Last Thursday, the Central Bank of Malta released its annual report for 2008. As happened in previous years, the Governor of the Central Bank, Michael C. Bonello was the speaker at a The Malta Business Weekly business breakfast held at the Le Meridien in Balluta, in which he described how the present world crisis is impacting on Malta and outlined some policy considerations.

Just before the crisis exploded, Mr Bonello began, for the first time, all the world’s economies were growing together. Then, in 2008, all economies went into freefall together. It all went very badly in the last quarter of the year. Following the Lehman Brothers collapse on 14 September 2008, trade collapsed, inventories (stocks) piled up. Unemployment rates increased but at a lagged pace. Unemployment had been at a record low since 2007, but in last January alone 250,000 joined the unemployed lists in the euro area.

All indications from industry went into negative but the service sector held out longer.

The global crisis and Malta

Membership of the euro strengthened the Maltese economy’s capacity to withstand external shocks. This is a major international currency that brought with it lower interest rates. Also, the soundness of the Maltese financial system helped shelter Malta from the crisis.

However, risks to the Maltese banking system could still develop from an expected weaker economic performance as the Maltese banking system, as is seen later on, is exposed to the property and the tourism sectors.

An analysis of the growth pattern of the Maltese economy shows it comes mostly from domestic demand and, to a lesser extent, from investment.

GDP growth slowed down in the last quarter of the year, accompanied by deterioration in the government deficit situation, due to increased expenditure on the dockyard workers terminal benefits and the increased subsidy on oil. It must be said, however, that the services sector improved in 2008 over the previous years. Tourism did badly too, especially in the last quarter of the year, as did tourism expenditure, but the first months of this year saw an increased average length of stay.

As stated, unemployment is a lagged sector, in that employment actually increased by 3.4 per cent up to the third quarter, with a high (for Malta) 59.6 per cent labour participation rate, and an increased female participation rate, while unemployment reached a record low of 5.8 per cent in September.

This was a much better performance than in the euro area, now suffering double-digit unemployment figures in some countries.

Government deficit was declining up to 2007, but in 2008 it rose to 1.8 per cent of GDP due to the dockyard early retirement scheme and the energy subsidy.

There was also a slight increase in government debt.

Inflation: a Maltese problem

Inflation in Malta goes contrary to the European trend. Malta’s inflation is consistently higher than that of the euro area, peaking in February 2008 and continuing to rise till it reached 5.7 per cent in October. It is 3.5 per cent now but the rate in the euro area is much lower.

Even excluding the price of energy, it would seem the top drivers in Maltese inflation come from higher food prices and hotel accommodation prices. This last has a higher weighting in the HICP.

It may well be that the divergence between the Maltese and the European rates of inflation then feeds into wages because of COLA, the indexation of wages linked to the cost of living, which undercuts our competitiveness. It must be said that Greece, Belgium and Cyprus have even greater indexation.

As to food prices, these were mostly flat in the euro area but in Malta they veered between spiking up and decreasing. This variation is difficult to explain as nearby Italy follows the euro area and its rates are mainly flat as well. It may well be that market imperfections in Malta are the main cause for this.

Unit labour costs increased in Malta and to a lesser extent in the euro area. This is due to the compensation lags even as the economy slid into reverse. For instance, the civil service is getting higher wages as a result of a collective agreement even as the country’s economic situation is deteriorating.

Malta’s economic performance was more competitive in 2004 to 2007 than it was from 2001 to 2004, but the unit labour cost growth in Malta is still higher than in the euro area. Today’s unit labour costs in Malta are 22 per cent higher than they were in 2001, but those in the euro area are only 15 per cent higher for the same timeframe.

Domestic credit is declining in the euro area whereas that in Malta is more volatile because of government borrowing. Private credit is still growing at nine per cent per annum, which is not the case in the euro area.

In Malta, lending to real estate is far higher than in the euro area: 70 per cent of credit growth is property-related, as is 60 per cent of outstanding private borrowing.

The lending rate in Malta tracks the ECB declining rate but in the euro area it was mainly passed on to consumers. Malta has the third lowest lending rates in the euro area.

Meanwhile, residential properties’ asking prices are on a declining trend – by 4.4 per cent in Q4, averaging 2.7 per cent for the whole 2008.

Where can we go from here?

IMF has changed its forecasts for world growth for 2009 from -1 per cent to -0.5 per cent and for 2010 from 1.5 per cent to 2.5 per cent to -3.2 per cent to even as low as 0.1 per cent as the downturn went into negative.

As for the euro area, the European Commission has changed its previous -2 per cent forecast to -1.9 per cent for 2009, the ECB staff from its previous -2.2 per cent to -2.7 per cent, IMF from its previous -1.2 per cent to -3.2 per cent and the OECD from its previous -3.5 per cent to -4.1 per cent.

Reviewing the forecasts was previously unthought of, but it has now become routine: the IMF has changed its forecasts for the euro area no less than five times.

This is a recession that forecasters have not understood, said a former ECB analyst.

As for inflation forecasts, and always with regard to the euro area, the EC foresees 1.0 this year, up from -1.2 per cent at the last prediction, IMF sees 0.8 per cent (up from -0.8 per cent), ECB staff see 0.4 per cent, (up from a previous -1.0 forecast) and OECD at 0.6 per cent, lower than a previous 0.8 per cent prediction.

There may well be some months this year of negative inflation because of the impact of lower energy prices, but then inflation is seen as beginning to creep up again around September.

The CBM predictions for Malta for real GDP growth forecast 1.6 per cent growth in 2008, 0.5 to 1.1 per cent in 2009, and 1.0 to 1.6 per cent growth in 2010.

But the CBM has lately revised downwards its predictions. It forecast reduced demand, although it foresaw more contribution from the government to the Maltese economy now that capital expenditure for Mater Dei has stopped. It forecast domestic demand at 1.7 per cent next year, up from last year’s and this year’s figures.

The most common assumption is that the big euro area countries will recover in 2010 and CMB is basing its assumptions on this.

But there are domestic risks, which could mean that in Malta the current crisis could be deeper and last longer. One reason could be that most people have the tendency to save in times of crisis rather than spend.

One likely result could be that prices will come down, internationally, and that internationally, compensations and unit labour costs will be slightly lower.

Policy responses

There are two main assumptions to be made here with regard to Malta’s situation.

The first is that the global crisis will have an impact on the Maltese economy.

The second is that some of today’s problems were developing before the current crisis. The current account deficit did not narrow despite the strong growth enjoyed between 2005 and 2007.

It could very well be that this cyclical downturn is revealing some structural weaknesses.

The two usual sources of growth, external demand and foreign investment, were negative even from 2005 to 2008. The growth that there was had been driven by domestic demand, and private and government consumption.

The main policy response to this crisis thus is that the economy’s long-term growth potential must be strengthened. Malta’s productivity is not high at all. Competitivity must thus be strengthened as a reliable engine for growth. Any expansion that will be there must be based predominantly on exports, as only this would guarantee foreign direct investment inflows.

The scope of fiscal policy in Malta is very limited given that Malta has a high deficit. On the contrary, fiscal consolidation should be given priority.

It is very easy to see why key revenue sources are very sensitive to economic cycles. In other words, government’s revenue depends on growth. But, on the other hand, most of the government’s spending is fixed. It is estimated that no less than 69 per cent of the government expenditure is fixed.

To this one must also factor rising unemployment and an ageing population. Hence the importance of fiscal consolidation and any government handouts must be strictly time-framed, specifically targeted and temporary, as we cannot afford them to be otherwise.

Malta’s present financial situation makes it imperative that to finance additional outlays savings must be made elsewhere. We need to invest more in healthcare and in education but it important to see what savings can be made as regards healthcare, and whether the stipends system at the university can be changed.

For every additional one per cent of GDP spent would add some e56 million to the government debt and also some additional e 2.5 million in additional interest payments per year. Calculate how many nurses this e2.5 million a year would be paying for.

We have to become more cost-conscious: this is the only way we can save Malta’s welfare system, by creating more wealth. Otherwise, we cannot continue to square the circle.

This does not apply to the public sector only. When the current recession lifts, Malta must be more competitive than it is now. This is the right time to tackle market rigidities, to increase competitiveness. Investment needs to be found and made and new markets tapped, as well as new products launched.

Once the recession is over, there will be increased competition out there and foreign buyers and purchasers will be more careful in their choice of products and services. We must be there when the gloom lifts but with new products and better competitivity.