The increase in the central intervention interest rate by the Central Bank, announced last Friday following the meeting of the Monetary Policy Council (MPC), proves that monetary policy has become sterile.

At a time when the economy is pretty flat, it is generally quite counter-productive to raise interest rates, as this can only result in discouraging the productive investments needed to regain a sustained tempo of economic growth.

But when you have an economy like ours, suffering from long years of benign neglect and money-no-problem fiscal irresponsibility, there comes a time when the choice has to be whichever is the lesser of two evils.

The MPC is facing a choice of either risking the loss of reserves necessary to defend the rigid rate of exchange peg it has adopted, or else having to apply higher rates that could suffocate a fragile economy.

Really the Central Bank, having publicly committed itself to defend a rigid exchange regime right through ERM II until the fusion of our currency with the euro at the earliest possible date, cannot but raise interest rates without much concern for the state of the internal economy. Hence my argument that monetary policy has already become a sterile instrument for economic management.

The increase in the interest rate announced last week can only be the first in a series. This was last changed in April 2003, when it was lowered by a quarter point to three per cent – the fourth such consecutive quarter point lowering in less than 12 months. Since then, for nearly two whole years, the rate was kept steady at three per cent.

In April 2003, the composite intervention based on the basket of currencies in our exchange rate peg was 2.2 per cent, allowing a premium of 0.8 per cent to holders of Maltese lira to help them resist the attraction of converting their savings into foreign currency without incurring exchange risks.

Since then the UK has increased its rate from 3.5 per cent to 4.75 per cent. The US has increased its rates from one per cent to 2.75 per cent. The pound sterling and the US dollar have a combined 30 per cent weighting in our exchange rate peg. The other 70 per cent is in the euro, which has not experienced any increases in interest rates.

While the US and UK have seen strong economic growth, explaining the need to tighten up their monetary conditions by raising rates, the euro area economy has had worryingly low economic growth, which is why interest rates for the euro have stayed steady at record low levels.

Before the MPC’s decision last Friday, the composite interest rate of the Maltese lira exchange peg was 2.625 per cent, offering Maltese savers just a 0.375 per cent premium reward for the risk of holding a conspicuously over-valued currency.

Is it any wonder that savers have decided to start switching their liquid savings from Maltese lira to foreign currency? Why refer to such sensible measures of capital protection as “speculation”, when Maltese savers are merely reacting to the paltry reward for the risk of holding a manifestly over-valued currency?

The quarter point rate rise widens the premium to 0.625 per cent, hardly sufficient incentive for holding the currency of an economy that has hardly grown these last four years, with chronic fiscal imbalances and arguably inadequate reserves to support the chosen exchange peg.

Raising rates by a series of measured pace approach therefore seems quite likely. This will, however, do nothing to achieve the real restructuring necessary in the economy. On the contrary, it could continue to enrich the financial sector at the expense of the productive sector.

It could also risk stimulating the very process it is trying to impede. As interest rates are perceived as set to rise, it could force Maltese lira bond investors to switch into more liquid and less interest-rate-sensitive investments, thus prompting consideration of switching into foreign currency, investments formerly locked out of the money supply measurement.

All this blind faith in the virtues of a rigid exchange rate peg, fixed at a clearly uncompetitive level, will continue to oppress the real economy, stimulating capital flight and forcing the need to raise domestic interest rates to protect our reserves position. Our exchange rate policy, with the consequent high interest rates necessary to defend it, is in fact a barrier (among many others) to economic growth at our true potential, without which it will be just too painful to address the fiscal deficit.

A good hard reconsideration of the need to realign the central exchange rate to the euro at a competitive level, which can be defended throughout ERM II without being forced to apply high interest rates on a flat economy, will not only give a growth boost to the productive sector but will help keep monetary policy attuned to domestic realities. Only when the economy is stable and growing at normal rates can we afford to give up our monetary and exchange rate policy management and fuse our currency with the euro.

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