Public Information Notice No. 99/59

Public Information Notice: IMF Concludes Article IV Consultation with Malta

July 13, 1999

On June 18, 1999, the Executive Board concluded the Article IV consultation with Malta¹.

Background

Economic activity slowed in 1997 and 1998 to around 3 percent, the external current account deficit declined to 5 percent of GDP in 1998, and inflation remains in the low single digit range.

Real GDP growth in 1997 and 1998 continued the declining trend of recent years. The contribution to demand from net exports offset weaker growth of real consumption and investment. Export volumes rose by 3 and 5 percent in 1997 and 1998, respectively, with machinery exports performing particularly strongly, while import volumes contracted in 1997 by 4 percent before rising by 2½ percent in 1998. Import behavior mirrored that of domestic demand, which slowed as the growth of household consumption fell to below 1 percent in 1997 and 1998 and as fixed investment contracted by 8 percent in 1997 and by a further 1 percent in 1998 as major investment projects were completed. In the context of moderating economic growth, unemployment edged up to a little over 5 percent in recent months.

Slow import growth—reflecting subdued domestic demand and the decline in international oil prices—alongside an increase in export receipts yielded a marked reduction in the external current account deficit. This fell from 10.7 percent of GDP in 1996 to 6.2 percent in 1997 and to 4.9 percent in 1998. These trends, alongside strengthening of capital inflows in 1998, were reflected in an increase in international reserves to $1.65 billion at end-1998.

Annual average Inflation declined from 4 percent in 1993-1995 to between 2 to 3 percent in 1996-1998. It rose slightly in 1997 due to increased indirect taxes on goods and services, and declined in 1998 to 2.4 percent reflecting muted growth of domestic demand and declining imported energy prices.

The decline in economic growth and the external current account deficit occurred alongside a further deterioration in the fiscal accounts in 1997 and 1998. The fiscal deficit on a cash basis rose to 9.7 percent of GDP in 1997 and rose further to 10.4 percent of GDP in 1998. In part, this trend reflected the impact of declining economic growth on the performance of direct taxes, but the loss of revenue from indirect taxation following the 1997 reforms and increased government subsidies and loans to the state enterprises accounted for the bulk of the deterioration. As a result of these fiscal trends, the ratio of public debt to GDP ratio has risen from 35.7 percent of GDP in 1995 to 55 percent in 1998, taking public and public guaranteed debt to 92 percent of GDP in 1998.

The 1999 budget reintroduced the VAT and targets a reduction in the fiscal deficit of 1.9 percentage points of GDP to 8.5 percent of GDP. This reduction is the first step in the authorities' newly adopted medium-term plan to reduce the fiscal deficit to 4 percent of GDP by 2004, which is equivalent to 3½ percent of GDP on the staff definition of the fiscal balance. The 1999 budget also anticipates a substantial increase in privatization receipts, which has already been achieved following the sale of a major domestic retail bank to a foreign strategic investor.

In 1997-98, external and fiscal imbalances prompted a modest monetary tightening. During 1997-98, the Central Bank of Malta (CBM) raised official short-term interest rates by 50 basis points to 5.5 percent. As international yields declined during 1998, the yield differential with the EU well above 100 basis points and was reflected in increased pressures for capital inflows. The CBM reduced its central intervention rate by 10 basis points in January 1999. Following further reductions in international interest rates in 1999 and continued signs of muted domestic inflationary pressures, the CBM reduced its central intervention rate by a further 40 basis points in April, and reduced its discount rate by 25 basis points in May 1999.

Executive Board Assessment

Executive Directors commended the authorities' recent initiatives to strengthen the policy framework, notably the reintroduction of the value-added tax, the adoption of formal medium-term targets for the fiscal deficit, and action to strengthen the privatization process. Since policies have been supportive, Directors noted that the decline in economic growth during the 1990s reflected supply side constraints and policy uncertainties. They emphasized that the key challenges ahead were to raise economic growth, while maintaining a sustainable external current account balance. This would require early actions to secure adherence to the medium-term fiscal targets, and continued efforts to sustain the momentum of structural reforms. These steps would also support Malta's accession to the European Union.

Directors welcomed the authorities' commitment to correct the deterioration in the fiscal accounts. They were encouraged by the initial steps taken by the authorities in the framework of the 1999 budget to reduce the fiscal deficit through increased revenue from indirect and labor taxes, the reintroduction of the value-added tax, and expenditure restraint.

Directors recommended that the fiscal adjustment efforts focus on the expenditure side, and they noted the considerable scope for improved efficiency in public spending, notably with regard to transfers and subsidies to public enterprises, and in the public wage bill. They also urged early action to ensure that the public enterprises do not overshoot their allocation in the budget.

Directors welcomed the adoption of a formal medium-term fiscal framework. They noted that meeting the medium-term fiscal targets would be a considerable challenge, and stressed that early initiation of technical work to identify appropriate reforms would help to underpin the credibility of the medium-term fiscal consolidation objective. Directors also attached importance to reform of the civil service.

Directors welcomed the steps that had already been taken to strengthen structural policy. They noted in particular that the reinvigoration of the privatization program would help to improve efficiency and reduce government debt, and that the commission on pension reform had also begun its work to improve pension provision. They welcomed the commitment to early rationalization of the trade levies and to further restructuring and privatization.

Directors agreed that Malta's fixed exchange rate system had proved to be an effective inflation anchor and that it remained appropriate for that purpose. They endorsed the authorities' intention to adjust the currency basket to increase the weight of the euro. They observed that the continued effectiveness of the peg will require firm implementation of the anticipated fiscal adjustment. Noting that the scope for capital account liberalization had been constrained by the difficult fiscal situation, Directors considered that the cautious liberalization contained in the 1999 budget was appropriate. In addition, they welcomed the authorities' intention to review closely the implications of the liberalization of capital flows for the supervision of domestic financial institutions.

Directors also welcomed the reductions in official interest rates since the beginning of the year. The decline in international interest rates provided the context for these actions, and the authorities had rightly underscored that official interest rates would be adjusted flexibly as needed.

While noting that the statistical base was adequate for surveillance, Directors reiterated their call for continued efforts to strengthen the database further. Some Directors encouraged the authorities to subscribe to the SDDS.