Updated - Malta's resilience cannot be taken forgranted, IMF warns

Updated - Adds statement in full - The International Monetary Fund (IMF) this afternoon warned that 2012 will be a tough economic year where nothing can be taken for granted but recognised Malta’s progress in the past years to consolidate and give credibility to its public finances.

At the end of a routine visit to Malta, IMF experts said that “the policy challenge now is to balance the imperative of maintaining growth and employment against the pursuit of long-term fiscal sustainability while, at the same time, navigating a very difficult international environment.”

Acknowledging that Malta has made strides forward in the past years to consolidate and give credibility to its public finances, particularly through the reduction of the structural deficit, the IMF warned that the island need to continue on these lines.

“Malta’s resilience to date cannot be taken for granted—continued vigilance is required,” the IMF said in its mission conclusion statement.

According to the IMF, confidence in Malta’s public finances has been shored up by the European Commission assessment that Malta has taken effective action to correct its excessive deficit.

The Fund said that this reflects due recognition of the structural fiscal adjustment in 2011, one of the largest among advanced countries.

The deficit is estimated to have narrowed to 3 percent of GDP and the primary balance turned into surplus for the first time since 2007. Following the announcement of the 2012 budget and additional expenditure measures in January, the fiscal deficit is expected to fall further this year. Nonetheless, the composition of adjustment remains suboptimal, relying excessively on one-off and revenue measures.

With the euro area expected to go into a mild recession in 2012, the Fund projects Malta’s real GDP growth in 2012 to be relatively modest at 1 percent.

“Risks and uncertainty around this scenario are significant, reflecting the potential for large negative spillovers from the euro area crisis,” the mission concluded.

STATEMENT IN FULL

Concluding Statement of the IMF Mission

Valletta, January 23, 2012

Growth in the Maltese economy is moderating and the outlook is subject to downside risks, reflecting the potential for large negative spillovers from the euro area crisis. The policy challenge now is to balance the imperative of maintaining growth and employment against the pursuit of long-term fiscal sustainability while, at the same time, navigating a very difficult international environment. Safeguarding the stability of the financial sector in this environment requires sound governance, effective supervision, and robust financial buffers. Longer-term policy challenges remain daunting, including those related to population aging, energy policy, education, and competitiveness.

1. After a strong recovery in 2010, the economy continued to perform relatively well amidst considerable turbulence across the euro area. Spillovers from the euro area crisis remained contained during 2011. Real GDP grew by 2¼ percent in the first three quarters of 2011 and labor market indicators improved. This reflects to some extent the government’s commitment to prudent macroeconomic policies and improvements in external competitiveness—evidenced by Malta’s rising market share in services exports. Despite the recent rating downgrade, sovereign bond spreads remain contained as government debt is predominantly held domestically. In turn, the sensitivity of the Maltese banking sector to sovereign risk events in Europe is low given very low exposures to EU periphery debt.

2. The economy now faces a worsening external environment that has created new risks and headwinds to growth and financial stability. Malta’s high degree of trade openness and very large financial sector heighten contagion risks. The fragile global macroeconomic environment and sustained market volatility are expected to dampen real export growth. Domestic sources of growth may not be sufficient to offset the drop in external demand, given headwinds from a soft real estate market, deteriorating confidence, and ongoing fiscal consolidation. At the same time, uncertainty in economic policy could adversely affect growth if investment decisions and structural reforms are put on hold. With the euro area expected to go into a mild recession in 2012, we project Malta’s real GDP growth in 2012 to be relatively modest at 1 percent. Risks and uncertainty around this scenario are significant, reflecting the potential for large negative spillovers from the euro area crisis.

3. The primary challenge in 2012 will be the ability to navigate a highly uncertain macroeconomic environment with a deteriorating economic outlook, and ongoing banking and sovereign crisis in Europe. Malta’s resilience to date cannot be taken for granted—continued vigilance is required. The authorities need to balance concerns over a slowing economy, which calls for accommodative policies, against increased risks that require more prudent fiscal management. In this context, the mission sees the following policy priorities for Malta:

Ensuring fiscal sustainability while supporting growth

4. Confidence in Malta’s public finances has been shored up by the European Commission assessment that Malta has taken effective action to correct its excessive deficit. This reflects due recognition of the structural fiscal adjustment in 2011, one of the largest among advanced countries. The deficit is estimated to have narrowed to 3 percent of GDP and the primary balance turned into surplus for the first time since 2007. Following the announcement of the 2012 budget and additional expenditure measures in January, the fiscal deficit is expected to fall further this year. Nonetheless, the composition of adjustment remains suboptimal, relying excessively on one-off and revenue measures.

5. The government’s aim to return to fiscal balance over the medium run remains essential. Further fiscal consolidation is required to ensure debt dynamics attain sustainability, thus reducing fiscal risks to manageable levels. The pace and composition of adjustment should be attuned to the economic cycle, within a strategy that addresses long-term fiscal pressures. Malta can afford a gradual deficit reduction path, by targeting a structural annual adjustment of ½ percentage points of GDP, while letting automatic stabilizers operate in full. This adjustment path would help offset the headwinds facing the economy in the near term, while achieving debt sustainability over the medium term. Proposed EU directives on budgetary frameworks and governance should help the government achieve its fiscal balance objective, by adding credibility to the consolidation effort and enforcing stronger and more effective fiscal discipline and transparency.

6. Bold policy actions are necessary to reduce contingent liabilities arising from the public corporations. Restructuring of Air Malta and Enemalta will help staunch losses and limit subsidies. It is essential to agree on a medium to long term strategic plan and permit professional management independently to lead these entities, subject to sound governance requirements, specified benchmarks, and performance targets.

7. Building on progress already made, further pensions reform will contribute to resolving anticipated long-term fiscal imbalances and support medium-term growth. The projected increase in ageing-related expenditures is twice the EU average, reflecting an expected sharp rise in dependency ratios that renders the current pay-as-you-go system unsustainable. We support the main recommendations of the Pensions Working Group, notably: (i) indexing the retirement age to longevity; and (ii) introducing a mandatory privately funded second pillar and voluntary third pillar. Consideration could also be given to introducing a notional defined contribution first pension and to accelerating the planned gradual increase in the retirement age to 65.

Improving financial system soundness

8. The financial sector has continued to perform strongly, but—given the large external risks—it is important to further strengthen the sector’s resilience. Banking and insurance companies appear healthy with relatively sound capital and liquidity ratios, but the sector’s sheer size (above 8 times GDP) and large foreign ownership represent a number of risks to financial stability and fiscal sustainability. These include concerns about too-big-to-save and the adequacy of backstopping resources in case of default or deposit run, the capacity to deal with a banking shock and its impact on the economy, as well as supervisory challenges. Maintaining financial sector stability requires a multi-faceted approach, encompassing macro-prudential policies and surveillance, micro-prudential regulation and supervision, and lastly contingency planning, safety net, and crisis management.

Macro-prudential Policy and Systemic Risk Monitoring

9. The authorities are constituting and clarifying the organizational elements of the macro-prudential framework. This includes determining the forum with ultimate decision-making power to recommend and enforce macro-prudential policies, and specifying its mandate, scope, powers, instruments, and governance. Further strengthening the analysis of risks posed by the financial sector, including the so-called international banks and insurers, is key to identifying and addressing systemic imbalances before they materialize. In this context, we commend the Central Bank of Malta (CBM) and the Malta Financial Services Authority (MFSA) for extending the EU-wide stress testing exercise to all domestic banks, and for participating in EU-wide insurance sector stress tests.

Micro-prudential Regulation and Supervision

10. Malta’s financial regulatory and supervisory framework should keep pace with the demands and risks of a sophisticated and fast-growing financial market. As part of its self-imposed quality controls, in 2010 the MFSA commissioned an independent assessment of regulation and supervision of banking, insurance, and securities markets against the respective international standards. The assessment concluded that progress had been made since the 2003 IMF Financial Stability Assessment Program (FSAP), but weaknesses remained in supervisory capacity (notably staffing), definition and monitoring of connected party transactions, and internal audit functions. The increase in recruitment of qualified staff, the creation of an enforcement unit, and work in the area of concentration risk represent commendable progress. Continuing efforts along the report’s recommendations are needed to more fully comply with international sound practice. A review of the MFSA’s consumer protection and business conduct functions could be considered to secure consumer protection, promote efficiency, and enhance the integrity of the financial system.

11. Substantial credit concentration in the banking sector and rising credit risks warrant close supervisory scrutiny and strong financial buffers. Lending is highly concentrated in housing and construction, loan quality has deteriorated, and the number of restructured loans increased. Bank profitability may suffer if loan losses were to increase further, due to further declines in real estate prices or a fall in growth. Banks’ financial positions may also be affected by the forthcoming Basel III/CRD IV requirements. Against this background:

• Banks with riskier profiles should be encouraged to increase provisioning and restrain dividend payout policies to strengthen capital buffers.
• Further improvement in the MFSA’s assessment of the robustness of banks’ processes for loan classification, impairment determination, and provisioning practices are needed, and plans to enhance these aspects of supervision are welcome.
• An action plan to enable the implementation of new liquidity regulations, including individual liquidity guidelines and liquidity stress testing, is needed since this would be the most constraining element of Basel III for Malta’s banks. In this context, banks should be encouraged to lengthen the maturity of their liabilities.

Financial Sector Safety Net

12. In light of the ongoing euro area crisis, it is imperative to ensure a sound financial safety net.

• Contingency planning for crisis preparedness should move to the forefront of the policy agenda and involve: (i) stress testing to assess the adequacy of financial buffers; (ii) the development of scenarios for key material risks; (iii) performing crisis simulation exercises regularly, covering all systemically relevant institutions, as well as cross-border dimensions; and (iv) reviewing existing coordination arrangements between the key institutions. It would be advisable for the MFSA to incorporate these techniques as standing components of its supervisory approach.
• The range of resolution tools will be broadened once new European regulations come in place. These encompass prompt corrective action, partial purchase and assumption, the use of bridge banks, and the establishment of a resolution fund.
• The target size of the Deposit Compensation Scheme (DCS) is unsatisfactory. A shortfall could have knock-on effects on the entire banking system through confidence and reputation effects and on the government’s budget in case the DCS needs emergency funding. As a small economy with a large financial sector and idiosyncratic features, the authorities should give due recognition to the potentially high risks to financial stability, by erring on the conservative side and imposing buffers above the suggested minima.

Improving competitiveness to secure sustained growth

13. The immediate challenges underscore the need to raise productivity growth and further improve competitiveness. Reforms to secure these objectives include continuing to diversify the economy into high value-added activities, reducing the economy’s dependence on energy imports, and strengthening female labor force participation and labor force skills. These steps should be supported by a cautious settlement of wage negotiations to ensure better alignment of wage and productivity developments.

The mission is grateful to the Maltese authorities and all our counterparts for their hospitality and for the very open discussions during our mission.