Public Information Notice No. 01/78

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Malta

August 3, 2001

On July 30, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Malta.¹

Background

Strong external demand boosted economic activity in 1999 and 2000 in combination with fiscal consolidation and structural reforms underpinned a strengthening of overall economic performance. Real GDP growth in 1999 and 2000 was robust, estimated at 4.0 and 4.7 percent respectively, driven by strong fixed investment and exports, and reflecting, inter alia, the expansion of activities of a large microchip plant. Private consumption also remained strong, on the back of declining savings.

Economic growth has been accompanied by rising employment. Private sector employment rose 3 percent in 2000, rising in most sub-sectors, while nominal and real wage growth declined led by wage restraint in the public sector.

Inflation has remained subdued, as the lira basket strengthened vis-à-vis the weak euro during 2000 and because rising international oil prices were not passed on to domestic consumers. The 12-month retail price inflation declined to 1.1 percent by the end of 2000.

On the external side, despite strong export growth, a number of developments compounded domestic demand pressures on the current account deficit. Real exports of goods and services rose by 8 and 6 percent in 1999 and 2000, respectively, with machinery exports performing particularly strongly. But imports rose even more strongly, buoyed by strong domestic demand and a large investment program in the microelectronics sector. In conjunction with a deceleration in tourist receipts, rising international oil prices, and a large dividend payment, the current account deficit widened to 14.5 percent of GDP.

Monetary policy was unchanged during 2000 as international rates rose, compounding downward pressures on international reserves. Capital outflows, notably from domestic commercial banks, reflected a negative yield differential for most of 2000, alongside stock adjustments following further measures to liberalize capital controls implemented in early 2000. As a result, international reserves declined to US$1.47 billion at end-2000.

The fiscal position improved significantly in 1999 and 2000, reflecting the impact of economic recovery and better tax enforcement. The government deficit, including off-budget items, was 8.6 and 6.9 percent of GDP in 1999 and 2000, respectively, a cumulative improvement of 4 percentage points since 1988. The fiscal consolidation in 1999 and 2000 marked significant progress towards the authorities' medium-term plan to reduce the fiscal deficit to 3-4 percent of GDP by 2004.

Executive Board Assessment

Malta has consolidated its economic performance in the past two years, reflecting strengthened policy and a benign external environment. The long deceleration in economic growth has stopped, employment has risen strongly in 2000 taking unemployment down towards 4 percent, and inflation remains low, anchored by the fixed peg exchange rate regime. These achievements leave Malta well placed to pursue its application to join the European Union.

Strengthened fiscal and structural policies since 1998 have underpinned these achievements. The reduction in the fiscal deficit of 4 percentage points of GDP, even faster than anticipated in the authorities medium-term projections, has boosted domestic savings, thereby supporting fixed investment, the external current account balance and the fixed exchange rate peg. In addition, tax policy has been strengthened, most notably by the successful reintroduction of VAT in 1999 and its subsequent extensions. Alongside other structural initiatives—including a reduction in trade protection and capital account controls, strengthened policies towards public enterprises, privatization, and enhanced financial sector regulation—the authorities have signaled a clear commitment to strengthened medium-term economic performance that has already begun to yield dividends.

Challenges remain, however. Though the sharp deterioration in the external current account balance in 2000 largely reflected temporary factors, the underlying external deficit remains high and will be boosted by the weaker external environment in 2001 and by prospective additional fixed investment in manufacturing and tourism. Thus, the authorities rightly remain intent on further fiscal consolidation in 2001 and over the medium-term to make room for additional fixed investment while containing the external imbalance. But fiscal deficit reduction in the medium-term will likely need to be more ambitious than anticipated if the macroeconomic framework is to remain sustainable.

Such fiscal deficit reduction would best be achieved through expenditure reform rather than through further increases in the tax burden. Thus, the broad thrust of proposed expenditure initiatives—notably on welfare, privatization, subsidies to public enterprises, and the public wage bill—is welcome. But implementation is urgent if the fiscal deficit targets are to be secured alongside securing progress towards reducing the share of tax in GDP. And, with labor shortages emerging in the private sector, efforts to rationalize public sector employment and the associated flow of subsidies to public enterprises should be given added priority. The beneficial impact of such steps could be maximized with increased fiscal transparency, in line with international codes, notably through the incorporation of off-budget flows into the main budget and into a formal restatement of the medium-term fiscal framework.

In the context of largely open capital accounts, monetary policy needs to acquire added flexibility so as to maintain strong international reserve levels even as foreign interest rates rise and fall. Given that competitiveness remains firm but with little room for maneuver, a flexible monetary policy stance will be key to maintaining confidence in the pegged exchange rate regime, achieving this effect in part by encouraging continued appropriate flexibility of nominal and real wage settlements. Proposals under consideration to strengthen the Central Bank of Malta Act would increase confidence that monetary policy will be conducted in this manner. And the effectiveness of such a policy stance will be enhanced by ongoing efforts to strengthen the performance and robustness of the financial sector, notably through privatization and continued strengthening of financial regulation.

The fixed exchange rate regime continues to serve Malta well. The durability of the peg, Malta's openness, the strength of the financial system, and the flexibility of private sector labor markets all indicate that the pegged regime remains appropriate. There may be a case, however, to review the weights of the currency basket.

Malta subscribes to the General Data Dissemination Standard and its statistics are generally of good quality. Surveillance would be enhanced, however, by shortening the lags with which some of the key data are produced.