Malta
2009 Article IV Consultation: Staff Report; Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Malta

Malta’s financial sector has so far weathered the global turmoil relatively unscathed; the real economy has been decelerating since the last quarter of 2008. The staff report for Malta’s 2009 Article IV Consultation underlies economic developments and policies. The fiscal position deteriorated sharply in 2008, owing to one-offs and spending slippages. The current account deficit improved to 5½ percent of GDP. The immediate goal for fiscal policy should be to mitigate the negative spillovers on activity from the global crisis without compromising the already fragile public finances.

Abstract

Malta’s financial sector has so far weathered the global turmoil relatively unscathed; the real economy has been decelerating since the last quarter of 2008. The staff report for Malta’s 2009 Article IV Consultation underlies economic developments and policies. The fiscal position deteriorated sharply in 2008, owing to one-offs and spending slippages. The current account deficit improved to 5½ percent of GDP. The immediate goal for fiscal policy should be to mitigate the negative spillovers on activity from the global crisis without compromising the already fragile public finances.

I. Context and Recent Developments1

1. Malta’s economy is facing its first test following successful EU entry in 2004 and euro adoption in 2008. Largely as the outcome of liberalizing reforms, Malta experienced a sustained expansion starting in the middle of the decade, underpinned by diversification to higher value-added exports. But the unfavorable external environment is now challenging the economy’s resilience, threatening to unravel past efforts at fiscal consolidation, and possibly holding back the reform impetus, even as the convergence process remains incomplete.

uA01fig01

GDP per Capita

(PPS, percent of euro area average, 2008)

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

2. The global economic crisis has started affecting Malta’s real sector. Following annual average growth of 3½ percent in 2005–07, the expansion of the economy slowed to 2½ percent in 2008, hampered by declining trade flows and investment as Malta’s main trade partners entered severe recession (Figures 1 and 2, Table 1). Semiconductor production and tourism, accounting respectively for 15 and close to 25 percent of GDP, were particularly affected. Private consumption, resilient so far, also weakened in the beginning of 2009, as employment prospects deteriorated. However, activities in services—into which Malta’s economy substantially diversified over the last few years—continued to hold.

Figure 1.
Figure 1.

Malta: Economic Indicators, 2004–2010

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

Sources: Central Bank of Malta; Eurostat; WEO; and IMF staff estimates.
Figure 2.
Figure 2.

Malta: Short-Term Indicators, 2006–2009

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

Sources: National Statistics Office; Central Bank of Malta; European Commission; and IMF staff calculations.
Table 1.

Malta: Selected Economic Indicators, 2005–2014

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

Contribution to growth.

3. The labor market was resilient before worsening at the end of 2008 (Figure 3). Job creation remained strong, driven by the services industries. Average compensation per employee rose 2¼ percent throughout the year, exceeding the across-the-board mandatory indexation to the cost of living (COLA), even though labor productivity gains tapered off. In particular, public wages, covered by a multi-annual collective agreement, increased by 4¼ percent. More recently, however, labor market conditions started deteriorating, with the unemployment rate inching up since the fall of 2008, to reach 7.1 percent in May 2009.

Figure 3.
Figure 3.

Malta: Labor Market Indicators, 2000–2009

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

Sources: Eurostat; National Statistics Office; European Central Bank; World Economic Outlook; and IMF staff calculations.1/ Year-on-year percent change.

4. Inflation has remained stubbornly high, topping the euro area since October 2008 and reaching 2¾ percent in June 2009 (Figure 4, Box). While there does not appear to have been any notable inflation boost due to euro adoption in January 2008, the positive output gap likely played a role. Additionally, the authorities increased utility tariffs in October 2008, food price inflation failed to moderate, reflecting an imperfect pass-through of the decline in international food prices, and prices in the hospitality sector remained buoyant until the recent deterioration in tourism. In contrast, housing price inflation continued moderating throughout 2008, with prices falling by about 10 percent in the first quarter of 2009, in part because of oversupply in certain segments of the market.

Figure 4.
Figure 4.

Malta: Inflation, 2001–2009

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

Sources: Eurostat; Central Bank of Malta; Global Insight; Standard&Poor’s; and IMF staff calculations.

–Inflation

Inflation in Malta has been the highest in the euro area since October 2008. While inflation has trended downward in the euro area since mid-2008, prices continued accelerating in Malta until recently. This development followed a period from mid-2006 to end-2007, when conversely, inflation was more moderate in Malta than in the euro area.

The inflation differential with the euro area has been particularly marked for food, fuel and hospitality prices, related to idiosyncratic developments on the island:

  • Utility services are governed by administered prices. Throughout 2007 and until October 2008, the authorities postponed the adjustment of these prices to oil prices hikes on the global markets, keeping energy prices artificially low in Malta. However, in the fall of 2008, prices were adjusted up, contributing to the build-up in the inflation differential as the euro area, conversely, was then starting to experience a deceleration in energy prices. With the authorities adjusting utility prices down again in April 2009, the discrepancy with the euro area in energy price inflation is expected to fade in the near future.

  • Hospitality price moderation throughout 2007 reversed in 2008, as new high scale hotels opened up and tourism picked up, following the arrival of low-cost airlines. These price fluctuations were magnified by the relatively large share of this segment in the price basket, at 17 percent against 9 percent in the euro area. Looking forward, with tourism prospects rapidly deteriorating, price moderation is likely to resume.

  • Food prices remained surprisingly buoyant in 2008 despite the generalized downward correction in global food commodity prices. Importers and domestic retailers failed to pass though this decline, possibly highlighting a lack of competition in the market.

More generally, the euro changeover did not affect Malta’s inflation more than in the neighboring countries; rather, inflation responded to the positive output gap in 2008. The authorities had put in place effective price monitoring prior to the currency changeover in January 2008, and the inflation differential with the euro area in Malta in 2008 remained in line with what Greece, Spain and Portugal experienced in 2002 and Slovenia in 2007: more than a changeover effect per se, it reflects the positive output gap at that time in Malta.

5. Fiscal consolidation came to a halt in 2008. The fiscal deficit reached 4.6 percent of GDP, after 2.2 percent in 2007, as the government took over the shipyards’ operations ahead of their ongoing liquidation and financed early retirement schemes—accounting altogether for close to 1¼ percentage points of GDP of deficit (Table 2 and Figure 5). Nevertheless, the structural relaxation amounted to 1 percent of GDP because of larger energy subsidies in the context of rising oil prices in the first half of the year and significant slippage on the wage bill and on spending on goods and services, partly related to the health care sector and to the elections in March 2008. Reversing the downward trend, public debt inched up to 63 percent of GDP and the sovereign spread vis-à-vis the German 10-year bond rose in line with regional peers, to reach about 110 basis points in May 2009. So far, the authorities have managed to finance the deficit without difficulties. Owing to the fiscal slippages, the European Commission reinitiated the excessive deficit procedure for Malta in May 2009 and recommended to bring the deficit below the Maastricht reference value by 2010.

Figure 5.
Figure 5.

Malta: Fiscal Sector, 2003–2014

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

Sources: Eurostat; European Commission; Maltese Authorities; and IMF staff estimates.
Table 2.

Malta: Fiscal Developments and Projections, 2004–2014

(Percent of GDP)

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Sources: National Statistics Office, Eurostat, and IMF staff estimates.

Malta: Fiscal Balance Decomposition, 2004-08

(In percent of GDP, unless otherwise indicated)

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Sources: Eurostat; Malta’s authorities; and IMF staff estimates.

One-offs include revenue from proceeds of property sale in 2004-08 in addition to a tax amnesty in 2007, the shipyards’ restructuring costs and reclassification as part of the general government in 2008.

6. The authorities passed a stimulus package in the 2009 budget. Measures include support to the manufacturing and tourism sectors, as well as increased public investment financed through higher EU fund absorption. The personal income tax regime was also modified to increase incentives to work, in particular for women. The overall package amounts to 1½ percent of GDP, two thirds of which would be financed by EU grants. Since early 2009, the authorities have also provided additional support to a small number of ailing manufacturing companies based on criteria related to investment and training plans.

7. The impact of the financial market turmoil on Maltese banks has so far remained contained (Figure 6, Appendix). The banking sector has expanded rapidly in recent years to over seven times GDP; most of this growth, however, has been driven by internationally oriented banks with traditionally little interaction with the domestic economy.2 Still, domestically oriented banks have been protected in the crisis by their limited exposure to structured financial products, a traditional retail funding model, and conservative lending policies. Credit has proved resilient, with loans to the resident private sector growing 10 percent in 2008, as banks continued to fund their operations mainly through domestic deposits. No government intervention to shore up capital or liquidity has been necessary to date. However, some institutions suffered large valuation losses on their security portfolio, resulting in negative returns in 2008. At around 50 percent of GDP, household indebtedness is below euro area average, but it has been trending up, and the share of nonperforming loans (NPL) remains high in domestically oriented banks.

Figure 6.
Figure 6.

Malta: Financial Indicators, 2005–2009

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

Sources: Bloomberg; Eurostat; Central Bank of Malta; and IMF staff calculations.

8. The current account deficit improved to 5½ percent of GDP in 2008 (Figure 7, Table 3). The goods balance worsened, as foreign demand faltered, most notably for semiconductors, whose export growth turned negative in nominal terms in the fall of 2007. Conversely, thanks to past efforts at export diversification, net services exports improved, led by business services and the remote gaming industry. Imports volumes slumped, as investment gradually dried up throughout 2008. Against this backdrop, competitiveness is deemed to have remained broadly stable. Moreover, the current account deficit continued to be more than financed by significant, yet declining, FDI net inflows. Portfolio and other investment flows remain heavily influenced by operations of internationally oriented banks.

Figure 7.
Figure 7.

Malta: External Sector, 2000–2008

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

Sources: Central Bank of Malta; Eurostat; IMF, Direction of Trade Statistics; and IMF staff calculations.
Table 3.

Malta: Balance of Payments, 2005–2014

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Sources: National Statistics Office; and IMF staff estimates.

Projection for 2008.

9. The reform-oriented Nationalist Party was reelected in March 2008 with a narrow parliamentary majority. Nonetheless, with the economy in recession and euro membership secured, the government’s immediate priority has shifted from liberalizing initiatives and fiscal consolidation to measures to support the economy.

II. Outlook

10. With recession affecting all main trade partners, growth in Malta is projected to turn negative in 2009. Staff projects activity to contract by about 2 percent in 2009, with the output gap turning negative and remaining so until 2014. As foreshadowed by the most recent confidence indicators, all private components of demand—exports, private investment and households’ consumption—would drive the slowdown in 2009. Higher public infrastructure spending and, to some extent, resilient activity in services, are expected to cushion the slowdown. A modest recovery, of about ½ percent, is projected for 2010, as exports pick up in line with trade partners’ growth, prompting a gradual revival in private investment and labor market conditions. The authorities concurred with staff that, in the context of the global crisis, potential growth would soften going forward.

uA01fig04

Contribution to GDP Growth

(Percentage points)

Citation: IMF Staff Country Reports 2009, 287; 10.5089/9781451826654.002.A001

11. Inflation is projected to moderate while the current account deficit would stabilize, with long-term sustainability risks mitigated by the positive net international investment position. With the output gap turning negative and world commodity prices lower, inflation would fall to 2¾ percent in 2009 from 4¾ percent in 2008, and the current account deficit would stabilize at 5¾ percent of GDP. Staff’s external sustainability analysis points to a strengthening in the net external creditor position as net FDI inflows would continue to more than finance the external deficit (Tables 4 and 5). Nonetheless, gross external liabilities stood at over 550 percent of GDP at end-2008, owing to strong growth in recent years in nonresident deposits held by internationally oriented banks; while these are backed by matching assets, the associated external vulnerability reinforces the need for fiscal and financial buffers to anchor investors’ confidence in Malta’s small open economy.

Table 4.

Malta: International Investment Position, 2002–2008

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Sources: Central Bank of Malta; and IMF staff estimates.
Table 5.

Malta: External Debt Sustainability Framework, 2004–2014

(In percent of GDP, unless otherwise indicated)

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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 US 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 non-interest current account and non-debt inflows in percent of GDP.

The implied change in other key variables under this scenario is discussed in the text.

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

12. Staff sees clear risks to the recovery in 2010. First, it is conditional on a gradual improvement in trade partners’ growth, which could fail to materialize. Risks also stem from potentially tighter credit conditions, as the economic slowdown inevitably leads to a deterioration in banks’ asset quality. Finally, in a context of more depressed global demand, the revival in activity could be further jeopardized if the strategy of export diversification were to falter for lack of foreign investor appetite. Risks to inflation are more balanced: persistent food price increases could continue to spur inflation, at least temporarily; conversely, a more severe slowdown in activity, especially for export-oriented sectors, could put downward pressures on prices.

13. The authorities’ outlook is more benign. In particular, they saw private consumption remaining more resilient, supported by wage and credit growth, and forecast a stronger pick up in corporate investment going forward. However, they agreed with staff that risks were on the downside and acknowledged that some downward adjustment to their projection could not be excluded as further macroeconomic updates came in.

III. Policy discussions

14. While responding to the crisis has become the authorities’ top priority, the structural reform agenda will need to regain preeminence. Key elements include: resuming fiscal consolidation once the recovery is established to build buffers against future external shocks and as the population ages; further strengthening the financial supervisory framework to keep up with the rapidly expanding sector; and completing the labor and product market reforms so as to further the move towards higher value-added activities.

A. Preserving Fiscal Sustainability In A Recession

15. The fiscal deficit is expected to narrow marginally to 4½ percent of GDP in 2009. However, excluding the substantial one-offs of 2008, the balance would deteriorate by over ½ percentage point of GDP. Slippages, in particular on utility subsidies, contributed to the fiscal relaxation in 2008; the authorities have curtailed them, and the structural consolidation for 2009 is projected to reach ¾ percentage point of GDP. Still, the authorities are letting automatic stabilizers play in full, providing support to domestic demand of about 1½ percentage points of GDP. In addition, staff estimates that EU funding of the stimulus measures would represent ½ percent of GDP of additional support to demand. Based on somewhat stronger real growth forecasts, the authorities’ fiscal projections are more optimistic, with a decline in the deficit of 1 percentage point compared to 2008, underpinned primarily by higher assumption of direct tax collection.

Malta: Medium-Term Fisc al Projections, 2008–14

(In percent of GDP, unless otherwise indicated)

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Sources: Malta’s authorities; and IMF staff estimates.

One-offs include revenue from proceeds of property sale in 2008, the shipyards’ restructuring costs in 2008–09, and the shipyards’ reclassification as part of the general government in 2008.

The projected consolidation in 2009 reflects the reversal of higher than budgeted energy subsidies in 2008 (½ percent of GDP) and the impact of utility subsidies reform (0.3 percent of GDP).

16. Staff agreed with the thrust of the authorities’ fiscal policy for 2009. The economic downturn called for a fiscal response to support activity, and the focus on public investment in the 2009 stimulus package is apposite, given infrastructure needs and its potentially high multiplier. While letting the automatic stabilizers play fully, the authorities are making fiscal room by cutting inefficiently targeted subsidies on utilities. In addition, boosting EU fund absorption prevents an excessive deterioration in the public finances and current account. For 2010, staff recommended only moderate structural consolidation, to the tune of ½ percentage point of GDP, so as not to jeopardize the modest recovery.

17. Measures taken to support enterprises raise some concerns, however. The measures implemented in the spring of 2009 to co-finance investment and training allowed for rapid and targeted support. Staff noted, however, that they could become entrenched and costly if the crisis continues, and that, in some cases, they might only postpone required restructuring. More recently, the authorities announced that they would tolerate late tax payments from companies with cash flow difficulties and also invited hotels and banks to work on debt restructuring. Staff underscored that, even if not widespread, these steps would risk undermining tax compliance and contract enforcement. The authorities agreed with the assessment but stressed that, given the small size of the economy and risk of spillovers, these measures had been necessary to shore up confidence.

18. All concurred that fiscal consolidation needed to resume forcefully once the recovery was established. The authorities are committed to consolidation and have taken significant steps with respect to the shipyards and the utility subsidies. However, staff stressed that these measures alone would fail to achieve the necessary consolidation: under an unchanged-policy scenario, the headline deficit would fall to the 3 percent mark only in 2013, with public debt topping 70 percent of GDP (Table 6). To secure a quick reversal in the debt trend and to build enough buffer against future shocks, a stronger consolidation path—with a structural effort of at least 2/3 percentage point of GDP per year over 2011–2014, more than double the current scenario—would be appropriate. Thus, staff urged the government to promptly identify commensurate underlying measures. The authorities agreed that the adjustment should be essentially expenditure based, as increasing the tax burden, already around 40 percent, would run against their competitiveness strategy. Additional tax cuts should be implemented only as cost savings materialize and compliance improves.

Table 6.

Malta: Public Sector Debt Sustainability Framework, 2004–2014

(In 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).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

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

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

The implied change in other key variables under this scenario is discussed in the text.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

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.