On behalf of the Maltese authorities, we thank staff for the well-written and informative report, which is a testament to the fruitful and close cooperation with the authorities.
Since the beginning of the year, Malta has been a member of the Euro Area, a landmark achievement in the authorities’ strategy of fostering an open economy fully integrated into the global economy.
Malta has enjoyed a three-year long economic expansion underpinned by strong foreign direct investment, rising productivity, export diversification, and value-added upgrade, all largely induced by structural reforms. Fiscal adjustment, privatization, and public sector streamlining have also contributed to the positive performance.
Growth accelerated to 3.8 percent in 2007 and unemployment reached record lows. Inflation was limited to 0.7 percent, but it is expected to accelerate to 4.1 percent in 2008, before easing to 2.7 percent in 2009, as food and oil prices stabilize. The trade deficit in goods and services declined to 1.9 percent of GDP in 2007, from 5.3 percent in 2005, as a result of a revival of tourism and exports of higher value-added products and services.
Substantial improvements in cost and noncost competitiveness have been key in this regard. The former reflects productivity gains and wage moderation while the latter results from FDI-driven export diversification, especially into new services, as well as terms-of-trade gains, originating from upward shifts in export quality and value-added.
Malta's history of stable institutional and business environment has attracted large FDI inflows, which have so far amply overfinanced the current account deficit; this pattern is expected to continue in the near future. Staff's external sustainability analysis points to a robust external balance sheet. However given the economy's small size and openness and its reliance on positive investor sentiment, there is a continuing need for prudent fiscal and financial policies.
The positive trends in Malta's competitiveness are partly captured by CGER-type estimates: for example, the macroeconomic balance approach indicates a competitiveness gap of around 3 percent, versus 10-15 percent last year.
Staff expect growth to decelerate to around 2.5 percent in 2008 and 2.3 percent in 2009 as a result of a weakening external environment that is testing the resiliency of the economy. The authorities envisage a shallower slowdown on account of better export performance. There is however agreement that, over the medium term, activity will recover rapidly toward trend, sustained by FDI, emerging exports activities, and terms-of-trade gains.
The authorities recognize that the early period of the new legislation provides the opportunity to advance fiscal, financial, and structural reforms, and are determined to make progress in this regard.
The authorities are aware that market liberalization and EU membership have to be supported by a low tax burden and robust fiscal savings in order to allow for public investment in education and infrastructure that would boost productivity.
Progress in fiscal consolidation over the last few years has resulted in a reduction of the overall budget deficit from 4.6 percent in 2004 to 1.8 percent in 2007, prompting the termination of the Maastricht Treaty's excessive deficit procedure. In the same period, public debt as a percentage of GDP fell from 72.4 to 62.4 percent.
For 2008, the authorities are targeting, in their stability program, a budget deficit of 1.2 percent of GDP; they are also pursuing a medium-term objective (MTO) of a balanced structural budget by 2010 in order to ensure domestic stability and reduce vulnerability to external shocks.
However, because of anticipated overruns for the 2008 budget, partly arising from higher than projected oil prices, the authorities are identifying and implementing offsetting cuts in discretionary spending and have already raised electricity prices to close the gap with costs.
In staff's view, the 2008 budget deficit will stand at 1.7 percent of GDP, as the planned measures limit the overall underperformance to 0.5 percent of GDP. This notwithstanding, the structural balance should mark a substantial step toward the MTO, improving from -2.6 percent of GDP in 2007 to -1.9 percent.
To safeguard the budget and prevent distortions, the authorities are increasing the pass-through of fuel prices while exploring means to shield vulnerable groups. They also intend to introduce a water and electricity tariff reform by the fall, aiming to protect low-income households and progress toward cost recovery.
To ease pressures on public finances, the authorities’ medium-term strategy is anchored in further expenditure reforms aimed at containing spending in three main areas: subsidies and state aid, the public wage bill, and the entitlement programs. They are also reinforcing the fiscal framework by pursuing more structured multi-year fiscal planning and by introducing methods of performance budgeting. Staff has recommended extending spending reviews to all major areas and parliamentary agreement on aggregate expenditure limits before starting budget appropriation discussions. In order to optimize the access to EU funding, evaluation procedures for investment projects are being improved.
The resiliency of the financial sector has been tested by the recent international developments, whose impact has so far been small.
According to the authorities and private sector analysts, a strong liquidity position and a good funding profile, which relies mainly on resident deposits, place the banking system in a good position to weather the global turmoil. Banks are profitable and have negligible exposure to subprime-related assets. Some banks’ financial results were affected by markdowns in security portfolios, while equity valuations saw substantial declines in 2008.
Banks are using opportunities for asset diversification created by EMU entry. More generally, the internationally oriented financial sector (now fully under uniform regulation) is expanding rapidly.
Close supervisory vigilance is needed in light of the banks’ large and growing exposure to the housing market. This remains broadly stable overall, although tightening credit conditions have resulted in real price declines in some market segments. Staff and the authorities concur that there is probably little, if any, house overvaluation relative to fundamentals.
Staff highlight that domestic asset quality remains weak due to relatively high, and thinly provisioned, non-performing loans (NPLs). The authorities partly shared staff concerns over the low and declining provision-coverage ratio, while noting that unprovisioned loans are fully backed by high-quality collateral.
The authorities are making good progress in introducing Basel II and other EU prudential standards, and, in light of lessons from the financial turmoil, are actively participating in EU-wide efforts to strengthen the national and cross-border framework for crisis prevention and resolution.
Memoranda of Understanding have been signed among key agencies and with relevant foreign jurisdictions, and, based on recent international experience, deposit insurance coverage is set to be strengthened.
The authorities are aware that Malta's competitiveness and economic prosperity hinge on a stable macroeconomic framework and are determined to proceed with reforms in the product and labor markets to improve economic efficiency and facilitate the reorientation toward high-growth export activities.
This is important in light of the potential further declines that the traditional manufacturing sector may experience, despite subdued unit labor cost growth, as a result of a weakening external environment and competition from low-cost economies. The authorities, however, see this decline as having largely run its course.
While remarkable progress has been made in strengthening the business environment and improving education outcomes, additional policies would contribute to enhance still low productivity and increase competitiveness. The authorities are seeking additional improvements in educational attainment and labor market participation, particularly among females.
The authorities acknowledge staff's remarks on the existing across-the-board mandatory inflation adjustment of wages (COLA), but point out that its impact is limited and facilitate consensus in wage negotiations.
As for the public enterprise sector, despite significant divestment in several areas over the last few years, it remains large and its administered price-setting mechanisms are a source of market distortions as well as take a toll on the public budget. To mitigate such distortions and, more generally, to further scale down the role of such a sector, the authorities are reinvigorating the liberalization agenda and the reform of public enterprises. They have announced their intention to restructure and privatize, shortly, the loss-making shipyards.
The authorities consider premature staff's recommendation to grant institutional independence to the competition authority (currently part of the Ministry of Finance), but agree that a proactive stance is crucial in fostering price flexibility and efficient markets. They view implementation of the EU services directive as an opportunity in this regard.