Public Information Notice No. 05/148

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Malta

October 24, 2005

On October 14, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malta.¹

Background

Notwithstanding Malta joining the European Union on May 1, 2004, growth languished in 2004 for a fourth consecutive year. Slow growth reflected the weakness of, and increasing competition in, Malta's export markets, as well as domestic factors. The slowdown had begun with shocks to the key sectors, and was reinforced by slow growth in Malta's trading partners and by recent oil price rises. Despite real effective exchange rate depreciation since 2002, exports suffered from increasing competition from Asia and emerging tourist destinations. Still, domestic factors have also played a role. Manufacturing sector restructuring resulted in declining sales in those sectors coming under increasing competition. Low employment rates and low human capital have also held back output and hobbled employment growth.

Although growth was weak, the fiscal balance was improved substantially in 2004, and parastatal reform gathered steam. In contrast with recent history, the fiscal outturn was on target in 2004, implying a decline of over 2 percent of GDP in the deficit. Much of the improvement reflected the strength in current revenues. Nontax revenues-namely the Fifth Italian Protocol, and European funds-accounted for the bulk of the increase, but also tax revenues were sustained by a hike of 3 percentage points in the VAT rate that rose to 18 percent and the establishment of an ecotax. On the expenditure side, total expenditure increased in relation to GDP, reflecting higher current spending; capital expenditure remained unchanged but lower than targeted. A fresh groundswell of parastatal reform resulted in tangible results, including a better-than-targeted operating outcome for Malta Shipyards. Nonetheless, public debt continued increasing, rising to over 75 percent of GDP in 2004.

The current account deficit deteriorated sharply to over 10 percent of GDP in 2004, as imports surged-reflecting an influx of consumer goods, strong imports of capital goods, and a mounting energy bill-and exports remained weak. External reserves loses were contained at 3¾ percent of GDP, however, partly due to large positive net errors and omissions, which could reflect unrecorded economic activity, notably in the financial sector.

Inflation spiked as a result of one-off factors in 2004. The long-standing exchange rate peg provided an effective nominal anchor, which was repegged to the euro (with no realignment) when Malta entered ERM2 on May 2, 2005. But prices jumped as tax rates were adjusted. Also, domestic energy prices reflected rises in world oil prices. Wage pressures remained subdued, however, as modest increases in public sector wages were partially offset by the declines in (private) service sector. And so far housing services-rental rates-have not followed the intensification of house price increases.

Given the subdued inflationary pressures and a sizable reserve cushion, the Central Bank of Malta had kept the key policy rate unchanged for more than 1½ years, but in April raised it 25 basis points to 3.25 percent in the face of persistent reserve losses since late 2004; the interest rate premium on the Maltese lira was further enhanced by entry into the ERM2 when the higher interest rates of the pound sterling and dollar dropped out of the relevant comparator. Broad money expanded modestly, while domestic credit increased by about 5 percent in 2004, fueled by real estate lending.

Executive Board Assessment

Executive Directors congratulated the authorities on Malta's successful accession to the European Union and the smooth initial transition to a lira/euro peg in the context of ERM2. Commendable progress has also been achieved in strengthening macroeconomic management, including the substantial reduction of the fiscal deficit in 2004 despite weak economic growth, and in reforming the parastatal sector. Directors observed that Malta is well-positioned to derive the full benefits of euro adoption, provided continued progress is made in consolidating fiscal accounts and reforming the economy to promote private sector-led growth.

Although short-term growth prospects are moderate, Directors stressed that continued consolidation of Malta's public finances remains a key priority in light of the sharp increase in public debt, which-if not addressed-would threaten macroeconomic stability and weaken the credibility of the exchange rate. Achieving the 2005 budget target will be essential, and Directors encouraged the authorities to identify proactively areas where current spending could be contained-a process that would be facilitated by assigning additional staff to the budget office. It will also be important to follow through should revenue projections prove to be overoptimistic.

Directors underscored the importance of high-quality fiscal adjustment to reduce the fiscal deficit further, while protecting capital spending in priority areas. While welcoming the authorities' commitment under the medium-term fiscal program and ongoing efforts to improve tax administration, they stressed that durable adjustment will entail lowering expenditure. This will involve politically difficult but necessary decisions aimed at reducing public sector employment, shifting part of the financial burden of health care to the end user, and reforming the welfare system to enhance its effectiveness as a social safety net. Directors also recommended extending means testing to those welfare benefits that are not currently covered. Progress in these areas will require continued consensus-building efforts, and some Directors also advised the authorities to proceed at a cautious pace in some of the most sensitive areas.

Directors saw the reforms envisaged in the White Paper on the pension system as important steps that would bolster long-run fiscal stability by addressing the fiscal consequences of population aging. In particular, they highlighted the importance of raising the statutory retirement age to secure the pension system's financial integrity. The establishment of a compulsory, privately funded second pillar should complement the pay-as-you-go old-age pension. Directors urged the authorities to begin implementing reforms promptly to ensure that measures can be phased in gradually, and to avoid the need to take more drastic actions when the demographic shock is imminent.

To revitalize economic growth and enhance competitiveness, Directors stressed the need to complement fiscal consolidation with structural reforms aimed at developing human capital and raising labor productivity. While acknowledging recent efforts to align student grants and stipends more closely with the needs of the economy, they saw room for further strengthening incentives for education, including through reforms to increase wage dispersion. Directors also underscored the importance of improving labor utilization and welcomed efforts to eliminate barriers to female participation in the labor market. In this regard, they urged the authorities to continue assessing the impact of the measures included in the National Action Plan for Employment, with a view to focusing efforts on those measures that prove to be effective.

Directors stressed that a business-friendly environment will be key to boosting investment and fostering job creation. They welcomed the authorities' commitment to the ambitious privatization plan, and looked forward to its expeditious implementation. Directors also encouraged further efforts to streamline bureaucracy, eliminate outdated regulations, and, more generally, lower the cost of operating on the island, including by reforming the port system and establishing a one-stop registration for businesses.

Directors welcomed the authorities' decision to increase domestic interest rates in the run-up to ERM2, and noted that markets have so far judged the interest rate premium on the Maltese lira as being appropriate. Going forward, they considered that Malta is well poised to benefit from euro adoption, since its openness to international markets and close trade links with the European Union are likely to increase even further as the introduction of the common currency will lower transaction costs, reduce exchange risk, and expand the range of profitable trading opportunities. Directors nevertheless emphasized that Malta's significant current account deficit underscores the need for the authorities to persevere with fiscal consolidation and step up structural reforms to boost the economy's competitiveness, including through greater attention to labor market flexibility and wage moderation.

Directors noted that Malta's financial system appears to be sound and well supervised. The highly capitalized banking system should be able to absorb economic shocks, as well as the new prudential requirements associated with Basel II standards. Directors cautioned, however, that the increasing bank exposure to the booming housing market calls for close monitoring. They urged the authorities to tighten prudential regulations to discourage banks from extending credit with high loan-to-value ratios. This could involve tying provisioning requirements to that ratio, and requiring that banks consider only the income declared for tax purposes when assessing the repayment ability of the self-employed. Directors also underscored the need to address the problems affecting the housing market, in particular by reforming the legal framework governing the rental market.