Malta-2008 Article IV Consultation Concluding Statement of the Mission
June 5, 2008
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
This document contains the preliminary conclusions of the IMF mission that visited Malta during May 20-May 30, 2008. The mission team would like to thank the authorities, as well as other participants in the meetings, for their excellent cooperation and generous hospitality. The discussion of the staff report for the Article IV consultation with Malta is expected to be held by the Executive Board of the IMF in August 2008.
1. The Maltese authorities must be commended for the successful adoption of the euro on January 1, 2008: a crucial landmark in their growth-oriented reform agenda. This agenda appropriately aims at leveraging Malta's strengths and income-generating potential through closer integration in the European and global economies. As cost-competitiveness in some traditional exports wanes, market liberalization and EU membership will facilitate upward shifts in the value-added and quality export ladder. This is a promising but demanding strategy that will require perseverant improvements in the flexibility, efficiency, and competitiveness of the economy. Much progress has already been made in this direction. Following sustained fiscal consolidation since 2003, the budget deficit was further reduced in 2007 to 1.8 percent of GDP and public debt fell to 62½ percent of GDP (from 72½ percent in 2004) helped by divestments. Also, direct public sector involvement in economic activities has been scaled down in the key areas of telecommunications, postal services, and airport and port services-though there remains a large unfinished agenda.
2. Largely as a consequence of these liberalizing reforms, Malta has experienced a three-year-long expansion underpinned by foreign direct investment (FDI) and export diversification. In the context of buoyant EU activity, growth accelerated to 3.8 percent in 2007 while the external current account deficit declined to 5½ percent of GDP. This reflected new export-oriented activities such as pharmaceuticals, on-line gaming, and financial and business services. Moreover, the arrival of low-cost airlines and price moderation triggered a revival of tourism. The resulting job creation and income gains supported domestic demand with beneficial ripple effects on domestically oriented businesses. Labor costs, however, rose ahead of productivity in 2007-hence contributing to inflation. This, coupled with euro appreciation, caused competitiveness losses in unit labor costs relative to trading partners.
3. In our central scenario, growth will decelerate to 2-2½ percent in 2008-09, reflecting unfavorable external developments. High international prices of oil, commodities, and food will keep inflation relatively high through most of 2008, although it will ease in 2009. Rising prices and already visible tighter credit conditions will curb domestic demand growth. Investment, however, is expected to support activity as ongoing and planned FDI projects should not be greatly affected. On the external side, the growth contribution of net exports is forecast to moderate owing to weak trading partners' demand and declining traditional exports. This, coupled with high import prices, will worsen the current account. Over the medium term, however, we expect the pace of activity to recover swiftly toward trend, sustained by FDI, emerging export activities, and terms-of-trade gains.
4. The primary risk to this scenario is the onset of complacency over reforms against the backdrop of an increasingly competitive global environment. The above projection hinges on continued redeployment of resources toward high-growth export activities, driven by FDI inflows and positive investors' sentiment. This underscores the importance of maintaining a stable macroeconomic environment, rolling back an overextended public sector, and rationalizing public spending in favor of growth-enhancing investment and education. Progress to date notwithstanding, the challenges ahead in these areas remain substantial: it is essential that EMU entry not give rise to complacency and a loss in reform momentum. Otherwise, Malta would risk falling back into a protracted period of economic stagnation as it has occurred in some euro area countries.
A. Cementing Fiscal Consolidation
5. Expenditure-based budget retrenchment continued in 2007, but the public finances remain fragile. Tight current spending control allowed tax cuts and achieved the first recorded current surplus in recent years. That is, current expenditure was covered by current revenue and thus borrowing could be fully allocated to investment-an important landmark from the standpoint of growth and fiscal sustainability. That said, however, excluding one-off measures (e.g., land sales), the underlying deficit remained little changed from 2006. Also, despite debt reduction, public enterprise-related guaranteed debt and other contingent liabilities remain high.
6. Making progress toward the authorities' objective of structural budget balance for 2010-or indeed forestalling a setback-requires determined action. The start of a new legislature argues for front-loaded initiatives. In our view, further sustainable reductions in the fiscal deficit require tackling three key areas of endemic budgetary strain:
· Subsidies (about twice the EU average) and state aid (four times the EU average). The authorities' decision to phase out subsidies on bread and review other subsidies is reassuring. Benefits from further savings in this area should be considered in conjunction with the reform of the public enterprise sector, including the restructuring or privatization of the loss-making Enemalta, Air Malta, shipyards, and other public enterprises. Public sector rationalization would enhance Malta's competitiveness directly by removing a major source of economic inefficiency, and indirectly by freeing budgetary resources to build up much needed infrastructure, the education system, and capacity in essential public service agencies.
· Public wage bill (13 percent of GDP). After declining in 2005-06, public employment edged up in 2007, partly reflecting new hiring in the health sector, while public wage increases are projected to be relatively high in 2008-10. International experience indicates that public employment reduction through "attrition" needs to be complemented by a more pro-active reallocation of employees and appropriate incentives to increase performance and efficiency.
· Aging-related and other social spending (over 13 percent of GDP). Spending on social benefits has been on the rise, notwithstanding positive results in curbing benefits fraud. To a significant extent, this spending is driven by demographic factors. In addition, savings from the recent pension reform will not be felt until some years from now. Thus, market-based measures to rationalize demand and increase the efficiency of supply of public services, particularly in health care, may need to be considered if administrative cost control measures prove ineffective.
While agreeing with the authorities' structural balanced-budget target for 2010, we recommend targeting a surplus in subsequent years. This would provide a valuable line of defense for the stability of Malta's small open economy, highly vulnerable to external shocks.
7. We support the authorities' intention to consider additional measures to meet 2008 budget targets. Given the outturn through April and oil prices, the budget allocations for subsidies, wages, and social benefits would be substantially overrun if prevailing policy parameters were maintained. It is encouraging that the authorities have started to identify expenditure cuts. In this connection, a revision of subsidized administered prices of electricity to drastically increase cost recovery is urgent. Also, tight spending control and efforts to identify potential savings should be intensified in all expenditure categories. Meeting budget plans in the first year of EMU membership will enhance Malta's credibility and investors' confidence.
8. Reinforcing the fiscal framework would help preserve the benefits of fiscal consolidation and reorient spending toward priority areas. The authorities are already introducing measures to improve investment project evaluation and the efficiency of hospitals. Additional initiatives in this direction are worth considering: initiating comprehensive spending reviews in the main ministries would help improve the quality of current public spending and possibly free resources. Education would be a particularly useful pilot, given the sector's key role in fostering competitiveness. Finally, prior parliamentary agreement on aggregate expenditure limits before starting the budget process could induce a better selection of relative budget priorities, while safeguarding the budget constraint.
B. Strengthening the Growing Financial System
9. Malta's banking system is well-placed to weather the current global turmoil. Banks have healthy liquidity positions and a good funding profile rooted in domestic retail deposits. Also, they appear to have no direct exposure to U.S. subprime mortgage-based assets. Some profitability indicators softened recently, partly as banks' international securities portfolios were marked down and euro conversion eliminated a source of foreign exchange revenue. These effects, however, seem temporary. The supervisory framework has been substantially modernized in connection with EU membership. Internationally controlled banks are subject to uniform regulatory requirements. Some are now expanding both their domestic and international operations, reflecting niche opportunities in the financial sector as the economy diversifies.
10. Given Malta's narrow economic base, concentration of exposures deserves careful vigilance-particularly as regards the slowing housing and construction sectors. Despite substantial reduction in recent years, the level of nonperforming loans in domestically controlled banks is still high, at 7.6 percent of total loans at end-2007. The provision coverage ratio (before counting collateral) for domestic banks-below 30 percent at end-2007-is low by international standards and unevenly distributed. The MFSA could usefully discuss with banks means to increase this coverage. While there is no indication of significant overvaluation of overall housing prices relative to fundamentals, there is some evidence of oversupply in certain market segments. Banks are particularly exposed to the housing market through mortgages and corporate lending (57 percent of resident loans). Thus, appropriately, they are reducing their exposure to the construction sector, where nonperforming loans have lately edged up. In particular, banks are increasingly cautious in extending mortgages with high loan-to-value ratios. Upgrading of risk management systems in nonsystemically important banks should be encouraged.
11. Steps toward international best practices will be key to the resiliency of the increasingly global Maltese banking system. Malta is making good progress in introducing the new Basel II international regulatory standard-which, inter alia, relies heavily on market discipline and transparency. In this context, more frequent (quarterly) public issuance of accounts by the main domestic banks should be encouraged. Relatedly, uniformity at the highest standards in the definition of nonperforming loans that are publicly reported would increase transparency. Unlike Malta, most major European jurisdictions allow the tax deductibility of specific provisions. Adoption of this practice would remove disincentives to provision and level the playing field for Malta-based banks.
12. As a member of the EU, Malta is actively strengthening its national and cross-border crisis management framework in the light of lessons from the recent international financial turmoil. Following international best practices, the Domestic Standing Group was established last year within the tripartite Framework for Financial Crisis Management, and began meeting periodically. Memoranda of understanding have been established both among the key domestic agencies and with supervisors in other jurisdictions of systemic importance to Malta's financial system. Malta is also participating in various EC and ECB fora that examine national and cross-border issues, as well as conducting simulation exercises and stress tests. Recent international experience regarding preparedness for crisis resolution should be seen as an opportunity to review the existing legal and institutional frameworks to ensure that all potentially necessary means are in place. These may include the legal authority to act expeditiously and a "fast track" parliamentary approval for systemic solvency support. Cross-border issues involving the rising presence of international banks are assuming increasing importance, although developments to date do not indicate any concerns.
C. Fostering the Efficient Use of Resources
13. Improving product market competition and labor market flexibility is essential to realize Malta's growth potential. The authorities have made remarkable gains in strengthening the business environment and improving education outcomes. Ensuring the necessary flow of qualified human capital will require further improvements in educational attainment as well as removing barriers to labor market participation. In this regard, female participation is particularly low in Malta relative to comparable countries-where it has proven to be a major driver of GDP per capita growth. The authorities' current attention to this issue is warranted and should lead to appropriate labor market and benefit system reforms. The across-the-board mandatory inflation adjustment of wages (COLA) decided by government is highly unusual among advanced economies. We advise considering its eventual removal as it hinders productivity-based wage increases and contributes to entrench inflation. In this vein, institutional independence of the competition authority (now part of the Ministry of Finance) and its adoption of a more pro-active stance would enhance market efficiency and help contain inflation-while benefiting all consumers. In addition, determined implementation of the EU services directive will offer an opportunity to increase competition in the services sector. Public and private sector decision-making would benefit from accelerated upgrading of economic statistics to Eurostat and international standards. Prompt filling of management vacancies at the NSO and allocating appropriate resources should be a priority.
14. Imparting renewed momentum to public enterprise reform is crucial. Privatization or outsourcing in the public services and enterprise sector continued in 2007 and unbundling of Enemalta's gas and petroleum divisions is currently underway. However, large subsidies remain as restructuring of the loss-making shipyards has stalled, and the periodic price adjustments for electricity and water provision result in losses at public utility companies. We advise replacing the current administered price system by a rules-based adjustment mechanism that avoids the need for discretionary government decisions, which are often protracted and unnecessarily controversial. Also, we urge the authorities to consider full privatization of Bank of Valletta to a suitable strategic investor. Experience shows that such action would crowd-in FDI and produce positive spillovers within the financial system.