Malta—2009 Article IV Consultation, Concluding Statement of the Mission
June 22, 2009
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.
1. Malta’s economy is facing its first test following successful EU entry and euro adoption. It experienced a sustained expansion starting in the middle of the decade, driven by export diversification and value-added upgrading. The prospect of euro area membership provided a useful anchor for reforms until 2007, and the common currency has helped Malta navigate troubled waters since then. Banks weathered the initial stage of the crisis relatively unscathed. Yet, the unfavorable external environment is now challenging the economy’s resilience, threatening to unravel past efforts at fiscal consolidation, and possibly holding back the reform impetus, even as the convergence process remains incomplete. For Malta to fully grasp its growth opportunity going forward and close the income gap with the euro area, the country needs to build consensus around a renewed reform strategy.
Outlook, Risks and Policy Priorities
2. Activity is rapidly decelerating. The mission projects a growth contraction of around 2 percent in 2009, followed by a modest recovery in 2010. The global recession will continue to exert a drag on foreign demand for Malta’s manufacturing goods and on tourism prospects. Meanwhile, private consumption, resilient so far, is expected to weaken as employment prospects deteriorate. Nevertheless, activity in services is continuing to hold and should, to some extent, cushion the negative headwinds from the global downturn—a testimony to the significant diversification Malta’s economy underwent in the last few years.
3. There are risks to the recovery in 2010. First, it is conditional on an improvement in trade partners’ growth, which could fail to materialize. Risks also stem from potentially tighter credit conditions. Finally, the revival in activity could be at threat if the strategy of export diversification were to falter for lack of foreign investor appetite; the external current account deficit could then deteriorate from its already elevated level.
4. In this context, while responding to the crisis has become the top priority, the structural reform agenda will need to regain preeminence. Key elements include: resuming fiscal consolidation once the recovery is established to build buffers against future external shocks and as the population ages; further strengthening the financial supervisory framework to keep up with the rapidly expanding sector; and completing the labor and product market reforms while continuing to reduce the public sector’s involvement in the economy, so as to further the move towards higher value-added activities.
Preserving Fiscal Sustainability in a Recession
5. Fiscal developments are being affected by the cyclical deterioration in the economy. The mission projects that, notwithstanding the disappearance of substantial spending one-offs related to the liquidation of the shipyards, the general government deficit in percent of GDP would only marginally improve from the 2008 outcome. This mostly reflects the working of automatic stabilizers. The government is also tackling utility subsidies and implementing stimulus measures of about ¾ percent of GDP in 2009, in the form of infrastructure projects and subsidies to enterprises.
6. The thrust of the fiscal policy for 2009 is appropriate given the current economic conditions. The economic downturn called for a fiscal response to support activity. The focus on infrastructure projects in the stimulus package is particularly relevant given their potentially higher multiplier and positive impact on potential growth. In addition, leveraging EU resources will prevent further deficit widening. However, to speed up implementation, the authorities should act swiftly to remove the bottlenecks that have so far held back EU fund absorption, possibly through a high-level inter-ministerial committee.
7. Measures taken to support enterprises raise some concerns, however. Assistance is provided based on specific criteria related to investment and training plans. While this setting has allowed for rapid and targeted support, such measures could become entrenched and costly if the crisis continues. In addition, in some cases, they may only postpone required restructuring. Therefore, the mission recommends gradually winding down this type of support as the implementation of infrastructure projects gather pace. More recently, the authorities announced that they would tolerate late tax payments from companies with cash flow difficulties; they also invited hotels and banks to work on debt restructuring. Even if not widespread, these steps risk undermining tax compliance and contract enforcement. For these taxes in arrears, expeditious negotiation of a repayment schedule will be critical.
8. The authorities should be mindful not to withdraw the stimulus too quickly in 2010, but consolidation should resume forcefully once the recovery is established. The sustainability of the current fiscal loosening hinges on a well-articulated medium-term consolidation strategy. In its absence, public debt and financing costs risk escalating. The government is committed to consolidation and has started taking significant steps with respect to the shipyards and the utility subsidies, two areas of traditionally large public outlays. However, these measures alone would fail to achieve the necessary consolidation: the mission estimates that the headline deficit would fall below the 3 percent mark only in 2013, with public debt reaching 70 percent of GDP. To secure a quick reversal in the public debt trend, the mission recommends a structural consolidation effort of at least 2/3 percentage point of GDP per year over 2011–2014—double the current scenario—backed by clearly identified measures.
9. Determined action on the expenditure side is required. The rigid spending structure—wages, transfers and interest payments account for more than two thirds of spending—hinders adjustment to shocks and crowds out capital outlays. Health care and education also stand out as areas needing rationalization, especially as the population ages. The authorities have so far relied on attrition to reduce public employment; a more proactive approach is called for, based on a general review of public services needs to identify areas for consolidation. Similarly, consideration should be given to market-based measures. These would provide the proper incentives to rein in demand for public services and increase the efficiency of supply. Meanwhile, social transfers and subsidies stand to be streamlined through broader means-testing of benefits.
10. Reinforcing the fiscal framework will also be essential, in view of the necessary consolidation. The mission would recommend informing fiscal projections with independent forecasts, possibly by expanding the mandate of the National Audit Office. In addition, the authorities need to strengthen their control capacity during the execution of the budget. Finally, a stronger involvement of Parliament, by having medium-term targets committed to in the annual budget act and by strengthening accountability, would also increase the credibility of the government’s consolidation plans.
Maintaining Financial Stability
11. Malta’s financial sector has so far withstood the global financial turmoil relatively well, but vulnerabilities have increased. Banks have been protected by their limited exposure to structured financial products, a traditional retail funding model, and conservative lending policies. Credit has continued flowing, and no government intervention to shore up capital or liquidity has been necessary. However, some institutions suffered valuation losses on their security portfolio, and exposure of foreign-owned subsidiaries to their parent company increased sizably. Profitability will remain under pressure from lower volumes, a narrowing in interest margins and rising nonperforming loans as the economy slows down.
12. A proactive approach toward building buffers is warranted. Concentration risk is significant, and banks are highly exposed to the real estate sector, currently undergoing a downward correction. In this context, banks should be encouraged to set provisions more proactively, including through the introduction of tax deductibility for specific provisions, in line with international practice. Furthermore, as the transmission channels of the global crisis continue to broaden, banks will need to build additional capital buffers well beyond statutory levels—on top of expected requirements from Pillar II implementation. Institutions are aware of it, having successfully tapped the domestic market to raise capital recently; they should be encouraged to continue to take advantage of the current liquidity in Malta’s financial market. The supervisor should also discuss with banks dividend payout policies.
13. The rapid expansion of the financial sector in the recent years comes with risks; these need to be better incorporated in the macro-prudential and supervisory framework. The internationally oriented banking sector currently accounts for about five times Malta’s GDP. While linkages with the domestic economy remain limited, they have been on the rise, as some institutions started participating in the domestic interbank market, issuing securities locally or collecting customer deposits. The Central Bank has accordingly gradually incorporated these institutions in its stability assessment and should continue to do so. It is also starting to upgrade its stress testing capabilities. More broadly, systemic considerations would need to be better taken into account when setting prudential standards. To this end, the project to run a stress testing exercise involving the Central Bank, the supervisor and individual banks is a step in the right direction. Monitoring of large intragroup exposure risks should follow a similar template, in collaboration with home authorities. Alongside these efforts, regulatory scrutiny should be intensified to match the growing sophistication of Malta’s financial sector.
14. The authorities should further enhance their communication strategy and strengthen their crisis management framework. At the height of the global crisis, the government provided assurance that it stood ready to support banks and substantially raised the level of deposit insurance, in line with EU peers. Going forward, regular communication to the public about the health of the financial sector should continue, and the publication of the financial stability report is a welcome development. Similarly, closer monitoring of financial sector issues in the Ministry of Finance is necessary, given the potentially substantial impact on public finances in case of crisis: its stronger involvement in the recently conducted crisis impact assessment was appropriate, and the mission recommends creating a dedicated unit in the Ministry to ensure its continuous engagement. Finally, the authorities should speedily finalize ongoing legislative work on a bank resolution regime and on increasing the funding of the deposit guarantee scheme up to average EU coverage.
Fostering Malta’s Competitiveness for the Post-Crisis
15. Completing the structural reform agenda will be key to buttress competitiveness. In a more competitive post-crisis world, it will take a concerted effort from all stakeholders to preserve cost competitiveness within the currency union and generate the required productivity gains to raise living standards. A social pact negotiated between the government and the social partners could offer a useful vehicle to forge consensus on policies.
16. The causes of persistent inflation have to be rapidly tackled. Inflation currently stands at 4 percent, substantially higher than in the rest of the euro area. While the lagged pass-through of oil prices to domestic energy prices accounts for part of the differential, food price inflation has remained high. The competition authority needs to adopt a more proactive stance, expeditiously addressing any monopolistic behavior in the wholesale and retail markets, while the regulated segments of the markets should be liberalized. Adequate capacities and institutional independence should be granted to the competition authority.
17. Wage developments will also need to play their role in strengthening Malta’s competitive position. As inflation remains high, the mandatory inflation indexation of wages (COLA) risks hampering necessary cost adjustments, especially in manufacturing industries hit by the global downturn, and in low-skilled employment intensive sectors. The mission advises introducing productivity-linked wage increases at the enterprise level instead. Upcoming negotiations on the public sector collective agreement should also set a conservative benchmark for the private sector. Finally, regular updates from the government on the growth outlook would contribute to more accurate expectations ahead of wage negotiations, especially in the current fluid economic environment.
18. The momentum toward reducing the state’s involvement in the economy should be maintained. The authorities are finalizing the privatization of the shipyards’ activities, and unbundling of Enemalta’s gas and petroleum divisions is underway. The introduction of a rule-based mechanism to determine electricity and water tariffs is welcome; the reform needs to proceed to ensure full cost recovery for the state-owned utility enterprises while providing consumers with transparency and predictability in tariff adjustments. The privatization process should continue, including with the search for strategic investors for Bank of Valletta, market conditions permitting.
19. Finally, improving the availability and skills of the workforce will be essential to realize Malta’s growth potential. Ensuring the necessary flow of qualified human capital will require further improvement in educational attainment and higher female labor market participation, particularly low in Malta compared to peer countries. The authorities’ current focus to these issues is warranted and should be part of a broader effort to increase the contribution of human capital to growth.
We would like to thank the authorities and other interlocutors for their excellent cooperation and warm hospitality.