Statement by Arrigo Sadun, Executive Director for Malta and Francesco Spadafora, Senior Advisor to Executive Director

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.

September 4, 2009

On behalf of the Maltese authorities, we thank staff for the well-written and informative report, which once again witnesses the fruitful and close cooperation with the authorities.

Overview

The global crisis resulted in an external shock that is testing the resilience of the Maltese economy. Annual growth averaged 3.5 percent over the last four years, but it will turn into negative territory (at around 2 percent) in 2009, driven by declines in all private components of demand. In particular, exports in the manufacturing and tourism sectors have fallen as a result of the recession affecting Malta’s trade partners. On the positive side, the services balance continues to improve due to the significant diversification of activities into higher value-added productions that took place over the last few years. The services balance is projected to increase to over 20 percent of GDP in 2009, up from about 17 percent one year ago.

For 2010 staff expect a modest recovery, with growth at about 0.5 percent, driven by improvements in external conditions. While agreeing that risks prevail on the downside, the authorities are somewhat more optimistic on account of expectations for resiliency in consumption and a more robust pick-up in corporate investment.

In the labor market, the robust activity in the services sector contributed to the satisfactory rate of job creation until the end of 2008, but conditions deteriorated afterwards. After having declined for three years in a row, the unemployment rate is projected to increase to 7.3 percent in 2009, still below the euro area average by about 2 percentage points.

Inflation remains at a relatively high level, a reflection of buoyant food, energy, and hotel prices. The inflation differential with the euro area in energy prices is expected to decline in the near future, helped by the downward adjustment in utility prices adopted by the authorities in April 2009. More generally, inflation will be brought down by the negative output gap projected through 2014.

FDI inflows, attracted by Malta’s stable institutional and business environment, have continued to overfinance a stabilizing current account deficit, thus strengthening the country’s net external position.

Fiscal Policy

The authorities responded to the global crisis by allowing a full play of automatic stabilizers, and by adopting a stimulus package of 1.5 percent of GDP, partly financed by EU grants. The package focuses on measures to increase public investment in order to upgrade the country’s infrastructure and further increase Malta’s attraction as an FDI destination. At the same time, the authorities foresee a fiscal consolidation of 0.75 percent of GDP in 2009, fully accounted for by cuts in subsidies on utilities. Moreover, to rein in public expenditures, the authorities have taken corrective measures with regard to the shipyards sector.

The authorities are committed to resume fiscal consolidation, when cyclical conditions improve, in order to reduce the budget deficit to below the 3 percent threshold and terminate the Maastricht Treaty’s excessive deficit procedure.

The authorities agree with staff that fiscal consolidation should be essentially expenditure-based. Currently, preparations for the 2010 budget are underway and, in this context, the authorities are considering measures to reduce government expenditure in a number of areas. This process will also involve consultation with the social partners. The authorities also see with favor a strengthening of the fiscal framework and budget execution discipline. To this end, initial steps have been taken to increase oversight of spending ministries.

The authorities are mindful of the potential side effects mentioned by staff with regard to their measures to support a small number of manufacturing enterprises, but they see them as instrumental in shoring up investors’ confidence in the Maltese economy.

Financial Sector

Over the last few years, the financial sector has grown in size and sophistication, reaching over seven times GDP, driven by internationally oriented banks that account for 70 percent of total assets. The global crisis has had a contained impact on Maltese banks so far. Domestically oriented banks have been virtually unscathed by the turmoil, as they lack exposure to structured financial products and rely on a traditional funding model based on retail deposits. This safe structure also underpins the resilience of credit to the private sector.

While banks’ profitability has been hurt, capital ratios, although declining, have remained well above regulatory minima and the liquidity position is stronger than in most peer countries. The local interbank market, whose development was fostered by the 2008 euro adoption, continues to function smoothly.

At the height of the crisis, the government committed to support banks, but so far there has been no need to actually provide additional capital or liquidity. A number of banks have been able to raise capital by tapping capital markets at relatively favorable price conditions.

Against this background, the authorities are aware that the financial turmoil has inevitably raised some vulnerabilities.

Rising nonperforming loans and the concentration of domestically oriented banks’ exposures in the construction and real estate sector are a source of concern. The authorities’ have conducted stress tests to better identify the risks; they agree with staff that a more proactive stance towards strengthening capital buffers is appropriate.

In view of the increased participation of internationally oriented banks in the domestic interbank market, the central bank has gradually incorporated these intermediaries in its stability assessment and stress testing exercises.

In December 2008, a “crisis impact assessment” was conducted jointly by the Ministry of Finance, the Central Bank of Malta, and the Malta Financial Services Authority to assess the channels of transmission in case of financial distress, and to evaluate communication between the different authorities. Going forward, in order to better gauge systemic risk, the authorities intend to run a stress testing exercise that will involve the central bank, the supervisor, and individual banks.

The authorities are also taking the legislative steps needed to increase funding for the deposit-guarantee scheme, and to modernize the regimes for crises management and bank resolution. Communication to the public has been enhanced through the publication of the financial stability report.

Structural Reforms

So far, the authorities have concentrated on supporting the economy in order to mitigate the fallout from the crisis, but they are committed to resume efforts to increase the economy’s competitiveness and attractiveness to FDI. As noted by staff, the country’s competitive position has evolved in line with structural changes in the export structure towards higher value-added sectors, and has remained broadly stable in the face of the downturn, with the euro shielding it from unnecessary currency volatility.

To further reduce the state’s involvement in the economy, the authorities are finalizing the privatization of the shipyards’ activities, and the unbundling of Enemalta’s gas and petroleum divisions. To reduce the potential fiscal consequences posed by the state-owned energy and water utility companies, the authorities have introduced a rule-based mechanism to determine electricity and water tariffs with a view to gradually achieving full cost recovery.

The authorities are aware of the need to tackle the causes of persistent inflation in a timely manner. Staff recommend that adequate capacities and institutional independence should be granted to the competition authority so that it may adopt a more proactive stance toward addressing any monopolistic behavior in the wholesale and retail markets. The authorities’ view is that the recommendation to grant institutional independence to the competition authority is premature, but they agree that a proactive stance is crucial in fostering price flexibility and efficient markets.

The authorities noted staff’s remarks on the existing across-the-board mandatory inflation adjustment of wages (COLA), but point out that the indexation mechanism had served the country well; they expressed cautious support for staff’s suggestion of a social pact to forge consensus on required policies.

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