Malta
2012 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion

This Article IV Consultation reports that Malta’s economy continues to perform well amidst considerable turbulence in the euro area. While spillovers have remained contained to date, Malta’s large financial sector and highly open economy heighten contagion and financial stability risks. The government, which has a one-seat majority in Parliament, narrowly survived a vote of no confidence. The policy challenge is to maintain growth and employment while building buffers against a highly uncertain international environment.

Abstract

This Article IV Consultation reports that Malta’s economy continues to perform well amidst considerable turbulence in the euro area. While spillovers have remained contained to date, Malta’s large financial sector and highly open economy heighten contagion and financial stability risks. The government, which has a one-seat majority in Parliament, narrowly survived a vote of no confidence. The policy challenge is to maintain growth and employment while building buffers against a highly uncertain international environment.

BACKGROUND AND RECENT DEVELOPMENTS

1. Malta is the smallest euro area economy, highly dependent on trade and tourism. Foreign-owned nonfinancial corporations dominate the domestic market and the economy relies on FDI flows and EU funds for investment. These factors make the economy vulnerable to external shocks.

2. In addition, Malta has a large financial sector with substantial international linkages (Box 1). The banking sector, whose assets are eight times GDP, is segmented into: (i) domestically-oriented banks (about 2½ times GDP), half of which are foreign owned, with sound capital and liquidity buffers, low leverage, and a conservative funding model (deposit-to-loan ratio above 100 percent); and (ii) internationally-oriented banks, including subsidiaries of EU banks, with limited involvement in the local economy.

3. Spillovers from the ongoing euro area debt crisis have, nonetheless, remained contained to date. After a strong recovery in 2010, the economy has continued to perform well amidst considerable turbulence across the euro area and North Africa (Figures 16). Despite weakening external demand in the second half of the year, real GDP growth is estimated at 2 percent in 2011, supported by private consumption and strong growth in tourism and services exports. In contrast with other euro economies, Malta’s real GDP is 1.5 percent above its pre-crisis peak (compared to 2 percent below for the euro area). Labor market indicators improved and the unemployment rate receded to 6.4 percent (from the crisis peak of 6.9 percent), well below the euro area average of 10 percent.

Figure 1.
Figure 1.

Malta: Economic Indicators, 2004–12

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

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

Malta: Short-Term Indicators, 2006–12

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: European Central Bank; Central Bank of Malta; European Commission; and IMF staff calculations.
Figure 3.
Figure 3.

Malta: Labor Market Indicators, 2000–11

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Eurostat; National Statistics Office; European Central Bank; World Economic Outlook; and IMF staff calculations.
Figure 4.
Figure 4.

Malta: External Sector, 2000–11

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Central Bank of Malta; Eurostat; IMF, Direction of Trade Statistics; and IMF staff calculations.1/ 2011 data is an average of three quarters.
Figure 5.
Figure 5.

Malta: Inflation, 2007–11

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Eurostat; Central Bank of Malta; Haver; and IMF staff calculations.
Figure 6.
Figure 6.

Malta: Fiscal Sector, 2005–16

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Eurostat; European Commission; Maltese Authorities; Bloomberg; Datastream; and IMF staff estimates.1/ Average term to maturity is based on government securities. Data for Malta as of the end of 2011.
A01ufig02

Contrary to other euro area economies, Malta’s real GDP is above its pre-crisis peak.

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Haver Analytics; and IMF staff calculations.1/ t-0 denotes first quarter of recession.

4. Financial contagion has also remained contained. Market reaction to the recent rating downgrades affecting Malta and a number of euro area economies was muted, as Maltese government debt is predominantly held domestically. In fact, bond yields declined slightly during 2011 on robust demand. In turn, the sensitivity of the Maltese banking sector to sovereign risk events in Europe is low. This reflects Maltese banks’ very low exposures to EU periphery debt, as well as domestic banks’ reliance on a traditional retail deposit-based banking model.

Structure of the Maltese Banking Sector

Within the euro area, Malta ranks among the highest in terms of banking sector assets to GDP. Malta’s banking sector, with total assets of almost eight times GDP, is composed of seven domestically-oriented and nineteen international banks, of which some are connected with the domestic economy

A01ufig03

Bank Assets to GDP

(Percent)

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Source: European Central Bank.

Domestically-oriented banks, with total assets of 244 percent of GDP, are a set of seven banks, which are important for domestic financial stability. Three are domestically-owned and four are subsidiaries of other EU banks. These banks operate a traditional business model and have limited exposure to troubled euro area countries and did not invest in ABS or other subprime securities. Deposit-loan ratios were above 125 percent in the first half of 2011, which suggests no direct (wholesale) funding pressures. Regulatory capital stood at 15.8 percent and the tier 1 ratio was 12.3 percent, well above market and EBA benchmarks, while leverage was relatively contained at 9 times total assets in the third quarter of 2011. Return on equity was 9.4 percent. Their main vulnerabilities are credit risk, stemming from high loan exposures to construction, real estate activities and mortgages; and spillover effects from the euro area crisis.

The international banking sector refers to a diverse group of banks with assets totaling about 550 percent of GDP. This segment can be further broken down into one which interacts in a limited way with Maltese residents (about 80 percent of GDP) and one with no links (about 470 percent of GDP). Ten of these banks are subsidiaries of foreign banks (of which seven from other EU countries), six domestic, and three organized as branches (of which two non-EU). Some of these institutions are very small, with assets of only €8 million, while the two largest have combined assets of nearly €20 billion. Most of their activity is focused on non-resident business (trade finance, investment banking, intra-group, international money transfer, custodian services). However, the sector’s interaction with domestic financing of the economy appears to be on the rise, mainly through deposit-taking, bond issuance and participation in ECB operations, and as such may also affect domestic financial stability. The average Tier 1 capital ratio for international banks amounted to 97.5 percent in June 2011 (40 percent excluding one outlier). Profitability was generally higher than for domestically-oriented banks. The sector’s main sources of risk are potential cross-border deleveraging pressures and sensitivity to international financial market trends (due to high reliance on market/wholesale funding, including intra-group), possibly affecting activities in Malta. For Malta as a financial sector hub, there may be reputation risks if one of these banks were to find itself in difficulties, as the country prides itself of a flexible yet robust supervisory regime.

A01ufig04

Slightly rising interaction with Malta’s economy, mainly via deposits.

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Central Bank of Malta; and IMF staff computations.1/ Use of ECB facilities was 65 percent of total by end -2011 (87 percent in 2010).
A01ufig05
Sources: Datastream; Bloomberg; and IM staff calculations.1/ The chart shows sensitivity (beta) of bank stock returns to GRC market returns, controlling for the broad market return, over two periods (Greece 2010: November 2009-April 2011 and Greece 2011: June-November 2011).

5. Compared to euro area peers, Maltese banks continue to outperform in terms of profits and capital adequacy (Figures 78). Bank profitability declined during 2011, but remains strong (Annex III). Interest income remains broadly stable thanks to a wide interest margin and a moderate pass-through of ECB policy rate changes. Credit growth fell in 2011, but remains well above the euro area’s loan growth rate (Box 2). Capital buffers for domestic banks remain sound, with a core Tier 1 ratio of 12.3 percent and low leverage (deposit to loan ratio of 127 percent). One Maltese bank was selected to participate in the 2010–11 EBA stress tests and passed, with a core tier 1 ratio of 10.4 percent. As a follow-up, all Maltese domestic banks were subject to similar stress tests by the authorities, with positive results.

Figure 7.
Figure 7.

Malta: Financial Indicators, 2005–12

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Bloomberg; Eurostat; Central Bank of Malta; and IMF staff calculations.
Figure 8.
Figure 8.

Malta: Financial Soundness Indicators, 2009–11

(Percent)

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: National Authorities; Financial Soundness Indicators, SNL; and IMF staff calculations.1/ First three quarters of 2011.2/ Euro area FSIs are calculated from SNL using individual bank data and refer to first half of 2011.3/ First half of 2011.
A01ufig06

Transmission of ECB policy to housing interest rates is not very fast and incomplete in Malta.

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: ECB; and IMF staff computations. Note: speed and long-run pass-through are based on a reduced-form monetary transmission equation iMFI,t= C0 + C1iMFI,t-1 + C2iECB,t where iMFI denotes the banking sector’s rate, iECB the ECB policy rate and t for time. The adjustment speed parameter is 1-c1and the long-run pass-through coefficient is c2/(1-c1). Estimation with monthly data from January 2008-November 2011.

6. Malta’s resilience also reflects the authorities’ commitment to prudent macro-financial policies and improvements in external competitiveness. As discussed in section III, fiscal tightening is underway to reduce public sector debt to manageable levels, and a number of reforms are aimed at strengthening the resilience of the financial sector. Recent gains in competitiveness are evident in Malta’s rising market share in services exports and its successful diversification into high-valued added activities (Annex I). The trade balance, which turned into surplus for the first time in 2010, improved further to about 5 percent of GDP in 2011. The current account thus improved, but remains in deficit reflecting large net income outflows related to the repatriation of profits by foreign companies (Figure 4).

Credit Growth, Bank Lending Conditions and Private Sector Deleveraging

Credit growth in Malta declined in recent years, mainly as a result of lower corporate lending, while household lending remains relatively high. Overall credit growth in 2011 was 3.5 percent, down from 4.2 percent in 2010. Lending to non-financial corporates (NFCs) grew at a negative rate in the first eight months of 2011, but subsequently firmed up to 2.9 percent in December 2011 (year on year). Loans to households fell slightly, from 6.6 percent in 2010 to 6.2 percent in 2011. These different credit growth patterns are also visible when expressed as a percentage of GDP. NFC lending appears volatile and procyclical, accelerating when global growth picks up and slowing down significantly when global growth declines. Household lending –house loans in particular–consistently grew at a faster pace than GDP, although slightly less so since late 2010.

A01ufig07

Corporate and OFI lending is quite volatile, house lending to GDP smooth .

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: ECB; IMF staff computations.

For lending to corporates, both falling demand and some tightening of standards played a role. The December 2011 bank lending survey suggested that some Maltese banks tightened standards on loans to NFCs but faced no supply-side constraints related to their own funding or capital position. Falling demand reportedly was a more important factor, on account of higher recourse to restructuring and lower financing needs. No substantial further deleveraging by NFCs took place in 2011, as the NFC debt/GDP ratio was fairly stable in 2011 and expected NFC loan demand remains unchanged.

A01ufig08

Some deleveraging in 2011, especially by households.

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Central Bank of Malta; Statistical Office of European Communities; and IMF staff calculations.

Lending to households remained mainly demand-driven. In the last quarter of 2011, credit standards and conditions (supply factors) remained unchanged at all banks. However, for the next three months, some banks expect household loan demand to fall, especially consumer credit. In fact, there were some differences in banks’ perception of housing market prospects and consumer creditworthiness. So far, housing prices have not declined much during the ongoing global financial crisis and they rebounded strongly in the third quarter of 2011 (see text figure). Similarly, creditworthiness seems underpinned by the low unemployment rate in Malta and some household debt deleveraging in 2011.

A01ufig09

House prices slightly below pre-crisis peaks.

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: CBM; Eurostat; IMF staff calculations.

7. Costs adjustment has proved critical to remain competitive. Recent gains have been underpinned by:

  • Narrowing inflation differential vis-à-vis trading partners. Inflation averaged 2.4 percent in 2011, below the euro area average of 2.7 percent, mainly driven by persistently high food and energy prices, coupled with a rise in excise duties and some revisions in VAT rates (Figure 5).

  • Wage moderation since 2009 has lead to declines in unit labor costs, despite Malta’s wage indexation mechanism.

  • The resulting real exchange rate depreciation (in the range of 4–10 percent, depending on the estimation method) has resulted in valuations that are broadly in line with fundamentals (Annex I).

OUTLOOK AND RISKS

8. The economy now faces a worsening external environment that is creating new risks to growth and financial stability. The fragile global macroeconomic environment and sustained market volatility are expected to dampen real export growth in 2012. Domestic sources of growth may not be sufficient to offset the drop in external demand, given headwinds from a soft real estate market and the ongoing fiscal consolidation. Combined with increased uncertainty, this will also keep private consumption subdued. In turn, private investment is projected to fall further on deteriorating business confidence. With the euro area expected to go into a mild recession this year, staff projects Malta’s real GDP growth in 2012 to be a modest 1 percent. Growth is expected to rebound in 2013 and remain near the potential growth rate of 2 percent over the medium-term.

A01ufig10

Malta: Growth Forecast 2012-13

(Percent)

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Elekdag and Kannan (2009), WEO and IMF staff calculations.

9. Downside risks to the baseline reflect the potential for spillovers from an intensification of the euro area crisis. Malta’s high degree of trade openness and very large financial sector heighten contagion risks.

  • Risks to growth. A deeper than expected downturn in the euro area could have a significant impact on growth through trade and tourism. Staff analysis suggests that Malta’s growth is particularly affected by spillovers from shocks in Italy, France, and the UK. A concurrent decline of trading partners’ growth by half a standard deviation could lower Malta’s growth by 0.5–0.7 percentage points in 2012 (Box 3). In addition, domestic uncertainty in economic policy could adversely affect growth if investment decisions and structural reforms are put on hold.

  • Risks to financial stability. Financial contagion could shake the confidence in the entire banking sector. Although the domestically-oriented banks are well-capitalized and funded by retail deposits, a massive retrenchment by parent banks in Europe could disproportionally affect the Maltese economy, whose size is negligible relative to parent banks’ balance sheets. And although a liquidity shock on internationally-oriented banks that rely on cross-border (mostly parent) wholesale funding would not materially impact the domestic economy, given their very low market share, it could have negative effects on the Maltese banking sector through confidence and reputational effects. These vulnerabilities are aggravated by an inadequately funded deposit compensation scheme, coupled by concerns about too-big-to-save and fiscal sustainability in case of default or deposit run that required the government to step in.

Authorities’ views

10. The authorities shared the views on key risks, but remain “cautiously optimistic” on the growth outlook. The authorities underscored the country’s ability so far to weather the euro area crisis well, attributed in their view, to the diversified nature of the Maltese economy. They highlighted that continued FDI inflows, increased tourism activity, resumption of trade with Libya, and sustained growth of financial and business services would support growth in 2012.

POLICY DISCUSSIONS

11. Malta’s resilience to date cannot be taken for granted. The main policy challenge in 2012 will be to navigate a highly uncertain macroeconomic environment with a deteriorating economic outlook and the ongoing banking and sovereign crisis in Europe. Staff emphasized the need for contingency planning for the event that growth is substantially worse than expected or there is financial contagion from a potential intensification of the euro area crisis. At the same time, the authorities need to balance concerns over a slowing economy, which calls for accommodative policies, against increased risks that require more prudent fiscal management.

A. Ensuring Fiscal Sustainability While Supporting Growth

Malta’s Growth Spillover Dynamics

Malta is a small but highly open economy through both trade and financial transactions. Its international trade accounts for two times GDP, with the export-to-GDP ratio amounting to about 100 percent. Malta thus ranks among the most open economies in the world. Malta’s major trading counterparts are the euro area (Italy 22%, France 14%, and Germany 12%), UK (13%), USA (8%), and some Asian countries (Singapore 9%, Japan 4%). Malta’s financial sector is also very large with total financial sector assets of almost 9 times GDP, of which ¾ of total assets are held by foreign financial institutions.

A01ufig11
Sources: NSO; WEO; and IMF staff calculations1/ Correlations of q-o-q output growth between Malta and each major trading partner, rolling over for 20 quarters. Data are from 2000Q1 to 2011Q3.

Malta’s high degree of openness exposes the country to external shocks. Historically, Malta’s growth has been relatively volatile and driven mostly by domestic components. However, growth has increasingly co-moved with that in the euro area since the start of the global financial crisis, reflecting increasing trade and financial integration supported by the Euro adoption in 2008. A VAR-based growth spillover analysis suggests that the large downturn during the 2008–09 crisis was mostly attributable to negative spillovers from other economies. In turn, the recent recovery was supported by improved external conditions. Going forward, Malta’s growth dynamics are expected to be aligned with its foreign counterparts, whereas domestic shocks will continue to be a drag. It is estimated that a concurrent decline of trading partners’ growth by half a standard deviation (equivalent to 1.2 percentage points of GDP) could lower Malta’s growth by 0.5–0.7 percentage point in 2012.

A01ufig12
Sources: Poirson and Weber (2011); and IMF staff estimates.1/ VAR-based model is estimated to decompose the growth rate into long-run, domestic and foreign dynamics. The sample includes Malta, Italy, Germany, France, UK, USA, and the rest of euro area. Quarterly data are from 2000Q1-2011Q3.

12. In an impressive turnaround, the authorities delivered a strong structural adjustment in 2011. The general government deficit narrowed to 3 percent of GDP in 2011, down from 3.7 percent of GDP in 2010, and the primary balance was in surplus for the first time since 2007 (Figure 6). After adjusting for substantial one off revenue measures in 2010, the implied structural adjustment was much larger—1½ percent of GDP, one of the largest among advanced countries (excluding EU peripherals). In recognition of this effort and the government’s plan to reduce the deficit further—as detailed in the 2012 budget and subsequent spending review—the European Commission assessed that Malta had taken effective action to correct its excessive deficit and no additional measures under the Excessive Deficit Procedure were needed.

A01ufig13
Sources: IMF, WEO; and IMF staff estimates.1/ Excluding Greece, Italy, Ireland, Portugal, and Spain. Excluding one-offs for Malta. Excluding financial sector support recorded above the line for the USA.

13. Nonetheless, the composition of adjustment remains suboptimal. Tax buoyancy and revenue measures, including increases in excise duties and a revision of VAT rates on accommodation, accounted for most of the improvement in the fiscal balance in 2011. In contrast, total expenditure-to-GDP remained largely unchanged, as savings from the expiration of the 2010 stimulus measures and limits on recruitment in the public sector were offset by increases in social transfers and goods and services. As in recent years, the absorption capacity of EU funds related to capital expenditures remains a problem, with less than two-thirds of the allocated amount utilized.

14. The government’s commitment to return to fiscal balance over the medium term remains essential. Further fiscal consolidation is required to ensure sustainable debt dynamics, thus reducing fiscal risks to manageable levels. The pace and composition of adjustment should be attuned to the economic cycle. After the strong effort in 2011, a gradual deficit reduction path of structural annual adjustment of percentage points of GDP, while letting automatic stabilizers operate in full, would be appropriate. Given the projected weakening of the economy, this may imply a slightly lower adjustment in nominal terms.

15. This moderate adjustment path would strike the right balance between the growth and debt sustainability objectives. More specifically, it would:

  • Offset somewhat the headwinds facing the economy in the near term. A larger fiscal contraction in 2012 would be detrimental to growth in light of the cyclical deceleration and Malta’s high exposure to countries also planning relatively large fiscal contractions.

  • Still achieve debt sustainability over the medium term. The suggested consolidation would put debt on a downward trend starting in 2013, reaching a debt-to-GDP ratio of 60 percent by 2018. This would allow Malta to cope with future adverse shocks and demographic-related spending pressures.

But notwithstanding Malta’s favorable debt management policies, it will be important to avoid the recent “stop-go” pattern of fiscal policy to ensure continued confidence in Malta’s public finances. Malta’s sovereign debt is predominantly (97 percent) held by residents, its average maturity is relatively high (7 years), and rollover risks are manageable with strong demand for government paper and a strategy to smooth the maturity profile.

A01ufig14

Structural Balance

(Percent of GDP) 1/

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: Maltese authorities; and IMF staff calculations.1/ Excluding one-offs.

Malta: IMF Staff Medium Term Fiscal Projections, 2010-14 1/

(Percent of GDP)

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

Projections reflect staff’s policy scenario.

16. To be credible, the adjustment should be backed by concrete measures and focused on containing spending. Staff projects the deficit to narrow by 0.3 percentage points of GDP (or ½ percentage points in structural terms) to 2.7 percent of GDP in 2012. The difference with the authorities’ target of 2.3 percent of GDP is explained by staff’s cautious assessment of the measures in the 2012 budget and spending review, more conservative growth projections (with widening output gap), and higher estimated outturn in 2011. The size of the projected adjustment is appropriate, in light of the weakening economy. However, the consolidation remains largely revenue-based. Further increases in excise duties, incentives to reduce tax arrears, and increases in social security contributions are expected to drive the adjustment effort. Indeed, expenditure-to-GDP is projected to increase, as announced tightening measures (0.6 percent of GDP) will be more than offset by increases in public investment and capital transfers—largely related to the planned Air Malta capital injection. Sound measures underpinning the fiscal effort beyond 2012 need to be specified for the consolidation to be credible.

17. Bold policy actions are necessary to reduce contingent liabilities arising from the public corporations. Government-guaranteed debt amounts to 17 percent of GDP, 60 percent of which is accounted for by Enemalta—the public energy utility corporation. This may increase further as Enemalta’s planned investments over the next three years amount to 6 percent of GDP. Staff indicated that sustained high oil prices may require tariff increases if the company is to avoid losses or government assistance. Better governance and restructuring of Air Malta and Enemalta will help staunch losses and limit subsidies, although the latter may entail some upfront fiscal costs.1 It is essential to agree on a medium to long term strategic plan and permit professional independent management to lead these entities, subject to sound governance and performance targets.

18. Building on progress already made, further pensions reform will contribute to resolving anticipated long-term fiscal imbalances and support medium-term growth. The projected increase in ageing-related expenditures is twice the EU average, reflecting an expected sharp rise in dependency ratios that renders the current pay-as-you-go system unsustainable. Staff recommended that the authorities build the necessary consensus to push forward the main recommendations of the Pensions Working Group, notably: (i) indexing the retirement age to longevity; and (ii) introducing a mandatory privately funded second pillar and voluntary third pillar. Consideration could also be given to introducing a notional defined contribution first pension and to accelerating the planned gradual increase in the retirement age to 65.

Authorities’ views

19. The authorities reiterated their commitment to fiscal discipline and the new EU fiscal guidelines. They concurred with staff’s recommendation to balance growth and debt sustainability considerations, but were confident that the 2012 target would be met. To this end, there had been an early budget review (instead of mid-year), which identified additional spending measures. Regarding composition of the fiscal adjustment, the authorities noted that one-off revenue measures reflected to some extent one-off spending items. The authorities acknowledged the long-run fiscal challenges. Pension reform is currently under review to increase the scheme adequacy and sustainability. The authorities highlighted some concerns associated with implementing a second pillar pension, including the fall in the value of pension funds world-wide as a result of the global financial crisis and the potential impact on employers (higher contribution costs) and employees (less disposable income). The authorities stressed that new EU requirements on budgetary frameworks and governance would add credibility to their consolidation effort (Annex II).

B. Improving Financial System Soundness

20. The financial sector has continued to perform strongly, but—given the large external risks—it is important to strengthen the sector’s resilience further. As noted in section I, the banking sector appears healthy, but the sector’s sheer size and large foreign ownership represent a number of risks to financial stability and fiscal sustainability. These include concerns about too-big-to-save and the adequacy of backstopping resources in case of default or deposit run, the capacity to deal with the impact of a banking sector shock on the economy, and supervisory challenges. The size of the non-bank financial sector is, on the other hand, relatively small and risks appear limited.

21. Maintaining financial sector stability requires a multi-faceted approach, encompassing macro-prudential policies and surveillance, micro-prudential regulation and supervision, and contingency planning, safety net, and crisis management (Annex IV).

Macro-prudential Policy and Systemic Risk Monitoring

22. The authorities are clarifying the institutional architecture for macro-prudential policy. In line with recent ESRB recommendations and IMF staff analysis2, this should include:

  • Determining the institution or forum with ultimate decision-making powers to recommend and enforce macro-prudential polices. The Maltese authorities are considering a joint financial stability committee between the Central Bank of Malta (CBM) and the Maltese Financial Services Authority (MFSA).

  • Defining the tasks, powers, and instruments of the macro-prudential authority.

  • Establishing clear lines of accountability.

  • Ensuring operational independence from political bodies and from the financial industry.

23. Macro-prudential policy requires a capacity to identify systemic risks early enough so timely action can be taken to support financial stability. Staff recommended further strengthening the analysis of risks posed by the financial sector, particularly the internationally-oriented banks that have or intend to grow their Maltese footprints, especially by taking deposits locally and investing them internationally. In this context, staff commended the Central Bank of Malta (CBM) and the Malta Financial Services Authority (MFSA) for extending the EU-wide stress testing exercise to all domestic banks, and for extensively participating in EU-wide insurance sector stress tests.

Micro-prudential Regulation and Supervision

24. Malta’s financial regulatory and supervisory framework should keep pace with the demands and risks of a sophisticated and fast-growing financial market. As part of its self-imposed quality controls, in 2010 the MFSA commissioned an independent assessment of regulation and supervision of banking, insurance, and securities markets against the respective international standards (Box 1, Annex IV). The assessment concluded that progress had been made since the 2003 IMF Financial Stability Assessment Program (FSAP), but weaknesses remained in supervisory capacity (notably staffing), definition and monitoring of connected party transactions, and internal audit functions. The increase in recruitment of qualified staff, the creation of an enforcement unit, and work in the area of concentration risk represent commendable progress. Continuing efforts along the report’s recommendations are needed to more fully comply with international sound practice. A review of the MFSA’s consumer protection and business conduct functions could be considered to secure consumer protection, promote efficiency, and enhance the integrity of the financial system.

25. Substantial credit concentration in the banking sector and rising credit risks warrant close supervisory scrutiny and strong financial buffers. Lending is highly concentrated in housing and construction, loan quality has deteriorated3, and the number of restructured loans increased. Worryingly, provisioning is a mere 19 percent of non-performing loans, substantially below the euro area average. Bank profitability may suffer if loan losses were to increase further, due to declines in real estate prices or a fall in growth (Annex III). Furthermore, Maltese banks may be adversely affected by the forthcoming EU Capital Requirements Directive (CRD IV). Preliminary estimates by the MFSA and CBM indicate that Maltese banks could face liquidity shortfalls under current proposals. Against this background:

  • Banks with riskier profiles should be encouraged to increase provisioning and restrain dividend payout policies to strengthen capital buffers.

  • Further improvement in the MFSA’s assessment of the robustness of banks’ processes for loan classification, impairment determination, and provisioning are needed, and plans to enhance these aspects of supervision are welcome.

  • An action plan to enable the implementation of new liquidity regulations, including individual liquidity guidelines and liquidity stress testing, is needed. In this context, banks should be encouraged to lengthen the maturity profile of their deposit base as they still rely largely on demand deposits. Anecdotal evidence indicates that this is already underway as various banks are offering multi-year deposits and new products at attractive rates.

Financial Sector Safety Net

26. In light of the ongoing euro area crisis, it is imperative to ensure a sound financial safety net.

  • Contingency planning for crisis preparedness should move to the forefront of the policy agenda and involve: (i) stress testing to assess the adequacy of financial buffers; (ii) the development of scenarios for key material risks; (iii) performing crisis simulation exercises regularly, covering all systemically relevant institutions, as well as cross-border dimensions; and (iv) reviewing existing coordination arrangements between the key institutions. It would be advisable for the MFSA to incorporate these techniques as standard components of its supervisory approach.

  • The range of resolution tools will be broadened once new European regulations come in place. These encompass prompt corrective action, partial purchase and assumption, the use of bridge banks, and the establishment of a resolution fund.

  • The target size of the Deposit Compensation Scheme (DCS)—0.77 percent of eligible deposits—is unsatisfactory. Given current resources, the DCS would be able to compensate 10 very small banks or one medium-sized bank, which is below IMF and EU recommendations.4 A shortfall could have knock-on effects on the entire banking system through confidence and reputation effects and on the government’s budget in case the DCS needs emergency funding. As a small economy with a large financial sector and idiosyncratic features, the authorities should give due recognition to the potentially high risks to financial stability, by erring on the conservative side and targeting buffers above the suggested minima.

A01ufig15

Cumulative insured deposits.

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Source: IMF staff calculations.

Authorities’ views

27. The authorities shared the mission’s emphasis on prudent management of the financial sector. As a precaution, the central bank has called on banks to maintain conservative dividend policies and increase provisioning. The authorities noted that the large size of the banking sector draws attention, but cause of alarm is mitigated by specific features of the structure of the sector. They stressed that the domestic-oriented banking segment is safe and sound, and the internationally-oriented segment poses no material risks for Malta. The authorities agreed with staff on the need to strengthen the Deposit Compensation Scheme, and plan to align their framework with the anticipated EU rules. In relation to the mission’s concerns about concentration risk on fixed property, the MFSA noted that Malta’s small size limits the ability of the banking sector to diversify. Regulators take the issue of concentration risk into account under Pillar 2 of Basel II. The MFSA noted that staff’s recommendation to increase provisioning and to address shortcomings in the regulation relating to asset classification and provisioning will give new impetus to the authorities’ initiatives to improve supervision in this area.

C. A Strong Structural Reform Agenda to Secure Long-Term Growth

28. Longer-term policy challenges remain pressing, including those related to population ageing, labor force participation, education, and energy policy. As discussed earlier, the budgetary impact of ageing, including pensions, is significantly higher in Malta than the EU average. Fostering participation of women in the labor market is another major challenge, given Malta’s lowest female employment rate in the EU. And so is raising the labor force skills: Malta has the highest rate of early school-leavers and records a low share of people with a tertiary level of education. Malta is also dependent on imported oil for energy, making the economy vulnerable to oil price shocks. Furthermore, current electricity production is both cost- and energy-inefficient, resulting in high energy costs and potential fiscal liabilities.

29. These challenges underscore the need to deepen and broaden the reforms so far, raise productivity growth, and further improve competitiveness. Policies should focus on further diversifying the economy into high value-added activities, reducing the economy’s dependence on energy imports, and strengthening female labor force participation and education attainment. A comprehensive ageing strategy is needed to resolve anticipated long-term fiscal imbalances. These steps should be supported by a cautious settlement of wage negotiations at the firm-level to ensure better alignment of wage and productivity developments. The ongoing review of the wage indexation formula is welcome. Overall nominal wage increases below those of Malta’s main trading partners will underpin confidence and secure recent gains in competitiveness.

A01ufig16

Labor Productivity and Wage Growth

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: IMF staff calculations; and European commission (2011), “Reaching the Employment Target: Progress and Thematic Surveillance”.1/ The 2011 labor productivity data for Malta are based on an average of two quarters and the data for EA17 is based on the first quarter. The unit labor cost for 2011 for both Malta and EA17 are based on a average of three quarters.

Authorities’ views

30. Malta’s National Reform Programme sets out ambitious targets and a policy action plan to address longer-term challenges. The authorities pointed to four strengths supporting future growth. These include: the increase in education levels, female labor force expansion facilitated by child and tax-friendly policies, oil search and energy policy reform, and continued wage moderation. As to the latter, the authorities agreed with staff’s recommendation of aligning wage increases with productivity growth, but underscored that the current wage indexation mechanism did not generally result in full inflation-indexation and was granted in absolute terms and only on a base salary. They also indicated that sectoral analysis of wage dynamics showed significant amount of flexibility.

STAFF APPRAISAL

31. After a strong recovery in 2010, the economy has continued to perform well amidst considerable turbulence across the euro area. Spillovers from the euro area crisis have remained contained to date. The growth momentum continued through 2011 and labor indicators improved. Despite the recent rating downgrades, sovereign bond spreads remain contained as government debt is predominantly held domestically. In turn, the sensitivity of the Maltese banking sector to sovereign risk events in Europe is low given very low direct exposures to EU periphery debt, though indirect exposures may be larger.

32. The fragile external environment has created new risks to growth and financial stability. Malta’s high degree of trade openness and very large financial sector heighten contagion risks. The fragile global macroeconomic environment and sustained market volatility are expected to dampen real export growth in 2012. Domestic sources of growth may not be sufficient to offset the drop in external demand, given headwinds from a soft real estate market, deteriorating confidence, and ongoing fiscal consolidation. At the same time, uncertainty in economic policy could adversely affect growth if investment decisions and structural reforms are put on hold. With the euro area expected to go into a mild recession in 2012, Malta’s real GDP growth in 2012 will be relatively modest. Risks and uncertainty around this scenario are significant, reflecting the potential for large negative spillovers from the euro area crisis.

33. Contingency planning needs to move to the forefront of the policy agenda. Malta’s resilience to date cannot be taken for granted. The main policy challenge now is to maintain growth and employment, while building buffers against a highly uncertain international environment. At the same time, the authorities need to balance concerns over a slowing economy, which calls for accommodative policies, against increased risks that require more prudent fiscal management.

34. Malta has taken effective action to correct its excessive deficit, shoring up confidence in Malta’s public finances. The structural fiscal adjustment in 2011 was one of the largest among advanced countries. The deficit is estimated to have narrowed to 3 percent of GDP and the primary balance turned into surplus for the first time since 2007. Following the announcement of the 2012 budget and additional expenditure measures in January, the fiscal deficit is expected to fall further this year. Nonetheless, the composition of adjustment remains suboptimal, relying excessively on one-off and revenue measures.

35. Returning to fiscal balance over the medium run remains essential. Further fiscal consolidation is required to ensure sustainable debt dynamics, thus reducing fiscal risks to manageable levels. After the strong effort in 2011, a gradual deficit reduction path of structural annual adjustment of ½ percentage points of GDP, while letting automatic stabilizers operate in full, would be appropriate. This adjustment path would help offset the headwinds facing the economy in the near term, while achieving debt sustainability over the medium term. The measures underpinning the fiscal effort beyond 2012 need to be specified for the consolidation to be credible.

36. Bold policy actions are necessary to reduce contingent liabilities and address Malta’s long-run fiscal challenges. Better governance and restructuring of the public corporations will help staunch losses and limit subsidies. With a large projected increase in ageing-related expenditures, it is crucial to build broad public consensus for further pension and health care reform aimed at increasing the adequacy and sustainability of the current schemes.

37. Given the large external risks, it is important to strengthen the financial sector’s resilience further. The financial sector has continued to perform strongly, but its sheer size and large foreign ownership represent a number of risks to financial stability and fiscal sustainability. These include concerns about too-big-to-save and the adequacy of backstopping resources in case of default or deposit run, the capacity to deal with the impact of a banking shock on the economy, as well as supervisory challenges. Improving the framework for financial crisis management and bank resolution and strengthening the deposit compensation scheme could help limit contagion risks. Ongoing efforts to strengthen financial buffers and tighten supervision relating to asset quality are welcome. Commendable progress has also been made to better align the regulatory and supervisory frameworks with international standards.

38. Financial stability will further benefit from establishing a formal framework for macro-prudential policy. Such a framework should define the tasks, powers, and instruments of the macro-prudential authority; establish clear lines of accountability; and ensure operational independence from political bodies and from the financial industry. It is crucial to improve systemic risk monitoring, particularly of spillover risks posed by international banks, and design contingency plans accordingly.

39. Longer-term policy challenges remain pressing. Challenges related to population ageing, labor force participation, education, and energy policy underscore the need to broaden the reforms so far, raise productivity growth, and further improve competitiveness. Reforms to secure these objectives include further diversifying the economy into high value-added activities, reducing the economy’s dependence on energy imports, and strengthening female labor force participation and education attainment. These steps should be supported by a cautious settlement of wage negotiations to ensure better alignment of wage and productivity developments.

40. It is recommended that the next Article IV consultation with Malta be held on the usual 12-month cycle.

Table 1.

Malta: Selected Economic Indicators, 2007–15

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Sources: National Statistics Office; Central Bank of Malta; Eurostat; and IMF staff estimates.
Table 2.

Malta: Fiscal Developments and Projections, 2007–14

(Percent of GDP)

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

2011 data as of September 2011.

Table 3.

Malta: Balance of Payments, 2007–15

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Sources: National Statistics Office; and IMF staff estimates.
Table 4.

Malta: International Investment Position, 2005–10

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Sources: Central Bank of Malta
Table 5.

Malta: Financial Soundness Indicators, 2008–11 1/

(Percent)

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Source: IMF, Financial Soundness Indicators (FSI) database.

Domestically-oriented banks.

First three quarters of 2011 (annualized).

Annex I. Preserving Malta’s Competitiveness1

Malta has successfully upgraded its export structure in recent years. It continues to gain competitiveness among new high-value-added export activities, particularly financial and business services and remote gaming. Market liberalization, a favorable tax regime, and a highly-skilled work force have facilitated these shifts. Going forward, Malta will need to continue enhancing its productivity by focusing on education, research and development as well as aligning wages with labor productivity in order to preserve its recent gain in competitiveness and sustain growth.

1. Malta has seen a significant gain in competitiveness in recent years through a sectoral shift toward export-oriented services. Services exports grew at double-digit rates during 2004–07. While negatively affected by the global financial crisis in 2009, the sector has steadily recovered. Overall, exports of services have tripled in size over the last decade and the share of services exports to total exports reached 60 percent in 2010, up from 30 percent in 2004. As a consequence, the current account deficit has shrunk by half over the past five years. The price and cost competitiveness indicators have also showed a correction after the 2008–09 financial crisis.

2. This note discusses recent developments in Malta’s competitiveness based on both price and non-price measures and policy recommendations. In particular, to further improve its competitiveness, it is essential for Malta to continue to diversify the economy into high value-added activities, raise productivity growth through the improvement of labor force skills, as well as strengthen female labor force participation. These steps should be supported by a cautious settlement of wage negotiations to ensure better alignment of wage and productivity developments.

Measuring Malta’s Competitiveness

3. Traditional cost and price competitiveness measures have improved recently. A decrease in unit labor costs and narrowing inflation differentials vis-à-vis trading partners translated into a real depreciation of about 4–5 percent on price-based competitive measures in 2011. Malta’s wage setting mechanism comprises the cost-of-living-adjustment (COLA) and other wage agreements. COLA consists of a base wage, indexed with the annual average retail price index (RPI) inflation. Although COLA has been applied at the national level, firm-level wage agreements could overwrite the COLA increase. It is evident that during the past crisis the Maltese social partners agreed on wage moderation—a 0.6 percent decline in wages and salaries in 2010 among the main sectors including industry, construction, and services, thus contributing to a correction in Malta’s competitiveness and maintaining employment through labor hoarding.

A01ann01ufig01
Sources: European Commission and IMF staff calculations.

4. The current account deficit narrowed significantly over the last two years, on account of strong export growth. The current account deficit narrowed to 4¼ percent of GDP in 2010 and to 3 percent of GDP in 2011 (from 7¾ percent of GDP in 2009). Exports of merchandised goods surged to around 35 percent in 2010 and continued to grow by the same pace in the first half of 2011. Exports of services, including business travel, communication and financial services, increased by 8.5 percent in 2010, though growth slowed down in the first half of 2011. Imports rose at a much slower pace, (19 percent for goods and 5 percent for services). As a result, the trade balance registered a surplus of 3.4 percent of GDP, the largest over the past decade. On the other hand, the net income account continued to record a large outflow of 7 percent of GDP, reflecting the repatriation of benefits by foreign companies, particularly banks which showed very positive results.

5. Estimates of the competitiveness gap also present significant improvement. The CGER-type estimates of exchange rate valuation are broadly in line with fundamentals.2 All three approaches point toward the same trend. The correction in the real exchange rate overvaluation was about 4 percent for the macrobalance and external sustainability approaches, and about 10 percent for the equilibrium real exchange rate approach. The decline in the real exchange rate gap is in line with recent development in wages and price, as well as the large swing in the current account deficit from 7.8 percent in 2009 to 3 percent in 2011 which sharply narrows the medium-term current account projections.

Estimates of Exchange Rate Valuation 1/

(Percent)

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Source: IMF Staff Estimate.

+/-indicates exchange rate over/undervaluation; see IMF Occassional Paper No. 261 for details on the methodology underlying the estimates in this table.

6. Market shares in services have been growing. Malta’s service exports have emerged as a new growth engine (Box 1). As of 2010, the sector reached 50 percent of GDP and hired about a fifth of the total work force. Remote gaming, financial services, call centers, and airplane services were buoyant. In particular, Malta’s banking sector is one of the largest in the EU in relation to GDP and has been resilient throughout the crisis. Malta is also home to a number of hedge funds and numerous administrations of funds and insurances. Furthermore, Malta’s tourism share continues to increase, benefiting last year from the geopolitical tensions in North Africa.

A01ann01ufig02

Malta: External Competitiveness 1/

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: IMF, IFS; UN Comtrade; and IMF staff calculations.1/ Size of the speres depicts the size of exports as a percentage of GDP in last available year. Area / presents sunrise industry; area /// presents sunset industry.

What Makes Malta an Attractive Financial Center?

Malta is an attractive location for financial services. Economic and legal, regulatory and tax framework are some of its key advantages.

As part of the euro area, Malta benefits from the EU passport regime as well as the effective and sophisticated legislation based on EU directives, thus facilitating the financial flows across member countries. Malta has been an EU member since 2004 and adopted the Euro in January 2008. The Euro adoption eliminated the currency risk among euro area members, while the adjustment process toward the Maastricht criteria had contributed to economic stability. Malta’s financial services legislation is also business-friendly and industry-oriented. The Banking Act is modeled on EU directives and complies with the EU’s stringent quality standards.

Financial sector is regulated efficiently and responsively. The Malta Financial Services Authority (MFSA) is the single financial regulator. Its mandate includes (i) supervising financial services, (ii) monitoring business practices in the supply of financial products, and (iii) promoting fair competition and consumer choice in the sector. Its area of responsibility spans from banking, insurances, investment services, and financial markets.

Malta’s EU-approved tax regime is competitive and efficient. Corporate income tax rate is 35 percent, but to promote investment activities, Malta has a number of tax incentives, including a reduced tax on approved projects (a reduced rate of 15.75 percent), a reduced tax rate in terms of double tax treaties with all major economies (a reduced rate of 15 percent), and tax credits allowing for further tax reduction. In particular, income and capital gains from participating holdings are tax exempted.

Other advantages include Malta’s strategic location and time zone, modern infrastructure, skilled labor supply, English language, and political stability.

Identifying Structural Bottlenecks

7. Further improving Malta’s productivity growth is key to sustaining recent gains in competitiveness. Strong growth in financial and business services will demand more high-skilled labor force. In particular, empirical evidence shows that productivity growth within these sectors significantly contribute to export growth (table below and see also Monteagudo and Montaruli (2011)3). Higher labor productivity growth in the services sector could potentially have a positive long-term effect on exports, estimated at 0.6 percent in the case of financial intermediation and 1.3 percent in the case of business services for each percentage point increase in the sector’s labor productivity. Therefore, the efforts to improve the quality of human capital would be crucial going forward. These results need to be interpreted with caution as the estimated based on limited data may be subject to small sample bias.

Exports and Services in the Euro Area 1/

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Source: IMF staff estimates.

Export demand equation is estimated using Arellano-Bond dynamic panel regression with robust variance. Sample includes 17 euro area countries for the period 1995-2007. Data are from AMECO, European Commission and EU KLEMS. All variables are in logs, except for labor productivity growth. Dependent variable is real exports of goods and services. The external demand measures the size of country’s export markets, proxied by real total imports of main partners weighted by country’s exports to such countries. REER is the real effective exchange rate index based on consumer price index (ULC-based REER is also tested, but does not alter the result). **, * shows significance at 5 and 10 percent respectively.

8. Malta’s productivity growth has lagged behind peers. Labor productivity growth over the last decade averaged only 0.2 percent, compared to 0.5 percent for the euro area and 0.8 percent for the European Union. Overtime, Malta’s productivity growth has tended to be volatile, it averaged around 0.5 percent in 2001-08 and declined by 1 percent during the global financial crisis. Nonetheless, the lack of sectoral productivity data limits the scope for competitiveness analysis. For Malta, where the economy is increasingly diversified, it would be worthwhile to develop labor productivity indicators across economic sectors or industries to differentiate developments. In turn, such analysis will be necessary to determine wage settlement policies by underlying wage adjustments based on sectoral productivity developments. This will also help cross-country comparisons, where the country comparators across sectors may be different.

9. Wage growth has exceeded productivity growth over the last decade, although recent wage moderation was encouraging. For Malta, wage growth (2.8 percent) was about 14 times productivity growth (0.2 percent) over the past decade. The wage indexation mechanism by which wages are indexed to the country’s inflation could contribute to persistently high wage growth, despite productivity developments. Nonetheless, Malta’s wage moderation in light of the crisis helped narrow the gap between wage and productivity.

A01ann01ufig03

Labor Productivity and Wage Growth

Citation: IMF Staff Country Reports 2012, 105; 10.5089/9781475503388.002.A001

Sources: IMF staff calculations; and European commission (2011), “Reaching the Employment Target: Progress and Thematic Surveillance”.1/ The 2011 labor productivity data for Malta are based on an average of two quarters and the data for EA17 is based on the first quarter. The unit labor cost for 2011 for both Malta and EA17 are based on a average of three quarters.

10. Structural changes in Malta’s production may lead to a bottleneck in the supply of highly skilled labor. Strong growth of new high value-added exports was fundamentally supported by Malta’s highly-skilled English-speaking workforce. However, Malta has the highest rate of early school-leavers among euro area peers, while the share of college graduates hits the lowest. Malta has also a long-standing issue of low female participation in the labor force. The lack of high-level education could create a shortage in the highly skilled-labor segment in the labor market, thus hindering the country’s potential and competitiveness. In addition, its research and development spending is the smallest among the euro area peers.

A01ann01ufig04
Source: Eurostat.1/ The share of the population aged 30-34 years who have successfully completed university or university-like (tertiary-level) education with an education level ISCED 1997 (International Standard Classification of Education) of 5-6. This indicator measures the Europe 2020 strategy’s headline target to increase the share of the 30-34 years old having completed tertiary or equivalent education to at least 40% in 2020.

Preserving Malta’s Competitiveness

11. Malta, therefore, will need to continue making progress on structural reforms along with the EU’s Lisbon agenda to address its structural weaknesses, boost productivity growth, and sustain growth. These include (i) improving the quality of human capital through education targeted on labor market needs, and encouraging female labor participation; (ii) adopting productivity-enhancing measures through training and R&D; and (iii) improving business environment and efficiency by removing rigidities and reducing an oversized and inefficient public sector as well as promoting energy efficiency. Furthermore, strengthening the AML/CFT preventive measures in the international banking sector and in the online gaming sector will contribute to preserve the sustainability of Malta’s competitiveness in these sectors.

12. Finally, Malta should maintain the reform momentum to reform the wage-setting and indexation to better align wage and productivity developments. The working group represented by social partners, the ministry of finance, and central bank of Malta has been set up and made progress on introducing some elements of productivity into COLA formula. The revised formula, however, still needs to be agreed among social partners. Furthermore, the wage-productivity relation could be enhanced by the more-refined sectoral analysis. The Maltese authorities should (i) continue to improve the national accounts output measures following best practices, particularly on data classification, treatment of deflators, as well as services output and price measures, in which these changes would improve both the quality of the national accounts and their international comparability, (ii) speed up the timeliness of labor productivity data, and (iii) in the longer term, account for labor quality, including educational level, age group and gender by industry.

Annex II. A Rules-Based Fiscal Framework for Malta 1

Malta has committed to reform its budgetary framework in line with the recently agreed EU fiscal compact treaty. Adhering to the new guidelines will strengthen fiscal policy making, by adding credibility to the government consolidation strategy and enforcing greater discipline and transparency. Malta-specific simulations suggest that a rules-based framework has the potential to improve fiscal outcomes and promote debt sustainability.

1. Malta’s current budgetary framework needs strengthening. A key weakness of Malta’s framework is the non-binding nature of the multi-annual targets, which implies a relatively short fiscal planning horizon. The multi-annual projections presented in the annual budget are not underpinned by an articulated medium-term strategy, nor by the detailed measures to achieve them. Other weaknesses relate to the lack of expenditure ceilings and corrective measures in the event of deviations from the target. Malta’s framework is also characterized by the absence of an independent budgetary institution to provide independent macroeconomic and fiscal forecasts and to assess fiscal sustainability and compliance with the fiscal mandate. Improving the monitoring of budget execution remains a key challenge, as public expenditure is still subject to discretionary decisions in the implementation phase.

2. The government’s commitment to implementing the EC directives on budgetary frameworks and the additional requirements envisaged in the Fiscal Compact agreed on January is a big step towards fiscal discipline. Twenty five EU members, including Malta, committed to achieving and maintaining structural deficits below ½ percent of GDP. Balanced-budget rules will be embedded into national constitutions or primary law. If the target is missed, an automatic correction mechanism will be triggered to bring the deficit back in track. Governments also committed to reducing their gross debt-to-GDP ratios at a pace equal to 1/20th of the distance between the current level and the 60 percent target. In addition to numerical targets, the implementation of the rule will also involve the monitoring of compliance by independent institutions.

3. The establishment of a permanent rules-based framework and strengthened fiscal governance could yield a number of benefits. The requirements outlined in the new treaty would provide a durable constraint on fiscal discretion ensuring sustainable debt dynamics The rising use of some form of fiscal rule over the last two decades reflects the view that well-designed and properly implemented fiscal rules could support credibility and discipline and help limit distorted incentives in policymaking (Box 1). After an appropriate transition period, once the public finances are closer to balance, the EU-mandated structural balanced budget rule could secure the gains of the consolidation process, support fiscal discipline, and anchor long-term expectations about fiscal sustainability.

4. In order to illustrate how a rules-based fiscal framework can improve budgetary outcomes, this annex simulates the hypothetical path of key fiscal variables predicted by various fiscal rules had they been in place in Malta since 2000. The rules-based simulated outcomes are then compared to the actual fiscal outturns over the same period. For simulation purposes, the deficit target is set to -3 percent of GDP, in order to assess what the fiscal outcome would be had Malta targeted the Stability and Growth Pact threshold since 2000. Three fiscal rules are analyzed. A formal representation of these rules and the choice of parameter values are discussed in Box 2.

  • Structural Balance Rule: This rule allows for temporary deviations in the overall fiscal balance from its medium-term structural deficit target according to cyclical developments. It allows for the full operation of automatic stabilizers leading to higher deficits when the output gap is negative and lower deficits when the output gap is positive. While this can be considered as being very similar to the structural deficit target in the EU treaty, it does not explicitly take into account how the deficit would adjust in case of a deviation from the target.

  • Augmented growth based (AGB) rule also allows for temporary deviation for the medium term target when the current period economic growth deviates from its long term trend. Hence, it has the countercyclical nature of the structural balance rule but without requiring explicit estimates of the output gap. In addition, this rule also allows for a gradual adjustment back to the medium term target when past shocks cause the balance to deviate from its target. Hence, differently from the structural balance rule, the AGB rule avoids unrealistically high adjustments in a single year by allowing more time for the balance to converge back to the target. In this respect, the AGB rule not only takes into consideration cyclical concerns like the structural balance rule does but also incorporates an automatic correction mechanism making it more likely to encompass the proposed fiscal rule in the EU treaty.

  • Expenditure Rule. This rule sets a ceiling for the annual growth rate of real expenditure. Revenues are not constrained by the rule. Real government expenditures can be set to equal the long term growth of real GDP. Cross country experience shows that this rule is usually associated with additional requirements such as debt brakes or deficit ceilings.

5. The three fiscal rules under consideration would have delivered better fiscal outcomes than the actual policy stance during the period 2000–07. In particular, the rules would have been more effective in:

  • Containing the fiscal deficit. The actual deficit during this period was 5.2 percent of GDP on average, while the deficit predicted by the structural balance and AGB rules would have been around 3 percent of GDP. Fiscal policy was quite expansionary and procyclical during this period, especially before Malta joined the EU (2000-04). An expenditure rule would have performed worse than the balance rules, though still achieving a better deficit outcome than the actual one. Simulated expenditure-to-GDP ratios under the rule are not very different to those that actually occurred, suggesting that actual real expenditure grew in line with real GDP during this period. This implies that the deficit underperformance was, largely, attributable to shortfalls in revenues, which are unconstrained by an expenditure rule, rather than spending overruns. This result underscored the need to place constraints in the overall fiscal balance, and not solely on expenditures.

  • Reducing debt. Debt under the three rules would have been lower. Actual debt during 2000-07 stood at an average of 62 percent of GDP, whereas the fiscal rules would have predicted a lower debt of around 50 percent of GDP for the structural and AGB rules and 58 percent for the expenditure rule.

Country Examples of Fiscal Rules

Multi-year Expenditure Rules in Finland, Netherlands and Sweden (Ljungman 2008)

All three countries have had positive experiences with expenditure ceilings, contributing to maintaining robust public finances. They all include a medium term framework, which in the case of Finland and Netherlands is 4 years (the amount of time that a government is in power), whereas for Sweden it includes a 3 year rolling ceiling. Ceilings are defined in real terms in the case of Netherlands and Finland, which are then adjusted for inflation and converted into nominal ceilings. In Sweden on the other hand, the ceiling is directly defined in nominal terms. The coverage of expenditure items differs across countries. While in all cases countries have opted to exclude interest payments on the grounds that it is a very volatile and procyclical item, their stance differs regarding the coverage of cyclically sensitive items such as unemployment benefits. Netherlands and Sweden expenditure ceilings are comprehensive, by covering almost all of central government spending. Finland, on the other hand, excludes cyclically sensitive items from expenditure ceilings in order to allow for the full operation of automatic expenditure stabilizers. During an economic downturn,, the cyclical component of expenditures would be allowed to increase without requiring a compensating cut in other expenditure items. While in all three cases expenditure rules are not regulated in legislation and there are no predetermined sanctions in case of deviations, political commitment and compliance has been high. It is also important to note that in all three cases such fiscal rule has been implemented in the aftermath of a serious fiscal crisis. However such rules were introduced after the consolidation had been achieved.

Structural balance rule in Germany

In June 2009, the German parliament amended the constitution to include a new rule for both federal and state governments. The rule requires the federal government’s structural deficit not to exceed 0.35 percent of GDP. The rule becomes binding in 2016, with a transition period starting in 2011. The states will be bound by a balanced structural budget from 2020. Execution errors are cumulated in a notional account that has to be corrected once errors accumulate above 1 percent of GDP. However, the adjustment only needs to start after an economic recovery is in place to avoid a procyclical tightening. The provisions allow for an escape clause that can be invoked by parliamentary majority in the event of natural catastrophes and other emergencies outside government control.

Augmented growth-based balance rule in Turkey

Turkey has recently considered adopting a fiscal rule that promotes countercyclical policy while circumventing the need to estimate the output gap. The draft law submitted to Parliament specifies a general government deficit target of 1 percent of GDP. In any given year, the actual deficit may deviate from the target to account for cyclical developments. In this case, the deficit may react to changes in the growth rate (relative to the long-run trend of 5 percent), rather than changes in the output gap. In addition, the rule allows gradual adjustment when the deficit is away from its medium-term target. As a result, the amount of required adjustment in any given year would almost always be feasible, making the rule more politically durable. For details see Fletcher and Benelli (2010).

Formal Representation of Fiscal Rules

Structural Balance Rule

Under a structural balance rule, the overall budget balance in any given year is equal to the medium-term overall balance target adjusted for changes in the output gap. Formally,

bt=b*+αytG,α>0

where bt is the overall balance (as a percent of GDP) in the current year, b* is the medium-term overall balance target, α is the semi-elasticity of the budget balance with respect to the output gap and ytG is the output gap in the current period. The parameter α can also be seen as the cyclical coefficient which determines the extent to which automatic stabilizers and discretionary countercyclical policy works. In the baseline simulation we follow Girouard and Andre, 2005 and set α equal to 0.45. With this value, the rule allows automatic stabilizers to work fully, but no discretionary policy countercyclical policy is allowed.. b*, the overall medium term balance target is set to be -3 percent of GDP.

Augmented Growth-Based Balance (AGB) Rule

The rule broadly mimics a structural rule, but makes some adjustments to avoid relying on output gap estimates, which in some cases are uncertain or subject to revision. The rule replaces the output gap with the difference between actual and long-term growth. To promote countercyclicality and avoid requiring an unrealistically large adjustment in any single year, the rule also includes a term that smoothes the adjustment from any deviation from the medium-term overall balance target in the previous year. Formally,

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