A. Output and Expenditure

3. After averaging 4.4 percent growth per annum in the first half of the 1990s, real GDP grew by 9 percent in 1995. The pickup in activity was driven primarily by an increase in domestic demand, although part of the recorded GDP growth—an estimated 2-3 percentage points—reflected improved coverage of economic activities resulting from the introduction of the VAT. The expansion in domestic demand was accompanied by a deterioration in the foreign balance, as the tourism sector turned in a disappointing performance and imports of consumer goods surged in response to the tariff reductions implemented at the beginning of the year (Tables A1 and A2). The pace of output growth eased to an estimated 4 percent in 1996: although consumption remained strong, fixed investment levels eased marginally as several investment projects were completed, and the foreign balance worsened, due primarily to continued weakness in the tourism sector.

4. Consumption expenditure grew by 10.2 percent in real terms in 1995—up from an average of 4 percent growth during 1991-94—and remained buoyant in 1996 (Chart 2). Rapid growth in private consumption (some 11.2 percent in real terms in 1995) was fueled by a high level of consumer confidence, an increase in the quantity and variety of imported goods that became available following the tariff reductions,¹ and a rapid expansion in consumer credit; improved recording of private services, following the introduction of fiscal receipts in connection with the VAT, was also a factor. The surge in private consumption continued into 1996, as domestic credit continued to expand and income tax reductions introduced in midyear provided a boost to household disposable income. Figures for the first three quarters of 1996 indicate a 9.3 percent real increase in private consumption relative to the same period in 1995. Public consumption also grew strongly in the last two years, by some 7.5 percent in 1995 and 5.9 percent in 1996. As in previous years, expenditure outlays on health and education absorbed the largest share of current expenditure in 1995-96.²

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MALTA: DOMESTIC DEMAND, 1989 - 96

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

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

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5. Investment expenditure has expanded vigorously since 1993. The expansion was initially led by the private sector, but public investment also picked up after 1993 (Chart 3). Fixed investment by the private sector increased by an average of 18.6 percent per annum during 1993-95, accounting for over three-quarters of total fixed investment during that period (Table A3). Private investment in construction more than doubled between 1994 and 1995, reflecting various projects undertaken in the retail and catering sectors; the construction or refurbishment of several four- and five-star hotels; and the construction of a number of private hospitals. Investment in plant and machinery by the private sector also rose significantly, due to higher levels of activity by several manufacturing industries (e.g., beverages, machinery, and paper and printing) and once-off expenditures such as the purchase of a floating dock by a local shipping company and the purchase of aircraft by the national airline.³ The level of private fixed investment eased in 1996, as several large projects in the tourism and health services industries were completed, and fewer once-off investment expenditures were made. In the first nine months of 1996, private investment was 7.7 percent lower compared with the same period in 1995.

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MALTA: INVESTMENT AND SAVINGS, 1989–96

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

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

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6. After a slow period in 1991-93, public investment—i.e., investment by the general government and public enterprises such as Enemalta, Telemalta, and Malta Freeport Corporation—picked up in 1994 with the commencement of several large capital projects in the energy and telecommunication sectors and the Freeport. Public fixed investment expenditure leveled off in 1995, but rose further in the first nine months of 1996, due primarily to increased construction outlays on physical infrastructure and in social projects.

7. Historically, the savings required to finance investment have been generated domestically: gross national savings averaged 30.4 percent of GDP against average total investment expenditure of 28 percent of GDP during the 1980s. However, recent years have seen a decline in national savings. Public savings have been on a downward trend since 1990, and private savings dropped significantly in 1995; the private saving rate fell from 28 percent of disposable income in 1991-94 to 24 percent in 1995 (Table A4). The drop in private saving stemmed almost entirely from the household sector: the household saving rate (as a percent of household disposable income) fell by 6 percentage points in 1995, reflecting, as noted earlier, the consumption boom induced by the tax/tariff changes and the easier availability of credit (Table A5).

8. The foreign balance made a negative contribution to real GDP growth in 1995 and 1996. The pace of real growth in exports of goods and nonfactor services slowed from an average of 8.6 percent per annum during 1990-94 to below 5 percent in 1995, due mainly to a drop in tourist revenues. The slowdown continued into 1996—real exports in the first nine months of 1996 were almost 6 percent lower than the comparable period in 1995—as the tourism sector remained depressed, and semiconductor exports registered an exceptional drop due to the termination of a subcontracting operation. Real import growth, on the other hand, accelerated sharply in 1995, from an average of 7.5 percent per annum during 1990-94 to over 10 percent, as imports of consumption goods jumped in response to widespread tariff reductions, and imports of capital goods mirrored the expansion in investment. Real imports were slightly lower in the first nine months of 1996 compared with the same period in 1995, as consumption and investment expenditures came down from peak levels.⁴

B. Sectoral Output Trends

9. In line with earlier trends, service activities—notably, distribution, tourism-related private services, and public administration—were the fastest growing sectors during 1991-96 (Table A6). The relative importance of industry continued to decline, although strong growth continued in export-oriented sectors, notably electrical machinery.

Services

14. Tourism, the most important service sector, experienced robust growth in the early 1990s, but encountered adverse demand shifts after 1994. Between 1990-1994, gross lira earnings from tourism increased at an average of 11.3 percent per annum and the number of tourist arrivals increased by an average of 7.3 percent per annum, peaking at 1.2 million in 1994. The momentum was not sustained in 1995: the number of tourist arrivals dropped by 5 percent, and gross tourism earnings fell by almost 4 percent. Tourism remained weak in 1996: the number of visitors was 5.6 percent lower and gross lira earnings were almost 2 percent lower compared with 1995 (Table A8).

15. The tourist sector has traditionally relied heavily on middle-income tourists from Europe, particularly the U.K. package tour market.⁷ Factors contributing to declining revenues in 1995-96 included a drop in outward tourism from the United Kingdom; uncertainty caused by the removal of the forward buying rate scheme and the belated introduction of a new subsidy scheme (Box 2); and increased competition from a range of other destinations, both within the Mediterranean and further afield (e.g., the Caribbean).⁸ The industrial relations climate in 1996 was reportedly also a negative factor, as cruise ship dockings were discouraged on several occasions by strikes and industrial disputes.

16. The tourism industry is currently undergoing restructuring, with a view to increasing the amount of revenue per tourist, diversifying its source markets, and achieving a better spread of tourist arrivals over the course of each year (Chart 4). Steps have already been taken to increase the supply of higher-quality tourist accommodation: the Industrial Development Act has been amended to offer incentives to hoteliers seeking to upgrade or renovate their facilities, and over 90 percent of the additional 8,000 or so tourist beds expected to come on stream in the next two years will be in the higher-quality range. The recently established Institute of Tourism Studies has also been active in providing training programs to improve the quality of labor in the sector.

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MALTA: TOURISM, 1989–96

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

Sources: Data provided by the Maltese authorities; and staff estimates.1/ Excluding transportation.

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C. Labor Market Developments

18. Conditions in the labor market remained tight in the 1990s, with the unemployment rate averaging 4 percent in 1992-94, and employment growing at a steady pace (Table A9). With the economy edging close to full employment, wage pressures have picked up in the last few years.

19. Employment growth jumped to 4.2 percent in 1995, well above the 1.2 percent average annual growth rate recorded in the past five years. This was entirely due to the private sector, which saw an increase of almost 10 percent in recorded employment (Table A10). The growth in employment was concentrated in the services sector; almost half of this increase—some 3,500 “new” jobs—likely reflected the surfacing of the black economy following the implementation of the VAT. Public sector employment, in contrast, fell by 4 percent in 1995, reflecting policy efforts (such as early retirement schemes) as well as privatization initiatives (notably, the privatization of the Bank of Valletta). Despite this reduction, however, the public sector continues to account for some 35 percent of total employment.

20. The labor market eased slightly in 1996, as the unemployment rate edged up to 4.1 percent of the labor force by November, and the pace of employment growth slowed to 0.5 percent. In early 1997, the government announced the imposition of a hiring freeze in the public sector as part of its fiscal adjustment effort.

21. Since the expiry of the incomes policy agreement at the end of 1993, wages in Malta have been negotiated by collective agreements at the firm level.⁹ However, mandatory universal cost of living adjustments (COLAs) continue to be set each year by the tripartite Council for Economic Development; these cost of living increases are announced by the government in the budget speech and then used as a starting point for collective agreement negotiations. The COLA for 1997 has been set at a flat rate of Lm 1.50 per week.

22. Collective bargaining contracts in the private and parastatal sectors generally last for three years; the last public sector wage agreement, signed in 1991 as part of the public sector pay reform effort, was a five-year agreement.¹⁰ The precise structure of contracts varies across the economy; the public sector, by virtue of its size, tends to be the standard-setter for the whole economy in terms of wages and employment conditions.

23. Both public and private sector collective bargaining contracts specify wage increases exclusive of the COLA.¹¹ In recent years, wages have been drifting upward, reflecting the tightness in the labor market: data from collective agreements and the schedule of pay scales for government employees indicate that average weekly wages (inclusive of the COLA but excluding overtime pay, bonuses, social security benefits, and allowances) rose by 7.2 percent in 1994 and 7.8 percent in 1995 (Table A11). With inflation hovering around 4 percent, real wages are estimated to have risen by some 3-3.5 percent during that time. Provisional estimates show slower growth in 1996.

24. The industrial relations climate became quite turbulent for a period in 1995-96, with strike activity affecting firms in various sectors, including many parastatals such as Air Malta, Gozo Channel, Mid-Med Bank, and the Kalaxlokk Company. A total of 5,300 man-days were lost as a result of industrial actions in 1995; this number more than tripled in the first nine months of 1996. A revision of the industrial relations laws, proposed in 1990, was never undertaken, and many points of disagreement—e.g., the right to sympathy industrial action—continue to exist between employers and unions.

D. Prices

25. Inflation in Malta is conventionally measured by the year-on-year percentage change in the retail price index (RPI). The RPI is compiled monthly by the Central Office of Statistics, under supervision by the RPI Management Board, which consists of representatives from the government, trade unions, and employers’ associations.¹² From 1992-1995, the RPI was based on weights derived from the results of a Household Budgetary Survey (HBS) conducted in 1988-89, using 1991 as the base year. Beginning in January 1996, a new RPI was introduced, based on the results of a more recent HBS held in 1993-94, using 1995 as the base year. The new index is more representative (the 1993-94 HBS covered more than twice the number of households used in the 1988-89 survey) and less sensitive to seasonal fluctuations (the weight of food items in the new index is 29.9 percent, down from 36.8 percent) than the old index, but has come under criticism from several quarters for being based on an outdated (pre-VAT) bundle of goods and services.¹³

26. As measured by the RPI, inflation was modest during the 1980s and early 1990s—averaging 1 percent per annum in 1983-92—but accelerated to 4.1 percent per annum in 1993-94 in the wake of the devaluation of the Maltese lira in November 1992.¹⁴ By 1995, the pass-through effects of the devaluation had largely disappeared but despite this—and falling inflation in Malta’s major trading partners—inflation remained close to 4 percent (Table A12). Price developments in 1995 were influenced by various (competing) factors such as domestic demand pressures, tariff reductions, and the introduction of the VAT, resulting in marked differences in the rate of price growth across sectors.

27. The pace of inflation eased somewhat during 1996, with 12-month inflation averaging 2.5 percent.¹⁵ It should be noted, however, that the calculation of 12-month inflation rates in 1996 is highly sensitive to the methodology used to link the old and new indices, and estimates range from 2.3-3.4 percent depending on the splicing period used.

A. The Budget

The budget structure

30. Budgetary revenues have averaged some 37 percent of GDP during 1992-95, dipping to 35½ percent of GDP in 1996 (Chart 6 and Table A14). Tax revenue provides some three-quarters of total revenues, split almost evenly between receipts from direct and indirect taxation (Chart 7). Tax reforms in recent years (notably VAT introduction) have led to a shift in the composition of tax revenues from direct to indirect taxes, with the latter increasing from 44 percent of tax receipts in 1992-94 to 48 percent in 1995-96. With the elimination of import duties from the EU in conjunction with the introduction of the VAT, revenues from import duties have fallen sharply in both absolute and relative terms, dropping from some 28 percent of total revenues in 1992-94 to a mere 3 percent of revenues in 1995-96.

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MALTA: BUDGETARY REVENUE, 1989-97 ¹/

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

Source: Data provided by the Maltese authorities.¹/ Data for 1997 refer to budget estimates.

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MALTA: BUDGETARY TAX REVENUE, 1989-97 ¹/

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

Sources: Data provided by the Maltese authorities; and staff estimates.¹/ Data for 1997 refer to budget estimates.

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31. Nontax receipts have declined in importance in recent years, from near 10 percent of GDP in 1992-94 to some 7 percent of GDP in 1995-96. Contributory factors have included weakening financial performance of public enterprises, leading to dwindling profit remittances; loss of dividend income, following asset sales and public enterprise reforms in the early 1990s; reduced interest receipts as the stock of outstanding government loans to enterprises contracted; and stagnation of profit remittances from the central bank.

32. Budgetary outlays averaged some 41 percent of GDP in 1992-95, increasing to near 43½ percent of GDP in 1996 (Chart 8 and Tables A15, A16, and A17). Expenditures for capital purposes account for about one-eighth of total outlays (some 5 percent of GDP), although this share is overstated because of the classification of subsidies to loss-making enterprises, notably Malta Drydocks and Malta Shipbuilding, as capital outlays.¹⁸ Classification problems also impair the analysis of current expenditure, for which a complete economic categorization is available only with a lag of about two years. An ad hoc analytical classification provided by the authorities affords a breakdown of current expenditure between spending on personnel (about one-third), social security benefits and health (some 40 percent), subsidies to enterprises (about 10 percent), interest payments (about 5 percent), and other. In recent years, total expenditure has been rising in relation to GDP, reflecting higher current outlays; contributing factors have included the increase in transfers (mostly to public enterprises), and rising interest payments on a higher debt stock. Capital expenditure—which includes infrastructure and social outlays—has been broadly unchanged in relation to GDP with the decline in infrastructure outlays offset by the rise in social outlays (e.g., care of the elderly and hospitals).

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MALTA: BUDGETARY EXPENDITURE, 1989-97 ¹/²/

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

Sources: Data provided by the Maltese authorities; and staff estimates.¹/ Data for 1997 refer to budget estimates.²/ Data prior to 1992 are not strictly comparable because of changes of coverage in the Consolidated Budget Fund.3/ Includes spending on police and armed forces.

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Budgetary developments

33. The budgetary position weakened significantly in 1994, with rising expenditure levels and government lending pushing the deficit up to 5.2 percent of GDP, some 2 points higher than in 1992-93.¹⁹

34. Fiscal developments in 1995 were influenced by the introduction of the VAT at the outset of the year, in conjunction with wide-ranging tariff reductions. Tax revenues rose sharply in relation to a rapidly growing GDP, with revenues from indirect taxation increasing from 11.4 percent of GDP in 1994 to some 14.4 percent in 1995. Aggregate revenue growth was more modest, however, with sizable declines in various nontax revenues (foreign grants, dividend income, and central bank profits) implying that total revenues increased only marginally in relation to GDP, from 36.9 percent in 1994 to 37.2 percent in 1995. However, some easing in the pace of growth of current outlays (notably on personnel) laid the basis for a drop in budgetary outlays from 42.1 percent of GDP in 1994 to 41.2 percent in 1995, and a decline in the budget deficit of some 1.2 points of GDP.

35. The 1996 Budget sought a further reduction in the budget deficit to some 3.5 percent of GDP, to be achieved through additional growth in indirect tax revenues that would more than compensate for a sizable programmed increase in capital outlays. The budget also included important reforms in the areas of income taxation (consistent with the broader objective of shifting toward greater reliance on indirect taxation) and social expenditures (to improve the targeting of benefits to lower income beneficiaries).²⁰

36. The income tax changes were intended to reduce the average rate of taxation, and make the system more equitable. Personal income tax brackets were raised, with the maximum tax rate of 35 percent (which remained unchanged) applied to an annual income exceeding Lm 10,000, up from Lm 6,000, and the exemption threshold increased from Lm 3,000 to Lm 3,500. These changes resulted in a cut in effective tax rates across the board (Table 2). In an effort to improve compliance, the complex system of tax deductions was also streamlined and income earned from part-time work taxed at a fixed rate of 15 percent.

Table 2.

Effective Income Tax Rates

(In percent)

Source: Data provided by the Maltese authorities.

Table 2.

Effective Income Tax Rates

(In percent)

Income in Lm	Married		Single
	1996	1995	1996	1995
Up to 2,500	0	0	0	0
3,000	0	0	0	4
3,500	0	2	2	7
4,000	0	5	4	10
4,500	2	8	5	12
5,000	3	10	7	14
5,500	4	11	9	16
6,000	5	13	10	17
6,500	7	15	11	18
7,000	8	16	12	19
7,500	9	17	14	21
8,000	10	18	15	21
8,500	11	19	16	22
9,000	12	20	17	23
9,500	13	21	18	24
10,000	14	22	19	24
11,000	15	23	20	25

Source: Data provided by the Maltese authorities.

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Table 2.

Effective Income Tax Rates

(In percent)

Income in Lm	Married		Single
	1996	1995	1996	1995
Up to 2,500	0	0	0	0
3,000	0	0	0	4
3,500	0	2	2	7
4,000	0	5	4	10
4,500	2	8	5	12
5,000	3	10	7	14
5,500	4	11	9	16
6,000	5	13	10	17
6,500	7	15	11	18
7,000	8	16	12	19
7,500	9	17	14	21
8,000	10	18	15	21
8,500	11	19	16	22
9,000	12	20	17	23
9,500	13	21	18	24
10,000	14	22	19	24
11,000	15	23	20	25

Source: Data provided by the Maltese authorities.

37. The social benefit reform replaced four distinct family benefits with a comprehensive child allowance. While benefits previously took the form of fixed sums given to families with children,²¹ the new child allowance seeks to achieve better targeting of benefits through means-tested eligibility. (My families with an annual income below Lm 10,000 are eligible for benefits and the allowance is proportional to the difference between Lm 10,000 and the family income with rates depending on the number of children under 16 years of age (Table 3).²² The 1996 budget also introduced a new type of social benefit, called supplementary assistance, for people with an annual family income below Lm 3,500 who were not eligible for the child allowance: the benefit is 1.5 percent of the difference between Lm 10,000 and the income earned.²³

Table 3.

The New Child Allowance

Source: Data provided by the Maltese authorities.

^1/For every child after the first four, the rate increases by 1.5 percent per child.

^2/If a family earns less than Lm 2,500 a year, the child allowance is calculated on Lm 7,500.

Table 3.

The New Child Allowance

	Number of Children
	1	2	3	4
Rates (in percent) 1/ 2/	6	9	11.5	13

Source: Data provided by the Maltese authorities.

^1/For every child after the first four, the rate increases by 1.5 percent per child.

^2/If a family earns less than Lm 2,500 a year, the child allowance is calculated on Lm 7,500.

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Table 3.

The New Child Allowance

	Number of Children
	1	2	3	4
Rates (in percent) 1/ 2/	6	9	11.5	13

Source: Data provided by the Maltese authorities.

^1/For every child after the first four, the rate increases by 1.5 percent per child.

^2/If a family earns less than Lm 2,500 a year, the child allowance is calculated on Lm 7,500.

38. The budgetary outcome for 1996 deviated sharply from programmed targets, reflecting both large revenue shortfalls (almost 4½ points of GDP below budget) and strong growth in current outlays (2 points of GDP above budget). As a result, the budget deficit reached some 8½ percent of GDP, compared with a 1995 outcome of 4 percent and a 1996 target of 3½ percent. Poor tax compliance and weaker collection efforts ahead of the general election, coupled with the incoming government’s commitment to remove the VAT, contributed to the poor revenue performance: in the last quarter of 1996, income tax receipts and revenue from VAT were 36.5 percent and 35.7 percent lower than in the same period of 1995, respectively.²⁴ Nontax revenue was sustained at 1995 levels through higher foreign grants, while the trend decline in central bank and public corporations’ profits continued.²⁵

39. Current expenditure increased to 37.4 percent of GDP from 35.7 percent in 1995, due to higher transfers, both to households and to public enterprises. Spending on social security benefits and pensions rose by 0.8 percentage points of GDP, while subsidies to public enterprises increased by over 25 percent in nominal terms (a half point of GDP). More than a third of the increase in subsidies to public enterprises was accounted for by higher subsidies to the Water Services Corporation (WSC). Capital expenditure rose from 5.2 percent of GDP to 5.6 percent, substantially less than budgeted.

40. The 1997 Budget was presented to parliament on January 13, 1997, some two months later than normal practice because of the timing of the general election. Measures contained in the budget include increases in excise taxes on spirits, tobacco, and petroleum products, and higher registration fees on motor vehicles, collectively projected to yield an additional 1 percent of GDP in revenues; higher tariffs for commercial use of water, allowing a cut in subsidies to the Water Services Corporation; and a hiring freeze in the public sector. The VAT is to be replaced by an alternative form of indirect taxation by midyear; details of the proposed replacement taxes were outlined in a White Paper published on January 30, 1997.

41. Revenues are budgeted to increase by some 0.7 percentage points of GDP in 1997, with higher tax revenues (up 2 points of GDP) being partially offset by a drop in nontax revenues (foreign grants, central bank profits).²⁶ The higher tax take reflects the impact of the new measures, supported by an assumed rebound in revenues from improved revenue collection efforts; a partially offsetting effect is the full-year impact of the income tax reforms introduced in July 1996. Noninterest current outlays are programmed to decline by 1.5 points of GDP, reflecting the hiring freeze and cuts in subsidies; but capital expenditures are set to rise by some 0.6 points of GDP, while the rising public debt level implies higher interest outlays (up 0.3 points of GDP). The budgeted deficit declines from 8.6 percent of GDP in 1996 to 7.5 percent in 1997, financed almost entirely through domestic borrowing, and government debt would reach 47 percent of GDP by end-year, up from 42 percent at end-1996.

B. VAT: Performance and Proposed Replacement

42. The VAT, introduced on January 1, 1995, applies to goods and services. It is levied at a standard rate of 15 percent and a reduced rate of 10 percent for selected hems including catering services and tourist accommodation. Zero-rated items include exports, certain food items, pharmaceutical goods, medical services, bus and ferry transport, and education. Financial services, letting and transfers of immovable property, and nonprofit organizations are exempt.

43. The VAT generated 6.8 percent of GDP in 1995 (23 percent of tax revenue). While this fell slightly in 1996, its productivity, at 0.45 percentage points of GDP for every percentage point of the standard rate, compares favorably to VATs in European countries (Table 4). Despite having a standard rate 15 percent below the average, the yield was only 1 percent below average. Italy, Spain, and the United Kingdom have equal or higher rates but lower yields. This strong performance is largely explained by the high proportion of imports in the VAT base and the existence of only one, minor, reduced rate.

Table 4.

Selected Comparisons of VAT Rates and Productivity

Source: Fund staff estimates.

Table 4.

Selected Comparisons of VAT Rates and Productivity

Country	Standard Rate (percent)	Other rates (percent)	Revenue (percent of GDP)	Productivity (percent of GDP per 1 percent of standard rate)
Greece (1994)	18	4,8	7.5	0.42
Ireland (1994)	21	12.5	7.5	0.36
Italy (1994)	19	4,9,12	6.4	0.33
Portugal (1994)	16	5,30	7.9	0.49
Spain (1994)	15	3,6	5.5	0.37
U.K. (1994)	17.5	…	6.7	0.38
Average	17.8	…	6.9	0.39
Malta (1995)	15	10	6.8	0.45

Source: Fund staff estimates.

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Table 4.

Selected Comparisons of VAT Rates and Productivity

Country	Standard Rate (percent)	Other rates (percent)	Revenue (percent of GDP)	Productivity (percent of GDP per 1 percent of standard rate)
Greece (1994)	18	4,8	7.5	0.42
Ireland (1994)	21	12.5	7.5	0.36
Italy (1994)	19	4,9,12	6.4	0.33
Portugal (1994)	16	5,30	7.9	0.49
Spain (1994)	15	3,6	5.5	0.37
U.K. (1994)	17.5	…	6.7	0.38
Average	17.8	…	6.9	0.39
Malta (1995)	15	10	6.8	0.45

Source: Fund staff estimates.

44. The White Paper published by the government on January 30 identified a number of problems with the current VAT system, namely, that it is (1) unfair and inefficient; (2) administratively burdensome, especially for small businesses, (3) over-complex, due to the use of zero-rating and exemptions; (4) an additional layer of taxation as businesses already pay income and social security taxes; and (5) insufficiently coordinated with other taxes, especially the income tax.²⁷

45. The proposed replacement for the VAT is a system of import duties and specific excises. Imports will be subject to a 15 percent import duty. Those goods currently not subject to VAT and import duty will be exempt. Imported elements of goods produced locally for domestic consumption in competition with imported final goods that are exempt from import duty shall also be exempt. Export industries and tourism will benefit through exemptions for capital imports and direct support services.

46. All nonexempt goods purchased within Malta, both imported and domestic, will be subject to a single-stage excise tax, known as the Excise Tax on Products (ETP), with a rate of 5 percent. The ETP will be levied on goods when sold to a business for its own consumption or to a retailer. Both the seller and buyer are obliged to maintain a record of the tax. Those items exempt from the import duty will also be exempt from the ETP. Businesses that buy goods to be incorporated into other products will not pay the ETP but will levy it on their output.

47. Selected services will be subject to an excise tax (ETSS). These services include services to businesses and some services provided directly to the public. They will be taxed at 10 percent, while pre-booked accommodation and catering packages will be subject to a rate of 5 percent.

48. The proposed replacement system for the VAT has several weaknesses. It is liable to the criticism of cascading because not all business inputs will be creditable or exempt: for example, it is unlikely that the tax component from exports can be entirely removed. Attempts to replicate the VAT system of crediting through use of exemptions will inevitably increase the degree of arbitrariness in the system and facilitate increased avoidance/evasion, and is likely to be administratively cumbersome.

C. Budget Financing and Public Debt

49. In recent years, the budget deficit has been financed primarily through domestic debt issues (Chart 9), but in the period 1994-95 asset sales were also an important source of financing (on average almost a third of the deficit). With the exception of 1994, net foreign financing has been negative.

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MALTA: BUDGET DEFICIT FINANCING AND GOVERNMENT DEBT, 1989–96

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

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

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50. Government debt has been rising rapidly since 1994 due to the deteriorating budgetary position and despite sizable asset sales in 1994 and 1995. The stock of government debt rose from 33.3 percent of GDP at end-1994 to 42.1 percent of GDP at end-1996.²⁸ Domestic debt increased even more rapidly, from 27.8 percent of GDP in 1994 to 38.1 percent of GDP in 1996, while foreign debt declined from 5.5 percent of GDP at end-1994 to 4 percent of GDP at end-1996 (Table A18).

51. At end-1995, three-quarters of the government’s domestic debt stock consisted of medium- and long-term securities: the rest was in the form of treasury bills. The proportion of treasury bills in domestic debt more than doubled between 1994 and 1996, as the limit on the issue of this instrument was raised from Lm 30 million to Lm 100 million in 1995 and to Lm 200 million in November 1996. At end-1995, over a fifth of treasury bills were held by the nonbank public, a ratio which has been rising and is projected to have reached one-third by end-1996. In March 1996, the nonbank public held about 47 percent of the stock of government bonds, the commercial banks 38 percent, with the remainder held by the CBM.

52. Debt of public corporations and authorities is estimated at some Lm 200 million (18 percent of GDP) at end-1995, three-fourths of which is external. Debt of other public enterprises is estimated at about Lm 57 million (5 percent of GDP), almost entirely external, bringing total public debt to Lm 669 million (58 percent of GDP). The government also extends guarantees on bank credits to a variety of entities—these amounted to Lm 403 million (33 percent of GDP) as of end-1996.²⁹

D. Public Enterprises

53. Public enterprises comprise: (1) public corporations and authorities that are entirely government owned, are established by specific legislation, and must have their annual financial statements approved by parliament; (2) direct government investments in firms deemed to be of strategic importance (e.g., commercial banks); and (3) investments undertaken through government agencies, notably Malta Development Corporation (MDC) and, more recently, Malta Government Investments Ltd. (MGI).

54. Since 1987, government policy has been to reduce the direct rote of the public sector in the economy through sale of investments in the government’s portfolio. To this end, in 1988, Malta Investment Management Company Limited (MIMCOL) was set up as an agency entrusted to take over management responsibilities of companies in the portfolio of MDC/MGI, and given the tasks of liquidating companies deemed unviable and improving the performance of those with good prospects to prepare than for sale. In line with this strategy, 12 companies assigned to MIMCOL were privatized in 1994-95 and a number were liquidated; 13 companies are now left with MIMCOL. The government also divested itself of some direct investments, most notably by selling shares in commercial banks, including Bank of Valletta. As of end-September 1996, the government had direct investments in 25 companies, including Mid-Med Bank (the largest commercial bank), Air Malta Co. Ltd., and Malta Freeport.

55. The main public corporations include Enemalta, Telemalta, the Water Services Corporation (WSC), the Maritime Authority, the Housing Authority, and the Transport Authority. Enemalta, the energy company, supplies and distributes electricity, gas and petroleum products. Until 1994, Enemalta was quite profitable, although it relied on cross subsidization of the electricity division with profits made by the petroleum division. In 1995, however, its operating surplus more than halved, reflecting the failure to pass on to consumers increased costs (notably the VAT and higher fuel costs) and inefficient capital outlays.³⁰ In the six months from October 1995 to March 1996, there was a further deterioration in the financial position of Enemalta, partly due to delays in the issue of electricity bills.

56. Telemalta is a public corporation responsible for the provision of telecommunication services.³¹ It is a profitable enterprise, but its profitability suffered with the introduction of the VAT, again not passed on to consumers, and the reduction of tariffs on overseas calls; in the financial year 1995/96, its profits declined by some 30 percent. Other factors contributing to the deteriorating financial performance were higher personnel costs and debt servicing.

57. Set up in 1992 in place of the Water Works Department, the WSC supplies and distributes water. Since its inception, it has relied heavily on budgetary subsidies to cover operating losses and has borrowed heavily from the domestic banks to finance large capital projects to improve the water supply in the island. Important problems afflicting this enterprise include the rise in operating costs due to the inefficient use of manpower, extensive wastage and pilfering, and, in 1996, the delay in issuing bills to consumers.

58. Large government subsidies are extended to Malta Drydocks and Malta Shipbuilding.³² Budgetary subsidies to these entities averaged 1.3 percent of GDP in 1995-1996, and the government has also provided advances to these companies outside the budgetary framework (Box 1, Chapter I).

A. The CBM and the Conduct of Monetary Policy

61. The CBM’s principal objectives as set out in the amended Central Bank Act are: (1) to promote balanced economic development consistent with the maintenance of monetary stability and the external value of the currency; and (2) to foster a sound financial structure and an orderly capital market. Notwithstanding the CBM’s increased autonomy in pursuing these goals, the Minister of Finance retains the prerogative to give the bank instructions that he deems appropriate in the national interest. The CBM’s board of directors, composed of the governor, the deputy governor, and three other directors, is responsible for deciding the broad outlines of monetary policy, with detailed implementation being delegated to the Monetary Policy Council (MPC), which meets once a month.

62. Monetary policy is conducted within the context of a fixed exchange rate; the value of the lira is pegged to a basket of currencies that includes the ECU, the U.S. dollar, and the pound sterling.³⁴ The presence of capital controls, coupled with imperfect asset substitutability, provides the CBM some capability to conduct an independent monetary policy, although gradual liberalization of the capital account in recent years increasingly limits the CBM’s room for maneuver. The set of instruments used by the CBM to influence monetary developments was expanded in 1994-96 to include term deposit auctions (used only in 1994-95), regular repurchase/reverse repurchase agreements (introduced at end-1994), and foreign currency swaps (Box 3). In setting policy, the CBM looks to a broad range of economic indicators, including external reserve levels (which, according to the CBM Act, must not fall below 60 percent of the CBM’s liabilities), the pace of broad money growth, and the level of economic activity; high weight is given to the objective of limiting interest rate fluctuations.

63. A simplified balance sheet for the CBM is presented in Table 5. External reserves accounted for some 69 percent of total assets at end-1995, with credit to government representing a further 9 percent of assets; other assets include foreign exchange deposits held abroad by the CBM on behalf of the government and public enterprises. Credit to the government takes the form of purchases of treasury bills (in the secondary market only, since early 1996) and government bonds, both in the primary market as the residual subscriber and in the secondary market. The CBM also used to extend short-term (intra-year) unsecured credit to the government through the advances account, but this facility was not used in 1996.³⁵ Base money represents over two-thirds of total liabilities, with the remainder including term deposits of banks, foreign exchange deposits of government and public enterprises, and capital and reserves.

Table 5.

CBM Balance Sheet; end-1995

(In millions of Maltese liri)

Source: Central Bank of Malta.

Table 5.

CBM Balance Sheet; end-1995

(In millions of Maltese liri)

ASSETS		LIABILITIES
External reserves	508.7	Base money		513.0
		of which: Currency		351.8
			Deposits of banks	80.0
Government securities	67.7	Government deposits		20.2
Other assets	163.4	Other liabilities		206.6
Total assets	739.8	Total liabilities		739.8

Source: Central Bank of Malta.

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Table 5.

CBM Balance Sheet; end-1995

(In millions of Maltese liri)

ASSETS		LIABILITIES
External reserves	508.7	Base money		513.0
		of which: Currency		351.8
			Deposits of banks	80.0
Government securities	67.7	Government deposits		20.2
Other assets	163.4	Other liabilities		206.6
Total assets	739.8	Total liabilities		739.8

Source: Central Bank of Malta.

64. Monetary developments in 1994 were influenced by both a sizable buildup in foreign reserves and a significant growth in credit to government (Chart 10, and Table A19). Auctions of term deposits were introduced by the CBM as a means to limit the impact of these inflows on liquidity; by end-1994, the stock of these deposits amounted to Lm 107 million (equivalent to 22 percent of reserve money), with maturities ranging between 2-12 months.³⁶ These auctions were discontinued in early 1995, with the CBM preferring to use the newly introduced repo/reverse repo auctions to influence short-term liquidity developments, which wore now being subjected to a contractionary impulse from the drop in external reserves. From the second quarter of 1995, the CBM conducted reverse repo auctions with a total volume of Lm 116.4 million, although the stock outstanding at end-year was a mere Lm 5.8 million, reflecting the short-term and self-reversing nature of such transactions. During 1996, the CBM continued to conduct reverse repo auctions to fine-tune liquidity expansion, with the end-year stock amounting to Lm 20.5 million.

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MALTA: CENTRAL BANK BALANCE SHEET, 1989–96

(Percentage changes)

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

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

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B. The Banking Sector

65. The banking sector includes the deposit money banks, the offshore banks, and other banking institutions. Deposit money banks hold substantial foreign assets (close to 30 percent of total assets) and more modest foreign liabilities (some 10 percent of total liabilities); allowing for domestic foreign currency liabilities, the banks still have a large open foreign exchange position (Table A20).³⁷ Loans account for about one half of total assets, with the largest exposures to the manufacturing and shipbuilding (about 20 percent of total local lending) and the wholesale and retail trade sector (about 19 percent of total lending) (Table A21). Holdings of government securities amount to less than 10 percent of assets, but have increased significantly in 1996 (Table A22). Capital and reserves are close to 20 percent of total liabilities, a share that has risen in recent years.

66. After a poor year in 1994, commercial banks’ profits, from both domestic and foreign sources, increased sharply in 1995 (Table A23).³⁸ Although nonperforming assets amount to some 20 percent of the loan portfolio, commercial banks have high solvency ratios (which average about 14 percent), reportedly use conservative real estate valuation practices for collateral purposes, and have a good recovery record.³⁹

67. The offshore banks, also called international banking institutions, engage in business exclusively with nonresidents, although two of them are subsidiaries of the two largest domestic banks. Most of the offshore banks are currently licensed and supervised by the MFSC, but responsibility for supervision is to be transferred to the CBM by 2004. Offshore banks are funded through nonresident deposits and borrowing from banks abroad; two-thirds of assets are held abroad, with domestic investments reflecting the practice by subsidiaries of domestic banks of placing funds with the parent company. The sector expanded in 1995 with the entry of two new banks. Tax advantages provide the motivation for the establishment of the offshore banks; benefits accruing to Malta include enhanced training opportunities, professional fees, and ancillary services, but employment creation is modest.⁴⁰

68. Other banking institutions include the mortgage bank and the two investment banks. Loans from deposit money banks provide the main source of funds, while almost all the assets are in the form of lending to the private and parastatal sectors.

C. Money and Credit Developments⁴¹

69. The Maltese economy is characterized by low money velocity (a high ratio of broad money to GDP), reflecting a high degree of bank intermediation in the economy.⁴² At end-1995, the ratio of broad money to GDP was 1.5, compared to 1.0, 0.6, and 0.4 for the United Kingdom, Germany, and Greece, respectively.⁴³ The ratio of broad money plus government securities to GDP was only marginally higher at 1.8.⁴⁴ Heavy reliance on bank intermediation is reflective of the underdevelopment of the stock exchange, the minimal role of private pension schemes,⁴⁵ and controls on capital flows that have constrained portfolio diversification abroad. Velocity has bean relatively steady in recent years, reflecting a stable and low inflation macroeconomic environment (Table A24).

70. In the past four years, time deposits have been the fastest growing component of broad money, while currency holdings have contracted significantly in relative terms: the ratio of currency to broad money declined from 35.9 percent in 1991 to 24.9 percent in 1996. With currency holdings falling and banks improving their treasury management in the face of interest rate liberalization and other deregulation measures, the (broad money) multiplier rose from 2.7 in 1991 to 3.6 in 1996 (Chart 11).

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MALTA: MONETARY DEVELOPMENTS, 1989–96

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

Sources: Data provided by the Maltese authorities; and staff estimates.1/ Broad money multiplier.2/ Broad money velocity.3/ Broad money comprises currency outside banks and demand, time, and savings deposits.

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71. Broad money increased by 14.9 percent in 1994, resulting from both higher NFA (which contributed 69 percent) and domestic credit (which contributed 54 percent) (Table A25). The most dynamic component of credit growth was credit to the parastatal (14 percent) and private (13 percent) sectors following continued brisk economic activity. Lending to the building sector, notably for the construction of new hotels, registered the largest increase (54 percent) followed by lending to the service sector, linked to upgrading of tourist facilities, and projects in the retail and catering sectors.

72. In 1995, broad money growth slowed to 7.7 percent: NFA decreased, while domestic credit expanded rapidly. Credit to the private sector increased by some 29 percent over the year, notably to the transport and communications, construction, tourism, and tirade sectors, while loans and advances to the personal sector rose very rapidly (42 percent), particularly for purchases of consumer durables. The surge in consumer credit was also spurred by financial innovation (e.g., flexicredits and leasing) and the banks’ active promotion of credit cards.

73. The pace of broad money continued substantially unchanged in 1996, with the fall in external reserves more than offset by the expansionary impact of domestic credit. Credit to the government accelerated to 37 percent, while credit to the private and parastatal sectors slowed to 15 percent. Indications for 1996 are that lending to the tourism sector, other services, and the personal sector remained strong.

D. The Rest of the Financial Sector

74. Recent innovations in developing government securities markets include the introduction of weekly auctions for treasury bills, a widening of the range of maturities of t-bills offered, and allowing nonresidents to hold government paper (although such holdings remain low). The CBM disengaged from the primary market for treasury bills in early 1996, but remains the market maker in the secondary market. Secondary market prices are quoted as a fixed spread on primary market prices (currently with the buying spread larger than the selling spread to promote sales by the CBM). Consideration is being given to modifying the price determination mechanism in the secondary market and it is expected that commercial banks will eventually take over the market maker-role from the CBM.

75. Medium- and long-term government securities with maturities ranging from 3-12 years are issued with a fixed interest rate, decided by the Minister of Finance in consultation with the CBM, usually three times a year. Government bonds are first offered to the nonbank public, then to the commercial banks, with the CBM being the residual subscriber. The CBM is the market maker in government bonds that are traded on the stock exchange: secondary market prices are set by the CBM with a view to maintaining a yield curve in line with monetary policy objectives. Plans for changes to the long-term government securities market are still in their infancy, but could eventually lead to floating-rate issues.

76. The CBM has sought to promote the development of interbank money and foreign exchange markets. Initially the CBM acted as a catalyst in domestic money market transactions, but now a commercial bank quotes two-way prices and interbank deals have risen from Lm 16 million in 1994 to Lm 252 million in 1996. Actions taken to encourage interbank foreign exchange transactions have included widening of the CBM buy-sell spread on foreign exchange, limiting the number of intervention currencies to three, and removing the cover for forward transactions.

77. Capitalization on the stock exchange, which started operation in 1992, reached Lm 528 million at end-1996. In addition to government bonds, which account for over half of the capitalization, seven equities (three of commercial banks), one mutual fund, and two corporate bonds are listed. Despite a significant reduction in transaction and brokerage fees and the automation of the trading system, the market is still very thin, with annual turnover of about Lm 25 million, mostly involving government bonds. Factors that impede the development of the exchange include: the low cost of bank credit, family-owned businesses’ preferences for maintaining tight control, the limited number of institutional investors, and selected legal constraints.

E. Interest Rates

78. Until recently, Maltese interest rates were subject to numerous administrative controls, including ceilings on deposit and lending rates and a complex system of preferential rates. Interest rates remained fixed for many years at a level considerably below foreign interest rates,⁴⁶ which, given the fixed exchange rate regime, was only possible because of extensive exchange controls (Chart 12). In recent years, interest rates have been liberalized: notable steps were the removal of the ceiling on deposit rates in January 1994 and the raising of the ceiling on lending rates to a nonbinding level in November 1995, preceded by the elimination of preferential rates.⁴⁷

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MALTA: INTEREST RATE DEVELOPMENTS, 1989–96

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

Sources: Data provided by the Maltese authorities; International Monetary Fund, International Financial Statistics (IFS); and staff estimates.1/ Weighted average of interest rates on 3-, 6-. and 12-month treasury bills.2/ Interest rate on 12-month federal debt register.3/ Interest rate on 3-month treasury bills.

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79. Maltese interest rates rose in 1995, in part reflecting the increase in most foreign rates: the three-month treasury bill rate increased to 4.9 percent from 4.4 percent at end-1994; the reverse repo rate rose from 4.75 percent in April to 4.94 percent in December; the interbank rate was within a few basis points of the reverse repo rate and remained so in 1996; while the CBM discount rate has remained unchanged in the last decade (Table A26). At end-1995, the spread over the synthetic yield on three-month instruments was still a negative 40 basis points. Interest rates on treasury bills remained unchanged in 1996, with the three-month treasury bill rate hovering around 5 percent, despite an increase of some 10 basis points in the reverse repo rate. However, with declining interest rates abroad, Maltese yields closed the year higher than the synthetic yield by a margin of some 30 basis points.

80. In March 1996, the two largest commercial banks announced an increase in interest rates on deposits (of some 50 basis points) and in consumer and real estate loans, which had been fixed for several years. The average deposit rate rose from 4 percent to 4.2 percent and the average interest rate on loans and advances from 7.5 percent to 7.7 percent. Banks also introduced a tier scheme for deposit rates and Mid-Med Bank announced the establishment of a “base rate” (currently 5.5 percent and equal to the CBM’s discount rate) to which all lending rates would be linked. Banks are reported to now link interest rates charged more closely to client risk assessments, and thus a more differentiated structure of interest rates across customers is emerging. Factors contributing to these changes included increased competition in in the banking sector spurred by the privatizatiaon of Bank of Valletta and the entry of Midland Bank, and more active cash management induced by the abolition of the interest rate on call accounts and the introduction of mi averaging reserve requirement.

81. The spread between average lending and deposit rates stood at 3.5 percent in 1996, unchanged from 1995 and slightly higher than 1994. A decomposition of the spread into prime rate spread (i.e., the difference between the prime rate and the average deposit rate) and the credit risk spread (i.e., the difference between the prime rate and the average lending rate) reveals that two-thirds of the bank spread is accounted for by credit risk spread, estimated to have increased in 1996 as the prime rate is reported to have remained unchanged. It is expected that bank spreads will decline with increased competition among banks.

82. Real interest rates have risen over the last two years as inflation has eased and nominal rate have increased slightly. In 1996, real interest rates paid on deposits averaged 1.2 percent, while rates charged on loans averaged 4.6 percent.

A. The Current Account

84. The current account deficit has widened progressively during the 1990s, from an average of 0.5 percent of GDP in 1990-92, to 4 percent of GDP in 1993-94, and 12 percent of GDP in 1995-96. The sharp deterioration in the current account position during 1995 reflected strong growth in consumer goods imports in the wake of the tax/tariff reforms introduced in the beginning of the year, a drop in tourist revenues, and shortfalls in investment income and unrequited transfers. The current account deficit remained substantial during the first nine months of 1996, with further deterioration in the balance on goods and services offsetting a recovery in official transfers (Chart 13, Table A27).

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MALTA: CURRENT ACCOUNT, 1989–96

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

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

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B. The Capital Account

98. In contrast to the late 1980s, when the rapid accumulation of net foreign assets by banks made Malta a net capital exporter,⁵² the 1990s have seen the re-emergence of a small surplus on the capital account, reflecting large international loans taken out by public enterprises and parastatal corporations, and an expansion in nonresident deposits placed with Maltese offshore banks and on-lent into domestic markets (Chart 14, Table A33). In 1995, the surplus on the capital account financed only about one-sixth of the current account deficit, as substantial inflows of direct investment (mainly reinvested earnings) wore partially offset by government debt repayments and an increase in the commercial banks’ net external position. Preliminary indications for 1996 are that capital inflows—mostly short-term, in the form of repatriation of residents’ deposits abroad and a rundown in commercial banks’ external reserves—have financed a larger portion of the (still substantial) current account deficit.

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MALTA: CAPITAL ACCOUNT, 1989–96

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

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

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99. Net direct foreign investment inflows have been positive and quite substantial during the 1990s. Capital flows in this category include reinvested earnings of foreign companies based in Malta, equity share capital from foreign companies establishing in Malta, and loans between Malta-based subsidiaries and their foreign parents. Between 1992 and 1994, direct foreign investment more than quadrupled from Lm 13 million (equivalent to 1.4 percent of GDP) to Lm 58 million (5.7 percent of GDP). Net direct foreign investment remained strong in 1995, at 3.8 percent of GDP, consisting mainly of reinvested earnings by the electronics sector and equity share capital from a foreign bank that established a branch in Malta.

100. Other long-term capital flows are classified into: (1) portfolio investment, which includes foreign borrowing by domestic private enterprises and public corporations such as Air Malta and the Freeport; and (2) official flows, which include foreign borrowing by the government and public enterprises. The portfolio investment component of long-term capital, historically less important due to restrictions and underdeveloped domestic money and capital markets, has seen a greater amount of activity in the past three years, notably, in 1994, when Freeport Terminal sold Lm 80 million (US$210 million) worth of guaranteed notes in the international market and Air Malta raised an international loan of Lm 15 million (US$40 million), and in 1995, when Air Malta borrowed a further Lm 10 million (US$28 million) overseas to finance its fleet expansion; on the debit side, capital outflows have also risen to reflect the higher level of loan repayments associated with the increased debt. Official long-term capital inflows have fallen off sharply since 1992; in 1995, a surge in the repayment of foreign loans by two large public corporations led to a net outflow being recorded in official long-term capital for the first time since 1988. Malta received its first international credit ratings in 1994: A2 from Moody’s and A from Standard & Poor’s, the latter subsequently upgraded to A+ in May 1996.

101. Short-term capital flows include: (1) private financial investment flows, such as changes in domestic residents’ deposits held abroad and net short-term portfolio investments abroad;⁵³ and (2) other private investment flows, such as trade credits and debits between locally based companies and nonparent companies abroad, and progress payments. Both types of flows fluctuate considerably from year to year. Short-term private financial investments swung from a net inflow of Lm 28.6 million in 1994 (due in part to a public enterprise’s rundown of term deposits abroad) to net outflows of Lm 2.5 million in 1995 and Lm 6.9 million in the first nine months of 1996; net inflows have been recorded in other private investments since 1993.

102. Transactions involving the domestic banking sector are recorded as a separate item in the balance of payments, under changes in the net foreign assets (NFA) of banks and financial institutions. Changes in the NFA of banks and financial institutions have been affected by the liberalization of financial markets and the expansion of international banking activity.⁵⁴ Net capital outflows of Lm 24.5 million were recorded from the banking sector in 1995; these outflows were reversed in the first nine months of 1996, when net capital inflows of Lm 28.4 million were recorded as commercial banks ran down their foreign assets in the face of strong domestic demand for foreign exchange.

C. Official Reserves and External Debt

103. After a significant buildup in the early 1990s, official reserves declined markedly in 1995. The drop in reserves, equivalent to about 10 percent of GDP, largely reversed the sharp jump recorded in 1994, when capital inflows were swollen by the Freeport Terminal’s international bond issue. By end-1995, official reserves stood at Lm 580 million (US$1.6 billion), equivalent to about 50 percent of GDP, or 5½ months of goods and services imports. The pace of the reserves rundown appears to have slowed in 1996; by September, official reserves stood at some Lm 550 million (US$1.5 billion), a decline of around 5.5 percent since end-1995.

104. The bulk of official reserves—over 90 percent in recent years—is held in the form of term deposits with foreign banks and securities denominated in convertible currencies; the remainder is held in the form of gold and precious metals, SDR holdings, and a reserve tranche position with the IMF.

105. External debt of the government, which averaged 5 percent of GDP between 1990-94, continued to remain at a low level in 1995-96. At the end of 1995, outstanding foreign loans by the government stood at Lm 53 million (US$147 million) or 4.6 percent of GDP. Debt service payments amounted to some 1.4 percent of exports of goods and services. The government’s external debt commitments are to foreign governments, development funds, and multilateral organizations; loans are earmarked to finance public capital investment projects. For the public sector as a whole, including parastatal corporations such as the Freeport and Air Malta, outstanding external debt was much higher: at end-1995, public sector external debt was on the order of Lm 253 million (US$0.7 billion) or 22 percent of GDP, with debt service payments of around 3.8 percent of exports of goods and services. Commercial banks in Malta have a significant net foreign asset position: for the banking sector as a whole (excluding the central bank), net foreign assets stood at just over Lm 200 million (US$560 million) in 1996.

D. Exchange Rate Management and Competitiveness

106. Since 1989, the Maltese lira has been pegged to a basket of three currencies: the ECU, the pound sterling, and the U.S. dollar. The weights attached to the three currencies are 67 percent (ECU), 21 percent (U.S. dollar) and 12 percent (pound sterling); these weights have remained unchanged since 1992. Commitment to the exchange rate anchor has served Malta well in terms of facilitating a high level of price stability over the longer term. In recent years, maintaining export competitiveness has also been an important consideration in exchange rate management. The 10 percent devaluation of the Maltese lira relative to the currency basket in November 1992—a move prompted by concern over the competitiveness of Malta’s exports in the wake of devaluations/depreciations in the currencies of the United Kingdom, Italy, Spain, and Portugal following the 1992 ERM crisis—resulted in a depreciation of some 8.5 percent in the real effective exchange rate index. Since then, however, rising inflation (in excess of that of key trading partners) has eroded this gain in competitiveness somewhat, as the real effective exchange rate appreciated gradually between 1993 and 1995, although it eased slightly in 1996 and remains some 5 percent below its pre-devaluation level⁵⁵ (Chart 15, Table A34).

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MALTA: EFFECTIVE EXCHANGE RATE DEVELOPMENTS, 1985–96

Citation: IMF Staff Country Reports 1997, 055; 10.5089/9781451826555.002.A001

Sources: International Monetary Fund, Information Notice System (INS); and staff estimates.1/ Based on consumer price indices.

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E. Developments in the Exchange and Trade System