Although the economic downturn in 2009 was relatively mild for Malta compared with other eurozone members, with GDP falling just 1.5 per cent, the forecast recovery in 2010-12 is more subdued than that of some of the zone's other small economies, according to the latest Ernst & Young Eurozone Forecast for Malta.

The forecast says Malta's economic growth is expected to reach a little over two per cent in both 2010 and 2011.

Ernst & Young says tourism, which suffered an 8.4 per cent drop in arrivals last year, and related services are set to recover strongly in 2010-11, helped by this year's euro depreciation.

"Although growth in arrivals and expenditure feeds through into imports, by 2011 this will help to restore the trend reduction in the current account deficit that was under way from 2006 until interrupted during 2009," the report says.

The inward investment that financed the wider deficit after EU accession has contributed to substantial improvement in tourism and transport infrastructure, raising the sector's capacity to service more visitors with higher average spending and to provide goods and services locally, it says.

The report says financial services will also benefit from recovery of investment flows and fund values in 2010-11. However, Malta's efforts to expand as a base for hedge funds and other specialist investment vehicles will not be helped by new EU proposals for their regulation, approved by a majority of finance ministers in May despite Malta supporting the UK's opposition., it says.

"The new rules are primarily intended to improve supervision of funds to stop them causing systemic instability, a move that would ultimately support the industry's growth by letting it attract more mainstream investment. But the changes could also result in greater movement of specialist funds to larger eurozone financial centres, disadvantaging the smaller players," Ernst & Young says.

The forecast says the outlook for manufactured export growth is less certain, as production and exports were set back by the eurozone downturn of 2008-09 despite their focus on new technology and software.

"Manufacturing's contribution to exports fell by more than 18 per cent in 2009 reflecting the tendency of multinational plants to reduce production pre-emptively in recession, as well as reduced and discounted sales of the goods produced.

"Higher-tech manufacturing is expected to gain in competitiveness as recent improvements in labour skills, R&D capacity and transport feed through into productivity. But there remains a geographical disadvantage (relative to central Europe) in becoming integrated in eurozone industrial supply chains, which is likely to be exacerbated by the introduction of tougher EU environmental rules on road transport.

"So while new sectors are beginning to replace the industrial employment and exports lost from the migration of the textiles industry to lower-wage economies, their growth is unlikely to arrest the fall in the share of manufacturing in GDP over the forecast period," it says.

The report says Malta's slowdown in GDP growth in 2008 led to a marked widening of the national debt even before recession struck, and the EU launch of an excessive deficit procedure underlines the difficulty in bringing the debt levels back down to eurozone norms.

Although Malta's budget deficit is not as high as in some other countries, at an estimated 4.5 per cent of GDP this year, it may prove to be more protracted.

"Without further action to narrow the deficit, it is set to remain above four per cent of GDP until 2012, not returning below the three per cent eurozone ceiling until 2014," it says.

The forecast says this slow decline in the deficit is unacceptable to Brussels because Malta's public debt was already close to 70 per cent of GDP by the end of 2009 and will climb further unless the deficit falls faster.

"The Central Bank, which forecasts debt to rise to 72 per cent of GDP in 2011, has called for a reduction of the deficit to three per cent of GDP as early as 2011, as a step toward the primary fiscal surplus that would begin to reverse the rise in debt."

Ernst & Young says there is no immediate danger to deficit financing, because most debt is domestically held and at relatively long maturities, while the erosion of real returns on other products attracted investors into government debt in 2008-09.

"The channelling of savings into public bonds is an understandable strategy for a rapidly aging population, whose dependency ratio (of numbers retired to numbers of working age) will rise to 59 per cent in 2060 from 21 per cent today (on Central Bank projections) if the retirement age stays at 65.

"But this appetite for public debt has diverted funds from private-sector investment and means that the impressive health of the banking sector through the 2007-08 credit crunch has not translated into an early upturn in business borrowing," it says.

The report says that Malta's eurozone entry has coincided with a shift from export-led to domestic expenditure-led growth, with the government an important source of this expenditure.

"The pattern will be relatively successful at generating growth with low inflation in 2010-14. But it leaves the upturn vulnerable to inward investment slowdown, which would force a reduction in the external deficit, and to EU pressure for faster fiscal deficit reduction," it adds.

The outlook for Malta says EU proposals to address the deficit, which follow standard OECD and IMF prescriptions, centre on containment of public service and pension costs. This, it says, would be achieved through a combination of restricted eligibility and increased private provision.

"This approach is unusually problematic in Malta's case because publicly financed health care and education are important contributors to private sector competitiveness, they are electorally supported and already operate with an efficiency that private providers might find hard to match," the report says.

It says that ironically, the recent EU recession may have helped Malta avoid a clash with the European Commission by generalising debt and deficit problems across the eurozone.

"The government is now better placed to argue that the economy's adjustment requirements and its size merit a more pragmatic approach to the use of deficit financing, rather than higher tax. Even so, the risk of faster action to reduce the deficit continues to weigh on the growth outlook, since eurozone membership has ruled out exchange rate adjustment to shift production from domestic to export markets."

Ernst & Young says difficulty in reducing public spending means that restoring balance is likely to result in a rise in the overall tax take, which has already risen substantially in the past 10 years but remains below the eurozone average at 36 per cent of GDP (on Eurostat figures, including social security transfers).

The report says inflation could become a further risk to output recovery and external deficit reduction. Price pressures will rise in the second half of 2010 due to import costs and a relatively tight labour market as well as the prolonged fiscal deficit.

The forecast points out that Malta's rising wage costs compared with eurozone competitors with larger labour pools will add to the difficulty of generating new manufactured exports, and may also begin to affect the tourist inflow, if not offset by sector productivity gains.

"Malta's Central Bank will press for a review of current wage indexation arrangements, in pursuit of greater flexibility to tie pay rises to efficiency gains or demand and supply, in particular in labour markets," it says.

The report says the government has time to pursue these and other structural reforms, with parliamentary elections not due until early 2013.

"But wage growth will become harder to contain if fiscal deficit reduction also forces restriction of entitlements and the slow-growing labour force will make it increasingly difficult to achieve faster growth without inflation rising even further above eurozone rates," it adds.