Faster growth is achievable but depends on greater cost competitiveness, higher productivity and sound public finances, none of which are attainable without further structural reform, Central Bank governor Michael Bonello has warned.
Malta's economy, he stressed, is facing its first major test since joining the eurozone.
In a wide-ranging, diagnostic, address to guests at the Institute of Financial Services' annual dinner, Mr Bonello also cautioned that any benefits the cost of living adjustment may be perceived to have must be weighed against its ultimate effect on price levels and competitiveness.
Sustained economic growth depended largely on Malta's ability to attract export-oriented foreign direct investment, but the only way to maintain a competitive advantage was by ensuring that unit labour costs rose by less than the competitors'. This challenging task was compounded by the fact that Malta's exports were largely destined to non-euro countries whose currencies had depreciated against the euro.
Citing the German experience, where wage growth was accompanied by productivity gains so that the country was among the first and few to register positive growth for the second quarter of the year, Mr Bonello warned the message was clear. Wage adjustments that were not coupled with more efficient production methods gradually eroded a country's competitiveness, especially when inflation was driven by internal cost pressures as in Malta's case.
COLA was estimated to have accounted for half of the increase in the average wage in 2004 to 2008. While its impact on public sector pay was limited up to 2010 under a collective agreement, it was not the case in the private sector.
"Any benefit that this mechanism may be perceived to have in terms of stable industrial relations must be weighed against its potential to ratchet price levels upwards, so that the initial improvement in earnings may prove to be short- lived," Mr Bonello warned. "This is because the higher wage costs that employers incur tend to be passed on in higher-end prices, with the resulting inflationary impact feeding into the following year's indexed wage adjustment. An attempt to restore consumers' purchasing power feeds a wage-price spiral in which there are no winners, only a possible loss of competitiveness."
Mr Bonello said that despite the eurozone emerging from recession, recovery was expected to be modest with the European Commission forecasting growth of 0.7 per cent next year and 1.5 per cent in 2011. Although Malta's membership of the eurozone had cushioned the domestic impact of the crisis, the economy's resilience had been strained.
Despite the shrinkage in the tourism and manufacturing sectors, expansion in the services industry mitigated overall decline and government support measures had served to contain job losses. The unemployment rate had remained below the rate in the euro area. Inflation, however, had failed to fall as fast as in the euro area, dragging down on purchasing power.
"Looking ahead, we expect economic activity to pick up over the next two years, but growth, while positive, will likely remain below trend," Mr Bonello said. "Exports will be conditioned by weak growth prospects abroad and by unfavourable cost trends in the price-sensitive electronics and tourism sectors. Private consumption should remain relatively subdued on account of continuing high unemployment and slow income growth."
If the expected international revival failed to materialise, Malta's wider economic outlook could be at risk and there was no room for complacency, the governor emphasised.
Sustainable growth depended on consistent production and provision of goods and services that met the demands of increasingly competitive and sophisticated markets.
With the exception of 2002, Malta's current account has been in the red since the mid-1990s, a possible sign of structural weaknesses that limited the economy's ability to expand its productive capacity and exports. Between 2000 and 2008, productivity grew by 3.6 per cent but nominal wages increased seven times faster by almost 28 per cent. Unit labour costs rose by over 23 per cent over these years. In the euro area, they rose by 15 per cent. Despite moderate relative cost growth, Malta had to make up for lost ground and the greatest effort must be made by other mainly non-traded sectors, including the public sector.
"To a large extent, Malta's weak productivity record explains why per capita GDP in relation to the euro area average has stagnated at around 70 per cent since 2003," Mr Bonello explained. "It is true that this subdued productivity performance was partly offset by higher labour utilisation in the past two years, but the latter is still some 88 per cent of the euro area level. This analysis suggests that the economy's growth potential can indeed be raised.
"This should be a key objective. As things stand, for example, should the Commission's growth projections prove accurate, in 2011 Malta's real GDP would only have recovered to its 2008 level."
Mr Bonello pointed out that despite advances made in sectors like aircraft maintenance, pharmaceuticals and financial services, Malta could not afford to rest on its laurels.
Overall labour productivity had fallen from over 90 per cent of the euro area average in 2000 to 79 per cent last year.
Improved prospects for productivity growth also required a heightened sense of value for money at the workplace.
Expenditure restraint seemed to be the only possibility to reduce the deficit as any increase in the tax burden - already high at 40 per cent of GDP - would have a negative impact on competitiveness.
Wages, social transfers and interest on the public debt, which absorbed more than two-thirds of the total, were destined to grow autonomously. Mr Bonello said health care and education, both of which have been identified as producing relatively less efficient outcomes in terms of output compared with the EU average, offered scope for rationalisation. Further savings could also be made in social transfers to households and subsidies to enterprises.
Studies by the Today Public Policy Institute and the European Commission had shown that in the long run, Malta's welfare system was unsustainable and a culture change was necessary.
"The projected reduction in the working-age population will translate into slower economic growth and will, therefore, negatively impact tax revenues, as the fiscal burden of a larger population of elderly people increases...," Mr Bonello said.
"Put simply, it needs to be understood that you cannot give away what you do not have. We must adopt a more cost-efficient approach to the provision of public goods and services, whereby only those demonstrably in need would benefit. Access to social benefits, healthcare and subsidies should be streamlined through a combination of means testing and market-based mechanisms.
"In addition, the benefits structure could be further refined beyond the recent Budget measures with a view to making work pay and reducing the disincentives to enter the labour market."