Statement by Andrea Montanino, Executive Director for Malta and Antonio Bassanetti, Senior Advisor

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.

The Authorities of Malta thank staff for the useful discussions during the IMF mission and for a broadly fair and objective Report. The assessment points to the strong fundamentals of the Maltese economy. Some challenges emerge, in particular on the fiscal side, but Authorities reiterate their strong commitment to reduce the deficit-to-GDP ratio within the EU limits already in 2013.

Outlook

The Maltese economy proved to be notably resilient since the onset of the global crisis. Authorities broadly agree with staff’s outlook projections anticipating an acceleration of GDP in the current and coming years, mostly driven by the strengthening of domestic demand. Exports are foreseen to expand and the current account balance should maintain a positive sign. Inflation is expected to moderate. While taking into account the significant degree of uncertainty surrounding macro projections, we consider risks to GDP forecasts to be broadly balanced.

Fiscal Policy

The fiscal slippage recorded in 2012 was partly attributable to a rather prolonged period of political uncertainty culminating in the rejection of the November 2012 budget and the subsequent call for elections. Such uncertainty was a factor behind the weaker domestic demand, with signs that private consumption was postponed. This deterioration was in contrast with fundamentals – particularly wages and employment growth – further suggesting that such developments were likely to be transitory. This also created cash flow constraints on a number of private operators. As a result revenue, especially from indirect taxes, was significantly weaker than expected. Authorities are convinced that now that the democratic process has taken its due course and a new administration is in place, economic activity will recover in line with fundamentals. Together with a number of structural measures this should influence positively the public finance situation in 2013.

In particular, Authorities remain firmly committed to close the current year with a deficit below the 3 percent threshold. To pursue the goal, several initiatives are being implemented, both on the expenditure and, mostly, on the revenue side.

On the expenditure side, a Spending Review Unit has already been set up within the Ministry of Finance to identify cost savings through the elimination of waste and inefficiencies. Further, the 2006 reform of the pension system is estimated to reduce expenditure and increase revenues from social contributions. The stepping up of the efforts to curb fiscal abuse and to increase efficiency in revenue collection will also provide a support. This shall be achieved through the acceleration of the process of consolidating the various functions of Government revenue into one authority. The largest part of the fiscal improvement, however, is estimated to reflect a tax revenue buoyancy supported by the favorable composition of growth projections, the stronger economic recovery and the easing of the above mentioned temporary cash flow constraints.

Still, Authorities take note of the more pessimistic deficit projections of both staff and the European Commission, mainly rooted in less favorable revenue developments. However, on June 1, 2013 the Government launched a new Malta residence programme for non-EU nationals, called Global Residence Programme. This scheme could have a positive impact on the revenue side.

Further, in order to ensure the achievement of the target, Authorities will be monitoring the fiscal situation on a month-by-month basis and be ready to intervene when and as required. They are also in the process of implementing the necessary reforms to the fiscal framework, including the introduction of numerical rules, independent fiscal institutions and a binding medium term budgetary framework. Malta has also just ratified the Fiscal Compact.

Finally, as noted by staff, the ongoing restructuring of Air Malta, the structural reforms in the energy sector and the financial restructuring of Enemalta should minimize the risk of a call on the contingent liabilities emanating from these major state-owned enterprises.

Financial Sector

Authorities concur with staff that the risks stemming from the relatively large Maltese banking sector are contained. Core domestic banks, which are systemically important, operate along traditional lines and have limited exposure to the countries which are under pressure. Non-core domestic banks play a more restricted role. International banks, which account for the largest share of the sector, have virtually no links with the domestic economy and are therefore of low systemic significance. As a whole, the structure of the Maltese banking sector is thus much different than those of stressed member States.

Further, as highlighted by the staff’s report, the sector is sound and robust. Capital adequacy ratio, profitability, and liquidity measures are higher than the EU average. Malta’s household wealth - the third largest in the euro area - contributes to the stability of the retail deposit base. The absence of funding distress is confirmed also by the modest recourse to Eurosystem financing.

Still, Authorities concur with staff that further improvements have to be achieved. In particular, they will continue to call for more prudent dividend policies in order to: i) further increase the banks’ capital base; ii) strengthen the Depositor Compensation Scheme; iii) enhance loan loss provisioning. On the latter issue we note that, while loans are mostly backed by real estate as collateral, the level of collateralization in Malta is very high and a fairly conservative haircut is usually applied. Concentration risk is, to some extent, unavoidable given the small dimension of the country. This notwithstanding, the real estate market proved notably resilient in recent years and currently there are no signs of overvaluation; in addition, as already emphasized, the banks’ liquidity position is very good and should shield them from shortages of liquidity.

Authorities remain highly vigilant to preserve financial stability, as proved by the daily monitoring of the liquidity position of banks that have been put in place since the onset of the crisis in Cyprus. They are determined to maintain high supervisory standards. Further, they aim at strengthening and updating the institutional framework: the establishment of the Joint Financial Stability Board (JSB) early this year is a step forward to a closer coordination among financial and monetary Authorities and responds to the European Systemic Risk Board recommendation regarding the macro-prudential mandate at the national level. So far, during its monthly meetings, the JFSB has devoted particular attention to the NPLs issue to verify the possibility to improve on directives. In this context, a revised Banking Rule (BR/09) will be implemented aiming at a more conservative approach to accounting impairment provisioning. The BR/09 encompasses also the implementation of conservative triggers to identify losses as early as possible; moreover it will require institutions to allocate additional capital buffers to address heightened levels of non-performing loans.

An FSAP will be required in due course. It is relevant to note that currently an asset quality review is being planned in association with the Single Supervisory Mechanism which is being set up by the ECB.

As regards the Anti Money Laundering regime, Authorities argue that most of the right laws and regulations are in place in Malta, as noted by staff. Furthermore, the legal framework for preventing terrorism activities is adequate and in line with international standards; Authorities stress that, however, it has never been used because no suspicious activities of terrorism financing have occurred in the country.

Competitiveness and structural reforms

The search for diversification of economic activities and market niches, especially in the service sector, has been a key factor for the resilience of the Maltese economy. The economic attractiveness of the country cannot be attributed just to a favourable tax regime, though this element clearly plays a role given the very small scale of the economy and its scanty endowment of natural resources. Other factors are crucial: the stability of the country, its strategic geographical location, well developed telecommunication infrastructures, relatively low costs of production, and the use of English as an official language also in legislation.

Still, competitiveness needs to be continually strengthened. To this purpose, a national reform agenda has been adopted. In particular, the new Government has set as top priorities: the increase of the participation rate, especially of the female component; higher educational attainments and improved labour force skills; a more efficient energy production system. The latter, as acknowledged by the staff’s report, implies a broad energy reform that will bring first results already in 2014 in terms of diversified sources, with a much reduced dependency on oil, lower costs and tariffs, enhancement of the energy company’s financial soundness.

Authorities take note of the staff’s suggestion to reform the wage setting mechanisms, in particular its cost-of-living adjustment component. At the same time, they emphasize that, according to a recent in-depth analysis, the current setting does not appear to have resulted in major erosion of competitiveness in Malta and had only a marginal impact on developments in the labour market. Indeed an important factor underpinning these results pertains to the partial indexation feature of the wage setting mechanism as applied in Malta.

As regards pensions, Authorities consider that the gradual increase in retirement age adopted in the 2006 reform remains valid and do not think there is an urgency in further accelerating the process. However they remain vigilant to ensure the long term sustainability of the system. Legislation for a voluntary third pillar of private pensions has already been approved and it will come into force in due time. Further, a Pensions Strategy Group is being set up with the task of reviewing the recommendations outlined by the Pensions Working Group, drawing a holistic strategy aimed at addressing the adequacy and sustainability of pensions.

As concerns health care, Authorities take note of recommendations made by staff and remain firmly committed to continue working on tightening controls on spending. In this context, various internal control mechanisms and the monitoring of operational costs will be introduced. Work is also underway on the setting up of a Health System Performance Assessment Framework that links inputs with outputs and outcomes, to check for the efficient use of resources.

Finally, Authorities are considering the establishment of a Development Bank to meet medium and long-term financing needs, particularly for infrastructural, social and environmental purposes. On this regard, they appreciate the useful suggestions put forward by staff and will take them in due consideration.