The Spring EY Eurozone Forecast (EEF) on Malta is again forecasting that the local economy will outperform the eurozone this year and grow by 1.7 per cent, after expansion of 2.4 per cent in 2013.

Household spending is building momentum. Indeed, having shown no growth in 2012, consumer spending rose steadily during the second half of 2013 (H2). As a result, import volumes fell by less than export volumes in 2013, meaning that net exports held down GDP growth last year.

Unemployment was 6.4 per cent in 2013, the same as in 2012, and almost half the eurozone average of 12 per cent. Though subdued, real wage growth remained positive in 2013 and the EEF, a quarterly EY publication based on Oxford Economics forecasts, expects it to improve this year, boosting consumer spending. Export demand picked up in H2 2013 and this should continue, supporting growth. However, investment remains weak, falling by 1.9 per cent on the quarter in Q4, the third successive fall, while construction remains below its early 2009 peak.

Real labour productivity per hour worked rose by just 1.2 per cent from 2005 to Q2 2013

However, a high level of youth unemployment is a concern. The unemployment rate among under-25s ended 2013 at 13.9 per cent – almost three times as high as the unemployment rate for those aged 25–74 (5.2%). In the 2014 budget the government announced measures to help young people find work, including a new employers’ tax deduction scheme for each work placement and each apprentice, and the Work and Training Exposure Scheme. But with the fiscal deficit estimated at 3.4 per cent last year, the government will be limited in the amount of help it can offer. As a result, youth unemployment is expected to fall only very slowly.

Although the budget deficit of 3.4 per cent in 2013 was in line with the target set by the EC, Malta is unlikely to meet the deficit target for 2014 of 2.7 per cent of GDP. However, the relatively benign fiscal position suggests that the EC will not impose additional austerity measures. Oxford Economics forecasts that the deficit will narrow gradually to two per cent of GDP by 2018, supported by higher indirect taxes and solid GDP growth underpinning steady growth in revenues.

The government is committed to increasing spending on education, health care and pensions this year, which should boost domestic activity. However, there is a risk that further fiscal consolidation might be required if the eurozone situation remains fragile, which would result in lower growth than currently expected. The health budget is due to increase by 9.3 per cent this year, while the government has reiterated its commitment not to increase the pension age. The government has also initiated a process whereby over a number of years the national minimum pension will reach 60 per cent of the average national income. Capital spending will increase by €66m this year, bringing total spending earmarked for capital projects to €453m.

Merchandise export volumes fell back in Q4 after rising for the first time in four quarters in Q3, but this is likely to be a temporary dip. Export volumes are forecast to pick up in 2014, helped by stronger demand from the eurozone. Tourist arrivals rose last year by over nine per cent, after two per cent growth in 2012. Since 2010, spending by tourists has risen by at least eight per cent a year and tourism now accounts for more than 10 per cent of GDP.

With global growth expected to pick up this year, Malta’s tourism industry should continue to grow strongly. And with more than a third of exports going to either the rest of the eurozone or the UK, if European demand is stronger than expected, it could lift GDP growth above these forecasts.

Joining the EU in 2004 helped Malta towards its aim of developing its economy as a significant financial centre. The financial sector now makes up nearly 10 per cent of GDP. So far, the MFSA has authorised around 600 investment funds. And the sector is set to expand further, led by the onshoring of hedge funds.

Malta has the potential to build market share in other services sectors as well and has a number of energy-sector projects under way this year that should boost investment. But the main economic challenge is to ensure that growing sectors, such as tourism, financial services and other high-tech industries, remain competitive. This implies that further investment will be required.

Average hourly labour costs of €12.3 in 2012 in Malta (on Eurostat’s last comparison) are only around a third of those in Germany (€30.4). But real labour productivity per hour worked rose by just 1.2 per cent from 2005 to Q2 2013. In contrast, productivity in Austria by almost 10 per cent over the same period and German productivity rose by seven per cent. It is crucial for the authorities to try to encourage higher productivity in order to maintain Malta’s competitiveness.

According to the 2014 budget, interest rates on loans to businesses will be reviewed by the government this year. The Central Bank of Malta reports that lending rates are around 2–3 per cent higher than in Germany, the Netherlands, Finland, Austria and Luxembourg. However, deposit rates are similar to these countries, so bank margins in Malta are higher. Lower lending rates would encourage faster credit growth, in turn encouraging greater investment.

A development bank is also being considered to help SMEs and to complement the main banks as a source of funding for large projects.

Inflation is expected to rise modestly and the current account surplus to persist.

Consumer price inflation averaged one per cent in 2013 and is expected to be 1.3 per cent this year, boosted by higher taxes for certain items such as tobacco and alcohol, and by stronger domestic activity. Nevertheless, the increase is fairly modest because, as promised in the government’s election campaign, prices for water and electricity will fall by 25 per cent from March 2014, offsetting higher prices in other categories.

The current account balance is estimated to have risen from 1.5 per cent of GDP in 2012 to 2 per cent of GDP last year, driven by higher net inflows on services as a result of strong tourism and by the trade deficit shrinking very slightly. The current account surplus is expected to fall to 0.5 per cent of GDP this year, as imports pick up more strongly.

Looking ahead, subdued investment growth and an ageing population will limit GDP growth to about 1.7 per cent a year in 2015-18, slightly above OE’s forecasts for the eurozone. But having peaked in 2010, the working-age population is already falling, and fixed investment remains almost 40 per cent below its 2007 peak. Both these factors are likely to constrain potential output in the medium term. The EC has raised concerns that Malta’s public finances may be unsustainable in the longer term due to higher spending on pensions and health care as a result of the older population. To counter this, Malta should accelerate its ongoing pension reform and increase cost-effectiveness in healthcare.