1. Structural developments

a. Policies

Malta’s economic development during the past seven years has been shaped by a mixture of deregulation, liberalization, and selected government intervention. Through its structural reform program some of the distortions to economic decision taking have been removed and incentives provided to improve competitiveness. The deregulation and development of the financial system has also helped to support an increase in saving rates, thereby facilitating the financing of a prolonged phase of sustained growth (Chart 2). At the same time, the ongoing transformation of the Maltese economy toward a more market-oriented and open system has been accompanied by a high level of public expenditure, both current and capital, and an active industrial policy.

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MALTA: SAVING AND INVESTMENT

(In percent of GNP)

Citation: IMF Staff Country Reports 1995, 052; 10.5089/9781451826548.002.A001

Source: Data provided by the Maltese authorities; and staff estimates.

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Regarding deregulation of the economy, the authorities almost completed the dismantling of the state bulk-buying and price stabilization scheme for imports of commodity goods during 1992 and 1993. From all the goods originally included in the scheme, only barley, maize, wheat and frozen beef are still subject to control. In addition, the system of Price controls (essentially the regulation of maximum profit margins) has been eased significantly since 1988–89 and retail prices are now only loosely monitored for the purpose of consumer protection. Furthermore, Parliament recently passed legislation to regulate anti-trust activities, which envisages the creation of an independent body that will be responsible for overseeing competition in Malta. This will permit the total abolition of price controls and will be complemented by a soon-to-be-enacted Consumer Affairs Bill to strengthen consumer protection. Significant deregulation has also been achieved in the financial sector where the Government’s majority shareholding in one of the three commercial banks has been privatized, interest rates have been partially liberalized, and steps have been taken to develop financial markets.^1/

In the area of trade barriers, most quotas have now been eliminated, import licensing requirements have been simplified, and tariff rates reduced.^2/ Further tariff reductions are scheduled for January 1, 1995 as the introduction of a VAT will not only complete a far-reaching tax reform, but also permit the adoption of an EU tariff structure.^3/ Earlier tax reform had included a radical reduction in marginal income tax rates. Finally, in the field of privatization, some 66 publicly owned enterprises have been sold off or liquidated in the past two years.

At the same time that structural policies have encouraged greater private sector initiative, the Government’s direct command of resources has remained at a high level. Public consumption grew at about 10 percent a year in real terms between 1987–91, primarily fueled by public sector wage rises and increasing expenditure on social programs, while capital expenditure by the combined general government and public enterprise sector increased by almost 40 percent a year in real terms in the same period. Current public spending continued to rise rapidly in 1992–93. However, an easing of the capital spending program from 1991 onward helped to contain overall public spending growth. Nevertheless, the government sector remains large as indicated by the fact that some 42 percent of the employed labor force currently works in the public sector.

In the case of industrial policy, the Government has placed a heavy emphasis on active promotion of investment in high value added export-oriented manufacturing activities. The principal vehicle for this policy is the Malta Development Corporation (MDC), which administers a comprehensive program of investment incentives established by the Government in 1987 and aimed primarily, but not solely, at foreign investors. The main incentives are low interest rate (3 percent) loans for investment in plant and equipment, tax holidays, the provision of rent-subsidized government-built factories, and training grants.^1/ Up to 1993, MDC granted soft loans averaging around Lm 1.4 million per annum to companies operating mainly in the electronics and electrical, medical and pharmaceutical, and textiles and clothing subsectors. MDC grants to companies for employee training totaled approximately Lm 2.6 million over the period 1987–92, benefiting around 470 companies and 19,600 employees (or around 17 percent of all persons employed in the manufacturing sector). On a per person basis, the training grants have amounted to approximately Lm 140 or around 3 weeks average earnings.

MDC operations expanded in 1993. In particular, it reached an agreement with Hambro European Ventures Limited to set up a venture capital fund “The Malta Development Fund” that will make equity investments in companies seeking development capital and it developed the Mosta Technopark, a custom-designed technology park that offers companies advanced levels of factory premises with supporting infrastructure, targeted at high technology electronics and information technology companies. Moreover, the Industrial Development Act was amended to recognize the potential growth in the services sector, allowing the Corporation to translate government economic policy into effective support to promote targeted service industries.

Direct subsidies are a further important element of industrial policy. The tourism sector has benefited in particular from a forward exchange rate subsidy provided to British package tour operators that in some years has exceeded 1 percent of GDP. The forward buying arrangement is scheduled to be phased out by the 1997 winter season. The shipbuilding and ship repair sectors have also been receiving heavy government subsidies, although lately the assistance has become more a means for survival than a promotion device. In recognition of the lack of profit potential, the authorities reached agreement in October 1994 on a restructuring of the sectors. The two sectors are to be merged, and part of the shipbuilding arm is to be split into two new companies, constructing cranes and containers. Some slimming of the 5,000 plus workforce is also envisaged through early retirement schemes.

b. Output trends

The policy framework in Malta has reinforced three trends in the structure of output since 1987. First, service activities have been growing at the expense of the industrial sector, with the insurance, banking, and real state sector, together with tourism-related sectors constituting the fastest growing sectors (Chart 3). Second, the declining relative share of the manufacturing sector includes subsectors that have maintained or even expanded their contribution to national output as a consequence of export- oriented strategies. Third, the public sector’s output share has continued to rise as a result of high government spending and investment by public enterprises.

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MALTA: SECTORAL DISTRIBUTION OF GDP

(In percent of GDP at factor cost)

Citation: IMF Staff Country Reports 1995, 052; 10.5089/9781451826548.002.A001

Source: Data provided by the Maltese authorities.

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(1) Industry

The share of industry in GDP at factor cost has declined since 1987, falling from over 40 percent in 1987 to 35 percent in 1993 (Table A1). Much of this decline was accounted for by the relatively poor performance of the manufacturing sector. The share of the construction and quarrying sector, which was sustained to some extent through 1991 by public infra-structure projects, declined only modestly.

The experiences of various subsectors of manufacturing have differed considerably since 1987. For example, the textiles, footwear and clothing industries, which still account for the largest share of value added (19 percent) and employment (23 percent) in the manufacturing sector, has experienced a further shakeout in their share of value added and employment following import liberalization in 1987. At the same time the export orientation of these industries has increased with 87 percent of combined sales going abroad in 1993 compared with 81 percent in 1987.

By contrast, the machinery sector (which includes electronics) has benefited from significant foreign investment in recent years and has seen its share of output rise. Most of the investment has been in the electronics industry, which is dominated by a single firm, SGS Thomson Micro-electronics, which imports most of it component inputs from Italy where its parent company is based. The machinery sector is almost wholly export oriented.

The chemical, paper and printing, and leather and rubber sectors have also competed successfully in the more open environment of recent years. Together they represent 13 percent of manufacturing sales, 15 percent of employment in manufactures, and 15 percent of its value added. Chemical exports as well as domestic sales have been growing impressively in recent years: between 1987 and 1993, total sales nearly doubled and exports have trebled. The paper and printing sector has also been experiencing strong growth since 1987, following a period of re-structuring in the mid-to late-1980s. Similarly, the heavily export-oriented leather and rubber sector has grown at an average rate of 15 percent in the last four years.

Another sector that has grown steadily in recent years is the relatively protected food and beverages sector, which in 1993 contributed about 19 percent of manufacturing value added and over 14 percent of manufacturing employment. While this sector remains highly domestically oriented with over 90 percent of sales dependent on the local market, export sales increased markedly over 1990–92 (averaging almost 50 percent per year), albeit from a low level.

Finally, structural adjustment has been slow in the large parastatal shipbuilding and ship repair companies which dominate the transport sector and provides about 7 percent of total jobs in the manufacturing sector. Both companies made persistent, large trading losses throughout the 1980s and remain heavily dependent on government subsidies for their survival. Although there has been some employment decrease, mainly because of an Early Retirement Scheme agreed between the Government and Malta Drydocks in 1989, the shipbuilding and ship repair companies still employ about 5,300 people (almost 4 percent of total employment). The restructuring agreement made in October of this year (see above) holds promise of a more radical restructuring.

(2) Services

The services sector experienced more than 10 percent growth on average in 1987–93, with the result that the share of service activities in GDP at factor cost has grown from 55 percent in 1987 to 62 percent in 1993. The strong expansion in the services sector has been broadly based, with notable strength in the tourism sector, which, in turn, has supported a strong expansion in tourism-related services (transport, retail trade, private and property services). Other areas of rapid growth have been banking, insurance, and real estate activities (which have increased as a share of GDP from around 5 percent in 1987 to 7.7 percent in 1993), and public administration (which has risen from around 13.9 percent of GDP in 1987 to over 16 percent in 1993).

Tourism is a key sector of the Maltese economy, accounting for a quarter of exports of goods and nonfactor services and contributing both directly and through related activities as much as one third of GDP.^1/ While direct employment in the tourism sector is only 6 percent of total employment, many downstream jobs are reliant on tourism. Tourism earnings and employment grew markedly over 1987–93, foreign exchange earnings increased by more than 16 percent per annum on average and tourism arrivals grew by almost 10 percent per annum on average.

The tourism sector has also undergone significant structural shifts. The proportion of tourists originating from the United Kingdom has declined from more than 70 percent in the early 1980s to about 50 percent, in part because of a deliberate strategy on the part of the tourism industry and Government to reduce dependence on the lower income segment of the U.K. market by increasingly targeting growth in earnings per tourist rather than tourist numbers. Correspondingly, tourists from continental European markets have expanded rapidly in numbers with German tourists now accounting for almost 17 percent of all tourist arrivals (up from around 3 percent in 1981). In pursuing this strategy, a number of initiatives (targeted marketing campaigns, ongoing upgrading of accommodation and other facilities, etc.) have been set in place. Somewhat anomalously, the authorities have continued the exchange rate subsidy provided to United Kingdom and Irish package tour operators, which distorts tourism market shares in a manner that is inconsistent with the objectives of diversification.^1/

2. Recent economic developments

a. Expenditure

The slowdown in real GDP growth in 1992 from its early rapid pace reflected a reduction in domestic demand growth to 0.3 percent from 4.9 percent in 1991, which offset a continued large contribution to growth from the external sector. In turn, the weak performance of domestic demand in 1992 reflected stagnant investment and heavy destocking; consumption continued to expand steadily. Conversely, led by a recovery in investment growth, domestic demand rebounded in 1993 to 4.5 percent in real terms, thereby supporting overall growth at a time when the recession in continental Europe dampened exports considerably (Tables A2 and A3 and Table 1 below).

Table 1.

Expenditure Components of GDP

(Real rates of growth, in percent)

Source: Table A2.

^1/First three quarters over corresponding period a year earlier.

Table 1.

Expenditure Components of GDP

(Real rates of growth, in percent)

		1989	1990	1991	1992	1993 1/
Private consumption		9.2	3.8	3.8	4.4	1.4
Public consumption		12.7	5.7	10.9	8.9	6.1
Gross fixed capital formation		1.0	17.9	—	-0.2	5.5
Increase in stocks		3.0	3.5	4.1	-0.4	2.7
	Total domestic demand	8.3	7.6	4.9	-0.3	4.5
Exports of goods and nonfactor services		10.7	13.3	7.5	9.7	1.9
Imports of goods and nonfactor services		11.1	15.7	5.4	3.0	2.8
Gross domestic product		8.2	6.3	6.3	4.3	3.8

Source: Table A2.

^1/First three quarters over corresponding period a year earlier.

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Table 1.

Expenditure Components of GDP

(Real rates of growth, in percent)

		1989	1990	1991	1992	1993 1/
Private consumption		9.2	3.8	3.8	4.4	1.4
Public consumption		12.7	5.7	10.9	8.9	6.1
Gross fixed capital formation		1.0	17.9	—	-0.2	5.5
Increase in stocks		3.0	3.5	4.1	-0.4	2.7
	Total domestic demand	8.3	7.6	4.9	-0.3	4.5
Exports of goods and nonfactor services		10.7	13.3	7.5	9.7	1.9
Imports of goods and nonfactor services		11.1	15.7	5.4	3.0	2.8
Gross domestic product		8.2	6.3	6.3	4.3	3.8

Source: Table A2.

^1/First three quarters over corresponding period a year earlier.

(1) Consumption

Real private consumption growth increased slightly in 1992 to 4.4 percent from 3.8 percent in 1991 as a slowdown in real disposable income growth (largely due to a sizable fall in net factor income from abroad) was more than made up for by a decline in the household saving rate (Table A4). In 1993, a further slowdown in real disposable income growth led to a pronounced reduction in private consumption growth, despite a further, albeit small, decline in the saving rate to 15.1 percent in the first three quarters of the year.^1/

Rising nominal incomes in recent years have mainly reflected strong growth in income from employment. The pace of growth in wage and salary income, which had accelerated in 1990–91 with the continued rapid expansion in economic activity and employment, remained at a high level in 1992–93. Nevertheless, this high growth was counterbalanced by declining income from foreign transfers and higher tax payments, while higher inflation eroded its real value.

Real public consumption continued to rise rapidly in 1992–93, due mainly to growth in general government wage and salary costs, attributable to both rising employment and increases in wage rates.^2/ As in previous years, expenditure outlays on education and health absorbed the highest amount of current expenditure in 1992–93, accounting for over 55 per cent of total general government final consumption.

(2) Investment and saving

After exceptionally strong growth in 1987–90, real investment stagnated in 1991–92 owing to a decline in real public investment growth as a number of key projects were completed. In 1993, while public investment remained weak, a strengthening of private investment led to a revival in overall investment growth to over 5 percent.

In recent years, machinery and equipment investment growth has been notably strong, and has especially supported the expansion in export and tourism capacity (Table A5). In 1992 and 1993, private investment was boosted by new purchases of aircraft by Air Malta, which accounted for all of the growth in investment in the transport and services sectors (amounting to some 15 percent in 1992 and almost 20 percent in 1993).^1/ By contrast, construction investment, after a prolonged period of continued growth, slowed down after 1991, mainly because of the completion of a number of public sector projects in infrastructure in the last three years. In 1992, real construction investment was broadly flat and in 1993 fell by more than 10 percent. This decline, however, masks an increase in construction registered by private sector initiative of Lm 2.6 million.

Since 1987 a high level of private savings has provided the main source of finance for investment (Table A6). Increasingly, these savings have been generated domestically, perhaps stimulated to some extent by the effects of tax reform and gradual financial liberalization. At the same time, there has been a corresponding decline in net factor income and transfers from abroad. Although private savings remained high in 1992–93, a decline in public savings (as cuts in public investment were the main source of budget consolidation) led to some decline in overall national savings. In 1993, national savings were supplemented by foreign savings as the current account moved back into deficit.

(3) Foreign balance

The pace of growth of exports of goods and nonfactor services, which had been substantial in the period 1987–91 (averaging 10 percent per annum in real terms), maintained its strength in 1992, before easing considerably in 1993 due to the recession in Europe and some special factors. The earlier performance had been attributable to strong growth in both tourism and manufactured exports, in particular semi-conductors and related products, and ships. The slowdown in 1993 was concentrated in the electrical machinery goods sector following particular weakness (partly cyclical) in the semi-conductor market, which counterbalanced the benefits to competitiveness of the devaluation in November of 1992.

Real imports increased by 3 percent in 1992–93, down from an annual average of 121/2 percent over 1987–91. The slowdown partly reflected the end of the adjustment of imports to the replacement of import quotas that had begun in 1987, and (particularly in 1992) the weakening in domestic demand growth. However, “lumpy factors", in particular the delivery of the aircraft for Air Malta also distort the underlying trends. In 1992, the import slowdown in the presence of rapid export growth implied a large net contribution to growth from the external sector. In 1993, the slowdown in export growth was associated with a negative contribution from net exports.

1. Background and institutions

The public sector, which comprises the central government, the social security system, and a large number of public enterprises and parastatal companies, plays an important role in the Maltese economy. General government revenues and expenditures represent around 40 percent and 43 percent of GDP, respectively (Chart 4 and Tables A14 and A15). More than 40 percent of Malta’s working population are employed in the public sector.

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MALTA: FISCAL INDICATORS ^1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 052; 10.5089/9781451826548.002.A001

Source: Data provided by the Maltese authorities, and Fund staff estimates.^1/ Figures for 1990 and 1991 have been adjusted to make them comparable with the numbers for subsequent years. 1994 data are based on budget estimates.

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The operations of the central government and the social security system are administered on a consolidated basis through the Consolidated Revenue Fund (the budgetary accounts). On a day-to-day basis, the Government’s main receipts and payments are transacted through the Treasury Clearance Fund. At year end, the operations of this Fund are consolidated with the activities of the Price Stabilization Fund generated by the Government’s bulk-buying scheme, the Sinking Funds established to pay off the Government’s long-term debts, a Contingencies Fund, several Lottery Funds, and a large number of relatively minor Trust Funds. The surpluses generated by the Price Stabilization Fund and the profits from the Lottery Funds are transferred to the Consolidated Fund, but the income generated by the investments of the Sinking Fund is not. Public debts not rolled over are repaid directly out of the Sinking Fund as they fall due.

The operations of the public enterprises are not consolidated in the budgetary accounts. Every public entity or enterprise is set up under specific legislation. These enterprises enjoy varying degrees of autonomy, but the Government retains the right to set budgets or to require payments out of profits.

Parastatal companies, which are established under company law, are companies in which the Government, directly or through its holding company Malta Government Investment Co. Ltd., owns 50 percent or more of the share capital. These parastatal companies, which are usually only subject to government policy through Board appointments, cover a wide range of mostly commercial activities. The Government’s income from the public enterprises and parastatal companies appears as nontax revenue in the budgetary accounts. Future participation of the private sector in public entities is not ruled out by the authorities.

2. Overview of fiscal developments

In recent years the Government has made substantial progress in reforming the structure of its public finances and reigning in earlier unsustainable budget deficits. At the same time, the scale of the Government’s involvement in the economy has not changed significantly since the mid-1980s. While accepting that the private sector will participate more in Malta’s economic development in the future, the Government continues to believe it should provide a “sense of direction” to the economy. In particular, the Government believes it has an important role in developing the country’s infrastructure and ensuring that no sector of the population is marginalized.

Partly due to an infrastructure boom, but also higher public sector pay, the budget deficit rose to a peak of over 5 percent of GDP in 1990 and 1991, a time of cyclical strength for the economy. Consolidation in the subsequent two years as infrastructure spending was cut back severely reduced the deficit from the earlier unsustainable levels, and the Government came close to achieving its target of limiting the deficit to 3 percent of GDP. However, progress in reducing the deficit has recently been reversed as infrastructure spending has once again risen sharply.

The reform of public finances has involved a comprehensive overhaul of the taxation system, which will come to a head when the new VAT is introduced on January 1, 1995. The structure of taxation will thereby be transformed from one relying heavily on import duties to one with a broad-based consumption tax and a level of excise duties that is more in line with international norms (Table 2). Earlier reforms included a large reduction in the top marginal income tax rate from 65 percent to 35 percent, an increase in the rate of employers’ social security contributions, higher tax exemptions for interest income, and the introduction of a Capital Gains Tax.^1/ The ratio of general government revenues to GDP has grown somewhat in recent years, but at around 38 percent is low in comparison with that in EU and other EU-applicant countries (Table 3).^2/

Table 2.

Malta: Structure of Taxation

(As percent of total revenues)

Sources: Ministry of Finance, Budget Estimates; Treasury, Malta Financial Report; and data provided by the Maltese authorities.

Table 2.

Malta: Structure of Taxation

(As percent of total revenues)

		1987	1988	1989	1990	1991	1992	1993	1994
									Budget
Direct taxes		41.7	36.0	38.8	39.2	36.4	39.1	42.8	40.5
	Income taxes	22.2	19.3	21.4	20.9	20.0	22.0	24.1	23.0
	Social security contributions	18.4	15.9	16.3	17.3	15.6	16.5	18.2	17.3
	Death and donation duties	1.1	0.9	1.1	1.0	0.7	0.6	0.4	0.2
Indirect taxes		29.2	27.5	32.0	32.3	32.8	33.7	31.9	32.8
	Excise duties	2.9	2.4	2.8	2.6	2.9	2.8	2.2	7.3
	Import duties	21.3	20.1	22.8	22.0	21.8	22.5	21.5	13.4
	Licenses, taxes, fines, etc.	5.0	5.0	6.3	7.8	8.1	8.4	8.2	12.2
Nontax receipts		29.1	36.5	29.3	28.4	30.8	27.1	25.4	26.6

Sources: Ministry of Finance, Budget Estimates; Treasury, Malta Financial Report; and data provided by the Maltese authorities.

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Table 2.

Malta: Structure of Taxation

(As percent of total revenues)

		1987	1988	1989	1990	1991	1992	1993	1994
									Budget
Direct taxes		41.7	36.0	38.8	39.2	36.4	39.1	42.8	40.5
	Income taxes	22.2	19.3	21.4	20.9	20.0	22.0	24.1	23.0
	Social security contributions	18.4	15.9	16.3	17.3	15.6	16.5	18.2	17.3
	Death and donation duties	1.1	0.9	1.1	1.0	0.7	0.6	0.4	0.2
Indirect taxes		29.2	27.5	32.0	32.3	32.8	33.7	31.9	32.8
	Excise duties	2.9	2.4	2.8	2.6	2.9	2.8	2.2	7.3
	Import duties	21.3	20.1	22.8	22.0	21.8	22.5	21.5	13.4
	Licenses, taxes, fines, etc.	5.0	5.0	6.3	7.8	8.1	8.4	8.2	12.2
Nontax receipts		29.1	36.5	29.3	28.4	30.8	27.1	25.4	26.6

Sources: Ministry of Finance, Budget Estimates; Treasury, Malta Financial Report; and data provided by the Maltese authorities.

Table 3.

Malta: Comparative Size of General Government, 1993

(As percent of nominal GDP)

Source: OECD, Economic Outlook, No.55, June 1994.

Table 3.

Malta: Comparative Size of General Government, 1993

(As percent of nominal GDP)

		Outlays	Revenue
EU Countries
	Belgium	58.4	51.2
	Denmark	62.3	57.7
	France	54.9	49.0
	Germany	50.0	46.7
	Greece	52.7	39.8
	Ireland	44.2	41.7
	Italy	56.2	46.7
	Netherlands	55.8	52.9
	Portugal	52.8	45.0
	Spain	46.9	39.8
	United Kingdom	43.5	35.8
EU applicants
	Austria	51.7	48.8
	Finland	61.5	53.7
	Sweden	71.3	58.3
	Malta	40.8	37.9

Source: OECD, Economic Outlook, No.55, June 1994.

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Table 3.

Malta: Comparative Size of General Government, 1993

(As percent of nominal GDP)

		Outlays	Revenue
EU Countries
	Belgium	58.4	51.2
	Denmark	62.3	57.7
	France	54.9	49.0
	Germany	50.0	46.7
	Greece	52.7	39.8
	Ireland	44.2	41.7
	Italy	56.2	46.7
	Netherlands	55.8	52.9
	Portugal	52.8	45.0
	Spain	46.9	39.8
	United Kingdom	43.5	35.8
EU applicants
	Austria	51.7	48.8
	Finland	61.5	53.7
	Sweden	71.3	58.3
	Malta	40.8	37.9

Source: OECD, Economic Outlook, No.55, June 1994.

On the expenditure side, reforms have concentrated on decentralizing decision-making and improving the accountability of public officials for the services they provide. Part of this has been the creation of the new public enterprises and the separation of the public enterprises from the government accounts. Some parts of the Government’s expenditures, however, have yet to be tackled. In particular, subsidies to the shipbuilding industry still absorb around 11/2 of GDP, social security benefits and pensions have risen significantly and are only now being subjected to rigorous analysis, and almost no progress has been made toward the Government’s target of reducing the proportion of the working population employed in the public sector.^3/

3. The budget outturns in 1992 and 1993

Performance in 1992 was significantly better than expected with an outturn deficit of 3.0 percent of GDP compared to the budgeted 4.3 percent.^1/ Higher-than-expected growth led to income tax receipts and social security contributions 6 percent and 11 percent, respectively, above budget. This more than offset a marginal shortfall in indirect taxes and disappointing nontax revenues due to delays to the privatization program, which cut receipts from the sale of shares by more than Lm -5 million.^2/ Foreign grants also came in 12 percent lower than budgeted. However, this was partly offset by higher profits from the Central Bank of Malta.

Current expenditure was broadly as budgeted, but capital expenditure was less than expected mainly due to shortfalls in the capital budgets for the health and education sectors (Tables A16 and A17). The savings would have been larger had not the subsidy to the shipbuilding industry been 18 percent above its budgeted level.^3/

The deficit remained at 3 percent of GDP in 1993, only slightly above the budgeted amount. As in 1992, higher-than-expected growth led to above-budget income tax receipts and social security contributions, but this time by only 3 percent and 4 percent, respectively. As a result of an increase in the social security contribution rate for employers and the abolition of the lowest rate for the self-employed, social security contributions in 1993 accounted for over 18 percent of government revenues.^4/

Indirect taxes performed poorly in 1993, collecting 9 percent less than budgeted, with revenue from the duty on motor vehicles particularly disappointing (Table A18).^5/ Revenue from the room occupancy tax was lower than expected because most bookings had been made before the tax came into effect. Nontax revenues came in almost exactly on budget. As in the previous year, profits from the Central Bank of Malta were higher than budgeted, and there was a higher-than-expected payment from Enemalta’s profits. Receipts from the Price Stabilization Fund were also higher than budgeted. However, completely offsetting these factors, foreign grants were lower than expected, as in the previous year, this time falling short by 35 percent.

Current expenditure in 1993 came in somewhat above the budgeted amount in part due to higher-than-expected spending on the police. This reflected a broader government initiative to train and equip the police force better, and to reform and upgrade the legal, judicial, and correctional systems and the Armed Forces. The subsidy given to the newly created Water Services Corporation was also higher than budgeted and the higher rates of pensioners’ bonuses pushed spending on social security benefits above budget. Delays to projected capital expenditures more than compensated for the overrun on current expenditures. Once again, spending on education and health were lower than budgeted, principally due to delays in tendering and acquiring permits, and there were shortfalls in expenditure on house building.

4. The 1994 budget

After two years in which the deficit had been budgeted to fall, the 1994 budget marked a turnaround in fiscal consolidation with a planned rise in the deficit to 3.3 percent of GDP. The rise in the deficit to a large extent reflected spending on a number of major social infrastructure projects, which underpinned planned growth in overall expenditures and net lending of nearly 14 percent to a level equivalent to 43.1 percent of GDP, very similar to its level in 1990 and 1991. The increase in spending would more than offset a projected 13 percent growth in revenues to a level equivalent to 39.8 percent of GDP. Reliance on foreign borrowing to finance the deficit was also expected to increase sharply after a small net repayment of foreign loans in 1993.

Income tax measures in the budget included a new income tax rebate of 17 percent on the first Lm 1,500 earned from overtime or part-time working. It was hoped that this would encourage declaration of such income. The budget also introduced a withholding tax for interest earned on bank deposits and government stocks. Taxpayers could opt to pay this tax at source at a preferential rate of 15 percent instead of incurring the normal applicable income tax rate if declared at the end of the year. This measure was expected to encourage disclosure of existing savings, deposit of savings held as cash, and repatriation of funds invested abroad. After factoring in the effects of these changes, income tax receipts were budgeted to rise by 8 percent, in line with the expected growth in nominal GDP. The Government had earlier come to an agreement with the trade unions that it would introduce additional tax credits to compensate for any unexpected increases in the cost of living after January 1, 1994.

Revenues from the duty on documents and the levies on restaurants and hotel occupancy were budgeted to expand strongly such that revenue from all indirect taxes was to rise by nearly 17 percent. As a precursor to the implementation of VAT, customs duties on a number of products including motor vehicles, petroleum, cement and alcohol were planned to be replaced by excise duties and a motor vehicle registration tax. The import duties on certain electrical goods were also to be reduced. Together these measures were expected to increase excise duties by Lm 21.5 million with a similar reduction in import duties. Nontax revenues were budgeted to rise by 19 percent due to higher profits from the Central Bank, a boost to privatization proceeds from the sale of one of the two remaining state-owned commercial banks, and a 50 percent increase in foreign grants. This last factor reflected the higher capital expenditure budgeted, as the majority of the grants Malta has been promised are linked to capital projects.

Current expenditure was budgeted to rise 10.6 percent in 1994, reflecting mainly higher levels of social security benefits and higher debt servicing costs (Table A17). The latter were budgeted to rise by 21.2 percent from their 1993 level largely because of the higher cost of servicing local loans which had been boosted in 1993 by the issue of Lm 28.1 million of new debt to fund the purchase by the Government of certain properties previously owned by the Church.^1/ Sharply higher spending on public administration was also planned, mainly on computerization, but also for the establishment of the VAT office, an office to manage the properties previously owned by the Church, and local councils.^2/

Capital expenditure was budgeted to rise by 19 percent, or some 34 percent excluding net lending. This reflected the start of work on a new hospital and the modernization of another, together budgeted to cost Lm 6 million in 1994, and the building and equipping of new schools and the extension of the University of Malta’s premises, together budgeted to cost Lm 5.7 million. Some of these projects had been delayed from previous years. Net lending was budgeted to increase only slightly, partly because the subsidy to the shipbuilding yards was expected to rise by only 4 percent.

5. 1994 estimated outturn

Provisional estimates indicate some modest revenue shortfalls and expenditure overruns that are expected to push the deficit to close to 4 percent of GDP in 1994. On the revenue side, the main shortfall is expected in indirect taxes due to weakness in import duties and revenue from the duty on documents.^1/ On the expenditure side, current expenditure is expected to come in slightly higher than budgeted largely as a result of higher public sector salaries, in part as the result of the final phase of a public pay reform initiated in 1991, while the capital program is expected to proceed broadly as planned. Some underspending due to delays to projects, notably in health and housing, will be broadly offset by the subsidy to the shipbuilding yards being Lm 2.2 million above budget at Lm 16.3 million (1.6 percent of GDP).

6. Public enterprises, parastatals and privatization

The public enterprises and parastatal companies play an important role in Malta’s economy. Up to 1992, the public enterprises consisted of Enemalta, Telemalta, the Housing Authority, Malta Drydocks and Malta Development Corporation. In the government accounts up to 1992, the capital expenditure of Telemalta, Enemalta, and the Housing Authority was included in capital expenditure, and an equal transfer from these enterprises to the Government was imputed as nontax revenue. Starting with the 1992 budget, this practice was discontinued. The Government also created five new public entities in 1992: the Water Services Corporation, the Maritime Authority, the Planning Authority, the Public Transport Authority, and the Employment and Training Corporation. The services these entities provide were hitherto carried out by government departments. The annual budgets of these public entities, which, in principle, are expected to be run on a profit-making basis, are separately approved by Parliament.

Over recent years some of the larger public enterprises have appeared to be profitable while others have required significant support from the Government. The two biggest public enterprises, Enemalta and Telemalta made substantial profits in both 1992 and 1993, and, overall, government income from the public corporations amounted to around 1 percent of GDP in each of these years. The early repayment of loans by Enemalta and Air Malta also helped to bolster the Government’s finances in 1993. However, the price of water in Malta remains artificially low and the newly created Water Services Corporation received subsidies equivalent to almost 1 percent of GDP in each year. The Public Transport Authority also received subsidies equivalent to about % percent of GDP in both 1992 and 1993. In addition, the liabilities of the Housing Authority exceed its assets by over Lm 1 million and subventions from the Government have been required to keep the Authority afloat. The Government has said it expects most of the expenditure of the newly created authorities to be financed out of their own resources or through bank borrowing. The Government’s aim, according to the 1993 budget speech, is that its relationship with these companies should be well defined and that any subsidies should be specified according to the service they offer.

The parastatal companies are semi-autonomous and cover a wide range of, mostly commercial, activities. They include the two largest commercial banks, Air Malta Co. Ltd., Malta International Airport Co. Ltd., Malta Shipbuilding Co. Ltd., Sea Malta Co. Ltd., Malta Export Trade Corporation Ltd., and Malta Government Investment Co. Ltd. which in turn owns stakes in other commercial companies.

Most of the companies owned by Malta Government Investments Ltd. are managed by Malta Investment Management Company Ltd. (MIMCOL), which, since 1988, has been charged with rationalizing the more minor investments, selling them as going concerns or groups of assets where possible, and liquidating them where not. MIMCOL made rapid progress initially and has only 26 companies left under its control. However, these are the more difficult or sensitive holdings for which MIMCOL looks to the Government for guidance as to how to proceed. It has been decided that MIMCOL will be abolished in 1995 and the remaining holdings will pass to the Malta Development Corporation, which also has responsibility for the Government’s direct investments. Total receipts from all of MIMCOL’s sales to date are estimated at around Lm 1 million. There remains scope for further privatization for which the Government does not at present have a comprehensive strategy.

One parastatal company, Malta Shipbuilding Company Ltd, has found it impossible to make profits in what is a very competitive international market. The Government’s relationship with the shipyards has been directed by a 10-year agreement reached in 1989. The agreement, includes a subsidy on value added (declining gradually from 28 percent in 1989 to 16 percent in 1993, after which it is to be eliminated); an annual development grant; payment of the running costs of a training center; relief from past debt service; provision for outside experts to advise on manpower requirements, shipyard organization, and financial management; relief from annual charges in connection with one dock; and provisions for an early retirement program. The company’s major assets at present are six ships built for the former Soviet Union that are caught up in a contract dispute. Were this dispute resolved, and the ships sold, there could be a significant cashflow that would allow Malta Shipbuilding Company Ltd. to pay off a part of its debts owed to the Government. It has recently been announced that Malta Shipbuilding Company Ltd. is to be merged with Malta Drydocks Company Ltd. Plans are in hand to rationalize the workforce and to create two new enterprises, one to manufacture cranes for Malta Freeport Ltd, the other to construct containers that will absorb around a quarter of the workforce currently employed by Malta Shipbuilding Company Ltd.

7. Financing and public debt

At end-1993 Malta’s public debt stood at Lm 304.8 million (32.7 percent of GDP), of which Lm 50.5 million was external (Table A20). Although low by international standards at present (Table 4), there has been a steady upward trend to the debt ratio in recent years owing to large budget deficits and, in 1992, to the issue of Lm 28.1 million of government stock to purchase land and buildings previously owned by the Church. At the end of 1989, public debt had been only Lm 119.3 million (17.8 percent of GDP).

Table 4.

Malta: General Government Gross Debt of EU Member Countries and Selected Applicants, 1993 ^1/

(As percent of nominal GDP)

Source: OECD, Economic Outlook, No.55, June 1994, Annex Table 32, p. A35.

^1/EU definitions differ from those used in this table (see European Commission European Economy, Annual Economic Report, No.56).

Table 4.

Malta: General Government Gross Debt of EU Member Countries and Selected Applicants, 1993 ^1/

(As percent of nominal GDP)

EU members
	Belgium	145.6
	Denmark	66.1
	France	52.5
	Germany	48.5
	Greece	106.1
	Ireland	90.5
	Italy	113.9
	Netherlands	79.0
	Portugal	67.5
	Spain	59.1
	United Kingdom	46.5
EU applicants
	Austria	57.0
	Finland	51.7
	Sweden	83.0
	Malta	32.7

Source: OECD, Economic Outlook, No.55, June 1994, Annex Table 32, p. A35.

^1/EU definitions differ from those used in this table (see European Commission European Economy, Annual Economic Report, No.56).

View Table

Table 4.

Malta: General Government Gross Debt of EU Member Countries and Selected Applicants, 1993 ^1/

(As percent of nominal GDP)

EU members
	Belgium	145.6
	Denmark	66.1
	France	52.5
	Germany	48.5
	Greece	106.1
	Ireland	90.5
	Italy	113.9
	Netherlands	79.0
	Portugal	67.5
	Spain	59.1
	United Kingdom	46.5
EU applicants
	Austria	57.0
	Finland	51.7
	Sweden	83.0
	Malta	32.7

Source: OECD, Economic Outlook, No.55, June 1994, Annex Table 32, p. A35.

^1/EU definitions differ from those used in this table (see European Commission European Economy, Annual Economic Report, No.56).

The local debt is made up of Local Government Stock, most of which is held by the commercial banks, and Local Development Registered Stock (LDRS) which is predominantly sold to the public. In earlier years, in order to make the stocks more attractive to the public, the Government had issued LDRS carrying tax exemptions and other incentives, as well as Bearer Debentures. Since trading began on the Maltese Stock Exchange, the bonds issued by the Government have not featured any tax advantages (but have instead offered higher coupon rates). The proportion of bonds taken up by the nonbank private sector has risen sharply to over 50 percent (Table 5). The average maturity of issues in recent years has risen to around 8 years (the longest maturity is currently 10 years) and the average maturity of the entire domestic debt stock is between 4 and 5 years.

Table 5.

Malta: Government Stock Issues (1989–93)

(In millions of Maltese liri)

Source: Central Bank of Malta Annual Report 1993.

^1/Excluding Lm 28.1 million issued directly to ecclesiastical entities.

Table 5.

Malta: Government Stock Issues (1989–93)

(In millions of Maltese liri)

			1989	1990	1991	1992	1993
Stocks issued			12.7	35.2	33.9	36.0	28.9 1/
	Taken up by:
		Banking system (in percent)	11.1 (87.2)	20.3 (57.6)	24.6 (72.5)	16.0 (44.5)	14.6 (50.5)
		Nonbank private sector (in percent)	1.6 (12.8)	5.3 (15.0)	9.3 (27.5)	20.0 (55.5)	10.7 (37.0)
		Government Sinking Fund (in percent)	—	9.6 (27.4)	—	—	3.6 (12.5)
Memorandum items:
	Average coupon rate (in percent)		5.9	5.8	5.3	7.3	6.8
	Average maturity (years)		6.0	6.4	7.1	7.9	8.3
	Proportion of bearer instruments (in percent)		—	3.4	16.2	—	—
	Proportion of instruments with tax advantages (in percent)		5.5	14.2	60.2	—	—

Source: Central Bank of Malta Annual Report 1993.

^1/Excluding Lm 28.1 million issued directly to ecclesiastical entities.

View Table

Table 5.

Malta: Government Stock Issues (1989–93)

(In millions of Maltese liri)

			1989	1990	1991	1992	1993
Stocks issued			12.7	35.2	33.9	36.0	28.9 1/
	Taken up by:
		Banking system (in percent)	11.1 (87.2)	20.3 (57.6)	24.6 (72.5)	16.0 (44.5)	14.6 (50.5)
		Nonbank private sector (in percent)	1.6 (12.8)	5.3 (15.0)	9.3 (27.5)	20.0 (55.5)	10.7 (37.0)
		Government Sinking Fund (in percent)	—	9.6 (27.4)	—	—	3.6 (12.5)
Memorandum items:
	Average coupon rate (in percent)		5.9	5.8	5.3	7.3	6.8
	Average maturity (years)		6.0	6.4	7.1	7.9	8.3
	Proportion of bearer instruments (in percent)		—	3.4	16.2	—	—
	Proportion of instruments with tax advantages (in percent)		5.5	14.2	60.2	—	—

Source: Central Bank of Malta Annual Report 1993.

^1/Excluding Lm 28.1 million issued directly to ecclesiastical entities.

To finance the 1992 and 1993 budget deficits, the Government issued stocks totaling Lm 36.0 million and Lm 28.9 million, respectively.^1/ The purchase in 1993 by the Government of the Church properties was financed by an additional Lm 28.1 million of Local Government Stocks, which were issued directly to the ecclesiastical entities concerned. The authorities budgeted to issue Lm 28.7 million of stock in 1994.

Although foreign debt disbursements were budgeted to exceed repayments in both 1992 and 1993, net foreign lending in fact fell slightly in both years. However, the value of foreign loans continued to grow in these years due to exchange rate movements (Table A22). In 1994, the value of foreign loans outstanding is expected to rise again by Lm 5.5 million to Lm 56.0 million.^2/ Even then, foreign loans will represent only around 5 percent of GDP. The majority of foreign loans are from the European Union or the Government of Italy, both of which have protocols promising grants and loans (some on preferential terms) totaling Lm 150 million by the year 2000, and which are linked to specified capital expenditure projects. The average maturity of the existing foreign debt exceeds 12 years.

In the past, the Government’s day-to-day transactions have been financed by using a ways and means overdraft facility at the Central Bank. Ways and means advances were limited to 15 percent of budgeted current revenues in the year in which the advance was made and had to be paid back in that same year. The Government could also raise up to Lm 30 million by the issue of 91-day Treasury bills. Under the amended Central Bank Act, the ways and means facility is to be abolished.

8. VAT

A value-added tax is due to be introduced on January 1, 1995 and has been the subject of intense debate in Malta. The Government has argued that VAT will be revenue neutral and have minimal distributional effects.^1/

As currently proposed, there are to be two rates of VAT, a standard rate of 15 percent and a lower rate of 10 percent for the-tourist and restaurant services that are currently subject to a levy at the rate of 10 percent that the VAT will replace. Exemptions from the VAT regime are to be created for the letting and transfer of immovable property; insurance, credit, banking and related services; postal and water services; sporting and cultural activities; government lotteries; and certain minor imports. Goods and services to be zero-rated include goods for re-export and services connected with exports; services to companies registered but not operating in Malta; goods in bond, supplies to duty free shops and freeport activities; port services; international transport and related goods and services; food (except that purveyed at catering establishments); pharmaceutical goods and health and welfare goods and services; education; transport; investment services; and printed matter. The authorities are currently engaged in a drive to register traders in the face of a non-compliance campaign organized by the trade unions and retail organization.

Although the broad shape of the proposed VAT is in line with recommendations made by an IMF technical assistance mission in September 1990, the list of goods and services to be zero-rated is a long one that includes some that in other countries are taxed or exempt.^2/ Examples include food, transport, investment services, and printed matter. Experience suggests that a large number of zero-rated goods not only makes enforcement more difficult, but also produces entrenched interest groups that later resist the extension of VAT to their products at higher rates. Although as a proportion of GDP, the revenue from the VAT budgeted in 1995 is not far below international norms, if the VAT is to bring its full benefit, the list of zero-rated goods and services will have to be rationalized and brought into line with international practice.

ANNEX: Differences Between Staff and Authorities’ Presentations of Fiscal Data

There are a number of differences between the authorities’ presentation of the fiscal data and that used by the staff, which are reconciled in Table 6.^1/ The only difference that affects the size of the deficit is that the authorities include as part of their current expenditure the contributions they make to the Sinking Fund set up for the repayment of long-term public debt. As noted in section 1 of Chapter III, the interest earned on these funds is not returned to the Consolidated Fund and repayments of debt are made directly out of the Sinking Fund as they become due. The staff ignores this expenditure and treats disbursement and repayments of public debt as part of financing.

Table 6.

Malta: Differences Between Presentations of Revenues and Expenditures, 1990–94

(In millions of Maltese liri)

Source: Data supplied by the Maltese authorities.

^1/Budget estimates.

Table 6.

Malta: Differences Between Presentations of Revenues and Expenditures, 1990–94

(In millions of Maltese liri)

				1990	1991	1992	1993	1994 1/
Revenues
	Staff’s presentation			273.9	307.3	325.1	353.2	400.4
	Repayment of loans			5.9	6.1	6.3	10.8	4.5
	Government ordinary social security contributions			23.7	24.0	26.4	32.6	34.6
	Authorities’ presentation			303.5	337.4	357.8	396.6	439.5
Expenditures
	Staff’s presentation			314.2	348.2	350.9	381.1	434.0
		Of which:
			Net lending	1.1	5.8	8.8	0.3	1.5
	Total expenditure			313.1	342.4	342.1	380.8	432.5
	Disbursement of loans			7.0	11.9	15.1	11.1	6.0
	Government ordinary social security contributions			23.7	24.0	26.4	32.6	34.6
	Sinking Fund contributions			3.7	4.1	4.0	3.8	5.4
	Authorities’ presentation			347.5	382.4	387.6	428.3	478.5
Deficit
	Staff’s presentation			40.3	40.9	25.8	27.9	33.6
	Sinking Fund contributions			3.7	4.1	4.0	3.8	5.4
	Authorities’ presentation			44.0	45.0	29.8	31.7	39.0

Source: Data supplied by the Maltese authorities.

^1/Budget estimates.

View Table

Table 6.

Malta: Differences Between Presentations of Revenues and Expenditures, 1990–94

(In millions of Maltese liri)

				1990	1991	1992	1993	1994 1/
Revenues
	Staff’s presentation			273.9	307.3	325.1	353.2	400.4
	Repayment of loans			5.9	6.1	6.3	10.8	4.5
	Government ordinary social security contributions			23.7	24.0	26.4	32.6	34.6
	Authorities’ presentation			303.5	337.4	357.8	396.6	439.5
Expenditures
	Staff’s presentation			314.2	348.2	350.9	381.1	434.0
		Of which:
			Net lending	1.1	5.8	8.8	0.3	1.5
	Total expenditure			313.1	342.4	342.1	380.8	432.5
	Disbursement of loans			7.0	11.9	15.1	11.1	6.0
	Government ordinary social security contributions			23.7	24.0	26.4	32.6	34.6
	Sinking Fund contributions			3.7	4.1	4.0	3.8	5.4
	Authorities’ presentation			347.5	382.4	387.6	428.3	478.5
Deficit
	Staff’s presentation			40.3	40.9	25.8	27.9	33.6
	Sinking Fund contributions			3.7	4.1	4.0	3.8	5.4
	Authorities’ presentation			44.0	45.0	29.8	31.7	39.0

Source: Data supplied by the Maltese authorities.

^1/Budget estimates.

The staff also removes from the authorities’s revenue and expenditure figures the “ordinary” contributions the Government makes to the social security scheme at the rate of 8.33 percent of salaries. These are considered by the staff to be intra-government. However, the staff’s presentation now includes in both expenditures and revenues the Government’s contribution to the social security system as employer as this is considered to show more accurately the cost of the Government’s ongoing activities.

The authorities also include loans made by the Government to the public enterprises and parastatal companies as part of capital expenditure, and the repayments of those loans as part of nontax revenues. By contrast, the staff nets these items together on the expenditure side as net lending.

1. Institutional developments

The Maltese financial system comprises the Central Bank of Malta (CBM), four commercial banks, three long-term lending institutions, three offshore banks, the stock market, and the Malta International Business Authority (MIBA), which supervises offshore companies.^1/ The Central Bank carries out the normal functions of the monetary authorities such as administering the exchange controls, implementing monetary and exchange rate policy, issuing currency, managing the country’s official foreign reserves, and acting as the Government’s bank. The commercial banks are allowed to attract demand, savings, and time deposits with maturities up to 5 years; loan maturities may not, in principle, exceed 5 years and lending rates are subject to ceilings. The Government retains a majority shareholding in two of the four commercial banks. The long-term lending institutions are also government controlled and make loans primarily to the commercial sector and for house purchase. The Malta Stock Exchange opened in January 1992 and initially concentrated on establishing a market for government bonds.

In the past two years, the Maltese Government has introduced significant institutional changes with a view to fostering a more market-oriented financial system and accelerating Malta’s development as an international financial center. These changes have included an overhaul of the banking legislation, the privatization of one commercial bank, the expansion of the stock market, and the partial deregulation of interest rates.

As part of the overhaul of the banking legislation, the Central Bank Act was amended to empower the Central Bank of Malta (CBM) to pursue monetary policy with greater autonomy (although not full independence). The amendment, which received parliamentary approval in October 1994 and is expected to come into effect next year, preserved the Central Bank’s main objectives: the control and supply of money to promote the development of the economy, and the maintenance of external reserves so as to safeguard the international value of the currency.^2/ Ultimate responsibility for setting the goals of monetary policy will continue to reside with the Minister of Finance; however, the CBM will have considerable independence in implementing monetary policy and a wider range of monetary instruments. In particular, the CBM will be entitled to determine interest rates, which, previously, under the Banking Act of 1970, was a prerogative of the Minister of Finance. It will also be authorized to issue its own securities in conducting open market operations.

With regard to government financing, the new Central Bank Act eliminates the ways and means account, which the Government has been operating as an overdraft facility with the CBM, repayable at each year’s end. In future, the Government will have to resort to Treasury bills or credit from private institutions, and face financial costs priced accordingly with market values. In a related measure, the Treasury bill rate, which had been rigidly administered by the Treasury between 1989 and 1993, has, since February 1994, been determined by auctions where the CBM has bid competitively for primary market issues.

Further important pieces of banking legislation introduced in September 1994 relate to the functions of the Malta Financial Services Centre and are intended to enhance the status of Malta as an international financial and trading center. The new laws include the amendment to the Malta International Business Authority Act, an amended Banking Act, a second amendment to the Income Tax Act, the Investment Services Act, the Professional Secrecy Act, the Prevention of Money Laundering Act, the Financial Institutions Act, the Insider Dealing Act, the Commercial Partnerships (Special Provisions) Act, the Companies Act and the Recognition of Trusts Act. Together, these mandates abolish the distinction between offshore and onshore financial activities and confer on the Malta International Business Authority (MIBA), now called the Maltese Financial Services Centre (MFSC), the duty of complete supervision in the fields of banking, insurance, investment services and similar areas in the field of financial services.

The new regulations on financial services supersede a number of special arrangements that had been put in place earlier to attract offshore financial business. Under these earlier arrangements, companies operated by nonresidents and trading in foreign currency outside Malta had been able to register offshore in the MIBA and enjoy a tax rate of only 5 percent (0 percent for nontrading companies). The new legislation is expected to provide a more certain environment to attract foreign companies to register in Malta and also to tempt former offshore companies to register onshore.^1/ The main incentive is a range of double taxation agreements (Malta is not a tax haven). Where no such agreements apply, a unilateral reduction in the rate of income tax from 35 percent to 25 percent will be available.

Especially influential among the new laws mentioned above is the Banking Act, which replaces the Banking Act of 1970. It brings Malta’s banking legislation into line with EU and BIS practice, in particular the EU’s Second Banking Directive. Specifically, the new act broadens the activities that credit institutions may undertake and introduces new regulations regarding issues such as capital adequacy, large exposures, and exchange of information between supervisory authorities at home and abroad. The new regulation of banking activities comes at a time when the Maltese banking system is being opened up to local and foreign competition. A major development in this regard was the privatization, in March of this year, of one of the three commercial banks where the Government had had a majority shareholding. The privatization of the other two commercial banks is in the Government’s program.

The stock market has continued its development, increasing the supply of assets available since its start up in January 1992. Although the main trading is still in government bonds, the ordinary shares of three of the four commercial banks are currently listed. Moreover, during September 1994, the shares of the first nonfinancial institution, Middle Sea Insurance Co. LTD, were listed, and, in October 1994, the first private bond issue in Malta (Gassan Finance Company Limited) started to be traded.

A further significant development has been the partial deregulation of interest rates. The legal notice 54 of April 1993 reduced the number of borrowing categories from eight to four and stipulated the maximum lending rate for each category. In December 1993, maximum rates were tied to the Central Bank’s minimum discount rate: 3 percent above it for all rates, except for loans and advances for the purchase of the first residential unit for one’s own use, up to the first Lm 15,000, where the maximum margin above the minimum discount rate was set at 1.5 percent. In January 1994, further changes to the lending regulations led to the removal of favorable facilities to the primary sector. As a result, the maximum 3 percent over the bank’s discount rate became applicable to every loan except for housing, where the margin remains 1.5 percent.^1/ At the same time, the ceilings on deposit interest rates were removed, although the CBM set a minimum of 3 percent on savings and time deposits intended to protect savers. Deposit-taking institutions were also allowed to offer term deposits of any maturity up to a maximum of five years.

2. Policy developments

Until recently, monetary policy had been viewed more as an instrument to promote development than as a tool of demand or exchange rate management. In effect, it aimed to provide the necessary funds to the public and the private sector at a relatively low cost via comprehensive regulation of interest rates and selective credit controls. Strict capital controls permitted such a policy despite adherence to a fixed exchange rate since 1972. Lately, with the changes in the financial system, the CBM has been preparing a more active role for monetary policy in demand management and has been setting up the required market-oriented instruments.

In the past, the Maltese financial system had been characterized by a situation of excess bank reserves, which originated from the balance of payments surpluses experienced during the 1970s and early 1980s (Table A23). The domestic situation changed greatly after 1989. Balance of payments deficits in a period of rapid growth, the introduction of required reserves in 1990, and some relaxation of limits on resident’s foreign currency holdings, all led to increasing strains on the banks’ domestic liquidity situation.^1/ Under these circumstances in 1992, the CBM resorted to buying Treasury bills and government bonds, placing limits on the banks’ foreign assets, and lowering the interest rates on the banks’ free reserves from 4.5–5.45 percent to 3–4 percent. At that time, the Central Bank also encouraged public corporations to borrow from abroad.^2/ The relative scarcity of liquidity in the market was reflected in marginally higher yields on Treasury bills and a rise in yields on primary market issues of government bonds. Nevertheless, the financing cost for the Government continued to be relatively low by international standards: the 91-day Treasury bill rate and the average yield of government stocks (average maturity 8 years) reached peaks in 1992 of 4.6 percent and 6.7 percent, respectively.

The liquidity situation changed again in 1993, with a significant increase in net foreign assets of the banking system as a result of capital inflows, dominated by foreign borrowing and short-term foreign currency deposits of offshore companies. The accompanying expansion of the money supply, in a period of a slowdown in economic growth, was again reflected in excess liquidity in the banking system, which tended to pressure government bond yields and coupon rates downward. At that time, it was judged that the position in the economic cycle did not call for a tightening of monetary conditions, which would have required measures to eliminate the excess liquidity in the system.

However, the Central Bank did start to prepare the field for a more active monetary policy: in April 1993, the CBM established its discount rate as a basis of all interest rates in the banking system and in January 1994 the ceiling on deposit rates was removed and further changes were made to the lending regulations. Moreover, in October 1993 the Central Bank’s internal Monetary Policy Committee (renamed the Monetary Policy Council in early 1994) was created, to assess monetary conditions on a monthly basis.^1/ Furthermore, to improve the consistency between monetary policy and the fiscal position, since early 1994 the Central Bank has served on a Joint Committee with the Ministry of Finance to regulate the formulation and implementation of public debt management policy.

In making its assessment, the Monetary Policy Council focuses on a set of intermediate targets, including the money supply, the level of the Central Bank’s net foreign reserves, the levels of domestic credit and bank liquidity, the inflation rate, and any additional indicators of real developments in the economy.^2/ Judged by the increased growth in the money aggregates, the downward pressure observed in Treasury bill rates and government bond yields, and low average real lending rates, monetary conditions remained on the loose side in the first half of 1994 (Table A25). However, with a slowdown in credit growth to the private sector in the first half of the year and the interpretation that the relatively high level of inflation was in large part due to temporary cost push factors—notably the devaluation and some seasonal price adjustments—a tightening of monetary conditions was again deemed unnecessary.

Nevertheless, during the second half of 1994, the CBM started to absorb gradually the excess liquidity in the system through more market-oriented means. In July 1994, time deposit auctions were introduced by the Central Bank. These deposits are freely transferable and emulate the role of central bank securities that were not available before the passage of the amendment to the Central Bank Act. These Central Bank’s time deposits are being used to mop up excess banking liquidity; a more direct policy, such as an increase in the reserve requirement, would have run counter to the goal of financial development. To date, the Central Bank has auctioned deposits with maturity of one week, two weeks, one month, and two months and other maturities will be offered in due course. Regardless, by the end of August 1994 this policy had had little effect on monetary conditions and money growth was 14.3 percent on a year-on-year basis, and the yield to maturity of 91-day Treasury bills had slipped to 4.1 percent from 4.2 percent in June of this year and an average of 4.6 percent in 1993.

3. Evolution of money and credit aggregates

In the last three years, broad money growth had accelerated from 9.3 percent during 1992, to 10.3 percent during 1993, and to 14.3 percent in the year to August 1994. In these years, broad money growth has persistently outstripped that of nominal GDP leading to a pronounced fall in velocity, which had been relatively stable since the mid-1980s (Chart 5). Both domestic and foreign sources have contributed to the increase in money growth (Tables A26 and A27). Domestic credit, particularly to the public sector, has experienced strong growth, while capital inflows have been boosted by several factors, including two big foreign loans taken out by Enemalta in 1992 and Freeport Corporation in 1994, and the introduction of a preferential tax rate on interest income in January 1994 that encouraged residents to repatriate capital from abroad.

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MALTA: VELOCITY OF MONEY ^1/

Citation: IMF Staff Country Reports 1995, 052; 10.5089/9781451826548.002.A001

Source: Central Bank of Malta, Quarterly Review.^1/ Ratio of nominal GDP to end-period money stock.

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The growth in broad money since 1992 has been concentrated in an expansion of quasi-money, i.e., saving and time deposits: quasi-money grew at an average annual rate of 14 percent in 1992 and 1993, and by 16 percent in the 12-month period ending August 1994, taking its share in broad money to almost 70 percent in August 1994 (Table A28). Although both saving and time deposits increased continuously during this period, since 1993, savers have tended to opt for the higher return of time deposits rather than the liquidity of savings deposits, perhaps reflecting expectations of decreasing interest rates over the period. Personal deposits continued to be the main source of money growth, growing at 14 percent on average in the last three years. Corporate and business deposits increased by 27 percent during 1992, but eased in 1993 and 1994 to about a 6 percent growth pace. Foreign currency deposits (which now amount to about 8 percent of broad money) grew at about a 9 percent pace during the last two years, or considerably slower than in the preceding period despite the fact that the 10 percent levy on purchases of foreign currency was abolished in February 1993. This slower growth probably reflected the easing of interest rates on most foreign currencies and the instability of foreign exchange markets during the recent period.

Currency in circulation fell in 1992, owing to the withdrawal of the 4th series Lm 20 note, and has subsequently only grown modestly (at around 4 percent a year). As a consequence, the currency share of broad money had declined to 24 percent in August 1994 in line with a long-term trend, which reflects the public’s increased awareness of the opportunity costs of holding cash, the increasing availability of alternative assets, and growing confidence in the banking system. Nonetheless, by international standards, the currency component remains relatively high, almost 40 percent of GDP in 1993, reflecting the underdevelopment of the financial system and the prevailing regulations on interest rates.

Following a return of the balance of payment to overall surplus in 1992, recent money growth has been underpinned by a strong expansion of domestic credit and of net external assets. The expansion in domestic credit since 1992 has been paced by rapid growth in public sector credit due to sizable growth in borrowing by parastatal companies and an increase in bank financing by the central government. Central government credit, which expanded by 13 percent in 1993, grew by 22 percent in the year to August 1994 (Table 7).

Table 7.

Malta: Contributions to Broad Money Growth ^1/

(In percent)

Source: Data provided by the Maltese authorities.

^1/The breakdown of domestic credit differs from that presented in the Financial Survey (Table A26) in that parastatal companies are included in the public sector.

^2/12-month change to August.

Table 7.

Malta: Contributions to Broad Money Growth ^1/

(In percent)

			1992		1993		1994 2/
			Percentage Change	Contribution to Money Growth	Percentage Change	Contribution to Money Growth	Percentage Change	Contribution to Money Growth
Broad money			9.3	9.3	10.3	10.3	14.3	14.3
Domestic credit			9.1	5.6	12.9	7.9	12.7	7.9
	Public sector		4.4	1.0	16.5	3.4	16.9	3.7
		Government	1.8	0.2	12.9	1.3	22.1	2.4
		Parastatal sector	6.9	0.8	19.7	2.2	11.8	1.3
	Private sector		11.7	4.6	11.1	4.5	10.4	4.1
Net foreign assets 1/			6.7	3.7	6.6	3.6	11.1	6.0
	Monetary authorities		6.2	2.5	11.7	4.5	12.1	4.8
	Financial system		7.9	1.3	-5.6	-0.9	8.3	1.2
Other items (net)			0.2	—	-7.8	-1.3	2.8	0.4

Source: Data provided by the Maltese authorities.

^1/The breakdown of domestic credit differs from that presented in the Financial Survey (Table A26) in that parastatal companies are included in the public sector.

^2/12-month change to August.

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Table 7.

Malta: Contributions to Broad Money Growth ^1/

(In percent)

			1992		1993		1994 2/
			Percentage Change	Contribution to Money Growth	Percentage Change	Contribution to Money Growth	Percentage Change	Contribution to Money Growth
Broad money			9.3	9.3	10.3	10.3	14.3	14.3
Domestic credit			9.1	5.6	12.9	7.9	12.7	7.9
	Public sector		4.4	1.0	16.5	3.4	16.9	3.7
		Government	1.8	0.2	12.9	1.3	22.1	2.4
		Parastatal sector	6.9	0.8	19.7	2.2	11.8	1.3
	Private sector		11.7	4.6	11.1	4.5	10.4	4.1
Net foreign assets 1/			6.7	3.7	6.6	3.6	11.1	6.0
	Monetary authorities		6.2	2.5	11.7	4.5	12.1	4.8
	Financial system		7.9	1.3	-5.6	-0.9	8.3	1.2
Other items (net)			0.2	—	-7.8	-1.3	2.8	0.4

Source: Data provided by the Maltese authorities.

^1/The breakdown of domestic credit differs from that presented in the Financial Survey (Table A26) in that parastatal companies are included in the public sector.

^2/12-month change to August.

Over the period 1992–94, the expansion of credit to the private sector has been at a more modest—but still relatively healthy—pace. Private sector credit expanded by 11 percent in 1992 and 1993, but eased slightly to just over 10 percent in the year to August 1994. In 1992–93, lending to the banking sector grew at a 35 percent annual pace and lending to the wholesale and retail trade sectors increased at a 15 percent annual pace, while lending to the manufacturing sector (including ship repair and shipbuilding) and for personal loans, was also relatively brisk. During 1994, loans to the banking and wholesale and retail trade sectors continued to absorb much of the new credit to the private sector. However, credit to the building and construction sector also increased significantly (by 23 percent in the year to August) after a halt in 1993.

Excluding the effect of the lira devaluation in November 1992, total net foreign assets of the banking system increased by 6.7 percent in 1992, accounting for about two fifths of broad money growth. Most of this increase represented international borrowing by a parastatal company, Enemalta. During 1993, net external inflows, basically in the form of foreign loans and foreign currency deposits of offshore companies, pushed up total net external assets of the banking system by a further 6.6 percent. The growth of total net external assets accelerated to 11.1 percent in the year to August 1994. A major factor behind this was the removal from January 1, 1994 of the declaration of capital assets from the income tax return and the introduction of a 15 percent withholding tax on interest earnings. This had the effect of reducing the rate of income tax previously paid by residents on such earnings, and thereby encouraged residents and expatriates to repatriate capital from abroad for investment in deposits with domestic banks. In addition, net foreign assets were swollen by the first tranche of a large foreign loan taken out by the Freeport Corporation.

1. Overview

Up to the late 1980s, the current account had been generally in surplus, as a positive services balance more than offset sizable deficits in the trade account. Any pressures on Malta’s external balance, such as those experienced in the early 1980s, were typically not met by adjustment in the exchange rate, which was primarily relied upon to provide a stable nominal anchor for the economy, but rather via an intensification of import restrictions and exchange rate and export subsidies. Since the late 1980s, deficits in the current account have become more prevalent (Table A32). This trend has reflected the transitory impact of the gradual reduction in the level of protection and, more fundamentally, the impact of the substantial acceleration in private and public investment. Higher investment has contributed to the elimination of the current account surpluses both directly via the savings-investment identity (in the face of a more or less stable overall savings rate) and by raising import demand, given its large import content. At the same time, while price stability has remained an important policy objective, the authorities have been more willing to direct exchange rate policy to maintaining an adequate level of competitiveness. The clearest example of this was a 10 percent devaluation of the Maltese lira in November 1992. Nevertheless, the accompanying improvement in competitiveness was unable to prevent a return to current account deficit in 1993, following the recording of a small surplus in 1992.

Malta has traditionally been a capital importer and this, in conjunction with the current account surpluses up to the late 1980s, has contributed to a comfortable level of foreign exchange reserves. In the late 1980s and early 1990s, significant capital outflows emerged, mainly associated (at least up until 1993) with a relaxation of restrictions on the expansion in banks’ net foreign assets. In the last few years, these outflows have been more than offset by other types of long- and short-term capital inflows. Thus, while the capital account has remained in surplus, its structure has changed substantially: the share of foreign direct investment has declined considerably, while the importance of much more volatile short-term capital inflows and long-term foreign public borrowing has correspondingly increased.

2. Exchange rate management and competitiveness

Since 1972, the lira has been pegged to a basket of currencies. While the basket weights have been periodically adjusted so as to generally correspond to the relative shares in Malta’s external trade, there have also been changes in the weights of a more discretionary nature. Until 1987, price stability constituted the primary objective of exchange rate policy, and the authorities avoided recourse to devaluation even when the external balance came under pressure. Since then, the authorities have adopted a more balanced strategy. While price stability remains an important policy goal, exchange rate policy is also set with an eye to maintaining Malta’s competitiveness at an adequate level. This policy shift is best reflected in the decision to devalue the lira in November 1992 in the wake of the EMS turmoil.

Up to 1989, the currency basket consisted of 10–11 currencies, principally of European countries and the U.S. dollar. In 1989, the list of currencies was reduced to three: the ECU, viewed as representing Malta’s trade with the EU countries (which constitute its main trading partners); the pound sterling, whose inclusion separately from the ECU was justified on the grounds of the importance of the U.K. in Malta’s external transactions, especially with regard to the tourism sector; and the U.S. dollar, viewed as representing Malta’s trade with the rest of the world (see tabulation below). Inclusion of the ECU rather than the individual EU currencies was of little practical significance at the time the change was made in view of the stability of the bilateral rates between the ERM currencies that had prevailed since the previous general realignment of 1987.

Table 8.

Malta: The Currency Basket of the Maltese Lira, 1983–1993

(End of period)

Source: Central Bank of Malta, Quarterly Review.

Table 8.

Malta: The Currency Basket of the Maltese Lira, 1983–1993

(End of period)

		1983	1985	1987	1989	1991	1992	1993
Deutsche mark		23.6	25.4	17.0	—	—	—	—
Pound sterling		21.1	27.0	25.2	16.3	17.2	12.2	12.5
Italian lira		17.1	11.9	—	—	—	—
Other EMS		7.7	11.4	6.7	—	—	—	—
ECU		—	—	—	58.6	59.9	66.3	64.8
U.S. dollar		35.4	16.6	19.5	25.1	22.9	21.5	22.7
SDR		—	—	18.2	—	—	—	—
Other		12.2	2.5	2.7	—	—	—	—
	Total	100.0	100.0	100.0	100.0	100.0	100.0	100.0

Source: Central Bank of Malta, Quarterly Review.

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Table 8.

Malta: The Currency Basket of the Maltese Lira, 1983–1993

(End of period)

		1983	1985	1987	1989	1991	1992	1993
Deutsche mark		23.6	25.4	17.0	—	—	—	—
Pound sterling		21.1	27.0	25.2	16.3	17.2	12.2	12.5
Italian lira		17.1	11.9	—	—	—	—
Other EMS		7.7	11.4	6.7	—	—	—	—
ECU		—	—	—	58.6	59.9	66.3	64.8
U.S. dollar		35.4	16.6	19.5	25.1	22.9	21.5	22.7
SDR		—	—	18.2	—	—	—	—
Other		12.2	2.5	2.7	—	—	—	—
	Total	100.0	100.0	100.0	100.0	100.0	100.0	100.0

Source: Central Bank of Malta, Quarterly Review.

The trends in the basket weights suggest significant changes in the formulation and objectives of Malta’s exchange rate policy over time. Up to 1987, it would appear that maintaining competitiveness carried a small weight in exchange rate policy as discretionary adjustments were made to the basket weights that had very little to do with Malta’s direction of trade.

In particular, during the period of the dollar’s pronounced appreciation in the early 1980s, the dollar’s weight was raised considerably to around 35 percent, resulting in the lira’s marked appreciation vis-à-vis European currencies. The appreciation was an important factor behind the fall in the price level during 1983–1985. On the other hand, when the dollar started depreciating in 1985, its weight was promptly reduced by almost 20 percentage points.

Since 1987, however, discretionary changes in the basket weights have been avoided and the weights have only been adjusted periodically to accommodate changes in the relative shares of the respective countries in Malta’s trade.^1/ This increased emphasis on competitiveness was probably prompted by the opening up of the economy and the associated significant rise in the share of foreign trade in GDP, which has rendered the economy much more dependent on developments in its external balance. At the same time, the steady dismantling of protective barriers progressively reduced the scope of import restrictions, which had been extensively relied upon in the past to provide relief to the current account during periods of stress.

Following a sharp appreciation in the early 1980s, measures of the real effective exchange rate index suggest a steady improvement in Malta’s competitiveness during the 1985–1992 period (Table A33). In the third quarter of 1992, the real effective exchange rate stood 25 percent below its level of the beginning of 1985. It should be pointed out that the index probably overstates the gain in competitiveness, in view of a general wage freeze which remained in effect until 1987 and the inadequate treatment of services in the consumer price index.^2/ These considerations notwithstanding, the steady growth of merchandise exports after 1987, averaging 19 percent per year during 1988–1992, and the significant gains in market share in the area of tourism, would suggest that Malta’s competitive position has remained strong.^3/

Against this background, the EMS turmoil of September 1992 generated considerable concern. While the real effective exchange rate index, which is weighted by shares in merchandise trade, would suggest only a moderate appreciation for the lira, the main victims of the turmoil were Italy (which left the ERM) and Spain and Portugal (which devalued), all three of which are important competitors for Malta’s tourism industry. This would suggest that the true losses in competitiveness were larger than indicated by the real effective exchange rate index.^1/ In addition, and perhaps even more important than these adverse developments in the lira’s bilateral spot exchange rates, the uncertainty inherent in the new environment was perceived as a threat to tourism’s prospects, particularly in view of the importance of forward contracts for the sector. In turn, a potential downturn in tourism was viewed as likely to generate major ripple effects for the rest of the economy. Under these conditions, the Maltese authorities decided at the end of November 1992 to devalue the lira by 10 percent with respect to the basket, which left the real effective exchange rate index 7 percent below its pre-crisis level. Since then, rising inflation, itself largely a result of the devaluation, has partly eroded this gain in competitiveness, with the lira appreciating by almost 3 percent in real effective terms between December 1992 and August 1994.

Up to now, the fixed exchange rate strategy for the Maltese lira has not come into serious question. In principle, a case for a more flexible policy regime could be made in the event of large country-specific shocks largely uncorrelated with the business cycle in Malta’s main trading partners. The high degree of specialization of the Maltese economy would suggest that adverse developments in its main export sectors would quickly become economy-wide shocks. However, while this feature may provide prima facie indications that a more flexible exchange rate policy may be warranted in response to nonbusiness-cycle-related shocks of this type, closer examination of the industries in question would suggest that extensive recourse to the exchange rate as an adjustment mechanism may be of limited usefulness. In particular, among Malta’s principal export industries, developments in the tourism sector would appear to be predominantly linked to cyclical developments in the European countries, to the currencies of which the lira is primarily pegged. And, quite apart from the fact that it is also highly sensitive to the global business cycle, the high import content and small domestic value added of manufacturing exports—especially the dominant electronics industry—suggest that the exchange rate would also not be a very potent instrument to offset shocks to this sector.^2/

A number of monetary policy considerations would also argue for a fixed exchange rate regime. In the first place, the experience of other small (though much larger than Malta), open European economies would suggest that alternative nominal anchors such as monetary aggregates have tended to become difficult to control and even interpret since the mid-1980s, especially in the context of domestic financial and international capital flow liberalization. Secondly, in the wake of capital flow liberalization, the anti-inflation credibility of the Maltese monetary authorities could be seriously tested by the financial markets. Under these conditions, a number of small, open economies have found it easier to peg to the currencies of stability-oriented countries, thereby “borrowing” their reputation for low inflation. It is of course widely recognized that a more flexible functioning of the Maltese labor and product markets would contribute to an easing of the inevitable costs on the real economy associated with a fixed exchange rate. In that sense, the success of the ongoing policies of structural reform acquire particular importance.^1/

On the other hand, the question of an appropriate currency basket for the lira is currently receiving considerable attention from the Maltese authorities, although no decisions in this area have as yet been reached. In particular, the authorities are considering the advantages of significantly raising the weight of the ECU in the currency basket, or even of pegging the lira exclusively to the ECU.

It can be argued that reducing the weight of the U.S. dollar (which is a poor proxy to represent Malta’s small share of non-European trade), or dropping it completely from the currency basket, would have important advantages. In view of the U.S. dollar’s record of high volatility vis-à-vis the European currencies, its current weight of over 20 percent could potentially result in substantial fluctuations of the effective exchange rate, thereby creating problems for both policy objectives of ensuring price stability and maintaining competitiveness. Nevertheless, while pegging the lira more closely to European currencies would appear warranted, and would be consistent with the prospect of Malta’s EU (and EMS) participation, the specific choice of an ECU peg may not be entirely appropriate. After the widening of the ERM fluctuation bands in August 1993, there is increased scope for substantial fluctuations of EU bilateral parities, and hence of the ECU parity vis-à-vis individual EU currencies. Under these conditions, an ECU peg for the lira could potentially require parity changes in response to developments in the exchange rates of countries that have very little to do with Malta’s external trade, while at the same time it may not be consistent with the objective of providing a low-inflation anchor. The latter could better be achieved via pegging the lira to the currencies of the most stability-oriented EU countries.

3. The current account

The current account, which had been typically in a small surplus prior to the beginning of the opening up of the economy in 1987, turned predominantly into deficit after 1988 (Chart 6, upper panel). While export growth over the latter period accelerated significantly, imports also grew at a fast pace, reflecting to some extent the gradual reduction of import restrictions, but more fundamentally the rapid growth in private investment and public infrastructure spending. Thus, the current account was continuously in deficit during 1989–1991, averaging just over 1 percent of GDP.

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MALTA: EXTERNAL DEVELOPMENTS

Citation: IMF Staff Country Reports 1995, 052; 10.5089/9781451826548.002.A001

Source: Data provided by the Maltese authorities.

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This trend was interrupted in 1992, as a narrowing of the trade deficit more than offset reductions in the services surplus and net foreign transfers. Accordingly, the current account registered a surplus equivalent to 1 percent of GDP. In 1993, however, a deficit in the current account of 2.1 percent of GDP re-emerged, as an improvement in the invisibles balance failed to offset a substantial widening of the trade deficit, despite the lira devaluation of November 1992. While the widening of the trade deficit was partly attributable to exceptional factors, mainly on the import side, it also reflected the different cyclical position of Malta relative to its main trading partners.

4. The capital account

Since 1985, Malta’s position as a persistent net capital importer has changed somewhat (Table A40). In particular, during the period 1985–90 capital account deficits were recorded in each year except 1988, with net annual capital outflows averaging 1.3 percent of GDP. The increased incidence of outflows on the capital account can be primarily attributed to a growing accumulation of net foreign assets by banks. However, strong growth in both long- and short-term net capital inflows contributed to the re-emergence of a surplus on the capital account during 1991–93, averaging 3.5 percent of GDP per year. During this period, the increased importance of short-term inflows and a much larger share of official borrowing in long-term inflows has led to a corresponding decline in the share of private direct investment (Chart 6, lower panel).

Net capital outflows from the monetary sector have increased substantially since 1988, averaging 6.4 percent of GDP during 1988–92, against 0.8 percent during 1982–87. This expansion of net foreign assets held by the banking system, especially the commercial banks, mainly reflects the increase in foreign currency deposits held by residents, especially following the permission granted to exporters from 1990 onward to hold such accounts with domestic banks in order to facilitate their payments for imports.^1/ This trend was further supported by the gradual increase since 1989 of the proportion of their lira liabilities that commercial banks were permitted to hold in foreign currency assets. Concern over the potential impact of this type of outflow on foreign exchange reserves led the monetary authorities to freeze during 1993–94 the maximum allowed foreign asset holdings by commercial banks to its 1992 level. As a result, these outflows declined to 0.9 percent of GDP in 1993. However, given the planned capital flow liberalization, the building up of the banks’ foreign exchange asset position can be expected to re-emerge as an important source of capital outflows over the medium term.

Short-term capital flows primarily reflect changes in foreign currency deposits held by nonresidents (both foreigners and Maltese migrants) with the domestic banking system. In contrast to earlier years, net inflows have been recorded since 1988, broadly in line with the development of Malta’s offshore financial center. These inflows, which exhibit substantial volatility, reached a high point in 1992, equivalent to 5.5 percent of GDP, coinciding with the opening of the Bank of Valletta International branch. The inflows declined to 1.9 percent of GDP in 1993. While more recent figures are not yet available, these short-term inflows are projected to expand again in 1994 following the introduction of a withholding tax on capital income which, at 15 percent, is much lower than the general income tax. Beyond 1994, short-term capital flows, being probably the most interest rate-sensitive item of the capital account, would be expected to exhibit even higher volatility in the context of the planned capital flow liberalization.

Long-term capital flows have remained positive since 1988, and have typically been the largest item to counteract the growing outflows resulting from changes in the banks’ foreign asset position. At the same time, the composition of these inflows has changed radically during the past two years. While the portfolio investment component has remained very low in the presence of existing restrictions and the underdevelopment of domestic money and capital markets, the importance of direct investment, which had been the largest component of long-term inflows up to 1991, significantly diminished during 1992–93. Instead, official capital inflows dominated the long-term capital account in these years, accounting for practically the entire long-term capital inflows in 1992 and for 79.3 percent of the total 1993 inflows. These inflows were made up of increased foreign borrowing by public enterprises but also central government borrowing under European Union and Italian Financial Protocols.

5. Official foreign reserves and external debt

Up to the mid-1980s, recurring current account surpluses combined with net capital inflows led to large increases in official foreign reserves, to the equivalent of over 20 months of merchandise imports. With the weakening of the current account and the emergence of capital outflows, this trend began to change. After 1988 official reserves started falling in absolute value, and by the end of 1991 they were 16.6 percent below their 1987 level (expressed in domestic currency), or equivalent to just under 8 months of merchandise imports.^1/ After 1991, the improvement in the overall balance of payments has contributed to a renewed increase in official reserves, and the import coverage ratio has more or less stabilized. By end-June 1994, official foreign exchange reserves were equivalent to 36 weeks of merchandise imports. The largest part of the reserves (92 percent as of end-June 1994) is made up of convertible currencies, with the remainder held in the form of SDR holdings, a reserve tranche position with the IMF, and gold.

The authorities attach a high weight on maintaining a strong foreign exchange reserve position over the medium term as a cushion for potential pressure on the balance of payments and to safeguard the external value of the lira. In fact, the Central Bank is obliged by law to maintain at all times its reserves of convertible currencies and gold at a level of no less than 60 percent of the sum of currency issued and deposit liabilities.^1/ At the same time, over recent years the Government has made a policy decision to finance its major program of infrastructure spending partly through the use of foreign reserves, a practice which potentially could come into conflict with the above objectives. From a shorter-term perspective, the Central Bank monitors the level of official reserves so as to be in a position to satisfy the liquidity requirements of the commercial banks. The importance of the level of official reserves as a policy target will greatly increase when capital flow liberalization gets under way and the Central Bank has indicated that, after full liberalization, official foreign exchange reserves (as a share of base money) will constitute the primary intermediate policy target in implementing a fixed exchange rate policy for the lira.

While Malta’s external debt has remained low compared to other developing countries, it has been rising in recent years as a share of GDP, in line with increased recourse to foreign public sector borrowing. At end- 1993 it stood at 5.5 percent of GDP, against 4.1 percent at end-1989. In relation to exports of goods and nonfactor services, debt service payments remain around the same level as in 1985 (roughly 1 percent). All foreign debt commitments are strictly earmarked to finance public capital investment projects, which are projected to generate sufficient return to facilitate debt servicing. In addition to aiming for the most favorable terms of borrowing possible, in terms of interest rates as well as conditions of repayment, an important objective is the lengthening of the maturity structure of external debt.

1. Exchange arrangements

a. Exchange rate system

The Maltese lira is pegged to a basket of currencies, consisting since 1989 of the ECU, the U.S. dollar and the pound sterling. The weights of the three currencies in the basket are periodically adjusted to reflect changes in Malta’s direction of trade, and stand at present at 65 percent, 23 percent and 12 percent, respectively.^1/ Until November 1992, when the lira was devalued by 10 percent, the currency’s nominal value against the basket had remained stable, even though significant changes of a discretionary nature in the basket weights during the first half of the 1980s had resulted in substantial fluctuations in the nominal effective exchange rate.

The guaranteed exchange rate for the pound sterling offered to British and Irish tour operators detracts from the uniformity of the exchange rate regime.^2/ When the system was set up in 1983, in the context of a sharply depreciating pound sterling, the element of subsidy (relative to the spot rate) was virtually zero, and its goal was to insulate the U.K. tourism market from expectations of continued weakening of the pound. Since July 1985, however, as the pound stabilized, a subsidy element was introduced into the system, in the sense that the forward rate has been set at a more depreciated level relative to the spot rate prevailing at the time of the agreement. The subsidy is paid out of central bank profits. The evolution of the guaranteed exchange rate scheme is presented in Table 9.

Table 9.

Malta: The Exchange Rate Guarantee Scheme

(1984–1995)

Table 9.

Malta: The Exchange Rate Guarantee Scheme

(1984–1995)

			Guaranteed Rate (Pound/Lm)			Average Spot Rate (Pound/Lm)		Subsidy (percent)
1984			1.52			1.63		7.2
Sept. 1985-March 1986			1.61			1.64		1.9
April 1986-Oct. 1986			1.45			1.70		17.3
Nov. 1986-June 1987			1.35			1.81		34.1
July 1987-Oct. 1987			1.45			1.76		21.4
Nov. 1987-June 1988			1.35			1.71		26.7
July 1988-Oct. 1988			1.50			1.70		13.3
Nov. 1988-May 1989			1.35			1.69		25.2
June 1989-Oct. 1989			1.50			1.77		18.0
Nov. 1989-May 1990			1.35			1.83		35.6
June 1990-Oct. 1990			1.55			1.73		11.6
Nov. 1990-May 1991			1.40			1.73		23.6
June 1991-Oct. 1991			1.57			1.77		12.7
Nov. 1991-May 1992			1.45			1.76		21.4
June 1992-Oct. 1992			1.58			1.79		13.3
Nov. 1992-May 1993			1.47			1.79		21.8
June 1993-Oct. 1993			1.63			1.73		6.1
Nov. 1993-May 1994			1.56			1.72		10.3
June 1994-Oct. 1994			1.65			1.74		5.5
Nov. 1994-May 1995			1.58			…		…
		1986	1987	1988	1989	1990	1991	1992	1993
Total cost of subsidy
	In Lm million	2.6	6.8	5.8	6.6	4.9	4.3	4.8	2.6
	In percent of GDP	0.5	1.2	1.0	1.0	0.7	0.5	0.6	0.3

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Table 9.

Malta: The Exchange Rate Guarantee Scheme

(1984–1995)

			Guaranteed Rate (Pound/Lm)			Average Spot Rate (Pound/Lm)		Subsidy (percent)
1984			1.52			1.63		7.2
Sept. 1985-March 1986			1.61			1.64		1.9
April 1986-Oct. 1986			1.45			1.70		17.3
Nov. 1986-June 1987			1.35			1.81		34.1
July 1987-Oct. 1987			1.45			1.76		21.4
Nov. 1987-June 1988			1.35			1.71		26.7
July 1988-Oct. 1988			1.50			1.70		13.3
Nov. 1988-May 1989			1.35			1.69		25.2
June 1989-Oct. 1989			1.50			1.77		18.0
Nov. 1989-May 1990			1.35			1.83		35.6
June 1990-Oct. 1990			1.55			1.73		11.6
Nov. 1990-May 1991			1.40			1.73		23.6
June 1991-Oct. 1991			1.57			1.77		12.7
Nov. 1991-May 1992			1.45			1.76		21.4
June 1992-Oct. 1992			1.58			1.79		13.3
Nov. 1992-May 1993			1.47			1.79		21.8
June 1993-Oct. 1993			1.63			1.73		6.1
Nov. 1993-May 1994			1.56			1.72		10.3
June 1994-Oct. 1994			1.65			1.74		5.5
Nov. 1994-May 1995			1.58			…		…
		1986	1987	1988	1989	1990	1991	1992	1993
Total cost of subsidy
	In Lm million	2.6	6.8	5.8	6.6	4.9	4.3	4.8	2.6
	In percent of GDP	0.5	1.2	1.0	1.0	0.7	0.5	0.6	0.3

Separate guaranteed exchange rates are set each year for the summer and winter tourism seasons. The summer rate is to be eliminated after the 1995 season. On the other hand, the winter rate is considered important in contributing to the desired seasonal pattern for Malta’s tourism. Accordingly, the subsidy element of the winter rate has been significantly higher and the authorities have postponed the elimination of the scheme, originally planned for 1995, until 1996–97. Even so, the subsidy element has been progressively reduced over time: the proportionate difference between the guaranteed and the spot exchange rate applicable to the winter season has declined from a peak of 35.6 percent in 1989–90 to 10.3 percent in 1993–94.^1/ The total cost of the subsidy has also fallen from 1.2 percent of GDP in 1987 to 0.3 percent of GDP in 1993.

2. The trade system