Malta joined EMU on 1 January 2008: a key milestone in the Maltese authorities’ strategy of boosting competitiveness through economic opening. Largely as a consequence of liberalising reforms, Malta has experienced a three-year-long expansion reflecting strong foreign direct investment, export diversification, and value-added upgrading. 

Growth (3.8% in 2007) has been underpinned by fiscal adjustment, privatisation and public sector streamlining. Tourism and new high value-added exports supported cost and non-cost competitiveness, trimming the current account (5.5% in 2007) and trade deficits. Growth is expected to decelerate to 2.25%–2.5% in 2008–09 as the external environment weakens. There are some downside risks as traditional export sector declines could outpace the emergence of new export activities, especially if reforms slow down. 

The authorities intend to press ahead with fiscal, financial and structural reforms in the early period of the recently inaugurated legislature. Further fiscal consolidation and public sector streamlining will be key. 

• Fiscal policy. The authorities are cutting spending to keep the 2008 budget on track - including passing through higher fuel import costs while protecting low-income households. Achieving the authorities’ medium-term objective (MTO) of structural fiscal balance by 2010 based on expenditure retrenchment will require tackling the high cost ofsubsidies, payroll and entitlements, and reinforcing the fiscal framework. 

• Financial sector. The banking system is well placed to weather global turmoil as banks have healthy liquidity and a good funding profile. However, exposure to the slowing housing market and low and uneven provisioning call for close supervisory vigilance. The authorities arereviewing mechanisms for crisis prevention and resolution in light of recent international experience, in collaboration with foreign supervisors. 

• Structural reforms. Reform of the public enterprise sector and administered price-setting mechanisms will be essential to mitigate market distortions and redirect public spending toward growth-oriented investment. Enhancing the competition framework and wage-bargaining flexibility would help fight inflation and increase competitiveness. The adoption of the euro is regarded as a crucial milestone in the authorities’ growth-oriented reform agenda. This agenda appropriately aims at leveraging Malta's strengths and income-generating potential through closer integration in the European and global economies.

As the cost-competitiveness of traditional low value-added exports wanes, market liberalisation and EU membership are intended to facilitate upward shifts in the value-added and quality export ladders. This is a promising but demanding strategy.  It will require enhancing market-based flexibility and reducing the inefficiencies created by an overextended public sector. Robust fiscal savings are needed to provide a stable macroeconomic setting, reduce debt, and maintain the tax burden low - as the authorities intend - while investing in education and infrastructure. Progress has already been made in this direction. Following sustained fiscal consolidation since 2003, the budget deficit was further reduced in 2007 to 1.8% of GDP, prompting the abrogation of the Maastricht Treaty’s excessive deficit procedure in June 2007. Public debt fell to 62.5% of GDP (from 72.5% in 2004) helped by divestments.

Also, direct public sector involvement in economic activities has been scaled down in the key areas of telecommunications, postal services, and airport and port services - though the public enterprise sector remains large, with subsidies and state aid among the highest in the EU. Largely as a consequence of liberalising reforms, Malta has experienced a three year long expansion underpinned by foreign direct investment (FDI) and export diversification. In the context of buoyant EU activity, growth accelerated to 3.8% in 2007 while the current account deficit declined to 5.5% of GDP.

Growth has been driven both by rising productivity and labour supply mobilisation. Increased female participation helped raise the employment rate, while unemployment reached record lows.This reflected booming new manufacturing and services export activities, and a revival of tourism. Strong FDI (29% and 13% of GDP in 2006 and 2007, respectively) provided welcome know-how and global market access. Employment and income gains supported domestic demand. However, while economic liberalisation has started to pay off, it is far from complete and a less favourable external environment will test the economy’ resilience. Despite recent positive economic performance, productivity is still low and the large public enterprise sector is a source of market distortions and budgetary strains - particularly since administered prices have lagged import price increases.  

The growth contribution of net exports became negative in the two quarters to 2008: Q1 as several export companies (textile and tobacco) closed down, and semiconductor sales (about half of goods exports) remained weak. During this latter period, activity was supported by domestic demand, notably government spending. Going forward, traditional manufacturing exports may experience further declines against the backdrop of softer external demand and an increasingly competitive global environment, despite subdued unit labour cost growth. Thus, Malta’s competitiveness and economic prosperity will hinge on a stable macroeconomic framework and continued reforms to facilitate the reorientation toward high-growth export activities - buttressing FDI and investor confidence. 

The March 2008 general elections returned to office the ruling Nationalist Party with a narrow parliamentary majority. During the pre-electoral period, the authorities continued with important liberalising initiatives and fiscal consolidation, but some controversial reforms were delayed -including restructuring of the loss-making public shipyards. In discussions with the IMF, the Maltese authorities emphasised their determination to proceed with reforms. They agreed that the initial period of the new legislature offered the opportunity to press ahead with crucial medium-term oriented reforms, thus anchoring investors’ expectations.

In this connection, they reiterated the 2008 budget deficit target of 1.2% based on a more favourable macroeconomic scenario than that of IMF staff), the MTO of structural budget balance by 2010 based on expenditure retrenchment, and the intention to meet remaining EU accession commitments.  The Maltese authorities are unbundling and opening to private participation the fuel and LPG operations of the public energycompany (Enemalta), and have recently announced their intention to restructure and privatise the shipyards shortly. The IMF held recent policy discussions with the Maltese government focused on the following areas, essential for success within EMU and economic stability. 

• Cementing fiscal consolidation. Despite substantial fiscal retrenchment, the public finances remain fragile. Reinforcing the fiscal position is a core policy priority to ensure the domestic stability of Malta, highly vulnerable to external shocks and with volatile growth. In this vein, staff supported the authorities’ target of structural budget balance by 2010 and argued for a surplus thereafter as a desirable policy buffer. 

• Strengthening the banking sector. The impact of international financial turbulence on the domestic banking sector is assessed to be small. However, lending concentration, real estate exposures, and thin provisioning pose risks. Malta is actively participating in EU-wide efforts to strengthen mechanisms for crisis prevention and resolution. 

• Improving economic efficiency. Reducing the role of the public sector is key. The authorities intend to reinvigorate, early in the legislature, their privatisation and liberalisation agenda, and reduce subsidies. The agenda could usefully be extended to competition policy and wage indexation, which however is not currently contemplated. 

Competitiveness

Early this decade, Malta’s narrow economic base (tourism, electronics) was shaken by the decline in tourism following the 9/11 events and the bursting of the dot-com bubble, while traditional manufacturing (eg, textiles) came under pressure from low-cost competitors. Moreover, wage-inflation pressures led to large REER appreciation. EU entry in 2004 marked the start of a reversal. Updated national statistics show ULC growth below competitors (and euro area) during most of the 2004–07 period, stemming from sizable productivity gains and relatively subdued labour costs. 

In recent years, FDI has driven the redeployment of resources toward new export activities. Within manufacturing, airplane maintenance, and a tripling of generic pharmaceutics output helped cushion the decline of goods exports. Also, new services exports have emerged, such as online gaming (9% of GDP), IT, call centres and other business services (10% of GDP) and financial services (3% of GDP).

Tourism rebounded recently owing to the airport opening to low-cost airlines, and harbour improvements enhanced cruise tourism. This reorientation has led to substantial terms-of-trade (TOT) gains (despite weak semiconductor prices), reflecting upward shifts in export quality and value-added. TOT gains are especially visible in services, which exhibit high price elasticity relative to trading partners’ income. However, competitive pressures on traditional manufacturing remain, with output and employment losses of 60% in textiles through 2004–07 amid factory closures.

Given the high import content of lower value-added manufactures, downsizing has caused a long-term downward trend in goods exports and imports. Some manufactures (eg, semiconductors) are counteracting competitive pressures by moving to higher skill andtechnology products. In the short run, the main risk lies in a faster-than-expected winding down in traditional manufacturing, adversely affected by euro appreciation, given the predominant weight of non-EMU export destinations (65% in goods).The positive trends in Malta’s competitiveness are partly captured by CGER-type estimates, which staff updated and extended in light of 2007 outcomes; new forecasts and revised historical trade, current account, and international investment position (IIP) statistics. 

• The macroeconomic balance approach indicates a competitiveness gap of around 3%, versus 10–15% last year—reflecting better-than-expected current account outturn and data revisions. Closing this gap would bring the underlying current account (estimated at -2.4% of GDP) to an estimated long-run equilibrium level of -0.8% of GDP. 

• The external sustainability approach indicates that stabilising the net international investment position at current levels would require a competitiveness improvement of 7.5% The decline of traditional export sectors poses short-term risks,underscoring the need to maintain cost competitiveness and reform momentum. The authorities see this decline as having largely run its course; any tail effects would likely be offset by the ongoing rapid growth of new exports.  IMF staff, on the other hand, saw the risks to its scenario somewhat tilted to the downside. In the short term, given the small size of the economy, even modest additional export losses in some individual companies subject to intense international competition could significantly disrupt output and employment.

The IMF emphasised the need to prevent wage growth from running ahead of productivity, while accelerating reforms that foster the ongoing economic transformation.  Competitiveness pressures within EMU might otherwise lead to a period of lacklustre growth as has occurred in some euro area countries. Long-term external sustainability risks are tempered by envisaged large FDI inflows and a strong net international investment credit position. The authorities pointed out that the current account deficit had been amply over-financed by FDI, supported by Malta’s history of stable institutions and internationally harmonised business environment - enhanced by EU and EMU membership.

The IMF’s external sustainability analysis also points to a robust external balance sheet. However, staff emphasised the need for fiscal and financial policy buffers given the volatility associated with theeconomy’s small size and its reliance on continued positive investor sentiment. Projects include the construction of an IT park by TECOM - strategic investor from Dubai in GO (former Maltacom) - starting at end-2008 and ongoing harbour investments by the private operator (a large French maritime transport company). 

The financial sector 

The financial sector appears to be resilient to international developments, though it has experienced some adverse effects. The authorities and private sector analysts considered the banks well-placed to weather the global turmoil. Banks have strong liquidity positions and no exposure to subprime-related assets. They are also profitable, although some banks’ financial results were affected by mark-downs in security portfolios, and equity valuations saw substantial declines in 2008 - possibly accentuated by local stock market thinness. The internationally oriented financial sector (now fully under uniform regulation) is expanding rapidly.  

Malta’s domestic banks, as elsewhere, have seen some fallout from the turmoil, including mark-downs in the security portfolios, trading losses, and increased funding costs. Lending surveys indicate tightening credit conditions, and securities valuation losses could increase in case of prolonged international market turbulence. But overall, the following factors indicate low risk of direct contagion. 

• Strong domestic franchises. The systemically important banks have robust brand recognition and a solid presence and expertise in key domestic sectors. 

• Good funding profile. Domestic banks rely mainly on resident deposits and little on wholesale market funding—being generally net lenders in cross-border interbank money markets. Hence, higher funding costs affect profits only moderately. 

• High liquidity. Liquidity ratios are well above the 30% prudentialrequirement. This buffer should permit the banks to recover valuation losses by holding securities (generally highly rated and with maturity under five years) to maturity.  

• Negligible subprime exposures. Main agencies have confirmed bank ratings with stable outlooks and reported very limited exposure to structured and similar instruments - a point confirmed by Central Bank of Malta’s surveys.