Malta--2010 Article IV Consultation Concluding Statement of the IMF Mission
November 22, 2010
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.
Malta weathered the global recession relatively well. Output fell less than the euro area average and unemployment rose only modestly, also reflecting government support. At the same time, the fiscal deficit remained relatively contained. Driven by external demand, a cyclical upswing is now underway and growth is projected at around 3 percent this year but lower next year. To achieve strong and sustainable growth over the medium term, policy makers need to adopt a strategic approach that includes growth friendly and ambitious fiscal consolidation and continued progress in establishing high value export activities. It also requires prudent macroeconomic and financial risk management and prevention policies. Here, efforts need to be stepped up to protect financial stability and safeguard against systemic and fiscal risks.
1. Malta is experiencing a cyclical upswing driven by strong external demand, but momentum is expected to fade. Manufacturing and tourism activity, hit hard by the global recession, have recovered with the latter near pre-crisis record levels. However, the recovery is not yet broad based and some sectors are lagging behind. On the back of softer real estate prices and somewhat higher unemployment, consumption growth slowed but is supported by very low interest rates. Investment, especially in construction, decelerated sharply and remains sluggish. Inflation has picked up as the ongoing rebound allows firms to rebuild profit margins and pass on higher energy prices but underlying inflation is expected to remain contained. Over the medium term, economic growth may exceed the euro area average if reform momentum and diversification into high value export activities is sustained.
2. Uncertainty remains high and the risks tilted to the downside. Real estate market weakness could turn out deeper and more protracted than expected as excess supply in segments of the real estate market and some debt overhang need to be worked off. If the fragile economic and financial situation in parts of the euro area worsened, negative spillovers might occur. Moreover, Malta’s attractiveness as a business location and some of its new high-growth export activities (e.g. some business and financial services, pharmaceuticals, etc.) could be adversely affected should EU or member state regulations or taxation change. On the upside, low interest rates and stronger demand for Malta’s exports could sustain growth momentum longer than anticipated.
The policy agenda
3. Strong, balanced and sustainable growth requires a strategic policy approach and prudent risk management. Fiscal consolidation should be growth friendly, supported by increased public sector efficiency and accompanied by the necessary reforms to raise productivity and employment rates. Recent international experience underlines that prudent financial regulation and supervision is indispensable, especially in view of rising vulnerabilities associated with high domestic credit risk and the growing linkages of Malta’s financial sector with the rest of the world in the context of volatile international financial markets.
Ensuring sustainable fiscal consolidation
4. The government’s goal of reducing the fiscal deficit to 1.4 percent by 2013 is welcome. Malta’s high vulnerability as a small and very open economy calls for particularly prudent debt management which should also anticipate the tightening of EU-wide rules on high debt. The increase in public debt, guarantees, and implicit liabilities also related to state-owned enterprises, necessitates ambitious fiscal consolidation. Consolidation should be expenditure based and not impede further progress in attracting high value added export activities. Setting expenditure priorities and containing entitlements are crucial for lasting fiscal consolidation.
5. However, there are significant risks that adjustment may fall short of targets, especially in outer years. The government seems on track to stay within its deficit target for 2010. Past revenue performance was boosted by tax amnesties, relatively strong bank profits, and, more recently, the sharp economic rebound. Economic growth and financial activity may slow more than currently expected by the government and future tax revenue turn out lower than the latest targets. On the expenditure side, the intention to contain government wages and spending on goods and services over the next years is welcome but slippages are likely. A more strategic approach that protects spending priorities, identifies areas to cut, is fully backed up with concrete measures and accounts for contingencies would raise the credibility of adjustment plans. This would limit the chance of last minute cuts, often at the expense of investment, or missing deficit targets.
6. A strengthening of fiscal institutions would safeguard the government’s consolidation plans. Ongoing initiatives to enhance accountability and transparency of the financial and budgetary framework are welcome. Progress on these and additional action should be supported by the recent EU directive on requirements for budgetary frameworks of Member States. The implementation of a legally anchored, strong fiscal rule to better control public expenditure growth should be considered. Further tax amnesties may harm tax collection over the medium term.
7. A bold and comprehensive pension reform is critical to contain future fiscal costs of the system. Under the current system, Malta’s age-related public spending is projected to increase significantly over the long term and by more than the EU average. Much of this reflects higher subsidies for the pay-as-you-go pension system due to an expected sharp rise in old-age dependency ratios. A timely but gradual introduction of an additional mandatory and privately funded pillar would allow the government to reduce further the benefits of the pay-as-you-go system over time. Another option would be to gradually transition from a pay-as-you go to a notionally defined contribution system under the condition it delivered the needed cost saving.
Safeguarding Financial Stability
8. Vulnerabilities are rising in Malta’s financial sector. Conservative funding models and a focus on domestic assets kept spillovers from the global financial crisis to banks in Malta at bay. However, the past real estate boom led private debt to increase significantly. The household debt-to-GDP ratio remains below euro area average but the non-financial corporate sector appears highly leveraged. Banks have tightened lending policies and bank credit growth has decelerated, although it remains relatively strong on the basis of continued household mortgage lending. Capital market activity has picked up markedly reflecting issuance of bank and other corporate bonds, also by large companies active in the commercial real estate market. After an extended period of high growth, real estate prices experienced some correction and appear to have stabilized more recently, but excess supply remains in segments of the market. Experience from other countries in the euro area underscores the importance of treating such potential imbalances proactively.
9. Profitability in the banking sector is coming increasingly under pressure. The sharp price recovery of equity and debt securities boosted profitability in 2009. But provisions and non-performing loans are on an upward trend, with both mortgage-backed household loans and commercial real estate loans being key drivers, weighing on profitability. Also, some banks have benefited from higher capital markets activity in Malta which may slow.
10. The authorities need to step up efforts to protect financial stability and safeguard against systemic and fiscal risks. Growing linkages in financial markets require that the central bank’s financial stability assessment includes all banks operating in Malta. This should be discussed in an appropriately differentiated manner in the central bank’s stability reports which should also include thorough assessments of the real estate and capital markets. For the latter, transparency should be raised as credit rating for domestic corporate bond issuance is absent and often involves retail investors. A strengthening of supervisory and regulatory arrangements to better link macro and micro prudential regulation is warranted, for both the banking sector and capital markets as is also being implemented at the European level. The crisis management framework should also be enhanced.
11. High credit risk and growing exposure to securities in parts of the Maltese banking sector call for heightened vigilance and determined supervisory action. Domestic credit risk is rising on the back of softer real estate prices and other sectors with still sluggish activity. Concentration risk is quite significant and many banks remain highly exposed to the real estate sector where variable mortgage rates prevail. Low coverage ratios and high uncertainty associated with real estate collateral valuation require a more conservative supervisory approach to ensure appropriate provisioning. At the same time, capital buffers need to strengthened, preferably through equity injections and retained earnings. Some banks are highly invested in foreign debt securities making full use of ECB enhanced credit support and low refinancing rates. The authorities should discourage bank business models that are overly reliant on ECB facilities for financing large investment portfolios. Supervisors should employ all available tools, including the issuance of directives, to aggressively reduce leverage in these cases.
Furthering the structural agenda towards a more sustainable growth model
12. The ongoing reallocation of employment and investment towards higher value-added production and services is improving external competitiveness and resilience to shocks. As a small and very open economy, Malta is adjusting to the challenges posed by globalization. Progress is being made in diversifying the economy into higher value-added activities, including aircraft maintenance, pharmaceuticals, financial and accounting services, ICT and more. Flexible and pragmatic polices played a crucial role and need to continue. Further upgrading and promoting synergies between the various economic clusters would reduce the risks stemming from potentially unfavorable changes in the international regulatory and taxation framework.
13. Raising productivity, skills and employment rates simultaneously is a challenge but necessary for catching up with incomes of richer European countries. State divestment has boosted economic efficiency and should be continued. Wages should follow productivity developments. Employment rates, in particular for women, remain low and more flexible arrangements for part-time work and flexible working practices could help. Support for higher education should increase, but a high quality public primary and secondary education system is also critical to reduce skill mismatch and ensure good employment and income opportunities for all.
We would like to thank the authorities and other interlocutors for their excellent cooperation, candid discussions and warm hospitality.