Although Malta returned to economic growth at the end of 2009 the country's sustained recovery depends on a rebound in tourism, according to the Malta Spring 2010 Ernst & Young Eurozone Forecast.

The report says that Malta's economic recovery will be slow, as fiscal policy tightens and weak growth in Malta's main trading partners weigh on the revival of exports.

"With tourism and related industries producing around one third of the GDP, and all energy imported, Malta's growth and inflation are extensively determined by international trends, particularly in the eurozone and the UK," it says.

Ernst & Young is forecasting a GDP growth of 1.4 per cent for this year, rising to two per cent in 2011.

The report said the severe recession last year, when GDP dropped by 1.8 per cent, mainly reflected a sharp setback to tourism, with arrivals by sea down by 20 per cent last year and arrivals by air down by three per cent.

"It also highlights slow progress in diversifying from tourism into other sources of export, despite some success at attracting multinational electronics, software and generic drugs assembly plants in recent years," it says.

It said the financial sector, focused on fund management, has survived the financial crisis fairly well. "A relatively high concentration of hedge funds was a source of vulnerability in 2007-08, but their rapid return to profit in 2009 underpinned recovery of the sector, which now comprises more than 12 per cent of GDP. Updates to regulation and continued low tax rate are set to attract more fund registrations."

It said the EU-driven target of reducing the fiscal deficit to three per cent of GDP by the end of 2011will be challenging given the slow growth rate.

"We forecast a slippage into 2012, as the government holds back on fiscal consolidation in order to support a sustained return to growth, especially given the short-term uncertainty over tourism receipts," it says.

Ernst & Young says that the pace of recovery in 2010-2011 will be constrained by the need to tighten the budget and the limited scope for growth in domestic consumption.

"Expansion this year will depend on sustaining the strong first quarter rebound in tourism, which will largely depend on domestic growth developments in the rest of the eurozone and the UK. Overall, we forecast a slow recovery with growth still only 2.8 per cent in 2012, and not exceeding three per cent in the medium term."

The report says the main diversification of the Maltese economy away from tourism has been into the financial sector "which somewhat surprisingly has held up fairly well during the global financial crisis".

It said this confirmed the effective regulatory environment and the foundation of recent financial expansion in real economy growth. The report also said that Malta's proximity to North Africa also promises a further growth both of mainstream and Islamic finance in the medium term.

However, the report points out that financial services income has been a much more volatile component of the balance of payments than tourism income and there will be strong competition with financial centres for footloose financial investment.

"Outside the financial sector, Malta is competing in very price sensitive industries - tourism and electronics. Tour operators cut prices aggressively last year to offset the appreciation of the euro. However, with only limited room for cost reductions, this kind of practice can only be short-lived. Export volumes are, therefore, forecast to grow by only around two to three per cent per annum."

The report says that in the first half of 2009, foreign direct investment was down by nine per cent to €207 million. It said that although recent foreign direct investment has been more weighted towards technology-based manufacturing, with improved potential for local employment and export generation, "Malta must now compete with newer EU member states which have attracted an increasing proportion of eurozone FDI flows since 2007, and have done more to cut their comparative costs during the recession".

The report forecasts Malta's inflation to average 1.2 per cent this year and says that the country's reliance on imported oil and downward wage rigidity means that inflation is forecast to go back to above two per cent by 2012 "as growth returns to trend".

Ernst & Young says Malta's public sector is unusually large for a eurozone county. It also says an ageing population, and generous age-related social spending makes it unclear whether the present budget plans are strict enough to keep the fiscal deficit down even with the economy returning to growth.

"The IMF's latest analysis points to difficulty in reducing it (the deficit) below three per cent of GDP before 2013, in line with our forecast, by which time public debt could rise as high as 70 per cent of GDP. The IMF is calling for significant reductions in state healthcare and education budgets," the report says.

The report highlights that Malta faces a number of challenges in trying to boost its medium-term growth prospects. It says: "It has struggled to become an attractive base for new light industries, to replace the textile production now effectively lost to low-cost Asian competition. The tax concessions offered in new export processing zones are frequently offset by high transport costs to the European mainland".

It says that although existing zones have attracted multinational electronic and pharmaceutical production units that now contribute significantly to exports, their linkage to the local economy is limited "and they are vulnerable to parent company relocation decisions".

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