following a recovery in import demand in the euro zone and a pick-up in tourism. We expect real GDP to grow by 2.5% in 2011, accelerating to 4.5% in 2012. We forecast that although the current-account deficit will contract further in 2011-12, it will remain large at an annual average of 12.4% of GDP.

The political scene

Mr Luksic became prime minister on December 29th 2010, when he formed a streamlined government, following the long-awaited resignation of Mr Djukanovic. The EU granted Montenegro the status of an EU candidate in mid-December 2010, accepting a recommendation to that effect from the European Commission. However, it was made clear to Montenegro that it should introduce further reforms before it could open EU accession talks. Montenegro's relations with Serbia have improved, as highlighted by the signing of an extradition treaty between the two countries at the end of October.

Economic policy

The budget surplus amounted to EUR11.9m (US$15.4m) in the third quarter of 2010, as expenditure declined more markedly than revenue. With the fiscal outlook remaining uncertain, the government has been discussing with the World Bank a possible budget support loan of US$85m.

The domestic economy

Industrial output rebounded in the third quarter by 41.7% year on year and grew robustly in October, albeit from a low base. Credit growth remained negative, with a year-on-year contraction of 12% in September. Inflation remained restrained, with the consumer price index rising by 0.6% in October, as higher transport and food prices were offset by lower utility tariffs.

Foreign trade and payments

Merchandise exports rose by 14.8% year on year to EUR86.9m in the third quarter, while imports increased by 6.8%, to EUR469m The EU's share in Montenegro's exports rose to 55% in January-October 2010, from 51% a year earlier, while its share in Montenegro's imports remained largely unchanged, at 37.4%.

Total area

13,812 sq km

Population

620,145 (2003 census)

Main cities

Population in '000

Podgorica (capital) 180

Niksic 75

Bijelo Polje 50

Climate

Temperate Mediterranean. Continental in northern Montenegro

Weather

Average air temperatures of 27.4°C in summer and 13.4°C in winter

Languages

According to Montenegro's new constitution, adopted in October 2007, the country's official language is Montenegrin. However, the Serbian language, as well as Bosnian, Albanian and Croatian, also have official status

Weights and measures

Metric system

Currency

The euro has been the official currency in Montenegro since January 1st 2002

Time

One hour ahead of GMT

Fiscal year

Calendar year

Public holidays

January 1st (New Year); January 7th (Orthodox Christmas); April 25th (Orthodox Easter); May 1st-2nd (Labour Day); May 9th (Victory Day); November 29th-30th (Republic Day)

Official name

Republic of Montenegro

Form of state

Democratic republic

Legal system

Based on the constitution of 2007

National legislature

Unicameral: Assembly (Skupstina), 81 seats

Elections

March 29th 2009 (parliamentary); next parliamentary election due in 2013; April 6th 2008 (presidential); next presidential election due in 2013

Head of state

President, elected by universal suffrage. Filip Vujanovic, the incumbent, was re-elected to a five-year term on April 6th 2008

National government

Headed by the prime minister, responsible to parliament. A new government, led by the Democratic Party of Socialists, and including the Social Democratic Party and minority representatives, took office on December 29th 2010

Main political parties

Democratic Party of Socialists (DPS); Social Democratic Party (SDP); Democratic Union of Albanians (DUA); Bosniak Party (BS); Movement for Change (PzP); Socialist People's Party (SNP); People's Party (NS); Democratic Serb Party (DSS); New Serb Democracy (NOVA); Liberal Party

Leading members of the government

Prime minister: Igor Luksic (DPS)

Deputy prime ministers:

;Information society & telecommunications: Vujica Lazovic (SDP)

;Justice: Dusko Markovic (DPS)

Key ministers

Agriculture: Tarzan Milosevic (DPS)

Culture, sport & media: Branislav Micunovic (DPS)

Defence: Boro Vucinic (DPS)

Economy: Vladimir Kavaric (DPS)

Education & science: Slavoljub Stijepovic (DPS)

Finance: Milorad Katnic (DPS)

Foreign affairs & European integration: Milan Rocen (DPS)

Health & social affairs: Miodrag Radunovic (DPS)

Human rights & minorities: Ferhat Dinosa (DUA)

Interior & public administration: Ivan Brajovic (SDP)

Labour & social affairs: Suad Numanovic (DPS)

Minister without portfolio: Rafet Husovic (BS)

Science: Tanja Vlahovic (DPS)

Tourism & sustainable development: Predrag Sekulic (DPS)

Transport & telecommunications: Andrija Lompar (SDP)

Parliamentary speaker

Ranko Krivokapic (SDP)

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The Democratic Party of Socialists (DPS) is in a good position to continue to dominate the political scene in the wake of a series of electoral successes, including a convincing victory in the parliamentary election in March 2009. The success of the DPS followed the return of its leader, Milo Djukanovic, as prime minister in February 2008 and the comfortable re-election of Filip Vujanovic as president two months later. The opposition, in contrast, remains weak, following a long period of fragmentation. The weakness of the opposition was highlighted by the results of the local authority elections in May 2010, which produced outright victories for the DPS and its allies in several municipalities. However, the main opposition parties contested the local elections as part of an electoral alliance, and if their new-found unity proves durable, they may begin to pose a more serious challenge to the government if the economic situation remains difficult.

The position of the DPS has been bolstered by the smooth transfer of power from Mr Djukanovic to his chosen successor, the finance minister, Igor Luksic, who took over as prime minister at the end of December 2010. In the months before his resignation Mr Djukanovic, who has been a dominant political figure in Montenegro for two decades, made it clear that he intended to leave the government to concentrate on his business interests. By stepping down from the post of prime minister four days after Montenegro had been granted EU candidate status, Mr Djukanovic was able to claim credit for a major foreign policy achievement. Despite leaving the government Mr Djukanovic remains a powerful figure, and this is reflected in the fact that he has stayed on as the leader of the DPS. Even if Mr Djukanovic decides to step down from the DPS chairmanship-perhaps at the party's next congress, expected in 2011-he is expected remain the eminence grise by virtue of his personal prestige and his extensive network of contacts.

To assert his authority, Mr Luksic will need to rely for the foreseeable future on Mr Djukanovic's backing in the face of possible challenges from other senior figures in the DPS, including the party's deputy leader, Svetozar Marovic, who has in the past resisted Mr Luksic's promotion to the post of prime minister. Mr Djukanovic may offer Mr Marovic, who lost his post as a deputy prime minister in the new government, another senior post. Mr Marovic could become the DPS's presidential candidate, although the next presidential election is not due until 2013. Apart from presenting a united front, the DPS leadership will also need to manage relations with the junior partner in the ruling coalition, the Social Democratic Party (SDP), which has in the past urged a more cautious approach towards privatisation.

The new government will regard as its main challenge in the coming months the task of promoting economic recovery, following an estimated modest rebound in 2010 from the sharp contraction in output in 2009, and coping with an expected upsurge in public discontent, which could include ethnic tensions. There is a risk of increased social unrest, as unemployment is set to remain high, before stronger growth returns in 2012. The government will attempt to defuse some of the potentially most dangerous discontent by giving financial support to the troubled Podgorica Aluminium Plant (KAP), where workers staged strikes and protests in 2010 against job losses. The authorities will continue to provide generous social assistance to the KAP workers who will be made redundant as part of a restructuring programme.

The opposition faces an uphill task trying to present a united front

Divisions among the opposition parties tend to run much deeper than those within the governing coalition, highlighted by the opposition's inability, until shortly before the May 2010 local elections, to form a broad-based electoral alliance. The leader of the Movement for Change (PzP), Nebojsa Medojevic, has been a long-standing advocate of a united front, and his achievement in 2010 in persuading the other opposition parties to join the PzP in an electoral alliance followed several failed attempts at forging unity. However, Mr Medojevic's success has not dispelled the sentiment shared by many Montenegrins that the opposition alliance brings together disparate elements such as the PzP, which campaigns on a strong anti-corruption platform, with parties representing the Serb community, and there are relatively few specific policies around which the opposition can rally.

It remains unclear who, if anyone, will become the de facto leader of the opposition. The Socialist People's Party (SNP), which again emerged from the election in 2009 as the main opposition force, lacks a clear policy focus now that the issue of Montenegro's independence, which it opposed at the time of the referendum in 2006, has slipped down the political agenda. There is speculation that the SNP could gradually move closer to the Democratic Party of Socialists (DPS), from which it split in the late 1990s, when it opposed the policy of the DPS leader, Milo Djukanovic, of distancing Montenegro from Serbia. Several senior figures within the DPS, including Montenegro's president, Filip Vujanovic, would welcome such a move, although it is not clear whether Mr Djukanovic would approve such a realignment. The SNP has twice as many seats in parliament as New Serb Democracy (NOVA), whose candidate, Andrija Mandic, came second in the presidential election in 2008. However, Mr Mandic's appeal will remain limited to the 30% or so of the population who identify themselves as Serbs. Despite the deep differences among the opposition-the PzP favours NATO membership, for example, whereas the parties representing ethnic Serbs oppose it-the establishment of an electoral alliance will represent an additional problem for the government.

By holding a parliamentary election 18 months ahead of schedule, in March 2009, Mr Djukanovic took advantage of the delayed impact of the global economic downturn, which at that stage had barely started to affect Montenegro. He also benefited from the continuing divisions within the ranks of the opposition to gain another four years in office for the DPS. Mr Luksic will hope that the economic recovery, which is expected to gather momentum in 2011-12, will pay dividends at the next election, due in 2013. However, without Mr Djukanovic's commanding presence in the government, the DPS may struggle to achieve another winning performance-the more so if Mr Luksic faces a degree of hostility from some influential figures in the DPS's old guard, who believe that they have a better claim to the post of prime minister than a man 20 years their junior. The DPS leadership is expected to extend the partnership with its coalition ally, the SDP, at the next parliamentary election.

The opposition parties will continue their efforts to forge a more united front, building on the foundations of their alliance in the most recent local elections. However, their ability and willingness to work together for electoral advantage will continue to be weakened by their widely disparate policies and constituencies. In addition, if the DPS leaders believe that their party's re-election is in doubt, they may attempt to neutralise the threat by offering a role in government to the Socialist People's Party (SNP), which split from the DPS in 1998.

The government has the overriding goal of advancing EU and NATO integration. By obtaining the status of a candidate for EU membership, Montenegro passed an important hurdle in mid-December 2010. The granting of candidate status, at a meeting of EU heads of state and government, followed a recommendation to that effect from the European Commission in early November. The Commission's recommendation came two years after Montenegro had submitted a formal application to join the EU, in December 2008. However, the granting of EU candidate status is not expected to translate into an early opening date for EU accession talks, which will need to be preceded by further reforms involving Montenegrin institutions, including more resolute action on tackling corruption and organised crime as well as improvements to the public administration. If Montenegro makes sufficient progress in time for the Commission's next annual progress report, due by November 2011, it could open EU accession talks in the first half of 2012 at the earliest. There is a risk that within the EU enlargement fatigue may deepen, in which case there are likely to be further obstacles on the way to Montenegro's advance towards eventual EU membership.

Montenegro hopes to receive an invitation to join NATO in the next few years, having been granted a Membership Action Plan (MAP) by the alliance in December 2009. Meeting the obligations arising from the MAP is the last formal stage that a country needs to reach before NATO membership can be obtained. In early 2010 Montenegro dispatched a small military unit to join NATO's security mission in Afghanistan in order to bolster its credentials as a membership candidate. However, NATO accession remains highly controversial in Montenegro, with opinion polls suggesting that there are more people opposed to membership than in favour of it. Anti-NATO sentiments are likely to weaken over time as memories of the alliance's bombing campaign against Yugoslavia during the Kosovo war in 1999-which included targets in Montenegro-fade.

Diplomatic relations with the country's former partner republic, Serbia, will come under strain from time to time because of differences over Kosovo and other issues. Serbia recalled its ambassador from Montenegro in January 2010 after Montenegro established diplomatic relations with Kosovo, which Serbia continues to regard as part of its territory. There are other contentious issues in bilateral relations, including Montenegro's reluctance to allow Serbia to establish consulates in three Montenegrin towns. On the positive side, the two countries signed an extradition treaty in October 2010, which should help the fight against organised crime.

The challenge in the short term is to accelerate the recovery from the severe economic downturn of 2009, while maintaining fiscal stability and continuing to rein in the current-account deficit, which ballooned in 2006-09. With credit growth having turned negative, policymakers will need to boost lending. In the medium term, measures to deal with the very large, albeit shrinking, current-account deficit could include resuming the practice of running larger than planned budget surpluses. However, in view of the tenuous recovery in 2010 and the modest economic growth forecast for 2011-which will prolong weak revenue performance-this option is not available in the short term.

The IMF has been urging Montenegro to safeguard its fiscal stability and to reduce public debt, at the same time as carrying out structural reforms to increase labour market flexibility and to boost export competitiveness. The IMF's leverage has been limited by the absence of a formal arrangement with Montenegro, and by the Montenegrin authorities' reluctance until now to seek financial assistance from the Fund. However, given the sizeable budget deficit expected in 2011, Montenegro may yet turn to the IMF for a precautionary funding arrangement, if not a stand-by loan. The pace of privatisation will be an important indicator of the authorities' willingness to carry out reforms over the forecast period. The large current-account deficit will also put the authorities under pressure to sell state assets. However, in spite of the sale to an Italian firm in 2009 of a controlling stake in the power utility, Elektroprivreda Crne Gore (EPCG), it will continue to be hard to attract foreign direct investment (FDI) during the sluggish recovery that is forecast for the EU and the Balkans in 2011. Montenegro has implemented the trade-related provisions of the stabilisation and association agreement (SAA) with the EU, which came into force in January 2008. Trade liberalisation will continue in 2011-12, alongside efforts to join the World Trade Organisation (WTO).

After a sharp deterioration in the public finances in 2009 pushed the budget into its first significant deficit since independence in 2006, the deficit in 2010 remained largely unchanged, at an estimated 4.4% of GDP, with a sluggish recovery keeping tax receipts weak. The outlook for the forecast period is brighter, and we forecast that the deficit will decline to 3.6% of GDP in 2011 and to 2% of GDP in 2012, as economic growth accelerates. Stronger economic growth should lift retail sales, which will increase receipts of value-added tax (VAT), the single largest source of budget income. Until the rebound in real GDP growth helps to produce a budget surplus in the medium term, the authorities will remain under pressure to reverse the loosening of fiscal policy that took place in 2009, as the de facto adoption of the euro reduces the range of policy tools that can be used to narrow the current-account deficit.

The authorities cut the rate of personal income tax from 12% to 9% in January 2010-following a cut of 3 percentage points a year earlier-despite the deteriorating fiscal situation. As in the first three quarters of 2010, the impact of the cut on the full-year budgets of 2011-12 will be limited, because personal income tax makes up a small share of revenue. Increased social insurance contributions, introduced at the same time, will offset the decline in revenue resulting from lower taxes. Nevertheless, the IMF, which had earlier urged the authorities to reconsider the tax cuts, has called on the government to pursue more prudent fiscal policies, while increasing the share of capital expenditure in spending.

The adoption of the euro as legal tender means that the Central Bank of Montenegro cannot influence the money supply, which is determined by flows on the balance of payments. This puts a greater burden on fiscal policy in responding to economic shocks. Until 2009 the Central Bank focused primarily on supervising rapid growth in commercial bank lending, which had raised concerns about banks' ability to assess risk. Its measures to limit banks' annual credit expansion and to institute a higher solvency ratio helped to slow the runaway growth in credit to single figures in early 2009. The Central Bank repeatedly eased the mandatory reserve requirement in 2009-lowering the rate to 10%-to boost liquidity in the banking system. However, with credit growth contracting since the third quarter of 2009 (and shrinking by 12% year on year in September 2010), the Central Bank is expected to consider further measures to encourage lending.

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After real GDP shrank by 5.7% in 2009-under the impact of the global economic downturn-the rebound in 2010 was tenuous, with economic growth estimated at 0.5%. The return to growth stemmed from a strong pick-up in exports, albeit from a very low base, and a resilient performance in services, mainly because of receipts from tourism. The outlook for Montenegro's export markets over the forecast period remains uncertain, as the recovery in the main euro zone economies may initially falter, following the replacement of stimulus packages by measures aimed at fiscal consolidation. However, the recovery will be promoted by stable international aluminium prices-generating nearly one-half of Montenegro's merchandise export receipts-which rebounded by around 25% in 2010. We forecast that real GDP will increase relatively modestly, by 2.5%, in 2011. It will then accelerate to 4.5% in 2012, as demand for Montenegrin exports picks up in the euro zone and in Balkan markets (where the weakening of the euro should boost Montenegrin sales), tourism expands and risk appetite for investing in emerging markets increases, bringing further investment in Montenegro's property sector.

There are significant downside risks to our growth outlook, owing to the large, albeit contracting, current-account deficit, which is forecast to average the equivalent of 12.4% of GDP in 2011-12. Such a deficit will be difficult to finance at a time when FDI inflows are not expected to match the record amount registered in 2009-which was boosted by the privatisation of EPCG-making Montenegro more dependent on foreign borrowing during a prolonged global credit squeeze. The authorities have few tools at their disposal to narrow the deficit, as the euro is the sole currency and the budget surpluses posted before 2008 will not recur during the forecast period. In addition to that risk, the Greek debt crisis will reduce import demand from Greece, which is Montenegro's second-largest export market.

Inflation, as measured by the consumer price index (CPI), has decelerated rapidly from an average of 3.4% in 2009, turning briefly into deflation in August 2010, when the CPI declined by 0.1%. We forecast that, after a sharp fall in annual average inflation to an estimated 0.6% in 2010, owing to depressed domestic demand, average inflation will accelerate in 2011-12 as a result of stronger economic growth. However, a sluggish recovery in domestic demand in 2011 and lower international commodity prices in 2012 will keep the rise in the CPI in check, and we forecast that average inflation in 2011-12 will be around 2.5% per year.

The current-account deficit contracted sharply in 2010, as exports rebounded robustly from the global economic downturn while import growth was constrained by depressed domestic demand, but it remained large, at the equivalent of an estimated 17.9% of GDP. We expect the trade deficit to shrink further 2011-12, as import demand remains initially weak and foreign sales of Montenegro's main exports, aluminium and steel, continue to recover. However, the rise in international oil and food prices in 2011 will limit the size of the contraction. In combination with recurring surpluses on income and transfers, revenue from services-primarily tourism, which will rebound, particularly as growth in the euro zone economies accelerates in 2012-will offset a larger share of the trade deficit. The annual average current-account deficit in 2011-12 is expected to shrink to the equivalent of 12.4% of GDP, as import demand remains depressed to start with, owing to a sluggish recovery in the construction sector and high unemployment in the aftermath the hesitant recovery from the recession. However, the deficit will remain large as a percentage of GDP, raising serious doubts as to its sustainability, and Montenegro may need IMF assistance to help to finance it.

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The prime minister, Milo Djukanovic, announced his resignation from the government on December 21st, nominating his long-standing protégé, the finance minister, Igor Luksic, as his successor. Mr Djukanovic's resignation followed months of intense speculation that he was planning to step down from his post in the near future. The speculation was fuelled further by remarks made by Mr Djukanovic to journalists in early November, in which he confirmed that he would resign from the government at some unspecified point.

Among the reasons that Mr Djukanovic, the longest-serving leader in Europe, gave for his departure was that it would help to strengthen Montenegro's democratic development. Having served as either prime minister or president since 1991, with only an 18-month break in 2006-08, Mr Djukanovic had previously said that he wanted to leave public office in order to concentrate on his business interests, as he was able to do briefly before he was recalled to take charge of the government because of the illness of his successor, Zeljko Sturanovic, in 2008. Mr Djukanovic strenuously denied claims by the opposition that his retirement from government had come in response to either international or domestic pressure. Mr Djukanovic's opponents argued that his departure was required by Montenegro's EU partners, who-the opposition claimed-had indicated that Montenegro could not expect to make further progress in its EU integration unless it was led by someone who was more willing than Mr Djukanovic to tackle corruption and organised crime.

Mr Luksic became prime minister on December 29th, when his government received a vote of confidence in parliament. Earlier, the dominant partner in the ruling coalition, the Democratic Party of Socialists (DPS), had formally endorsed Mr Luksic's nomination. Although Mr Luksic is only 34 years old, he has been regarded as Mr Djukanovic's chosen successor for a number of years, and that position was reinforced by his promotion to the post of deputy prime minister in charge of international economic co-operation in 2008, while retaining the finance portfolio. Although Mr Luksic's succession is believed to have been blocked for several years by a number of senior DPS figures, including the Montenegrin president, Filip Vujanovic, and the DPS deputy chairman, Svetozar Marovic, it was reported in the Montenegrin media in recent months that Mr Djukanovic had finally been able to overcome their opposition.

To ensure a smooth succession Mr Djukanovic, who is relatively young at the age of 48, has retained the key position of DPS chairman, and Mr Marovic remains his deputy. However, there is no place in the new streamlined government formed by Mr Luksic for Mr Marovic, who was a deputy prime minister under Mr Djukanovic. The exclusion of Mr Marovic will make it easier for Mr Luksic to assert his leadership of the new government. The new prime minister can also expect to enjoy the continuing support of Mr Djukanovic in the face of any possible challenges to his authority.

Mr Luksic has trimmed the government from 24 members to 18, reducing the number of deputy prime ministers from three to two and the number of ministers without portfolio from two to one. In order to increase efficiency, he has got rid of some duplication of functions by abolishing ministries or ministerial responsibilities for specific portfolios that are within the remit of the two deputy prime ministers: Dusko Markovic, who is in charge of justice, and Vujica Lazovic, who is in charge of information society and telecommunications. Among the other changes that Mr Luksic has put in place, the previously separate ministries of foreign affairs and European integration have been combined under the incumbent foreign minister, Milan Rocen.

On forming his government, Mr Luksic promised a policy of continuity, focusing on implementing measures required by the EU before Montenegro can open EU accession talks. Mr Luksic, who is an economist by profession, outlined ambitious plans to return the budget to a surplus in 2012, and he said that the government will put in place structural reforms to improve healthcare, education and social welfare. He is also expected to accelerate the fight against corruption and organised crime, which made little progress under Mr Djukanovic, who himself faced an investigation in Italy in the early 2000s over alleged involvement in cigarette smuggling dating back to the 1990s.

Montenegro was granted the status of a candidate for EU membership at a meeting of EU heads of state and government in Brussels on December 17th. The decision by the EU summit followed a positive response from the European Commission to Montenegro's application to join the EU with the publication, on November 9th, of a recommendation which stated that the applicant was ready to become a candidate for EU membership. Montenegro had formally applied for EU membership in December 2008, and the EU's decision represented a significant achievement for the government, putting Montenegro ahead of most of the rest of the western Balkan region on the path of EU integration. The EU enlargement commissioner, Stefan Füle, commended the government's efforts to prepare the country for candidate status. Mr Djukanovic-whose term in office was crowned with a major foreign policy achievement-expressed his confidence before his resignation that accession negotiations could begin in the course of 2011.

The Commission's annual progress report on Montenegro, issued at the same time, praised progress in bringing the country's legal framework into line with EU norms and in improving its administrative and institutional capacities. It also commended Montenegro's constructive role in the region and in fostering good neighbourly relations-a key criterion for the EU in assessing the countries of the western Balkans following the conflicts of the 1990s.

However, the progress report emphasised several remaining shortcomings that will need to be addressed if eventual negotiations are to proceed successfully. These relate in particular to the implementation of reforms. The report noted the poor functioning of democratic institutions, observing that parliament did not exercise effective oversight over the government. It concluded that the public administration remained weak and highly politicised. Shortcomings in the rule of law have persistently been raised by the Commission, and this report once again noted the politicisation of the judiciary. The need for greater efforts in the fight against corruption and organised crime was stressed. Thus while the Commission's recommendation on candidacy status was undeniably positive, it also underlined that more needs to be done to meet the accession criteria before membership negotiations can commence.

The leaders of the three most prominent opposition parties, the Socialist People's Party (SNP), New Serb Democracy (NOVA) and the Movement for Change (PzP), told Mr Füle that they favoured opening accession negotiations as a spur to bringing about change. However, they expressed scepticism about the will of the authorities to meet the EU's criteria, notably in the fight against corruption and organised crime.

The opposition parties have long accused Mr Djukanovic and others in the DPS of links with organised crime. The PzP leader, Nebojsa Medojevic, has said that it was well known who the leading organised crime figures were and what kind of connections they had with politicians, the police and the judiciary. At the beginning of November Mr Medojevic called on the state prosecutor, Ranka Carapic, to resign, claiming that she was not allowed by the authorities to prosecute certain individuals, and that she was afraid to implement the law.

Pro-Serb opposition parties have long opposed the government's aim of seeking NATO membership. This stance is in part linked with continued ill-feeling over the NATO bombing of Serbia and Montenegro during the 1999 Kosovo conflict, when the two countries were still united in the Federal Republic of Yugoslavia. The issue is complicated for the government by the fact that it would not be able to attain the required two-thirds parliamentary majority in favour of joining NATO without the support of at least part of the opposition. The alternative would be to hold a referendum on the issue. However, the outcome of a referendum would be uncertain, with opinion polls showing a larger proportion of respondents opposing NATO membership than supporting it.

In a speech in mid-November the foreign minister, Mr Rocen, alluded to the possibility that PzP support for NATO entry could help to secure a two-thirds parliamentary majority. Mr Medojevic quickly responded that, although the PzP supports NATO membership, the government could not count on his party to provide the votes needed in parliament, stating that the matter should be decided in a referendum. He claimed that the DPS's support for NATO membership was insincere, and that the ruling party did not in practice want democratic control over the security services or to fight against organised crime.

As in a number of previous instances, this issue revealed the awkward position of the pro-independence PzP when it finds itself supporting a policy advocated by the government. While not wanting to give any succour to the ruling parties, it does not wish to break ranks with its partners in the pro-Serb opposition parties either. The PzP's support for the new constitution, adopted in October 2007, resulted in enormous rancour between it and the pro-Serb parties, which had bitterly opposed its adoption, and the ensuing distrust has never been entirely dispelled. Mr Medojevic would be loath to risk damaging relations with his opposition allies. That said, he is also wary of identifying too closely with parties representing the Serb minority, realising that to defeat the DPS he will need to win broad support, including attracting some DPS voters.

Divisions within the SNP have also emerged, among other issues over policy on NATO membership. The SNP has always been less stridently pro-Serb than NOVA, stressing that it is a Montenegrin party, although it opposed the break with Serbia at the time of Montenegro's independence referendum in 2006. As part of a desire to reshape the SNP's policy and public image, a number of its officials have started to advocate a change of approach, with the SNP presenting itself as a civic, Montenegrin party. However, at a meeting of the SNP's main committee in November the pro-Serb majority rejected a proposal calling for the display of the Montenegrin flag and the singing of the Montenegrin national anthem at the party's forthcoming congress.

In another attempt at a break with the past, the reformers inside the SNP have started to support NATO accession, which continues to be opposed by prominent party figures-including a former SNP leader, Predrag Bulatovic-who insist that a referendum should be held before Montenegro joins the alliance. Opponents of NATO entry say that participation in its Partnership for Peace (PfP) programme, seen by many other countries as an anteroom for eventual full NATO membership, is a sufficient basis for relations with the alliance.

The visit by the president of Serbia, Boris Tadic, to Montenegro's capital Podgorica on November 19th signalled an improvement in relations between the two countries, which have been strained since Montenegro's declaration of independence in 2006. The strains were highlighted by Montenegro's recognition of Kosovo's declaration of independence from Serbia in 2008, and more recently by accusations on the part of the Serbian authorities that Montenegro was sheltering criminals, including drug smugglers wanted in Serbia. As part of the relaxation of tensions, at the end of October the two countries signed an extradition treaty, which may help overcome the disagreements over tackling crime. During his visit to Montenegro Mr Tadic and Mr Vujanovic expressed mutual support for their two countries' EU accession bids. Mr Vujanovic responded positively to Mr Tadic's suggestion that the two states could establish joint diplomatic offices in some countries.

Mr Tadic also met Mr Djukanovic, but for the second time in recent months he spurned the speaker of parliament, Ranko Krivokapic. Mr Tadic's decision may have been prompted by his irritation about having been drawn into a dispute between Montenegro's parliamentary speaker and president. As part of the dispute Mr Krivokapic had accused Mr Vujanovic of seeking to establish closer links with Montenegro's pro-Serbian opposition parties by holding a secret meeting with Mr Tadic earlier in the year.

The Economist Intelligence Unit's democracy index for 2010 ranks Montenegro 68th out of 167 countries—three places down on its ranking in 2008—putting it among states that are considered to be flawed democracies. It shares that category with 14 other formerly communist-ruled European countries. Two of Montenegro's neighbours, Albania and Bosnia and Hercegovina (BiH) are ranked lower among hybrid regimes. Montenegro's overall score (out of 10) declined from 6.43 in 2008 to 6.27 in 2010.

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Montenegro's highest score is in the electoral process category. National elections are generally regarded as being free and fair. Political parties and civil society are relatively vibrant, with a large number of parties and non-governmental organisations (NGOs). Transfers of power after parliamentary elections have also been orderly, although this is largely because the Democratic Party of Socialists (DPS) has practically monopolised power since it emerged as the successor to the ruling communist party in 1991. Montenegro also scores well in the civil liberties category, indicating that political, religious and ethnic minority rights are broadly respected, and efforts are made to deal with violations of these rights.

Democracy is weakened by the poor quality of the public administration

Montenegro has a relatively poor score in the functioning of government category. The local authorities are under pressure from the EU to improve the capacity of the public administration and to strengthen the rule of law—especially after the EU's decision in December 2010 to grant Montenegro the status of a candidate for EU membership. The European Commission has frequently expressed concern about constitutional and legal uncertainty, politicisation of the administration, low implementation capacity, high levels of corruption, and the influence of organised crime. Montenegro also has a relatively poor ranking in the political culture category, partly because of the prevailing system of political patronage operated by the DPS, and partly because opposition parties frequently resort to walk-outs instead of arguing their case in parliament.

The impact of the economic crisis

Montenegro's scores in the electoral process, civil liberties and political culture categories have declined since 2008, partly under the impact of the economic downturn of 2009, which followed years of robust growth. Citizens' trust in democracy was adversely affected by the government's decision to call a parliamentary election 18 months ahead of schedule, in March 2009—before the full impact of the recession had become clear to the public. The economic crisis also appears to have contributed to the authorities' efforts to tighten their control over their clientage network, which was highlighted by the replacement, in October 2010, of the independent-minded governor or the Central Bank of Montenegro (CBM) with a member of parliament representing the DPS. However, concerns that the combined impact of the recession and the weakness of the traditionally fragmented political opposition might result in the public's discontent being expressed through extra-parliamentary protests have not materialised. Nevertheless, a weaker than expected economic recovery may yet trigger more serious street demonstrations and other forms of direct action by workers, especially by those employed at the troubled Podgorica Aluminium Plant (KAP).

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A global heat map showing regime types and a free white paper containing the full index and detailed methodology can be found at www.eiu.com/DemocracyIndex.

Note on methodology

There is no consensus on how to measure democracy and definitions of democracy are contested. Having free and fair competitive elections, and satisfying related aspects of political freedom, is the sine qua non of all definitions. However, our index is based on the view that measures of democracy that reflect the state of political freedom and civil liberties are not "thick" enough: they do not encompass sufficiently some crucial features that determine the quality and substance of democracy. Thus, our index also includes measures of political participation, political culture and functioning of government, which are, at best, marginalised by other measures.

Our index of democracy covers 167 countries and territories. The index, on a 0 to 10 scale, is based on the ratings for 60 indicators grouped in five categories: electoral process and pluralism; civil liberties; the functioning of government; political participation; and political culture. The five categories are inter-related and form a coherent conceptual whole. Each category has a rating on a 0 to 10 scale, and the overall index of democracy is the simple average of the five category indexes.

The category indexes are based on the sum of the indicator scores in the category, converted to a 0 to 10 scale. Adjustments to the category scores are made if countries fall short in the following critical areas for democracy:

• whether national elections are free and fair;
• the security of voters;
• the influence of foreign powers on government; and
• the capability of the civil service to implement policies.

The index values are used to place countries within one of four types of regimes:

• full democracies—scores of 8 to 10;
• flawed democracies—score of 6 to 7.9;
• hybrid regimes—scores of 4 to 5.9;
• authoritarian regimes—scores below 4.

The fiscal situation improved in the third quarter of 2010, with the budget posting a surplus of EUR11.9m (US$15.4m), following a contraction of 15.8% year on year in expenditure and a 5.5% decline in revenue. Tax receipts shrank by 2.6% year on year, following a collapse in direct tax revenue, with personal income tax and corporation tax receipts plunging by 25% and 71.2% year on year, respectively, partly as a result of tax rate cuts introduced in January 2010. Indirect taxes fared better, with the biggest source of fiscal revenue, value-added tax (VAT), up by 7.6% year on year, excise duty rising by 0.3% and customs tariffs by 15%. The increase in the rate of social contributions levied on wages, which was introduced at the same time as the tax rate cuts, helped to boost social contributions by a robust 14.2% year on year. All other revenue categories posted year-on-year contractions, with receipts from fees down by 4.8%, from duties down by 15.9%, and from loan repayments down by 96.6%.

The sharp drop in expenditure was the result mainly of a significant contraction in non-current expenditure. Current expenditure shrank by only 1.2% year on year, with the two wage bill categories, gross salaries and contributions and "other personal income", soaring by 32.8% and 69.5% year on year, respectively. Among the other current expenditure categories, spending on supplies and services declined by 17.9% year on year, interest payments were down by 34.2%, and subsidies were down by 67.5%.

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Social security transfers declined in the third quarter by 5.2% year on year, but at EUR109.5m they remained EUR17m above the receipts from social contributions. Other transfers dropped by 26.4%, while capital expenditure was halved compared with a year earlier, contributing to a large underspend in the first nine months of the year, with only slightly more than one-third of the planned expenditure being spent in that period. Loans and credits plunged by 93.8% year on year in the third quarter-down to EUR1m from EUR15.2m a year earlier.

The surplus in the third quarter, together with a surplus of EUR23.9m in the second quarter, helped to eliminate the cumulative deficit of the first nine months of 2010. The outturn was considerably better than the projected January-September deficit of EUR156.3m contained in the budget. The improved fiscal outcome resulted from a sharper under-execution of expenditure than revenue; the outturn of expenditure was 81.9% of the planned amount, while revenue amounted to 96.9% of the planned amount. However, with much of the annual expenditure usually executed in the final quarter of the year, the full-year budget for 2010 was set to produce a large deficit.

Despite the better than expected budget outturn in January-September, Montenegro's fiscal outlook remains uncertain owing to the continuing decline in revenue. The most recent projection of the Ministry of Finance expects a budget deficit of EUR120m (or 4% of the projected GDP) in 2010, as a result of accelerating spending in the final quarter of the year. To secure financing, the government has been discussing with the World Bank a possible budget support loan worth US$85m, to be made available in early 2011.

The financing of the deficit has been made more difficult by the sluggish pace of privatisation. Receipts from privatisation and the sale of publicly owned real estate amounted to only EUR2.8m in the first nine months of 2010 compared with EUR44.3m planned in the budget. The poor receipts from privatisation were a reflection of the lack of interest on the part of foreign investors. A case in point is Montenegro Airlines, in which a 30% stake was put up for sale again in September 2010, following the failure of a tender in 2009. The response to the latest tender has so far been muted.

The Council of the Central Bank of Montenegro (CBM) headed by the new governor, Radoje Zugic, adopted monetary policy guidelines for 2011 at its meeting on November 30th. The document underlined the need to continue strengthening the supervision of the financial and banking systems and reiterated the CBM's support for the government's policies to foster economic growth, as long as these policies did not compromise the bank's key objective of maintaining price stability. The inflation report for the third quarter of 2010, adopted by the council, expected inflation at end-2010 in the range of 0.6%-1.5%, and it noted that the Montenegrin economy had moved out of recession in the third quarter. A survey carried out by the CBM pointed to an increasing number of enterprises planning to hire new staff and increasing investments in the near future, which should ensure the gradual acceleration of economic growth in late 2010 and in the course of 2011.

The European Commission's annual progress report on Montenegro, published on November 9th, was sufficiently positive for the Commission to be able to issue a recommendation that Montenegro should be granted the status of a candidate for EU membership. However, the Commission recommended that the applicant needed to implement further reforms before EU accession talks could get under way. The Commission praised Montenegro's good track record in the implementation of economic reforms and a broad domestic consensus on the fundamentals of economic policy. The report acknowledged the role of privatisation and the abolition of price controls in the establishment of conditions for the functioning of a market economy, and it commended the steps taken to improve the business environment, which had attracted sizeable foreign direct investment (FDI). The Commission assessed the Montenegrin economy as being very open, as manifested by the high volume of foreign trade and FDI and by the high degree of integration with the economies of the EU and the rest of the western Balkan region.

However, the Commission noted that Montenegro needed to address a number of internal and external imbalances before it could be considered as a functioning market economy. In particular, the report pointed to the weaknesses of the financial sector, which had been exposed by the global financial crisis, and it called for the strengthening of the regulation and supervision of the Montenegrin banking sector. Addressing the issue of the persistently high level of unemployment, the report argued that this should be tackled by relaxing some labour market rigidities and by reforms in Montenegro's educational and vocational training systems. Among the other weaknesses that the Commission highlighted were the insufficient development of the energy and transport infrastructure and the existence of a large informal sector, which has a negative impact on the business environment.

Industrial output in the first ten months of 2010 rebounded by 11.9% year on year. After declining by 14.4% year on year in the first quarter, growth in industrial output returned at a rate of 22% year on year in the second quarter, accelerated to 41.7% in the third quarter, and continued at 37.1% in October. The improvement in industrial performance was driven by a surge in output in the energy and in the mining and quarrying sectors. The expansion in the energy sector was helped by the privatisation of the state-owned energy company, Elektroprivreda Crne Gore (EPCG), and the ensuing investments in boosting capacity. The increase in electricity generation-with two-thirds of Montenegro's output provided by the hydropower stations at Perucica and Piva and one-third by the thermal plant at Pljevlja-accelerated from 22% year on year in the second quarter to 41.7% in the third quarter and to 50% in October. Electricity output in the first ten months of 2010 was 48.2% higher than a year earlier and was well above projections.

The robust rebound in production, coupled with sluggish domestic demand, made it possible for Montenegro to export electricity for the first time in several years. The prospects for medium- and long-term growth in the energy sector received a boost in late November with the signing of an agreement on the construction of a 450-km energy-interconnector-cable linking Montenegro and Italy under the Adriatic Sea. The project, worth around EUR860m, involves building additional grid infrastructure to link Montenegro with Bosnia and Hercegovina (BiH) and Serbia, which will turn Montenegro into a key energy hub in the region in a few years' time.

Manufacturing performance improved markedly in the course of 2010, with the decline in output slowing from 31.3% year on year in the first quarter to 5.1% in the second quarter, before growth returned at a rate of 4.3% year on year in the third quarter and 21.6% in October. The improvement reflected strong results in chemicals and mineral products and a modest rebound in the key sector, basic metals, which accounts for around one-half of manufacturing output. Output of basic metals rose by 1.7% year on year in August-marking the first increase since early 2008-before declining by 1.5% in September and expanding again by 17.2% in October. After more than two years of continuous decline, associated with the collapse of output at the troubled Podgorica Aluminium Plant (KAP), the output of basic metals in January-October 2010 was around one-third of the pre-crisis level achieved in the same period in 2007.

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The volume of retail trade at constant prices rose by 3.9% in the third quarter, down from 6.3% growth in the second quarter. In January-September the volume of retail trade was 3.2% higher than a year earlier (or 1.8% higher at current prices), increasing the likelihood that the biggest sector by value added of the Montenegrin economy will have made a modest positive contribution to real GDP growth in 2010.

Transport and telecommunications-the second-biggest sector after retail trade-produced mixed results in the third quarter. While road transport of goods and people shrank by 20% and 12.5% year on year, respectively, air transport of freight soared by 177.2% and of people by 22.5%, continuing the good results of the previous quarter. Rail transport of goods rose by 34% year on year in the third quarter, while rail passenger traffic contracted by 5.2%. Sea transport of goods declined by 6.7% in the third quarter. Telecommunications recorded a strong quarter, with one of the key indicators, the number of minutes used in mobile telephone calls, up by 8.5% compared with the third quarter of 2009.

After peaking at 17.7% year on year in August, gross wage growth slowed to 13.6% and 12.3%, respectively, in September and October. The higher tax burden, starting with the introduction of an increased rate of social contributions in January 2010, depressed net wage growth, which decelerated from 9.3% year on year in August to 4.6% in October. Viewed by sectors, net wages have been rising the fastest in mining and quarrying, where they increased by 25% year on year in October, and accelerated markedly in manufacturing, from 0.5% in June to 19.2% in October. The thriving energy and catering sectors also produced double-digit increases in net wages on a year-on-year basis in recent months. In contrast to these increases, net wages in financial intermediation declined by 4.9% in October, and there was a similar contraction in most public sectors, including the state administration and health and social care.

The average monthly wage in the first ten months of 2010 amounted to EUR475, up by 2.8% on the same period last year. Employees in financial intermediation were the best-paid, with a net wage that was 84% higher than the average, while those working in the energy sector, mining and quarrying, and transport and communications were paid, respectively, 44%, 36% and 30% more than the average. The lowest-paid were employed in fishing, retail trade and catering, with wages corresponding to 37%, 62% and 76.2% of the average, respectively.

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Despite the conclusion by the Central Bank of Montenegro (CBM) that Montenegro had moved out of recession, credit to the economy continued to shrink in the third quarter, with the rate of contraction in the volume of credit, at around 11-12% year on year, little changed since February 2010. Credit to firms, accounting for around 60% of the total, shrank by 14.3% year on year in September, and credit to households declined by 9%.

The dynamics of deposit growth were strongly influenced by base effects. Deposit growth, which accelerated in July and August to 4.5% and 7.9% year on year, respectively, turned negative in September and declined by 6.2%, reflecting a one-off surge in deposits a year earlier. In September 2009 state company deposits soared by 290% year on year-up from 9.3% in August-as a result of the partial privatisation and recapitalisation of the state-owned power company, EPCG. Household deposits grew steadily in the third quarter of 2010, accelerating from 15.7% year-on-year growth in June to 18.5% in September. Time deposits, accounting for two-thirds of all household deposits, led the expansion, accelerating to 19.7% year on year in September, the fastest rate in two years.

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After declining by 0.1% in August, the consumer price index (CPI) rose by 0.3% in September and by 0.6% in October, driven by higher food and fuel prices. Food price inflation picked up from 0.9% in August to 2.2% in October, reflecting rising prices of bread and cereals, sugar and vegetables. Inflation in the transport and communications category accelerated as a result of higher motor fuel prices, which increased from 7% year on year in August to 11.4% in October, and the introduction of higher prices for postal services, which went up by 11.6% month on month in October. The prices of alcohol and tobacco continued to decline, helped by the absence of any increase in excise duties in 2010. However, the authorities have announced that they will raise alcohol and tobacco excise duty rates in January 2011 in a move towards harmonising domestic excise rates with the minimum rates prevailing in the EU.

Inflation in most other categories remained subdued, reflecting the continuation of weak domestic demand and low prices on the markets of countries that are the main sources of Montenegro's imports. Deflation in housing and utilities-the biggest spending category after food-stabilised at around 7% year on year in the third quarter, reflecting a decline in rents and an 11.3% decrease in the price of electricity.

Montenegro's export performance remained strong in the third quarter of 2010 and in October, although the rate of growth slowed markedly compared with the second quarter. The value of exports rose by 14.8% year on year in the third quarter and by 8.1% in October-down from 66.3% in the second quarter-with the growth driven largely by raw materials and energy. Exports of petroleum products surged by 191.4% year on year in July-September and by 114.7% in October. Electricity exports benefited from the increased domestic surplus, rising from zero in 2009 to EUR11.9m, which was the equivalent of 4.6% of total exports in the first ten months of the year. Exports of metal ores and scrap metals soared by 191.2% year on year in the third quarter and by 112.9% in October. However, the dynamics of Montenegro's main export commodity, aluminium, took a turn for the worse, plunging from an increase of 146.3% year on year in the second quarter to growth of 9.4% in the third quarter, and then shrinking by 14.4% in October.

Imports increased more modestly, growing by 6.8% year on year in the third quarter-unchanged from the second quarter-and contracting by 8.7% in October. Imports of foodstuffs accelerated gradually, from a contraction of 0.4% year on year in the second quarter to growth of 3.3% in the third quarter and 5.7% in October. Demand for machinery and transport equipment slowed, with growth decelerating from 13.2% year on year in the second quarter to 8.3% in the third quarter, before contracting by 26.3% in October. There was robust growth in demand for petroleum, with imports rising by 31% year on year in April-June, by 27.5% in July-September and by 39.2% in October.

The EU remained the largest export market for Montenegrin goods, with its share in total exports rising to 55% in the first ten months of 2010, from 51% a year earlier. During the same period the share of Central European Free Trade Agreement (CEFTA) countries in Montenegro's exports declined to 40% of the total, from 46.3% in the first ten months of 2009. Serbia remained the biggest single-country destination for Montenegrin exports, with a share of 23.2% in January-October, shrinking from 27.6% a year earlier, which reflected the growing competitive disadvantage stemming from the weakening of the Serbian dinar. Greece and Italy remained in second and third place, respectively, with the share of the former at 19.3% and that of the latter at 11.3% of total exports, representing a modest decline compared with the year-earlier period. Exports to several smaller EU markets rose robustly, with sales to Hungary soaring by 99.6% year on year, to Austria by 67.7%, and to the Netherlands by 52%.

The share of the EU in Montenegro's total imports remained largely stable, declining to 37.4% in the first ten months of 2010, from 38% a year earlier. The share of CEFTA countries as a source of imports increased by 1.3 percentage points to 40.6% during the same period. Serbia retained its position as the biggest source of Montenegrin imports, with a 26.2% share of the total in January-October, which represented a modest year-on-year contraction. There was little change in the value of imports from Montenegro's other main trade partners, Greece, China and Germany, except for Bosnia and Hercegovina (BiH), which increased sales to Montenegro by 52.4% year on year in the first ten months of 2010.

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