Governor sees tough inflation challenge

Malta Central Bank Governor Michael Bonello has adopted a cautious line on euro adoption by January 1, 2008, saying that getting inflation down in time was a major challenge but the country was still committed to that target date.

Speaking at an interview with Reuters in Frankfurt, he also said that the Maltese economy was expected to grow by 2.3 per cent this year and something similar in 2007.

When he spoke on inflation, Mr Bonello pointed out that Malta had been hit hard by high oil prices and it was still unclear if inflation would fall enough to meet the strict euro entry criteria by April next year, when Malta's application is likely to be assessed.

"What will happen by then is very difficult to say," Mr Bonello said. "At this stage it wouldn't be prudent to stick one's neck out and make a prediction ... but we have to remain committed to that (2008) date."

Reuters said Mr Bonello's caution contrasted with the optimism of Prime Minister Lawrence Gonzi about euro adoption. While most economists polled by Reuters in early August still thought Malta was on track to join in 2008, ratings agency Fitch at the end of last month pushed back its estimate to 2009. Malta would not be the first to fall foul of tough EU inflation rules, which forced two countries, Lithuania and Estonia, to postpone euro entry earlier this year.

Applicants' inflation must be within 1.5 percentage points of the three lowest-inflation countries in the whole EU, currently Finland, Sweden and Poland.

Mr Bonello said Malta's fixed exchange rate policy had delivered it low inflation in the past, but as a small, open economy it was hard for either the Central Bank or the government to control short-term inflation movements.

"Given our total dependence on oil, not just for fuel but to change sea water into drinking water, this explains our exposure to external shocks," he said, adding that other EU countries with more diverse energy supplies had less of a problem.

He hoped Malta would still meet the inflation criterion if oil prices stabilised at current levels, as that should lead to inflation falling towards the end of the year when the price shock fades.

There was little else Malta could do in the short term, he said, as the Central Bank's interest rates were geared to keeping a fixed exchange rate against the euro and he saw little scope for government budget policy to bring a sustainable reduction in prices in time.

Mr Bonello said he was sure that the deficit criterion for euro adoption would be met later this year when the government reduced its budget deficit to 2.7 per cent of gross domestic product.

Central Bank rates, currently at 3.5 per cent, would also at some point have to converge with euro-zone rates - currently at three per cent but forecast by analysts to rise to 3.5 per cent by the year's end.

Mr Bonello was non-committal on whether he would allow this convergence by default, stressing he was not committed to matching the ECB hike for hike, and that he would give the Maltese economy as much support as allowed by his bank's euro-peg policy.

Mr Bonello forecast economic growth of 2.3 per cent this year, just below potential of around 2.5 per cent, and something similar in 2007.

But he said the country needed to diversify its economy to make it less vulnerable to external shocks and reform its public sector - and that euro entry was crucial to that.

"Not having to manage a currency would liberate a lot of energy to tackle structural reform."