Governor calls for consensual approach to fiscal consolidation

The Governor of the Central Bank, Michael C. Bonello, has insisted that a higher proportion of budgetary resources needs to be devoted to wealth-creating activities.

In a statement forming part of the CBM's annual report, tabled in parliament yesterday, Mr Bonello welcomed the government's intention to bring the fiscal deficit down to three per cent of GDP by 2006 - a precondition for early adoption of the euro.

"Given the structural nature of the deficit and the fact that international experience shows that reforms centred on expenditure reduction are the most successful, some social components of budgetary spending, such as the pension system and the provision of health and other social services, will need to be critically reviewed. Since this is likely to imply short-run sacrifices, there is need for a consensual approach to fiscal consolidation in an attempt to reconcile what is socially desirable with what is financially affordable."

The report was tabled by Prime Minister Lawrence Gonzi in his capacity as Minister of Finance.

In his statement Mr Bonello referred first to the opportunities which membership of the European Union will present for developing a modern economy with the capacity to generate wealth on a sustainable basis, emphasizing, however, that these benefits were not automatic.

"A crucial factor will be the ability of the government to create a congenial policy and operating environment, and of entrepreneurs to exploit it."

The Governor pointed out that the small size of the economy made it highly susceptible to developments in external demand. Economic activity in Malta was more volatile than in its main trading partners, a consequence of a heavy reliance on a few key sectors, such as tourism and the electronics industry.

A major policy challenge was the persistence of fiscal and external deficits. Unless their underlying causes were addressed decisively, these deficits could threaten the country's past achievements.

Mr Bonello pointed out that the combination of slow economic growth and persistent macroeconomic imbalances suggested the need for policies aimed at improving competitiveness. Since there was growing evidence that these imbalances were due to structural as well as to cyclical factors, corrective action must focus on strengthening the economy's supply capabilities. Enhanced competitiveness would make it easier to cope with fluctuations in external demand, reducing the economy's inherent vulnerability to exogenous shocks.

Given the Maltese economy's heavy dependence on foreign trade, efforts at improving competitiveness must be accompanied by a more forceful export-oriented approach. This implied, for example, that increases in wages must be matched by improvements in productivity and that waste and inefficiencies need to be eliminated. At the same time, the resources available must be used more effectively, while structured efforts should be made to promote innovation and the upgrading of skills. Consequently, the growing competitive pressures being faced in export markets and the need to integrate successfully into the EU single market constituted compelling reasons for accelerating the reform process and broadening its scope.

The public sector could play a crucial role in facilitating the development of export-oriented activities by fulfilling its functions in a more cost-effective and timely fashion. A higher proportion of budgetary resources needed to be devoted to wealth-creating activities. Distortions to the price mechanism should be removed and productive activity encouraged. Welfare schemes should be reviewed to eliminate disincentives to work and introduce more flexibility in the labour market. Finally, the continued subsidisation of activities and practices that were not economically self-sustaining must be phased out.

Mr Bonello observed that the EU itself was encouraging member states to become more competitive through the implementation of the Lisbon Strategy (on competitiveness) and the single currency project, pointing out that both these initiatives were indeed appropriate focal points in Malta's quest for greater competitiveness.

Mr Bonello said the Maltese economy was not only well suited to participate in the common currency area, but there were relevant arguments in favour of an early adoption of the euro, an event that held out the prospect of significant gains such as reductions in transaction costs, in exchange rate risks and in interest rates - all of which meant lower costs for traders and investors - as well as an increase in policy credibility.

In Malta's case the transition towards the euro should be characterised by continuity and stability. The Maastricht criteria on inflation and long-term interest rates had been met on a sustainable basis and there were no indications of major misalignment in the value of the Maltese lira. The stability of the currency was, in fact, one of the economy's main competitive strengths and the existing imbalances in the fiscal and external accounts could not be attributed to an incorrectly valued exchange rate. "Nor are these imbalances likely to be remedied through an adjustment to the external value of the lira."

There was, therefore, good reason to expect that the central rate for the lira in ERM II (the two years which precede adoption of the euro) would be close to the market rate prevailing at the time of entry.

Mr Bonello cautioned, however, that these expectations were subject to the adoption of coherent macroeconomic policies and to the absence of economic shocks. A supportive policy framework was crucial because during the transition period, which would also be characterised by the free movement of capital, the Central Bank would be obliged to focus primarily on safeguarding the external value of the Maltese lira. This meant that the onus of economic adjustment must then fall on fiscal and structural policies.

In consequence, therefore, the major challenge on the way to a rapid and orderly adoption of the euro was the structural nature of the fiscal deficit. Persistent fiscal deficits implied a relatively high risk premium on Maltese lira interest rates, which, among other things, inflated government expenditure through the increased cost of debt servicing.

Against this background Mr Bonello welcomed the government's intention to bring the fiscal deficit down to three per cent of GDP by 2006. Given the structural nature of the deficit and the fact that international experience showed that reforms centred on expenditure reduction were the most successful, some social components of budgetary spending, such as the pension system and the provision of health and other social services, would need to be critically reviewed.

Since this was likely to imply short-run sacrifices, there was need for a consensual approach to fiscal consolidation in an attempt to reconcile what is socially desirable with what is financially affordable.

Success in this endeavour must be made a priority objective, because fiscal consolidation was necessary independently from considerations relating to the adoption of the euro.

Putting government finances on a sounder footing would bring about a reduction of the public debt, interest on which amounted to 3.5 per cent of GDP and was equivalent to more than two-thirds of the cost of retirement pensions. It would also allow fiscal policy to be recovered as a tool of macroeconomic management.

"Fiscal consolidation based on expenditure control and structural reform is clearly key to achieving the mutually reinforcing objectives of increasing the economy's competitiveness and of eventually adopting the euro. It is, therefore, essential that the social partners come to perceive the reforms as necessary, effective in achieving the final goal of sustainable economic growth and employment creation, and as involving an equitable distribution of costs and benefits."

Faced with continued weak growth prospects in increasingly competitive export markets, and the implied threat to existing employment levels and living standards, the social partners in Malta would have to shoulder a heavy burden of responsibility if they failed the country at this time of need.

In its comments on the Maltese economy, the annual report sees a modest pick-up in activity during 2004, underpinned by higher public sector investment as well as a recovery in exports. The latter is based on the assumption that external demand will strengthen as economic growth in Malta's trading partners becomes more robust. Inflation is projected to rise "sharply" due to the upward adjustment in the standard VAT rate to 18 per cent, while unemployment is expected to increase slightly as the restructuring process gathers further momentum. The report cautions that domestic growth prospects remain subject to a number of downside risks, particularly relating to the strength of the global economic recovery.

GDP growth, estimated at 0.7 per cent last year, is expected to be between 1.1 per cent and 1.7 per cent at constant market prices this year.

The Central Bank last year made a net operating profit of Lm18.2 million compared to Lm19.8 million in 2002.

The Central Bank is projecting GDP growth this year of between 1.1 and 1.7 per cent at constant market prices