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Can Montenegro make up for breaking the rules on the Euro?

Montenegro looks to be a strong candidate to become the EU’s next new member state, but its government’s unilateral adoption of the Euro as the country’s sole currency in 2002 may yet stand in its way. In order to have any chance of concluding negotiations on EU acquis chapters related to monetary policy and financial control while retaining the Euro, the Montenegrin government will need to prove that it is willing to play by the rules in future and to crack down on widespread financial irregularities and corruption.

Montenegro made its first steps towards unilateral adoption of the Euro in 1999. Yugoslavia had by this time been reduced by dint of war and politics to a two-republic federation comprising Montenegro and its senior partner, Serbia. But Serbia’s economy was in tatters as a result of economic sanctions placed on it during the war, and it had become an economic albatross for Montenegro. Fearing further economic turmoil, the government unilaterally declared the Deutschmark parallel legal tender with the Yugoslav Novi Dinar in Montenegro. Over the next two years, a Montenegrin Central Bank was established, the Dinar was slowly withdrawn from circulation, and the Deutschmark was eventually declared the country’s sole legal tender.

By this time, the Deutschmark was already pegged to the Euro, which had been in existence as a virtual currency since the 1st January 1999. Three years later, it was introduced as a physical currency and the sole legal tender of eleven EU member states, as well as San Marino, Monaco and the Vatican City, all of which had made prior arrangements with the EU. Montenegro had not made any such agreement, but as the Deutschmark ceased to exist, it too switched to the Euro with “a kind of tacit consent” from the Union [1].

A timeline of the introduction of the Euro (created by the author using piktochart.com)
A timeline of the introduction of the Euro (created by the author using piktochart.com)

Economic & Political factors

Euroisation in Montenegro was motivated by both economic and political considerations. The economic motives were clear; hyperinflation had led to five revaluations of the Dinar between 1990 and 1994, when it was replaced with the Novi Dinar at the rate of 13 million to one; a significant proportion of the country’s trade was oriented towards the EU, and it had “significant workforce flexibility” with a relatively large proportion of its population already working abroad [2]. Furthermore, Serbia was retaining any income made through seniorage of the Novi Dinar, that is money derived from the difference in the cost of producing money and the value it represents. Katarzyna Kubiszewska writes that is in exactly such circumstances, where a small but relatively open economy “[has] experienced hyperinflation and obtain[s] relatively low seniorage incomes” that the adoption of a foreign currency becomes both economically viable and advantageous [3].

Yugoslav Dinar banknotes during hyperinflation
Yugoslav Dinar banknotes during hyperinflation

There were three main economic advantages to be gained through the adoption of the Euro. Firstly, it should foster macroeconomic stability which was at the time still under threat from the shattered credibility of the Yugoslav economy. Secondly, it should lower the risk premium of doing business in Montenegro as the Montenegrin government could realistically assure potential investors that there would be no sudden devaluation of its currency. Thirdly, the Euro would eliminate transaction costs between Montenegro and the Eurozone, thus easing trade and investment, as well as the transference of remittances from the not inconsiderable number of Montenegrins living in the Euro area [4].

Politically, adoption of the Euro also allowed the Montenegrin government to disassociate itself from the widely unpopular régime of Slobodan Milošević in the eyes of the West. It would also help prepare the Montenegrin people for independence. At the time, the government was investing significant efforts in state building efforts, for example the creation of a Council for the Codification of the Montenegrin Language in 1998, which aimed to create a standardised Montenegrin language differentiated from the Serbian standard. While Montenegro did not achieve independence until 2006, the state-building process began much earlier [5].

Of course, adoption of the Euro was not without its costs. Most importantly, Montenegro lost its ability to pursue an independent monetary policy adapted to its own economic needs, rather than those of the Eurozone. The European Central Bank (ECB) is under no obligation to consider the needs of non-Eurozone countries, and thus in the event of an asymmetric shock disproportionately affecting the Montenegrin economy, the needs of the Eurozone will always take precedence. Furthermore, should the Eurozone experience economic troubles (as was the case after 2008/9), Montenegro would be much more vulnerable to its fallout than if it maintained its own currency.

Mixed results

Despite these considerations, the Montenegrin government went ahead with its plan to unilaterally adopt the Euro. The results of this were, in fact, generally positive. A European Central Bank report in 2004 wrote that “with euroisation, post-war reconstruction was put on a sound monetary footing, eschewing credibility problems related to the former domestic currency” [5a]. With the Montenegrin government committing itself to first German and later Eurozone economic policy, inflation rates in Montenegro rapidly declined [4]; Foreign Direct Investment (FDI), concentrated mainly in the tourist sector, increased from €52 million in 2004 to €330 million in 2013 [6]; and significant contributions to the Montenegrin economy were made in the form of remittances [2].

Euroisation was not without its challenges, however. It removed Montenegro’s ability to use monetary policy instruments to react to asymmetric shocks and fluctuations in the business cycle not experienced within the Eurozone. The financial crisis in Europe since 2008  has had a particularly bad effect on the Montenegrin economy, partly due to this limitation of government economic policy, and GDP growth was reduced from 10.7% in 2007 to -5.7% in 2009 [4]. Since 2009, growth has fluctuated between these two points, but is yet to settle for a longer period.

The main casualty of Montenegro’s unilateral adoption of the Euro, however, is its relationship with the European Union itself. While the Montenegrin economy is not large enough to have a substantial effect on the Eurozone, the EU does not want to encourage other economically unstable states adopt the Euro with no formal agreement. The ECB maintains strict conditions for membership of the Eurozone in terms of economic stability and public finances, known as the Maastricht convergence criteria. These conditions include a cap on government debt in relation to GDP of 60% and a government deficit of no more than 3%, both of which Montenegro currently exceeds [10]. Moreover, even if Montenegro were to meet these standards, the EU maintains that any country adopting the Euro needs, “first and foremost, to be a member of the EU” [7].

ECB_2268036b
ECB Headquarters in Frankfurt

The EU has also expressed concern over Montenegro’s financial management, and particularly the problem of money laundering, which has been eased significantly by the country’s use of the Euro without the stringent financial checks of the Eurozone itself. Charles Tannock MEP, the European Parliament’s rapporteur on Montenegro claimed in 2010 that it is ”a very easy place for organised crime to go, buy large amounts of unregistered euro notes through the banking system and launder them for their notes coming from another jurisdiction, because the banks don’t keep track of where the notes come from.” He also condemned the Montenegrin government’s complicity in a cigarette-smuggling operation, which it has claimed was necessary to finance the country’s deficit budget [8]. Clearly such arrangements will not be tolerated if Montenegro hopes to move forward in its membership negotiations with the European Union.

 Commitment to change

While the ECB has neither explicitly condemned nor sanctioned the country’s adoption of the Euro, Executive Board Member Benoît Coeure argues that “[h]aving the euro as a currency in a sense puts the bar even higher in terms of sustainable convergence, if you don’t have your own currency any more, you’ve got to be even more serious in terms of reducing external imbalances, in terms of achieving fiscal sustainability” [9]. The Montenegrin government claims that it’s current efforts are squarely aimed at proving this commitment, imposing strict austerity conditions, including a freeze on pensions and additional taxation of earnings [1].

President Đukanović meets with European Council President Donald Tusk
President Đukanović meets with European Council President Donald Tusk

Earlier this year, however, protests broke out on the streets of Podgorica, with protestors claiming that what the country needs is not austerity but an end to economic mismanagement and corruption, and calling for the resignation of long-time Prime Minister, Milo Đukanović. In an opinion piece for the Financial Times in October 2014, Đukanović claimed that his government is “deeply committed to the European path” and has implemented “far-reaching economic and political reform” [6]. Yet here too he has faced criticism from those who accuse him of undermining their investments and appropriating private property. A series of commercial disputes with investors currently being examined by international courts could cost the country up to €1 billion in total at a time when it can ill-afford such a massive capital loss [10].

The EU certainly has a role in helping Montenegro overcome these difficulties. In September 2014, a Memorandum of Understanding was signed by ECB president Mario Draghi and the governor of the Central Bank of Montenegro, Milojica Dakić. At the same time, the ECB launched a Eurosystem Cooperation Programme with the Central Bank of Montenegro in order to help it meet the conditions necessary to join the European System of Central Banks (ESCB) upon future EU accession. Almost €300,000 was allocated to this programme, and it is hoped the result will be a marked improvement in the country’s financial sector [11].

How can Montenegro avoid the worst?

Only time will tell what the outcome of EU efforts in Montenegro will be. A worst case scenario for the country would be a return to its own national currency and later adoption of the Euro as a EU member state. The EU is unlikely to force such a scenario, which would have serious repercussions for the Montenegrin economy, but nor will it allow Montenegro’s unilateral adoption of the Euro to serve as an example to other non-EU states experiencing economic instability, for example Ukraine. Instead, the EU will most likely adopt a position that lies somewhere between the two extremes, allowing Montenegro to continue to use the Euro, but not to formally join the Euro area until certain strict criteria have been met.

But this comes with a caveat. The EU has already shown its willingness to help the country to achieve this aim, but without sustained and serious reform on the part of the Montenegrin government, as well as action to tackle organised crime and money laundering, Montenegro risks becoming a liability to the Euro area and the EU as a whole. This could lead to increased EU intransigence and opposition to the country’s future membership and even its continued use of the Euro. To avoid such a scenario, Montenegro should strive to align its financial regulation with that of the EU and to meet the Maastricht convergence criteria as soon as possible; money laundering should be tackled head-on in line with European standards and efforts should be made to root out corruption at all levels of governance. The costs of a failure to do so while hoping to retain the Euro would be severe.

References and further information

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