OREANDA-NEWS. Malta is growing strongly, helped by policy initiatives. However, high growth cannot be taken for granted. There is now a window of opportunity to push ahead with mutually reinforcing reforms on multiple fronts. Raising medium-term growth will require building fiscal buffers, maintaining a healthy financial sector and sustaining structural reforms.

1. Malta has remained resilient in the face of global shocks. The reliance on domestic funding and the relatively well diversified economy have helped preserve the stability. Boosted by large scale infrastructure investments, low oil prices, a weaker euro, direct income tax cuts, and recent reform efforts, growth accelerated to 5.1 percent in the first half of 2015 and unemployment is at historic lows.

2. The outlook is strong and risks are balanced. Growth is expected to remain solid in 2016-17, driven initially by domestic demand and later by a gradual recovery in external demand. Domestic demand and production are supported by energy related infrastructure projects, increasing female labor force participation and further reduction in income taxes. The ECB’s asset purchase program has supported exports through a weaker euro, lowered borrowing costs for the government, and likely contributed to the recent increase in real estate and equity prices. With low yields, corporate bond financing has also picked up. Inflation is projected to gradually pick up with the positive output gap and the exchange rate pass-through. While, downside risks include slower global growth, delays in implementation of structural reforms, fiscal slippages, and regulatory and tax changes elsewhere, upside risks stem from increased energy efficiency and further increases in labor participation. The future of migration flows, the majority of which coming from other EU countries, remains uncertain.

3. Strong migration inflows boost potential output. Malta has experienced large inflows since the early 2000s. These inflows, the majority of which originate from other EU countries, have offset Malta’s declining working age population and raised potential growth. Refugee inflows have also been significant, but have declined since 2013. The planned agency for refugees should help enhance coordination between institutions to ensure smooth integration of refugees into the labor market and society.

4. The challenge is to preserve high and stable growth. Given uncertainty regarding the global recovery, volatile migration flows, and ongoing efforts to enhance competitiveness by euro area neighbors, raising potential output in a sustainable manner will depend on i) building fiscal buffers to cope with adverse shocks; ii) maintaining financial sector stability and providing financing for growth; and iii) sustaining structural reforms.

Building fiscal buffers

5. The authorities’ proposed pace of fiscal consolidation for 2016-18 is appropriate. The fiscal deficit declined to 2.1 percent of GDP in 2014, and deficit reduction has continued in 2015, despite rapidly growing current expenditures, supported by revenue measures and stronger-than-expected revenues. The authorities aim to reduce the overall deficit to -0.2 percent in 2018, but measures beyond 2016 are not well specified at this stage.

6. Fast growth in current expenditures makes targeted debt reduction challenging, particularly beyond 2016. Current expenditures rose from 38.3 percent of GDP in 2012 to 39.1 percent of GDP in 2014. With the expected moderation of growth towards its long-term trend, the fast growth of sticky current expenditures makes the planned consolidation difficult. To ensure that the proposed fiscal targets are met, additional expenditure measures should be considered. In this context, public sector negotiation of collective agreements should be done within the framework of planned fiscal consolidation and should not result in increases higher than inflation. With the output gap closed, revenues in excess of targets (because of either higher than expected growth or windfalls from quantitative easing) should primarily be used to build fiscal buffers. The spending review on social security helped contain expenditure growth. Similarly, ongoing spending review on health care and planned spending review on education will help contain expenditures. In addition, the ongoing restructuring of state owned enterprises (such as Enemalta and Airmalta) is critical to contain fiscal risks. It is important to disclose, analyze, and manage risks to public finances from SoEs in a consolidated manner.

7. Pension measures introduced in the 2016 budget are steps in the right direction. These include measures addressing both adequacy and sustainability as recommended by the pension strategy group— such as raising minimum pensions, increasing contribution periods, topping up pension rate to incentivize late exits in the private sector. Given that Malta ranks second worst in the euro area in its age related spending increases, further consideration could be given to i) ensuring that contributory years reflect life expectancy in the next assessment; ii) linking pensionable income to life time incomes with a fair valorization to ensure equity across groups; iii) ensuring that incentives lead indeed to an increase in the effective retirement age; and iv) avoiding indexation to wages. The planned equity release program and measures to incentivize participation in the voluntary third pillar will help support disposable income at old age. Ongoing efforts to increase the efficiency of health care spending—such as increasing the administrative efficiency and strengthening the primary care—should help contain age related spending growth and support pension reforms.

8. Ongoing efforts to strengthen fiscal governance and institutions should continue. The fiscal advisory council continues to build its capacity and has produced its first set of reports, increasing fiscal transparency. Continued efforts to strengthen fiscal institutions and the budgetary framework are encouraged to increase efficiency, transparency, and ultimately avoid fiscal slippages. Ongoing efforts to link sectoral budget allocations and any new public spending to medium-term plans and outcomes is welcome and will help track the impact of reforms and their medium-term fiscal implications.

Maintaining financial stability

9. The banking system remains resilient. Banks are well capitalized, profitable, and liquid. Solvency and liquidity of core domestic banks and other peer banks remain above the minimum regulatory requirements, and their profitability is above the euro area average.

10. But nonperforming loans (NPLs) and the cost of credit remain high. The loan to deposit ratio is about 60 percent (core domestic banks) and lending to corporations remains weak. System wide NPLs declined from their peak in 2014, but they are still high, mainly due to legacy NPLs, contributing to high cost of credit.

11. Given the large size of the financial sector and ongoing regulatory and supervisory changes, continued policy actions are needed on multiple fronts:

  • Asset quality reviews (AQRs) and action plans: The implementation of the action plans resulting from the ECB’s comprehensive assessment is ongoing, and additional AQRs are being undertaken using similar principles. Their completion is essential for a level playing field and sound supervision.
  • Resolution framework: The EU Bank Recovery and Resolution Directive (BRRD) was transposed into national law, and the MFSA established a separate resolution unit. The focus is now, appropriately, on developing bank recovery plans and the collection of contributions for the resolution fund.
  • Deposit compensation scheme (DCS): The minimum for the DCS fund is set at 1.3 percent of covered deposits, and the share of special contributions (i.e., not cash) will be reduced in line with the EU directives. These measures will help preserve financial stability, given the large size of covered deposits relative to GDP.
  • High NPLs: The mission welcomes the increase in the coverage ratio and the authorities’ consideration of using Pillar II measures to reduce NPLs, and encourages further increases in coverage ratios as envisaged. The completion of the ongoing work on insolvency legislation, reducing court proceedings time and enhancing contract enforcement, will improve NPL resolution greatly.
  • Macroprudential policies: With the below trend credit-to-GDP ratio, the CBM seems minded to set counter cyclical capital buffers to zero. Further consideration should be given to precautionary measures, such as loan-to-value and debt-to-income ratios, given the rapid increases in mortgages and pick up in real estate prices— fueled by a combination of factors such as tax incentives for first time buyers, increase in rental demand stemming from the international investor program, increased migration, and the ECB’s QE.
  • FSAP: The authorities’ request for a Financial Sector Assessment Program Update is very timely, as the last FSAP was conducted in 2003.
  • AML/CFT Framework: In light of the large financial sector, the rapid growth in the online gaming industry, and high demand for the international investor program, the MFSA, the Financial Intelligence Analysis Unit (FIAU), the Malta Gaming Authority (MGA), and Identity Malta should continue to coordinate closely and ensure robust implementation of the AML/CFT framework in line with the 2012 FATF standard. In this regard, the FIAU’s shift to risk based AML/CFT supervision is a positive step.

Raising potential growth

12. The government’s reform priorities, as outlined in the national strategy program, are appropriate. Advancing reform implementation will help enhance Malta’s medium-term growth.

13. The authorities should ensure that reform momentum continues and the measures taken so far translate into outcomes. In particular:

    • Budgetary measures supporting female participation have been paying off, particularly for younger cohorts, offsetting the adverse demographic trends and supporting the potential growth.
    • Achieving goals set by the national education strategy, such as reducing early school leavers and improving lifelong education, will help boost human capital. Efforts to link the budget allocations to explicit outcomes are welcome.
    • • The ongoing work to improve the judicial system is commendable. The current focus on the insolvency regime and second chance act is targeted to improve contract enforcement and the business environment, reduce the length of court procedures, and resolve corporate balance sheet problems. The mission encourages the authorities to carry out an impact assessment to better track and demonstrate the results.
    • Efforts are underway to improve access to credit. The emphasis on NPL resolution, judicial reforms, planned credit registry, and multi trading facility by the stock exchange will help reduce the cost of credit and increase access to credit, particularly for SMEs. The planned development bank (to facilitate SME and infrastructure financing) should be effectively supervised and have strong governance.