Malta
2007 Article IV Consultation: Staff Report and Public Information Notice on the Executive Board Discussion

This 2007 Article IV Consultation highlights that Malta’s economic recovery is gaining traction, owing in large part to cyclical strength and some structural change. A public investment boom, financed largely by grants from the European Union, reignited growth in 2005. A modest recovery in exports and robust consumption growth, supported by rising employment and household borrowing, helped sustain the upswing in 2006. Although financial stability has continued to improve, the concentration of loan portfolios in real estate has continued to rise. Although nonperforming loans declined further, levels remain high and provisioning uneven.

Abstract

This 2007 Article IV Consultation highlights that Malta’s economic recovery is gaining traction, owing in large part to cyclical strength and some structural change. A public investment boom, financed largely by grants from the European Union, reignited growth in 2005. A modest recovery in exports and robust consumption growth, supported by rising employment and household borrowing, helped sustain the upswing in 2006. Although financial stability has continued to improve, the concentration of loan portfolios in real estate has continued to rise. Although nonperforming loans declined further, levels remain high and provisioning uneven.

I. Introduction

1. The Council of the European Union (EU) decided on July 10 to allow Malta to join the European Monetary Union (EMU) on January 1, 2008. Upon entry, the Maltese lira will be converted at its current fixed exchange rate to the euro, the central parity of the exchange rate band that was adopted upon entry into the Exchange Rate Mechanism II (ERMII) in 2005. Preparations for EU Membership in 2004 spurred broad-based reform that helped mitigate structural impediments, especially by initiating the restructuring of the vast and inefficient public-enterprise sector (PES) and liberalizing the trade regime. However, saddled with high wage growth in the late 1990s and low labor productivity, the dominant exporters—a single, large electronics producer and the tourism sector remained under competitive pressure (Figure 1). Consequently, real GDP growth averaged 1¼ percent per annum so far this decade, notwithstanding the recovery that began in 2005. Against this background, the discussions focused on policies to bolster competitiveness, advance fiscal adjustment, and enhance financial sector stability, all within a stable macroeconomic environment.

Figure 1.
Figure 1.

Malta: Economic Performance in a Regional Perspective

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Source: Eurostat.
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Euro Area: Average Real Growth, 2001-06

Percent

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Source: Eurostat.

II. Background

2. The economic recovery is gaining traction, owing in large part to cyclical strength and some structural change. A public investment boom, financed largely by grants from the EU and Italy, reignited growth in 2005 (Table 1).1 A modest recovery of exports, in addition to robust consumption growth, supported by rising employment and household borrowing, helped to sustain the upswing in 2006. At the same time, the emergence of higher-value-added service activities mitigated the adverse effects of continued restructuring in the manufacturing sector.

Table 1

Malta: Selected Economic Indicators, 2003-12

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Sources: Central Bank of Malta; National Statistical Office; Eurostat; and IMF staff calculations.

Contribution to growth, in percent.

Malta: Fund Policy Recommendations and Implementation

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3. Inflationary pressures proved temporary and the Maastricht inflation criterion was met. Rising energy prices boosted headline inflation in 2005-06, but their unwinding caused a decisive decline in the harmonized index of consumer prices (HICP) in late 2006 to below the convergence criterion (Figure 2). Indicative of the competitive pressures on the tourism industry, inflation in the hospitality sector has declined steadily for almost two years, contributing to a fall in headline inflation to negative 1 percent year-on-year in May 2007.

Figure 2.
Figure 2.

Malta: Convergence Criteria, 2001-07

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Sources: Bloomberg; CBM; IMF staff calculations.

4. The fiscal deficit nearly halved during 2004-06, with the adjustment reliant on one-off revenues as well as structural measures, but structural expenditure pressures loom large. The general government deficit declined to 2½ percent of GDP in 2006 (Table 2), with broadly equal contributions from revenue and expenditure, and the EU’s excessive deficit procedure was abrogated in early June 2007. Besides a substantial boost to capital revenue from EU and other grants, one-off revenue from land sales (1.0 percent of GDP over 2005-06) helped lower the deficit. Continued efforts to curtail the large public-sector wage bill reduced general government current expenditure by almost 1½ percentage point of GDP during 2005-06. Nevertheless, social expenditure has remained high, mainly owing to health care and pension outlays, and benefits fraud; considerable subsidies to the PES also weigh on the budget. Deficit reduction, in conjunction with substantial receipts from the privatization of Maltacom, lowered the government’s debt-to-GDP ratio to 64 percent of GDP at end-2006.

Table 2

Malta: Medium-Term Fiscal Projections, 2003-12

(Percent of GDP)

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Sources: Central Bank of Malta; National Statistical Office; Eurostat; and IMF staff calculations.

Budget 2007 estimates reflect revised GDP data.

5. The exchange rate has remained stable amid gradual monetary policy tightening. Upon ERMII entry the fixed exchange rate regime in place since 1968 was modified and the weight of the euro in the currency basket raised to 100 percent. Including its most recent move (May 2007), the Central Bank of Malta (CBM) has raised its policy rate by a cumulative 125 basis points since mid-2005, to 4.25 percent (Table 3 and Figure 3).

Table 3

Malta: Monetary Developments, 2003-07

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Sources: Central Bank of Malta; and IMF staff estimates

Last column refers to May 2007

Figure 3.
Figure 3.

Malta: Interest Rate and Monetary Developments

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Sources: CMB; ECB; Haver Analytics; IFS; and IMF staff calculations.
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Inflation

(Y-o-y growth, in percent)

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Source: National Statistical Office.
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Fiscal balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Ministry of Finance and IMF staff estimates.

6. Notwithstanding last year’s improvement, the current account remains in a protracted deficit. Thetrade balance, the service account, and the factor income balance have all deteriorated so far this decade (Tables 4 and 5). Nevertheless, the fast-growing remote gaming industry generated a substantial increase in net transfers, reflecting the difference between bets placed by foreigners and wins paid.2 While these transfers reached almost 8 percent of GDP, the net contribution of the mostly foreign-owned industry to the external accounts is considerably smaller. Staff estimates that gaming-related service imports (e.g. marketing) and profit transfers reached almost 7 percent of GDP in 2006.

Table 4

Malta: Summary Balance of Payments, 2003-12

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Sources: Central Bank of Malta; National Statistical Office; and IMF staff calculations.
Table 5

Malta: Indicators of External and Banking Sector Vulnerability, 2003-07

(Percent of GDP, unless otherwise indicated)

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Sources: Central Bank of Malta; Central Office of Statistics; and IMF staff estimates and projections.

Claims on private sector excludes credit to public nonfinancial enterprises.

7. The economic recovery has bolstered banking-sector earnings, but the concentration of loan portfolios in real estate has continued to rise. Banking-sector earnings recovered in 2005-06, amid rising loan demand from the private sector (especially households), lower loan loss provisions, and an increase in banks’ interest margins due to rising policy rates. Although nonperforming loans (NPLs) continued to decline, their levels remained high and provisioning uneven (Table 6). Moreover, the decade-long real estate boom fueled mortgage lending and raised banks’ exposure to households and other real-estate-related sectors, including construction, with these sectors accounting for more than half of banks’ portfolios.

Table 6

Malta: Financial Soundness Indicators, 2004-06 (Percent)

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Source: Central Bank of Malta.
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Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Source: National Statistical Office.
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Household Lending

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Source: Central Bank of Malta.

8. The outlook is overall positive. Domestic demand continues to be boosted by public-sector investment and, increasingly, private consumption. After two years, wage moderation—especially in the public—sector is coming to an end. Consumption is also driven by employment growth, further credit extension, and the conversion of undeclared cash balances into euro (dehoarding). Against this background, staff forecasts growth in 2007 to remain broadly unchanged (3 percent), while HICP inflation is projected to decline to 1 percent, amid continued competitive pressures on the hospitality sector. The current account deficit appears set to reach 9¼ percent of GDP. Over the medium term, a broadening shift towards a more service-based economy is projected to support growth and contribute to a decline in the external imbalance.

9. Risks to the outlook are broadly balanced. The authorities noted that the momentum generated by new service activities and the effects from dehoarding may surprise on the upside. However, they saw risks in rising interest rates and oil prices, especially given the economy’s high energy dependency. Aside from such global factors, staff drew attention to the risks posed by a downturn in the domestic real estate market, and the risks to the medium-term outlook from weak competitiveness within monetary union. Unless durable measures to strengthen competitiveness are implemented, growth risks remaining weak for a prolonged period.

III. Policy Discussions

A. Bolstering Competitiveness

10. There was agreement that the dominant export sectors remain under substantial competitive pressure. In the tourism industry, following a period of significant weakness, there are indications that the contraction is ending, with the arrival of low-cost airlines and rebranding efforts. Nevertheless, increasing global competition continues to pressure profit margins in the industry. Separately, strong global demand is helping the electronics sector to emerge from years of difficulty. A shift to higher-value-added products appears to have been broadly successful, but risks could emerge as innovation continues to shorten product cycles.

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Sources: US Bureau of Labor Statistics; Eurostat; and National Statistical Office.

11. The authorities are of the view that emerging financial and business services could deliver important improvements in competitiveness. They noted that EU entry had spurred interest in Malta as a location for service providers, including call centers, aircraft repair, and back-office operations. These activities were attracted by Malta’s skilled work force, which benefited from significant public investment in technical and vocational training (particularly through the Malta College of Arts, Science, & Technology, MCAST). Staff welcomed the emergence of these new activities, but cautioned that their scale had so far remained relatively small.

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Full-Time Employment: Growth and Contributions by Sector

(2006, in percent)

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Sources: Employment and Training Corporation.

12. Notwithstanding diversification, staff expressed concern about weak competitiveness within monetary union. The protracted external deficit, the steady appreciation of the REER, and the continued loss of export market share in several major sectors all point to weak competitiveness (Box 1). The authorities were mindful of the associated risk of a prolonged period of weak growth, but they stressed the difficulty in measuring competitiveness, especially for a small open economy such as Malta’s. They viewed the competitiveness gap, if any, to be smaller than considered by the staff and in the process of being corrected by diversification and structural change in the economy. Furthermore, they considered exchange rate policy to be ineffective in restoring competitiveness, given wage indexation and the economy’s high degree of openness, and consequently accepted the need to rely on productivity-enhancing structural reforms.

Malta’s Deteriorating External Competitiveness

Malta is a prototypical small open economy with a narrow economic base. It is a price-taker in international markets and, at 83 percent, the share of exports in GDP (2006) is high. Two major sectors tourism and electronics generate more than one third of GDP and half of exports. Underscoring the fragility of the economic base, a single semiconductor plant belonging to a large multinational corporation generates the bulk of electronics exports.

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Sources: Eurostat; IMF; Travel and Tourism Competitiveness Report 2007; and World Economic Forum.

Several indicators suggest rising competitive pressures. Deteriorating trade and services balances and an appreciating REER, are evidence of eroding competitiveness. Although increasing trade integration has contributed to a declining share of value added in output including for the tourism and electronics sector profit margins appear to be falling. Moreover, market share declines, including for the major exports, point to a possible loss of competitiveness.

Public Enterprise Sector: Size and Performance 1/

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Source: Ministry of Finance.

Four largest public enterprises by employment.

13. PES reform will need to be at the center of the strategy to bolster productivity. While a significant reduction in public sector employment was achieved, staff noted that the PES remains large by international standards and is a drag on economy-wide productivity. There was agreement that, although restructuring was at an advanced stage, public-sector retrenchment remained incomplete and structural reforms needed to be intensified.

  • All agreed that port reform is key to lower high maritime transport costs. Following the award of the operating contract to a private company in 2006, the focus has shifted to improving work practices.

  • The authorities recognized that further losses by Malta Shipyards could not be tolerated beyond the EU-required elimination of subsidies in 2008, but firm restructuring and privatization plans remain to be drawn up.

  • The authorities concurred that there remain important inefficiencies in the energy sector. Labor hoarding in Enemalta, the electricity supplier, contributed to substantial loss-making, and cross-subsidization raised inefficiencies. Plans to privatize its gas and petroleum storage operations were progressing. Nevertheless, large investment requirements would frustrate efforts to return the core-electricity business to profitability.

  • The financial state of Air Malta was improving, but continued losses necessitated further restructuring. However, the authorities considered the company of strategic importance and noted that losses were covered by asset sales. Staff noted that, at a minimum, the resulting costs to the public needed to be made more transparent.

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14. Staff stressed the importance of continued wage restraint to help lower unit labor costs (ULCs). Amid efforts to curtail wage growth, real unit labor costs declined in recent years. Nevertheless, this decline did not keep pace with the adjustment in the euro area and, therefore, relative ULCs are still higher than at the beginning of this decade (Figure 4). A two-year period of wage moderation in Malta’s public sector, however, came to an end last year: average wages are expected to increase by 3 percent this year and 4¼ percent per annum in 2008-10 (including wage indexation projected at around 2 percent per annum). The authorities explained that these increases were part of a six-year agreement, compensating for earlier wage restraint. They generally did not share staff concerns about the signaling effect for private sector wage setting, citing decentralized wage bargaining.

Figure 4.
Figure 4.

Malta: Labor Productivity

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Eurostat; and IMF staff calculations.

B. Advancing Fiscal Adjustment

15. Deficit reduction is continuing in 2007, albeit with continued reliance on one-off measures. Staff projects the fiscal deficit to decline to 1.9 percent of GDP in 2007, in line with the latest official forecast, but 0.3 percentage points of GDP better than this year’s original budget target. Besides the boost to tax revenue from the economic recovery and continued strides in tax administration, staff noted that the improved budget performance remains largely reliant on one-off measures, including from land sales (0.5 percent of GDP) and a further tax amnesty. On the expenditure side, the targeted reduction in the wage bill is ambitious, given renewed public-sector wage hikes. The authorities agreed that there are significant social expenditure pressures, while completion of the large Mater Dei hospital raises capital expenditures this year. They stressed that temporary measures would be phased out in their medium-term fiscal strategy.

Medium-Term Fiscal Projections

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Sources: Ministry of Finance and IMF staff estimates.

Ministry of Finance estiamtes from May 2007.

Land sales and asset registration.

16. However, medium-term budget pressures risk undermining progress. While the completion of the domestically financed hospital will help lower spending and the deficit in 2008 (to around 1¾ percent of GDP), staff noted that structural expenditure pressures were on the rise. These include the potential restructuring costs for loss-making public enterprises, rising pension expenditures, and ballooning health care costs. The authorities concurred that aging-related expenditure pressures were increasing, but saw less of a risk of costly redundancies in the PES. Staff estimated that additional expenditures could reach 2¼ percent of GDP by 2012:

  • The restructuring costs of the PES, including for redundancies in Malta Shipyards and Enemalta, could reach ½ percent of GDP per year.

  • The 2006 pension reform mobilizes important savings, but these will begin to materialize only in the middle of the next decade. Cost pressures, from a pronounced increase in the dependency ratio in the interim, will gradually rise from 0.1 percent of GDP in 2008 to 1.2 percent of GDP by 2012.

  • Aging-related increases in health care expenditures are estimated to rise from 0.1 percent of GDP in 2008 to 0.5 percent of GDP in 2012. Operating expenses from the expansion of hospital capacity remain to be budgeted and are estimated to amount to 0.2 percent of GDP.

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17. There was agreement these challenges would be best addressed through expenditure restraint, following pronounced increases in the revenue ratio over the past decade. Staff suggested priority should be given to further reductions in public consumption and subsidies (Figure 5), while the small notional surplus of the pension system should not beeroded. While demographic pressures would increase pension outlays over the medium term, the authorities stressed that excessive pressures would be addressed no later than in 2009, as part of the first review of the pension reform. Moreover, major initiatives were underway to introduce financial incentives to curtail health-care spending, including pilot projects for hospital budgeting and initiatives to address overprovision of medication. Against this background, the authorities did not see a need for introducing co-payments at this stage.

Figure 5.
Figure 5.

Malta: Public Sector

Citation: IMF Staff Country Reports 2007, 305; 10.5089/9781451826630.002.A001

Sources: Eurostat; EU commission; and Ministry of Finance.1/ As defined by the EU Commission, including direct subsidies, tax expenditures, soft loans, and guarantees.

18.The authorities concurred on the benefits of a more transparent medium-term fiscal framework. Staff noted that Malta’s commitment to the fiscal objectives in the Maastricht framework required a more proactive approach to policy making. Broad-based economic and fiscal analysis is needed to reduce the margin of error associated with budget projections especially for tax revenue and social expenditures. The authorities agreed, and noted that improvements were underway, including by extending the budget planning horizon from three to five years. However, more significant improvements would require additional staff.

19.Staff recommended targeting a budget surplus in the medium term. Malta is a small open economy with a concentrated economic base and public debt above 60 percent of GDP and, hence, highly vulnerable to external shocks (Table 7). The authorities agreed that to absorb economic shocks a buffer would be advisable and, in this context, referred to the government’s commitment to achieve its medium-term objective of a balanced structural budget, defined as cyclically adjusted balance net of one-off revenues, over the cycle.

Table 7

Malta: Public Sector Debt Sustainability Framework, 2003-12

(Percent of GDP, unless otherwise indicated)

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General government and gross debt.

Derived as [(r - p(1 +g) - g + ae(1 +r)]/(1 +g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/as r -π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/as ae(1 +r).

For projections, this line includes exchange rate changes.

Last 6 years. The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.