IMF Executive Board Concludes 2012 Article IV Consultation with MaltaPublic Information Notice (PIN) No. 12/43
May 7, 2012
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2012 Article IV Consultation with Malta is also available.
After a strong recovery in 2010, the economy has continued to perform well amidst considerable turbulence in the euro area, supported by robust consumption and services exports. Output has surpassed its pre-recession level and labor market indicators have improved. The trade balance, which turned into surplus in 2010, improved further in 2011. Recent gains in competitiveness have been underpinned by wage moderation, a narrowing inflation differential vis-à-vis trading partners, and continued diversification into high-value added activities.
Malta has taken effective action to correct its excessive fiscal deficit, shoring up confidence in the country’s public finances. The structural fiscal adjustment was one of the largest among advanced countries. The general government deficit is estimated to have narrowed to 3 percent of GDP and the primary balance turned into surplus for the first time since 2007. Following the announcement of the 2012 budget and additional expenditure measures in January, the deficit is expected to fall further this year. Nonetheless, the composition of adjustment remains suboptimal, relying excessively on one-off and revenue measures.
Despite the recent rating downgrades, sovereign bond spreads have remained contained as government debt is predominantly held domestically. In turn, the sensitivity of the Maltese banking sector to sovereign risk events in Europe is low given very low direct exposures to vulnerable countries, as well as domestic banks’ reliance on a traditional retail deposit-based banking model. Compared to euro area peers, Maltese banks continue to outperform in terms of profits and capital adequacy.
While spillovers from the euro area crisis have remained contained to date, Malta’s large financial sector (above eight times GDP) and highly open economy heighten contagion and financial stability risks. The fragile macroeconomic environment and sustained market volatility are expected to dampen export growth in 2012. Domestic sources of growth may not be sufficient to offset the drop in external demand, given headwinds from a soft real estate market, deteriorating confidence, and ongoing fiscal consolidation. At the same time, uncertainty in economic policy could adversely affect growth if investment decisions and structural reforms are put on hold. With the euro area expected to go into a mild recession in 2012, Malta’s real GDP growth in 2012 will be relatively modest. Risks and uncertainty around this scenario are significant, reflecting the potential from large spillovers from the euro area crisis.
Executive Board Assessment
In concluding the 2012 Article IV consultation with Malta, Executive Directors endorsed the staff’s appraisal, as follows:
The government’s commitment to prudent macroeconomic policies has helped Malta weather the euro area crisis relatively well. But the fragile external environment has created new risks to growth and financial stability. The main policy challenge now is to maintain growth and employment, while building buffers against a highly uncertain international environment. Malta’s resilience to date cannot be taken for granted. Contingency planning needs to move to the forefront of the policy agenda for the event that growth is substantially worse than expected or there is financial contagion from a potential intensification of the euro area crisis. At the same time, the authorities need to balance concerns over a slowing economy, which calls for accommodative policies, against increased risks that require more prudent economic management.
The government’s commitment to return to fiscal balance over the medium-term remains essential. Further fiscal consolidation is required to ensure sustainable debt dynamics, thus reducing fiscal risks to manageable levels. The pace and composition of adjustment should be attuned to the economic cycle. Following a significant fiscal effort in 2011, a gradual deficit reduction path of structural annual adjustment of ½ percentage points of GDP, while letting automatic stabilizers operate in full, would be appropriate. This will help offset the headwinds facing the economy in the short-term, while achieving debt sustainability over the medium-term. The measures underpinning the fiscal effort beyond 2012 need to be specified for the consolidation to be credible.
Bold policy actions are necessary to reduce contingent liabilities and address Malta’s long-run fiscal challenges. Better governance and restructuring of public corporations will help staunch losses and limit subsidies. With a large projected increase in ageing-related expenditures, it is crucial to build broad public consensus for further pension and health care reform aimed at increasing the adequacy and sustainability of the current schemes.
Given the large external risks, it is important to strengthen the financial sector’s resilience further. The financial sector has continued to perform strongly, but its sheer size and large foreign ownership represent a number of risks to financial stability and fiscal sustainability. These include concerns about too-big-to-save and the adequacy of backstopping resources in case of default or deposit run, the capacity to deal with the impact of a banking shock on the economy, as well as supervisory challenges. Improving the framework for financial crisis management and bank resolution and strengthening the deposit compensation scheme could help limit the impact of contagion. Ongoing efforts to strengthen financial buffers and tighten supervision relating to asset quality are welcome. Commendable progress has also been made to better align the regulatory and supervisory frameworks with international standards.
Financial stability will further benefit from establishing a formal framework for macro-prudential policy. Such a framework should define the tasks, powers, and instruments of the macro-prudential authority; establish clear lines of accountability; and ensure operational independence from political bodies and from the financial industry. It is crucial to improve systemic risk monitoring, particularly of spillover risks posed by international banks, and design contingency plans accordingly.
Longer-term policy challenges remain pressing. Challenges related to population ageing, labor force participation, education, and energy policy underscore the need to broaden the reforms so far, raise productivity growth, and further improve competitiveness. Reforms to secure these objectives include further diversifying the economy into high value-added activities, reducing the economy’s dependence on energy imports, and strengthening female labor force participation and education attainment. These steps should be supported by a cautious settlement of wage negotiations to ensure better alignment of wage and productivity developments.