This staff report on Malta’s Article IV Consultation highlights economic development and policies. Risks from the large international bank sector appear contained given limited balance-sheet exposure to the Maltese economy, though continued vigilance is warranted. Regulatory changes to increase loan loss provisions, and the funding of the deposit compensation scheme would help contain risks in the domestic banking sector. The main challenges for fiscal policy are to reverse the deterioration of public finances, and to strengthen the governance framework. Additional measures are needed to ensure that the fiscal deficit falls below 3 percent of GDP in 2013 and that public debt remains on a sustainable path.

Abstract

This staff report on Malta’s Article IV Consultation highlights economic development and policies. Risks from the large international bank sector appear contained given limited balance-sheet exposure to the Maltese economy, though continued vigilance is warranted. Regulatory changes to increase loan loss provisions, and the funding of the deposit compensation scheme would help contain risks in the domestic banking sector. The main challenges for fiscal policy are to reverse the deterioration of public finances, and to strengthen the governance framework. Additional measures are needed to ensure that the fiscal deficit falls below 3 percent of GDP in 2013 and that public debt remains on a sustainable path.

Context

1. Compared with its euro area peers, Malta has shown remarkable macroeconomic resilience. Average growth of the Maltese economy (relative to historical average) has been the best in the euro area since the beginning of the crisis. Malta suffered lower output and employment losses than most advanced economies, and none of its financial institutions required solvency or liquidity assistance. As a result, real GDP is now 2½ percent above pre-crisis level (compared with 2¼ percent below for the euro area) and unemployment is close to historical lows (Appendix I). However, economic growth slowed in 2012 to about ¾ percent, from 1¾ percent in 2011, reflecting a weak external environment and subdued domestic demand. In addition, the fiscal deficit widened by ½ percent to 3.3 percent of GDP and government and guaranteed debt is uncomfortably high (90 percent of GDP), constraining the fiscal space in the event of further shocks.

uA01fig01

Average Growth 2007-2012, Relative to Historical Average

(Percent)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig02

Real GDP1/

(t=100)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: IMF, World Economic Outlook; and IMF staff calculations.1/ t denotes first quarter of recession.

2. Robust exports have been the main source of growth, bringing the current account into surplus in 2012. The sizeable improvement in the trade balance (10 percent of GDP since 2006) reflected successful export diversification and depreciation of the real effective exchange rate, which is broadly in line with fundamentals (Box 1). As a result, Malta’s export market share in services increased rapidly, driven by strong growth in the traditional tourism sector and some new high value-added activities, including financial and business services, online gaming, and ICT. Indeed, Malta’s track record of innovation and finding export-oriented opportunities has been remarkable (see Appendix II).

uA01fig03

Change in Trade Balance, 2006-2012

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: Eurostat

Malta’s Competitiveness Developments

Malta’s price competitiveness measures have improved over the last few years. The CPI-based real effective exchange rate depreciated by 9.5 percent between 2009 and 2012, fully offsetting the appreciation that followed Malta’s accession to the EU in 2004. The improvement of the real effective exchange rate based on unit labor cost has been smaller but also substantial. Owing to the relative size of Malta’s trade with the United Kingdom, Asia, and the United States, the depreciation of the euro against the UK pound, US dollar, Singaporean dollar and yen between 2009 and 2012 has contributed to this improvement. In contrast, Malta has lost price competitiveness within the euro area given its higher rate of inflation and stronger labor cost growth.

uA01fig04

Real Effective Exchange Rate

(2005=100)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: IMF, Information Notice System.

The estimates of exchange rate valuation are broadly in line with fundamentals. The correction of the equilibrium real exchange rate has been almost 15 percent since the 2009 Article IV consultation. The macro balance and external sustainability approaches also show very small deviations from the equilibrium.

Estimates of Exchange Rate Valuation 1/

(Percent)

article image
Sources: IMF article IV staff reports; and IMF staff estimates.

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

3. Despite the slowdown in growth, inflation remained elevated in 2012. The HICP inflation inched up to 3.2 percent in 2012 from 2.5 percent in 2011. The main reason, however, was higher prices and some methodological changes related to tourist services, which are mainly oriented towards foreigners and therefore have little impact on domestic consumption. That being said, inflation moderated to 0.8 percent in May 2013.

4. Financial spillover from the euro area crisis has so far remained contained reflecting limited reliance on external finance by core domestic banks and the government.

  • The core domestic banking sector is largely funded by resident deposits, while the large international banking segment has limited balance sheet exposures to the Maltese economy (Box 2). Unlike many other EU countries, Malta has not experienced any deleveraging pressures, deposits and credit to the private sector continued to grow in 2012, albeit at a slower pace than in 2010-11, and Maltese banks outperformed European peers in terms of profitability (Box 3). Since developments in Cyprus, the fluctuation of bank liabilities has remained within the historical average.

  • The Maltese sovereign bond market weathered the storm in other euro area debt markets unscathed, with yields declining on strong domestic demand and manageable government financing needs. In contrast with other advanced economies, 96 percent of Maltese government debt is held by residents, limiting financial spillovers.

uA01fig05

Ten-year Government Bond Spreads

(Over 10-year German bunds, basis points)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig06

Nonresident Holding of General Government Debt, 2012

(Percent of total)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Datastream; Bloomberg; country authorities; and IMF staff calculations.

5. Balance sheet vulnerabilities of the non-financial private sector remain contained. Household debt has increased rapidly since EU accession and reached 63 percent of GDP by end-2011 (latest data available), broadly catching up with the EU average. Despite this increase, households’ net financial assets remain positive, standing at 170 percent of GDP, which is among the highest in the euro area. The corporate debt stands at 140 percent of GDP in 2012, which is relatively high. However, this reflects to some extent the presence of foreign firms, resulting in a large share of intra-group loans matched by intra-group claims on the asset side. Furthermore, around half of this debt is in the form of long-term loans, and the corporate sector also has sizeable assets.

uA01fig07

Household Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig08

Non-financial Corporations Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: Eurostat; and IMF staff calculations.

Structure of the Banking Sector

Malta has a large and sharply segmented banking sector. While total banking sector assets exceed 8 times GDP, the largest part of the sector has no balance sheet exposure to the Maltese economy and transactions are exclusively with non-residents. The Central Bank of Malta (CBM) classifies banks in three different categories according to the extent of their involvement in business with residents. Core domestic banks provide around 97 percent of bank lending to residents in Malta, and collect around 94 percent of resident deposits. At the other end of the spectrum, international banks have no balance sheet exposure to the Maltese economy.

uA01fig09

Total Assets

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Central Bank of Malta; and European Central Bank.

Banks’ disparate balance sheet structures imply different risk profiles.

  • Core domestic banks have a traditional business model: they are largely funded by resident deposits and most of their assets represent claims on residents. This segment is dominated by two banks (HSBC and Bank of Valletta). Their main vulnerability is credit risk stemming from high exposure to the property market and collateral in the form of real estate.

  • International banks rely mostly on equity, wholesale (including intra-group) funding and non-resident corporate deposits of relatively long maturities. These banks lend these funds abroad and operate with a very small physical presence in Malta. Their main risk is liquidity risk. Two branches from Turkey have combined assets exceeding 300 percent of GDP. The largest subsidiaries are Deutsche Bank and Commbank Australia, with combined assets of about 100 percent of GDP.

  • Non-core domestic banks have a more diverse asset and liability structure, and about 10 percent of their balance sheet is linked to the domestic economy in the form of resident deposits and domestic loans and securities. The main risks stem from potential claims on the deposit compensation scheme and from cross-border deleveraging pressures.

uA01fig10

Banking sector assets

(Percent of total assets)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig11

Banking sector liabilities

(Percent of total liabilities)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: Central Bank of Malta

Performance of the Banking Sector

Despite turbulence in the euro area, the performance of Maltese banks has been relatively good.

  • Banks are adequately capitalized, profitable, and liquid. The aggregate capital adequacy ratio of all bank peer groups is well above the required minimum. The return on assets and return on equity ratios have actually improved in 2012 underpinned by higher non-interest income. The liquid assets cover substantial part of short-term liabilities, and the reliance on Eurosystem funding is very low.

  • The share of nonperforming loans (NPLs) has slightly increased in 2012, mainly due to subdued conditions in the construction and real estate sectors. Just under one third of all loans to the construction companies are classified as nonperforming.

  • Banks continued to expand their balance sheets in 2012 albeit at a slower pace than in 2010-11. Resident customer deposits and nonresident customer deposits increased during 2012, while the amount of wholesale funding remained broadly unchanged. Loans to residents have also marginally increased, driven primarily by mortgage lending and (to a lesser extent) loans to the manufacturing sector operating across a range of activities. The exposure of Maltese banks to EU sovereign debt is very low and diversified.

Key Financial Soundness Indicators, Dec 2012

(Percent, unless otherwise indicated)

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Sources: Central Bank of Malta; and European Central Bank.

Percent of GDP

Outlook and Risks

A. Staff’s Views

6. Despite good performance overall, GDP growth remains below potential and uncertainties abound. Domestic demand has remained lackluster, reflecting sluggish investment and private consumption and headwinds from a soft real estate market. Going forward, staff projects a moderate acceleration in real GDP growth in 2013-15, which means that Malta would continue to outperform the euro area average. The pick-up in activity to 1¼ percent in 2013 (from ¾ percent in 2012) is predicated on the recovery of private consumption and improved confidence, as policy uncertainty related to the electoral cycle decreases. While this would lead to some increase in imports, the current account balance is projected to remain slightly positive.

7. Short-term risks to this scenario are largely related to the external environment. A protracted period of slower growth in Europe or re-emergence of euro area financial stress if policy momentum is not sustained, would negatively affect the economy through the trade channel. In addition, close financial integration with the euro area entails a spillover risk via banking and financial markets channels (see Risk Assessment Matrix). However, relatively strong fundamentals in Malta, including a comfortable external position, very small reliance on external financing by the government, and relatively healthy balance sheets of households and nonfinancial corporates limit the vulnerability against these risks.

8. Recent events in Europe have heightened perceptions about risks of hosting a large banking sector in a small country. In the case of Malta these risks are contained because the large international banking segment (with assets about 5 times GDP) has limited balance sheet exposures to the Maltese economy and negligible contingent claims on the deposit compensation scheme. The sharp segmentation of the Maltese banking sector implies that the nature of potential threats to financial stability differs substantially across the various institutions.

  • The main risk facing the core domestic banks is credit risk, particularly related to the significant concentration of loans to the real estate and construction sectors and loans backed by real estate as collateral. The real estate market risk is contained by the very high share of owner-occupied properties, prudent loan-to-value ratios, and fair market valuations. However, the real estate market is particularly sensitive to shifts in confidence linked to the external environment and it could act as a channel that amplifies the impact of external risks. Furthermore, the over-reliance on immovable collateral may pose risks if the property market were to slow significantly.

  • A few non-core domestic and international banks could be exposed to liquidity risk. A change in perceptions of the risks facing creditors may lead to an increase in funding costs of these banks, particularly those which rely significantly on wholesale funding. However, given the insubstantial balance sheet links of these banks with residents, the effects on the economy are likely to be small in the near to medium term (see Appendix III).

9. In the longer term, regulatory and tax reform at the European and global level could adversely affect Malta’s attractiveness as a financial and business location. The Maltese economy has greatly benefitted from a business-friendly tax regime (see Appendix III). Although these gains are hard to quantify, the large increase experienced in financial services and other niche activities since 2004 are likely related to Malta’s accession to the EU, its macroeconomic stability, and relatively favorable tax regime. Over the last ten years, more than half of the growth in value added is explained by the growth in financial services, ancillary activities (legal, accounting, and consulting), remote gaming, and ICT. These sectors alone account for a quarter of total value added and 12 percent of employment. It is possible that greater fiscal integration of EU member states and a potential harmonization of tax rates could erode some of these benefits, with consequences on employment, output and fiscal revenues.

uA01fig12

Financial Services and Other Niche Activities

(Percent of total gross value added)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig13

Gross Value Added by Financial Sector, 2012Q41/

(Percent of total)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: Eurostat.1/ Ireland data is from 2012Q1, latest available.

The Authorities’ Views

10. The authorities broadly agreed with the outlook. Official projections of GDP growth and inflation in 2013-16 are very similar to those of staff. The authorities concurred that the main risk to growth comes from abroad, given continuing weakness in the euro area. The authorities are concerned about possible reputational risks to Malta following events in Cyprus, but expressed confidence that the Maltese banking sector is robust and stable. They also noted that the banking sector in Malta differs substantially from that of banks in some other EU countries affected by the crisis. In particular, the authorities emphasized that the size of Malta’s domestic banking system is below the euro area average. The rest of Malta’s banking sector is made of non-core and international banks with limited or no links to the domestic market. The authorities were also of the view that an EU-wide tax harmonization would not happen in the short or medium term.

Policy Discussions

A. Maintaining Financial Sector Stability

Staff’s Views

11. Malta has made progress in strengthening the oversight over its financial sector. To enhance monitoring of systemic risks a Joint Financial Stability Board (JFSB) was established by the Central Bank of Malta (CBM) and the Malta Financial Services Authority (MFSA) in January 2013. The JFSB was set up following the recommendations of the European Systemic Risk Board to EU member states and is having monthly meetings. In March 2013, following the intensification of the crisis in Cyprus, the authorities adequately strengthened supervision and introduced extraordinary monitoring of banks through daily reporting of liquidity. The authorities should continue monitoring closely developments in all banks, including links between foreign parent banks and their Maltese entities in the context of the existing colleges of supervisors. The authorities should also stand ready to take action if spillovers from abroad become imminent or the internationally-oriented banks increase their exposure to the domestic economy. In particular, the emerging trend by some small non-core banks of attracting resident deposits—often accompanied by aggressive interest rate policies—to finance assets outside of Malta, requires closer monitoring, though magnitudes are currently small.

12. Further efforts are still needed to shore up the resilience of Maltese banks and ensure financial stability. The ratio of provisions to nonperforming loans for core domestic banks has been hovering around 20 percent in recent years, which is the lowest among the EU countries. Despite ample availability of collateral, the authorities should tighten provisioning rules in order to increase the available buffers to cover loan losses. To this effect, the MFSA could issue guidelines, which would set common parameters for impairment triggers, forbearance measures, and homogeneous collateral valuation practices. In this context, the planned revisions to Banking Rule 09 should ensure that the incurred loan losses are recognized as early as possible, ensuring a more conservative approach to the measurement of provisions within the context of IFRS and providing a level playing field for provisioning in the banking sector. It would also be important to conduct a review of the judiciary procedures related to the foreclosure of the seized properties, which are currently very slow, impacting recovery values.

13. Work should also continue to strengthen crisis preparedness and management frameworks. The authorities could start strengthening the bank resolution framework in line with forthcoming reforms at the EU level. It might also be useful to conduct a crisis simulation exercise, given that the bank resolution framework in Malta is untested (there have been no bank failures in Malta in the past decade, and no bank required liquidity or solvency assistance since the beginning of the European financial crisis in 2008). Of particular importance is the need to boost the available resources of the Deposit Compensation Scheme (DCS). Recent amendments to the regulations to increase the size of the DCS to 1 percent of eligible deposits (from 0.77 percent) within the next 3 years are a step in the right direction. However, more needs to be done in view of sizeable contingent liabilities (relative to the size of the economy) and a potential large increase in eligible deposits covered by the scheme—as foreseen in the EU draft directive on the harmonization of the deposit insurance among EU countries.

Maximum Recourse on the Deposit Compensation Scheme, as of March 2013

(Percent of GDP)

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uA01fig14

Insured (Covered) Deposits, March 2012

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: Central Bank of Malta; and European Central Bank.

14. Looking ahead, like other EU countries, Malta will have to implement EU-level initiatives relating to the bank regulatory and supervisory frameworks. These include:

  • Basel III and Capital Requirement Directive IV (CRD IV). Although the Maltese banks have strong capitalization, the higher capital adequacy requirements of CRD IV may pose difficulties for individual banks facing the need to form additional provisions to deal with higher nonperforming loans. Therefore, these banks should be encouraged to further enhance capital buffers through higher profit retention, in line with the timeline proposed under Basel III. Tougher liquidity standards seem unlikely to create any challenges for banks. While an ample transition period for liquidity standards is envisaged, the Maltese authorities should continue to ensure that banks remain well prepared for the implementation of new requirements.

  • Single Supervisory Mechanism (SSM). As a result of the EU Council agreement on SSM of December 2012, Malta’s two largest domestic banks (Bank of Valetta and HSBC) and possibly CommBank Europe, will be placed under the direct oversight of the ECB from 2014. The MFSA should work closely with the ECB to ensure a smooth transition in the supervision of these banks. While the new framework is expected to result in a more efficient supervision over a longer term, efforts should be made to ensure no reduction in the supervisory capacity of these banks during the transition period.

15. Staff recommends a prompt and an in-depth examination of the financial sector under the IMF Financial Sector Assessment Program (FSAP). The MFSA is commended for its self-imposed quality controls of commissioning regular independent assessments against international standards. In line with previous staff recommendations, the MFSA is also undertaking a review of the consumer protection and business conduct functions with a view to enhance the integrity of the financial system. An FSAP would report progress since the 2003 assessment and point to areas where further efforts may be needed.

16. In light of the rapid growth in financial sector activities and online gaming, all relevant institutions should maintain an effective anti-money laundering framework. Malta has become an active destination for small international banks and non-bank financial intermediaries, such as re-insurance companies and various investment funds, whose activities are mostly outside Malta. While Malta has a comprehensive legal system to combat money laundering and has increased the resources devoted to the Financial Intelligence Analysis Unit (FIAU), the increasing complexity of the Maltese financial sector warrants closer AML/CFT related monitoring. The FSAP would be an opportunity to conduct a detailed AML/CFT assessment. The ongoing practices of joint inspections carried out by the MFSA and FIAU is a welcome step, but the number of on-site visits remains low and is not commensurate with the size of the financial sector (see Appendix III). To strengthen human resources, consideration should be given to hiring experts from abroad, financed by non-punitive levies on the financial sector.

17. The intention of the authorities to establish a development bank has merits, but requires careful evaluation. Development banks play an important role in many countries in extending the outreach of credit and other financial services to customers, who may not have easy access to commercial banks. However, the international experience with development banks has been mixed, as these banks have sometimes been subject to undue political pressure and weak supervision, which resulted in substantial losses to taxpayers. The authorities should ensure that the conditions required for successful operation of a development bank are in place (Box 4).

The Conditions Required for Successful Operation of a Development Bank

Recently, the Central Bank Governor has expressed interest in creating a development bank (DB) to address the national financing gaps not met by the commercial banks. The purpose of the DB would be to provide long-term financing for public projects in infrastructure and social sectors, such as education, communications, and environmental protection and rehabilitation. While the market failure to obtain finance and the positive externalities of such projects provide a rationale for the establishment of a DB, state intervention in the banking sector should be carefully crafted to mitigate the risks of political interference, poor governance, uncontrollable fiscal contingent liabilities, and unfair advantages of the DB over private banks. Some of the steps that can be taken to ensure that the social rate of return from the DB’s activities exceeds the private and fiscal costs are listed below:

  • Establish a clear mandate: The DB mandate should aim at filling the financing gaps arising from market failures. The mandate should specify the DB’s objectives, the time period required for implementing and achieving the objectives, and the provisions for transparent accountability.

  • Relationship with the private banks: The objective should be to act complementarily with respect to private banks, not compete with them.

  • Financial sustainability: The DB should be financially sustainable over time. However, the objective should not be to maximize profit but generate the resources required for the completion of mandated projects. The DB should be regulated and supervised as a commercial bank.

  • Instruments used: The mandate should be clear, specific and direct about the instruments used to correct the market failure.

  • Accountable and efficient governance: Good and accountable governance is critical to prevent government interference in credit decisions. One possible option could be to organize the DB as a corporation comprising shareholders, board of directors and management with each group clearly informed about its rights and responsibilities

The Authorities’ Views

18. The authorities agreed with the staff’s assessment. The Financial Stability Report of the CBM has encouraged banks to increase loan loss provision, strengthen capital buffers through higher profit retention, and ensure higher funding for the deposit compensation scheme. The MFSA is working on imposing additional capital requirements via Pillar II to account for concentration risk and heightened levels of non-performing loans. The authorities noted that the work on Basel III and SSM is under way, and the Joint Financial Stability Board has already met several times since its inception in January 2013. The Domestic Standing Group, composed of representatives of the CBM, MFSA, and Ministry of Finance, remains another forum for discussion of systemic risks. The daily monitoring of liquidity position of individual banks has not revealed any signs of excess volatility or abnormal capital inflows or outflows. The authorities plan to request an FSAP and think that it could validate the findings of the recent independent assessment of Malta’s regulatory and supervisory frameworks. The authorities support the establishment of a development bank in Malta to channel the excess liquidity in the system to infrastructure, social, and environmental projects and to deploy government assets (e.g. underutilized real estate) more efficiently. Their view is that commercial banks cannot fill this gap because of the medium to long-term nature of the projects. In turn, budget financing is constrained by the high level of public debt.

B. Ensuring Fiscal Sustainability

Staff’s Views

19. The fiscal consolidation path was reversed in 2012 amid the election cycle. After notable progress in 2011, the fiscal deficit widened by ½ percent to 3.3 percent of GDP in 2012 and government debt rose to 72.1 percent of GDP, or almost 90 percent of GDP including guaranteed debt (Box 5). This has triggered a reassessment of Malta’s public finances under the EU Excessive Deficit Procedure (EDP), which Malta had exited in 2012. In late May 2013, the European Commission recommended to initiate the first steps towards re-opening of the EDP, with the deadline to achieve a durable correction of the deficit set for 2014. The fiscal slippage in 2012, which amounted to 1 percentage point of GDP relative to the budget target, was the result of overruns in all components of current spending and lower-than-expected revenues.

  • Revenues improved relative to 2011, albeit by less than anticipated by the government. Direct tax revenues increased substantially driven by higher income tax receipts from firms and households. However, the ratio of indirect taxes to GDP fell, reflecting weaker than expected consumption growth because of increased uncertainty surrounding the elections.

  • Overruns in current expenditure reflect the fast growth of health care spending and pension outlays. In addition, new collective wage agreements and settlement of arrears from previously acquired wage commitments resulted in a large increase in the wage bill. The increase in current expenditure more than offset the impact of a significant amount of deficit-reducing one-off measures (close to 1 percent of GDP). Since 2009, recourse to such one-off and temporary measures to reduce the deficit has averaged more than ¾ percent of GDP per year.

20. The government’s objective to balance the budget over the medium term remains essential, but it requires credible and sustainable consolidation efforts. On April 8, the newly elected government and the opposition agreed to approve the 2013 budget rejected by Parliament in December 2012, with only minor modifications. The budget proposed a fiscal deficit of 2.7 percent of GDP in 2013 and a moderate structural adjustment of about ½ percent of GDP per year over the medium-term. However, the discretionary measures announced for 2013 are expansionary and tax revenue projections appear optimistic in light of the moderate growth outlook and developments so far. On a cash basis, the deficit through March 2013 already exceeds the authorities’ deficit target for the year. Therefore, in the absence of additional measures, staff projects the deficit to widen further to 3.5 percent points of GDP in 2013, and to remain above 3 percent of GDP in the near to medium term. As a result, the government debt-to-GDP ratio is expected to continue to rise over the next three years.

uA01fig15

General Government Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig16

General Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Eurostat; Malta Ministry of Finance; and IMF staff calculations.

21. Staff urges the Maltese authorities to adopt additional measures to ensure the deficit falls below 3 percent of GDP in 2013 and public debt remains on a sustainable path. These measures should be designed to contain the fast growth in current expenditures, particularly intermediate consumption and social transfers, which show an unsustainable upward trend, and compensation of employees, which is one of the highest in the EU. The focus should be on tightening controls on the growth of health spending, greater use of means-testing of government benefits, and containing the wage bill through prudent collective wage agreements and compression of public sector employment through attrition. On the other hand, there is a need to preserve capital spending and to increase absorption capacity of EU funds. There is also a need to reduce reliance on one-off and temporary measures to ensure a sufficient and sustainable improvement of the structural balance.

uA01fig17

Government Current Spending, Selected Items

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig18

Wage Bill, Average 2010–12

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Eurostat; and IMF staff calculations.

Malta: General Government Debt Decomposition

Since 2008 public debt has been rising continuously. The debt-to-GDP ratio increased by 11.4 percentage points between 2008 and 2012, reaching a level of 72.1 percent at the end of 2012. This box identifies the main drivers of public debt accumulation during this period, by means of a debt decomposition exercise that uses data from the financial and non-financial government accounts.

uA01fig19

Debt Decomposition

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Central Bank of Malta; National Statistics Office of Malta; and IMF staff calculations.1/ Mainly EFSF contributions in 20122/ ESM contributions and capital injections to Malita
uA01fig20

Deficit Decomposition

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Persistent deficits have contributed to the increase in public debt, but intergovernmental loans to support euro area countries have also been an important contributor in recent years.

  • Interest payments represent the largest component of the government deficit. The structural primary deficit played an important role in 2008, 2010, and to a lesser extent in 2012.

  • The government has tended to rely on one-off measures to reduce the deficit, as evidenced by the negative contribution of the cyclical primary balance, which includes one-offs, on the deficit in four out of the five years considered.

  • In 2012, cash and deposits of the government fell significantly to finance the deficit, contributions to the EFSF, and an accumulation in net receivables.

  • This is consistent with the trend observed in the government’s balance sheet data. While the cash position declined significantly in 2012, non-cash financial assets increased substantially in 2012.

uA01fig21

General Government’s Balance Sheet Components

(Millions of euro)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

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

22. Restoring the profitability and viability of large public corporations is crucial to alleviate fiscal pressures. The high level of government-guaranteed debt and delicate financial position of Enemalta (the public utilities corporation) and Airmalta heighten concerns about Malta’s fiscal sustainability. Progress on the restructuring of Airmalta appears on track and the restructuring plan of Enemalta was recently approved. In this context, budget assistance to Enemalta needs to be phased out. Staff supports the government’s objective to reduce energy costs—one of the highest in the EU—and to diversify energy sources. However, any reduction in electricity tariffs should be contingent on the success of the government’s strategy to reduce costs and restore Enemalta’s financial health (see Appendix IV). It would also be important to make Enemalta’s financial reporting more timely and enhance transparency by issuing progress reports on Enemalta’s restructuring and the government’s energy reform plan.

23. Further progress is needed to strengthen the fiscal governance framework. The authorities need to undertake the necessary reform to ensure that its fiscal governance framework meets the EU requirements under the six-pack and fiscal compact by end 2013 (Box 6)1. A clear rule-based multi-year fiscal policy framework would reinforce the linkage between annual budget laws and the medium-term target. Fiscal discipline and governance should also be strengthened by establishing an independent fiscal council to guide and assess the government’s consolidation efforts. The fiscal council should have a comprehensive mandate, which includes the provision of unbiased macroeconomic estimates and an assessment of consistency between fiscal outcomes and the government’s targets derived from the fiscal rules.

The Authorities’ Views

24. The authorities were more optimistic than staff regarding the fiscal outlook. The authorities emphasized their commitment to reduce the budget deficit to 2.7 percent of GDP in 2013. With regards the 2013 budget, the authorities highlighted that small changes had been made to the budget proposed by the previous government, largely because of the need to honor previously acquired commitments. They also noted that their revenue projections were less optimistic than those of the previous government and that improvements in tax collection could yield substantial revenues. The authorities agreed with staff about the need to achieve a sustainable fiscal consolidation and to tackle the risks posed by the fast growth of certain current expenditure items. The government is committed to strengthening the governance framework and is considering various options for the mandate and responsibilities of a fiscal council.

Malta: Fiscal Governance Framework

In order to prevent the build-up of fiscal imbalances, the six-pack and fiscal compact require EU member countries to reform their fiscal frameworks by making changes to their legislation. This set of directives, regulations and agreements, establish that the necessary elements to build a strong fiscal framework are: fiscal rules, fiscal councils, medium term budgetary planning, budget coordination, and budget monitoring.

Member States should have clearly defined numerical fiscal rules that promote compliance with the Stability and Growth Program (SGP). Fiscal rules may target the deficit, public debt or government expenditure, and should be reflected in the annual budget. These rules must be effectively monitored, and non-compliance should only be allowed under exceptional circumstances. The effective enforcement of fiscal rules requires a gradual, well-defined and credible sanctions mechanism, which leaves only very limited room for political discretion. To strengthen the enforcement of fiscal rules and counteract governments’ inherent deficit bias, compliance with fiscal rules should be monitored by an independent body, such as a fiscal council.

Independent fiscal councils improve the transparency and quality of fiscal policies. These independent bodies contribute to the effectiveness of fiscal rules, by providing unbiased and realistic macroeconomic and budgetary projections, or by scrutinizing the government’s projections. Overly optimistic projections yield excessively positive assessments of the underlying fiscal stance, thus masking emerging fiscal imbalances.

  • In fact, projections of economic growth and government revenue have been “too optimistic” in a number of EU Member States over the past decade. The Government’s excessive optimism is proxied by its revenue projection errors. From 2000 to 2011, Malta has registered one of the highest projection errors among EU countries, while the projection errors have been smaller in countries where forecasts are produced or scrutinized by independent bodies, such as in the Netherlands, Austria and Belgium.

  • To contribute to the enforcement of fiscal rules and the eradication of the government’s deficit bias, the fiscal council must have the following characteristics: be strictly independent from the government; have a comprehensive mandate; and have the tools to persuade the government by being visible. That is, if the government fails to meet a target or does not follow a given rule, then it must publicly explain the deviations from the fiscal council’s advice. Alternatively, the government could be asked to publish the results of ex-post reviews prepared by the fiscal council.

uA01fig22

Government Revenue Projection Errors

(Percent of GDP, average 2000–2011)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: European Central Bank Monthly Bulletin, Feb 2013.

To promote a sound and credible medium-term fiscal planning, a multi-annual fiscal budgeting framework is required. Transparent multi-annual budgetary objectives, for the general government’s expenditure, deficit and debt should be published, including the projections of the main revenue and expenditure items for the budget year and beyond. Further, these projections should constitute the basis for future budget preparations. A description of the medium-term policies envisaged should be provided, as well as a forecast of the impact that these policies may have on long-term fiscal sustainability.

Strong budgetary coordination between the different levels of government is important for ensuring full compliance with fiscal rules. EU Member States should have appropriate coordination mechanisms in place across the different sub-sectors of general government. These mechanisms should ensure comprehensive and consistent coverage of all government entities with respect to annual and multi-annual fiscal planning and compliance with the numerical fiscal rules.

Finally, an adequate monitoring framework is a crucial element of fiscal surveillance. To ensure that fiscal slippages are detected at an early stage, governments should be required to provide timely and accurate budgetary data, including the publication of data on contingent liabilities, as these could have a large impact on public budgets.

The figure below puts into perspective the progress Malta has made in adapting to the new regulatory framework. Relative to its EU peers, the Maltese government needs to make further efforts in adopting a clear fiscal rule, establish a fiscal council and impose its multi-annual fiscal projections as targets.

uA01fig23

Overview Fiscal Frameworks - Fiscal Rules

(Percent of EU 27 member countries)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

uA01fig24

Overview National Fiscal Frameworks

(Percent of EU 27 member countries)

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Source: European Commission; and European Central Bank.

C. Boosting Long Term Growth and Competitiveness

Staff’s Views

25. Steady implementation of structural reforms is critical to boost potential growth and ensure the sustainability of public finances. The mission welcomes the government’s recent adoption of the National Reform Program that includes specific measures in different areas, but progress on other reforms has been slow, notably pension reform. If continued income growth depends on flexibility in developing niche service industries, there will be a premium on tackling the country’s low female labor force participation and tertiary education and relatively inflexible wage-setting regime. The priority areas should include:

  • Advancing pension and health care reform to ease long-term fiscal pressures. Without the implementation of mitigating reforms, Malta’s deficit would worsen by over 8 percentage points of GDP by 2060, reflecting an expected large increase in ageing-related spending (twice the EU average). The mission recommended: (i) indexing the retirement age to longevity, (ii) accelerating the planned increase in the statutory retirement age to 65, and (iii) introducing a mandatory privately funded second pillar and a voluntary third pillar to supplement the pay-as-you-go system. The latter, which would require an appropriate legal framework, would support the development of the local capital market and allow households to diversify their sources of savings (Appendix V).

  • Strengthening female labor participation. The authorities have recently introduced tax incentives and child care and maternity support measures to promote female labor participation, which is the lowest in the euro area. This will also help alleviate long-term fiscal pressures from ageing spending through a reduction in the dependency ratio.

  • Enhancing education attainment. The demand for high skilled labor in Malta is likely to increase with the growth of the financial sector and other high-value added activities. Yet, the rate of early school leavers in Malta is among the highest in the EU, and the rate of tertiary education is among the lowest. Education reforms should focus on promoting greater social inclusion and linking vocational training more closely with labor market needs.

  • Reforming the wage setting mechanism. Collective wage agreements should ensure better alignment of wage and productivity developments. Wage growth has exceeded productivity growth and increases in unit labor costs continue to outpace the euro area average. While the removal of the cost of living adjustment (COLA) may not be politically feasible and may raise social equitable considerations, a gradual moderation in the indexation mechanism and its greater integration in the collective wage negotiations could help make the labor market more efficient and competitive. Appendix VI discusses possible reform initiatives.

  • Improving the business climate. Malta ranks particularly poorly in the areas of starting a business, getting construction permits, and contract enforcement. Measures to minimize start-up barriers and improve the legal environment would create a more welcoming business climate.

26. More generally, these reforms would make the economy less vulnerable to sectoral setbacks and more resilient to a potential harmonization of tax rates at the EU level. With Malta’s growth model increasingly dependent on financial and niche services, measures to broaden competitiveness would help diversify the economy. This is particularly important at a time when many of Malta’s trading partners are undergoing internal devaluation, fiscal consolidation, and structural reforms to restore their competitiveness.

The Authorities’ Views

27. The authorities broadly agreed with the assessment but emphasized several obstacles to the swift implementation of some of the proposed reforms. They acknowledged that increasing the retirement age beyond what is already planned would help reduce public expenditure and increase contributions. However, they noted that this would not be politically acceptable in the short term, just as the introduction of the mandatory second pension pillar. The government is exploring measures to reform the public pension system by assessing potential enhancements to the first pension pillar, allowing the development of the third pension pillar, and reviewing incentives aimed at encouraging individuals to save with private pension funds. The authorities noted that measures to increase female labor force participation and education attainment are included in the National Reform Program under the Europe 2020 strategy. The government emphasized that COLA has served the country well in terms of social cohesion and industrial peace, and noted that wage growth already reflected productivity growth in some sectors of the economy.

D. Statistical Issues

28. There is room to strengthen data collection and analysis. The recent IMF technical assistance mission on balance of payments (BOP) identified several actions that the CBM and National Statistics Office (NSO) should implement to achieve the latest internationally accepted methodological standards and good practices. The current data collection system is based on a direct reporting system covering the largest companies, which raises concern in terms of coverage and timeliness, particularly in the context of the rapid growth of new activities facilitated by tax incentives.

29. Large revisions to the first released estimates in certain areas, in particular services, point to the need of a re-examination of the data collection strategy. It would be important to build up more robust sampling frames to conduct benchmark and/or regular BOP surveys. The enrichment of the BOP register would constitute a first step. The inclusion of special purpose entities (SPEs) in the external sector accounts would be one of the milestones for which the country has committed as part of BPM6 adoption in 2014 by Euro area members. The release of new estimates should be preceded by a thorough analysis of their impact on the external sector accounts and other macroeconomic indicators, including GDP. There is a need to reinforce the scarce human resources, in particular at the NSO, to facilitate the implementation of these measures.

30. Although the current provision of statistics is sufficient for surveillance, further efforts in specific areas are needed. For instance, it would be advisable to compile series for household disposable income and household savings.

Staff Appraisal

31. Malta has shown remarkable resilience in the face of a major crisis in Europe. Since the beginning of the crisis, the average real GDP growth in Malta has been one of the best among all EU members and the unemployment rate remains one of the lowest. This resilience was underpinned by robust service export growth and a sound banking system. As a result, the current account balance has improved gradually in recent years, turning into surplus in 2012. Although, economic growth slowed in 2012 reflecting weak external conditions and subdued domestic demand, staff projects a moderate acceleration in 2013-15, which means that Malta would continue to outperform the euro area average. The pick-up in activity is predicated on the recovery of private consumption and improved confidence. While this would lead to some increase in imports, the current account balance is projected to remain slightly positive.

32. Recent events in Europe have heightened perceptions about the risks of hosting a large banking sector in a small country, posing difficult policy challenges for the authorities. These risks are contained in Malta because the large international banking segment has limited balance sheet exposures to the domestic economy. Nonetheless, the authorities should re-double their efforts to monitor closely developments in all banks, including links between foreign parent banks and their Maltese entities, and take concrete measures to strengthen the resilience and bolster the reputation of Malta’s financial system. Specifically, loan loss provisions should be increased; the crisis preparedness and management frameworks should be enhanced, notably by boosting the resources of the deposit insurance fund; and, in light of the rapid growth in financial sector and online gaming activities, the implementation of the anti-money laundering framework should be further strengthened. In this regard, staff welcomes the establishment of the Joint Financial Stability Board to monitor system-wide risk and conduct macro-prudential policy, and urges the authorities to undergo a prompt and in-depth examination of the financial sector under the IMF’s Financial Sector Assessment Program, including an AML/CFT assessment.

33. The authorities’ intention to establish a development bank has merits, but requires careful evaluation. The authorities should ensure that the conditions required for the successful operation of a development bank are in place, including clear mandate and identification of the market failure that the development bank is expected to mitigate, robust governance structure to ensure financial sustainability, and the use of best practices of the private sector. In addition, the operation of the development bank should not cause significant market distortion or compete with the private sector.

34. The immediate challenge for fiscal policy is to reverse the deterioration in the fiscal balance and to strengthen the fiscal governance framework. The fiscal position deteriorated in 2012 amid the election cycle and the level of public debt is uncomfortably high, constraining the fiscal space in the event of further shocks. Furthermore, discretionary measures announced for 2013 are expansionary and tax revenue projections appear optimistic. In the absence of additional credible measures, staff projects the deficit to widen further to 3.5 percent of GDP in 2013. Efforts should focus on containing the fast growth of current spending and reducing the reliance on one-off and temporary measures, while preserving capital spending. Further fiscal consolidation will be required in the medium-term to meet a structural balanced budget and ensure sustainable debt dynamics, thus reducing fiscal risks to manageable levels.

35. Much more needs to be done to reduce contingent liabilities and address Malta’s long-term fiscal challenges. Pension and health care reforms are crucial to improve the adequacy and sustainability of the schemes. In particular, the retirement age should be aligned with life expectancy, and second and third pension pillars should be introduced. The latter, which would require an appropriate legal framework, would support the development of the local capital market. Staff supports the government’s plans to restructure Enemalta, reduce energy costs, and diversify energy sources. However, there are significant potential fiscal risks from these initiatives that require close monitoring.

36. With Malta’s growth model increasingly dependent on financial and niche services, the medium-term challenge to broaden competitiveness, diversify the economy, and boost long-term growth appear increasingly daunting. Maintaining macroeconomic stability and a sound financial system are necessary but not sufficient for long-term growth. Going forward, policy efforts are needed to strengthen female labor force participation and educational attainment, ensure better alignment of wages and productivity at the enterprise level, promote foreign investment and R&D, and improve the business climate and the judicial system. These reforms would also make the economy less vulnerable to sectoral setbacks and more resilient to a potential harmonization of tax rates at the EU level.

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

Malta: Risk Assessment Matrix2

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Figure 1.
Figure 1.

Malta: Economic Indicators

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Central Bank of Malta; Eurostat; IMF World Economic Outlook; and IMF staff calculations.
Figure 2.
Figure 2.

Malta: Short-Term Indicators, 2006–2013

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

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

Malta: Labor Market Indicators, 2000–2013

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Eurostat; National Statistics Office; European Central Bank; World Economic Outlook; and IMF staff calculations.1/Data for Euro Area is based on countries for which data was available.
Figure 4.
Figure 4.

Malta: Inflation, 2007–2013

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Eurostat; Central Bank of Malta; Haver; and IMF staff calculations.
Figure 5.
Figure 5.

Malta: Fiscal Developments

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Eurostat, IMF World Economic Outlook; and IMF staff calculations.
Figure 6.
Figure 6.

Malta: Financial Soundness Indicators

Citation: IMF Staff Country Reports 2013, 203; 10.5089/9781475553093.002.A001

Sources: Central Bank of Malta; and Malta Financial Services Authority.
Table 1.

Malta: Selected Economic Indicators, 2009–2015

(Year on year percent change, unless otherwise indicated)

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

Malta: Fiscal Developments and Projections, 2007–2015

(Percent of GDP, unless otherwise indicated)

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Sources: Maltese authorities; and IMF staff projections.
Table 3.

Malta: Balance of Payments, 2007–2015

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Sources: National Statistics Office of Malta; and IMF staff projections.
Table 4.

Malta: General Government Financial Balance Sheet

(Millions of euros)

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Sources: Eurostat; National Statistics Office of Malta; and IMF staff calculations.
Table 5.

Malta: International Investment Position, 2005–2011

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Source: Central Bank of Malta
Table 6.

Malta: Financial Soundness Indicators, 2009–2012

(Percent, unless otherwise indicated)

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Source: Central Bank of Malta