Malta
2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Malta

This 2008 Article IV Consultation highlights that Malta has experienced a three-year-long expansion reflecting strong foreign direct investment, export diversification, and value-added upgrading. Financial soundness indicators held up in 2007 despite unfavorable international developments. The banking sector’s liquidity and funding profile are healthy, and banks have remained profitable despite markdowns in security portfolios. Nonperforming loans fell further but are still comparatively high and thinly provisioned. The authorities are unbundling and opening to private participation the fuel and gas operations of the public energy company.

Abstract

This 2008 Article IV Consultation highlights that Malta has experienced a three-year-long expansion reflecting strong foreign direct investment, export diversification, and value-added upgrading. Financial soundness indicators held up in 2007 despite unfavorable international developments. The banking sector’s liquidity and funding profile are healthy, and banks have remained profitable despite markdowns in security portfolios. Nonperforming loans fell further but are still comparatively high and thinly provisioned. The authorities are unbundling and opening to private participation the fuel and gas operations of the public energy company.

I. Introduction and Background

1. Malta successfully adopted the euro on January 1, 2008: a crucial milestone in the authorities’ growth-oriented reform agenda. This agenda appropriately aims at leveraging Malta’s strengths and income-generating potential through closer integration in the European and global economies. As the cost-competitiveness of traditional low value-added exports wanes, market liberalization and EU membership are intended to facilitate upward shifts in the value-added and quality export ladders. This is a promising but demanding strategy. It will require enhancing market-based flexibility and reducing the inefficiencies created by an overextended public sector. Robust fiscal savings are needed to provide a stable macroeconomic setting, reduce debt, and maintain the tax burden low—as the authorities intend—while investing in education and infrastructure.

2. Progress has already been made in this direction (Appendix I). Following sustained fiscal consolidation since 2003, the budget deficit was further reduced in 2007 to 1.8 percent of GDP, prompting the abrogation of the Maastricht Treaty's excessive deficit procedure in June 2007. Public debt fell to 62½ percent of GDP (from 72½ percent in 2004) helped by divestments. Also, direct public sector involvement in economic activities has been scaled down in the key areas of telecommunications, postal services, and airport and port services—though the public enterprise sector remains large, with subsidies and state aid among the highest in the EU.

uA01fig01

Malta: Fiscal Indicators 2003-07

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

3. Largely as a consequence of liberalizing reforms, Malta has experienced a three-year-long expansion underpinned by foreign direct investment (FDI) and export diversification. In the context of buoyant EU activity, growth accelerated to 3.8 percent in 2007 while the current account deficit declined to 5½ percent of GDP. Growth has been driven both by rising productivity and labor supply mobilization. Increased female participation helped raise the employment rate, while unemployment reached record lows. This reflected booming new manufacturing and services export activities, and a revival of tourism. Strong FDI (29 and 13 percent of GDP in 2006 and 2007, respectively) provided welcome know-how and global market access. Employment and income gains supported domestic demand.

uA01fig02

GDP Growth

(Percent)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Source: Eurostat.
uA01fig03

GDP per Capita

(PPP, percent of EU-27 average, 2007)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

4. However, while economic liberalization has started to pay off, it is far from complete and a less favorable external environment will test the economy’ resilience. Despite recent positive economic performance, productivity is still low and the large public enterprise sector is a source of market distortions and budgetary strains—particularly since administered prices have lagged import price increases. The growth contribution of net exports became negative in the two quarters to 2008:Q1 as several export companies (textile and tobacco) closed down, and semiconductor sales (about half of goods exports) remained weak. During this latter period, activity was supported by domestic demand, notably government spending. Going forward, traditional manufacturing exports may experience further declines against the backdrop of softer external demand and an increasingly competitive global environment, despite subdued unit labor cost growth. Thus, Malta's competitiveness and economic prosperity will hinge on a stable macroeconomic framework and continued reforms to facilitate the reorientation toward high-growth export activities—buttressing FDI and investor confidence.

5. The March 2008 general elections returned to office the ruling Nationalist Party with a narrow parliamentary majority. During the preelectoral period, the authorities continued with important liberalizing initiatives and fiscal consolidation, but some controversial reforms were delayed—including restructuring of the loss-making public shipyards.

II. Report on the Discussions

6. The authorities emphasized their determination to proceed with reforms. They agreed that the initial period of the new legislature offered the opportunity to press ahead with crucial medium-term oriented reforms, thus anchoring investors’ expectations. In this connection, they reiterated the 2008 budget deficit target of 1.2 percent of GDP (although premised on a more favorable macroeconomic scenario than staff's), the MTO of structural budget balance by 2010 based on expenditure retrenchment, and the intention to meet remaining EU accession commitments. Regarding the latter, the authorities are unbundling and opening to private participation the fuel and LPG operations of the public energy company (Enemalta), and have recently announced their intention to restructure and privatize the shipyards shortly.

7. Policy discussions focused on the following areas, essential for success within EMU and economic stability.

  • Cementing fiscal consolidation. Despite substantial fiscal retrenchment, the public finances remain fragile. Reinforcing the fiscal position is a core policy priority to ensure the domestic stability of Malta, highly vulnerable to external shocks and with volatile growth. In this vein, staff supported the authorities’ target of structural budget balance by 2010 and argued for a surplus thereafter as a desirable policy buffer.

  • Strengthening the banking sector. The impact of international financial turbulence on the domestic banking sector is assessed to be small. However, lending concentration, real estate exposures, and thin provisioning pose risks. Malta is actively participating in EU-wide efforts to strengthen mechanisms for crisis prevention and resolution.

  • Improving economic efficiency. Reducing the role of the public sector is key. The authorities intend to reinvigorate, early in the legislature, their privatization and liberalization agenda, and reduce subsidies. The agenda could usefully be extended to competition policy and wage indexation, which however is not currently contemplated.

uA01fig04

Standard Deviation of Real GDP Growth,1970–2006

(Percentage points)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Source: World Development Indicators; and IMF staff calculations.

A. Outlook: Competitiveness and External Stability

8. Improvements in cost fundamentals affecting competitiveness continued in 2007 (Figure 1, Box 1). After large competitiveness losses through 2004, ULC increases have generally been below trading partners’ reflecting productivity gains and wage moderation. These trends continued in 2007, resulting in a ULC-based real depreciation of 1 percent relative to the rest of the euro area. On a multilateral trade-weighted basis, however, the ULC-based REER appreciated by 1.2 percent, highlighting Malta's vulnerability to euro appreciation—non-EMU countries account for 65 percent of goods exports. Labor cost growth has remained low (Figure 2) as the end of the agreed wage moderation period in the public sector appears not to have affected the private sector so far. Going forward, ongoing investment is likely to sustain productivity gains, while labor cost growth is expected to remain contained by slowing activity. All said, staff sees only a moderate competitiveness gap, based on CGER-type analyses, in the range 3–7½ percent.

Figure 1.
Figure 1.

Malta: Cost Competitiveness

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: European Commission; ECB; Eurostat; INS; and IMF staff calculations.
Figure 2.
Figure 2.

Malta: Labor Market Developments

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: Eurostat; and Ameco.
Figure 3.
Figure 3.

Malta: External Current Account Developments

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: National Statistics Office; European Commission; Eurostat; Semiconductor Industry Association; IMF Direction of Trade Statistics; IMF Balance of Payments Statistics; and IMF staff calculations.
Figure 4.
Figure 4.

Malta: External Competitiveness, 1995–2007

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: NSO; IMF Balance of Payments Statistics; and IMF Direction of Trade Statistics.1/ Size of spheres depicts the size of exports as a percentage of GDP in last available year.
uA01fig05

ULC Growth

(Percent)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

uA01fig06

Labor Productivity

(Growth in percent)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

9. Noncost competitiveness trends—central to the authorities’ strategy—have been particularly positive. Terms-of-trade (TOT) gains and FDI-driven export diversification, especially into new services sectors, epitomize these trends.1 The export structure is rapidly

Competitiveness

Early this decade, Malta's narrow economic base (tourism, electronics) was shaken by the decline in tourism following the 9/11 events and the bursting of the dot-com bubble, while traditional manufacturing (e.g., textiles) came under pressure from low-cost competitors. Moreover, wage-inflation pressures led to large REER appreciation. EU entry in 2004 marked the start of a reversal (Figure 1). Updated national statistics show ULC growth below competitors (and euro area) during most of the 2004–07 period, stemming from sizable productivity gains and relatively subdued labor costs.

In recent years, FDI has driven the redeployment of resources toward new export activities (Figures 3,4). Within manufacturing, airplane maintenance, and a tripling of generic pharmaceutics output helped cushion the decline of goods exports (Box Figure A below). Also, new services exports have emerged (Box Figure B), such as online gaming (9 percent of GDP), IT, call centers, and other business services (10 percent of GDP) and financial services (3 percent of GDP). Tourism rebounded recently owing to the airport opening to low-cost airlines, and harbor improvements enhanced cruise tourism. This reorientation has led to substantial terms-of-trade (TOT) gains (despite weak semiconductor prices), reflecting upward shifts in export quality and value-added. TOT gains are especially visible in services (Box Figure C), which exhibit high price elasticity relative to trading partners’ income.

However, competitive pressures on traditional manufacturing remain, with output and employment losses of 60 percent in textiles through 2004–07 amid factory closures. Given the high import content of lower value-added manufactures, downsizing has caused a long-term downward trend in goods exports and imports (Box Figure D). Some manufactures (e.g., semiconductors) are counteracting competitive pressures by moving to higher skill and technology products. In the short run, the main risk lies in a faster-than-expected winding down in traditional manufacturing—adversely affected by euro appreciation, given the predominant weight of non-EMU export destinations (65 percent in goods).

The positive trends in Malta's competitiveness are partly captured by CGER-type estimates, which staff updated and extended in light of 2007 outcomes; new forecasts; and revised historical trade, current account, and international investment position (IIP) statistics.2,3

  • The macroeconomic balance approach indicates a competitiveness gap of around 3 percent, versus 10–15 percent last year—reflecting better-than-expected current account outturn and data revisions. Closing this gap would bring the underlying current account (estimated at -2.4 percent of GDP) to an estimated long-run equilibrium level of -0.8 percent of GDP.

  • The external sustainability approach indicates that stabilizing the net international investment position at current levels would require a competitiveness improvement of 7½ percent.

Box Figure A:
Box Figure A:

Goods Exports World Trade Share

(2000=100)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Box Figure B:
Box Figure B:

Malta: Services Exports

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Box Figure C:
Box Figure C:

Malta: Terms of Trade

(1995=100)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Box Figure D:
Box Figure D:

Malta: Goods Trade

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: Ameco; NSO; Central Bank of Malta; IMF Direction of Trade Statistics; and IMF staff estimates.

changing due to strong expansion of niche exports and tourism (Figure 5). As a consequence, the trade deficit in goods and services narrowed to 1.9 percent of GDP in 2007 (from 5.3 percent in 2005). Thus, the authorities felt that traditional aggregate cost-based competitiveness analyses should be complemented with micro-based angles—particularly in small economies. Staff's research also shows that quality upgrading and trade-specialization shifts have supported export performance in several neighboring euro area economies.4 Indeed, there was broad consensus among the mission's interlocutors that changes in export structure were an equilibrium response to a higher REER—a hypothesis supported by sustained improvements in the goods and services trade balance despite a broadly stable ULC-based REER (after a large appreciation early in the decade).

Figure 5.
Figure 5.

Malta: Tourism Services Exports

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: NSO; Eurostat; World Economic Forum Travel; and Tourism Competitiveness Reports.1/ Rank out of 130 countries.
uA01fig07

Trade and Cost Competitiveness

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: National Statistics Office; and European Commission.

10. Staff's central scenario envisages growth decelerating temporarily to 2¼–2½ percent in 2008–09 reflecting unfavorable external conditions (Table 1); the authorities see a shallower slowdown. Staff does not project a growth contribution of the external sector in the short term on account of weak foreign demand and further traditional manufacturing export contraction. This, coupled with high import prices will temporarily widen the current account deficit to close to 7 percent of GDP—partly reflecting high dependence on oil and food imports. Domestic demand, in turn, will be dampened by relatively high inflation during 2008 (annual average of about 4 percent, Figure 6), sluggish employment and real income growth, and tighter credit conditions. Inflation is expected to ease in 2009 as food and oil prices stabilize, the pricing power of the tourism sector weakens with the global environment, and base effects from the recent electricity price hike fade. Output is estimated to have reached its trend level in 2007, although the envisaged slowdown will reopen a modest gap in 2009, contributing to moderate inflation. The authorities envisage a more supportive external environment and thus project better export performance. There is broad consensus that investment will support activity, reflecting planned FDI projects. 5 There was also agreement that, over the medium term, activity will recover swiftly toward trend, sustained by FDI, emerging export activities, and terms-of-trade gains.

Table 1.

Malta: Selected Economic Indicators, 2004–13

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

Contribution to growth.

Figure 6.
Figure 6.

Malta: Price Developments

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: Haver; Central Bank of Malta; Bank of Spain; and Eurostat.

Dependence on Food and Fuel Imports

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Sources: Eurostat; IMF.

In kg/€’000 (euro area=100) for 2005.

Average of 2006 and 2007.

Excludes Norway and Russia

11. In staff's view, the decline of traditional export sectors poses short-term risks, underscoring the need to maintain cost competitiveness and reform momentum. The authorities see this decline as having largely run its course; any tail effects would likely be offset by the ongoing rapid growth of new exports. Staff, on the other hand, saw the risks to its scenario somewhat tilted to the downside. In the short term, given the small size of the economy, even modest additional export losses in some individual companies subject to intense international competition could significantly disrupt output and employment. Staff emphasized the need to prevent wage growth from running ahead of productivity, while accelerating reforms that foster the ongoing economic transformation. Competitiveness pressures within EMU might otherwise lead to a period of lackluster growth as has occurred in some euro area countries.

Main Economic Projections, 2008–09

(Percent)

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12. Long-term external sustainability risks are tempered by envisaged large FDI inflows and a strong net international investment credit position (Tables 2 and 3). The authorities pointed out that the current account deficit had been amply overfinanced by FDI, supported by Malta's history of stable institutions and internationally harmonized business environment—enhanced by EU and EMU membership. Staff's external sustainability analysis also points to a robust external balance sheet (Table 4). However, staff emphasized the need for fiscal and financial policy buffers given the volatility associated with the economy's small size and its reliance on continued positive investor sentiment.

Table 2.

Malta: International Investment Position, 2002–06

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Sources: Eurostat; and Maltese authorities.
Table 3.

Malta: Summary Balance of Payments, 2004–13

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Sources: Eurostat; Central Bank of Malta; and IMF International Financial Statistics.
Table 4.

Malta: External Debt Sustainability Framework, 2003–13

(Percent of GDP, unless otherwise indicated)

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External debt in this table relates to net external debt.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in U.S. dollar terms; g = real GDP growth rate; e = nominal appreciation (increase in dollar value of domestic currency); and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both noninterest current account and nondebt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and nondebt inflows in percent of GDP) remain at their levels of the last projection year.

B. Cementing Fiscal Consolidation

13. Expenditure-based consolidation continued in 2007, though the public finances remain fragile (Figure 7). Tight spending control achieved the first recorded current surplus in recent years while allowing some tax cuts. The structural deficit (net of one-offs, mainly land sales) improved by almost ½ percentage point of GDP (Table 5). However, the public finances are under endemic stress from sizable subsidies (about twice the EU average) and state aid (four times the EU average); health care costs; the public wage bill (13 percent of GDP); and pensions and other social spending (over 13 percent of GDP). Also, public enterprise guarantees, and other contingent liabilities remain high.

Figure 7.
Figure 7.

Malta: Fiscal Developments

Citation: IMF Staff Country Reports 2008, 276; 10.5089/9781451826647.002.A001

Sources: Eurostat; European Commission; EPC; and IMF staff calculations.
Table 5.

Malta: Fiscal Developments and Projections 2004–13

(Percent of GDP)

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Sources: NSO; Eurostat; and IMF staff estimates and projections.

14. The authorities are adopting additional measures to meet the 2008 budget target (1.2 percent of GDP). 2008 data show a significant increase in outlays. The authorities indicated that there had been frontloaded expenditures that they planned to claw back within the year. They anticipated, however, that given higher-than-projected oil prices and other costs, the budget would be substantially overrun if prevailing policy parameters were maintained through year end. Thus, the authorities were planning offsetting cuts in discretionary spending, including prioritization and sequencing of capital projects, additional hiring controls, and other savings in current spending. They also have raised electricity prices by about one-third since the mission (although staff estimates that they remain some 25 percent below cost recovery). This latter measure will limit electricity subsidies to 0.7 percent of GDP (0.25 percent in the original budget). In staff's view, the measures in train will limit overall 2008 underperformance to ½ percentage point of GDP relative to budget—partly due to the play of automatic stabilizers, given lower growth assumptions. The structural balance, however, is forecast to improve by ¾ of a percentage point of GDP—making a sizable contribution toward the MTO.

Medium-term Fiscal Targets in the Stability Program

(Percent of GDP)

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15. The authorities anchor their medium-term strategy in further spending retrenchment, which will require expenditure reforms. The authorities intend to continue reducing subsidies and still-high public employment (about 30 percent of full-time employees). In particular, they have announced the elimination of shipyard and bread subsidies in 2009, and are identifying savings on other subsidies and health costs—although delivery-point health care charges have been ruled out. The mission encouraged early formulation of detailed and more explicit multiyear measures to reduce current spending.6 This would minimize uncertainty and the encroachment, forced by events, on growth-enhancing capital spending—especially, in view of upside risks to expenditure plans, including unbudgeted potential costs of public enterprise restructuring. Staff suggested complementing attrition with proactive personnel redeployment and selection based on training and performance; and consideration of market-based measures to rationalize public services demand and increase supply efficiency, including in health care, if administrative cost control measures prove ineffective. There was agreement that 2009–10 revenue projections were appropriately conservative—given authorities’ indications that tax cuts would be implemented prudently, as cost savings materialized.

16. The authorities are reinforcing the fiscal framework with a medium-term orientation. They are pursuing more structured multiyear fiscal planning and the introduction of performance budgeting methods. Evaluation procedures for investment projects (crucial for optimizing reduced EU funds) and hospital performance are being improved. Staff recommended extending spending reviews to all major areas (particularly education, given its competitiveness-enhancing role), and parliamentary agreement on aggregate expenditure limits before starting budget appropriation discussions. On longer-term issues, the EU pensions working group projects age-related spending to be relatively benign, though revised estimates of the 2006 pension reform impact still need to be finalized.

C. Strengthening the Growing Financial System

17. The financial sector appears to be resilient to international developments, though it has experienced some adverse effects (Box 2). The authorities and private sector analysts considered the banks well-placed to weather the global turmoil. Banks have strong liquidity positions (Table 7) and no exposure to subprime-related assets. They are also profitable, although some banks’ financial results were affected by markdowns in security portfolios, and equity valuations saw substantial declines in 2008—possibly accentuated by local stock market thinness (Figure 8). The internationally oriented financial sector (now fully under uniform regulation) is expanding rapidly.

Table 6.

Malta: Public Sector Debt Sustainability Framework, 2005–13

(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 six 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.