In its autumn economic forecast this week, the European Commission anticipates a “fragile recovery” for Malta, as Europe looks for a way out of the recession that has threatened to cripple economies the world over.

The EC observed that Malta had registered strong economic growth in the years preceding the global economic crisis, pointing out how, between 2005 and 2007, real GDP growth averaged almost four per cent, mainly driven by domestic demand.

In the meantime, exports, dominated by electronics and tourism, expanded due to a growing services sector.

Although euro area membership (since 2008) has cushioned the impact of the crisis by offering enhanced financial stability, the EC observed how the Maltese economy’s resilience has come under strain, underscoring the importance of strengthening competitiveness.

The global crisis affected Malta primarily through the trade channel, as external demand for its products fell.

Exports of electronics were hit hard, while the tourism sector suffered as a result of fewer visitors from key source markets. Real GDP growth slowed in the last few months of 2008 as the global recession took its toll on Malta’s small and open economy.

In 2008 as a whole, real GDP growth decelerated to 2.1 per cent. Domestic demand held up well, as the strong growth in private and public consumption outweighed the sharp decline in investment caused by lower construction activity.

The impact of the global financial turmoil on the banking system was limited, reflecting the fact that banks are funded from resident deposits and their lending is almost exclusively local, while their involvement in inter-banking activity with overseas banks is limited. The liquidity position of the banking sector remains relatively strong, even if the vulnerability of the system has increased in the wake of the ongoing decline in property prices.

With no need to directly assist the financial sector, Malta’s response to the crisis consists of several fiscal measures to support the real sector in 2009.

The main focus of the recovery measures, which amount to around 1.5 per cent of GDP, is on increasing public infrastructure and on support to manufacturing, tourism and SMEs. At the same time, measures have been taken to help contain the widening of the government deficit.

Sharp output contraction

gives way to a fragile recovery

On the back of a significant contraction in output in the first half of the year, real GDP is expected to shrink by 2.2 per cent in 2009. Even if, on a quarterly basis, the pace of contraction eased in the second quarter of 2009, the scope for a quick turnaround appears limited. Economic activity is projected to gradually improve in 2010 and 2011, although growth is set to remain below historical trends

Declining exports, the Commission forecasts, will continue to weigh on real GDP throughout 2009. Imports are set to fall by slightly more than exports, due to weak domestic demand and the import-intensity of exports, leading to a positive contribution of net exports to GDP growth.

In the medium term, foreign sales of goods and services are projected to move into positive territory, albeit mildly in view of weak economic prospects in Malta’s key trading partners, as well as unfavourable cost developments affecting the price-sensitive electronics and tourism sectors.

Despite increased public capital spending, gross fixed capital formation is forecast to act as a drag on GDP growth in 2009, as low capacity utilisation, weak external demand and lower profits induce companies to scale back their investment plans, while construction activity is expected to remain weak.

For 2010-11, investment is set to recover marginally, supported by the construction of a major ICT business park and improved conditions of foreign-owned companies, in line with the assumed global economic turnaround.

Private consumption is set to contract in 2009 due to lower real disposable income stemming from rising unemployment and slower wage growth. This is expected to more than neutralise the support to purchasing power provided by personal income tax cuts and overall lower inflation. Looking forward, private consumption is anticipated to post a mild recovery, mainly as a result of improved labour market conditions.

Risks to the macroeconomic outlook stem from a protracted period of weak external demand, given Malta’s reliance on trade flows. Private consumption may be dampened further as a result of deteriorating labour market conditions and possible adverse wealth effects from the correction in property prices.

Wage growth exceeds productivity growth

After moderating until 2007, wage inflation accelerated in 2008. Apart from cost-of-living adjustments, these dynamics reflect pay increases in the public sector. Despite the contraction in output, nominal wages continued to accelerate in the first half of 2009 compared to the same period in the previous year, which may jeopardise competitiveness.

In addition, the cost-of-living adjustment in line with the high inflation rate registered in past months is expected to entail nominal wage growth above the euro-area average in 2010, although the relatively flexible private sector wages may limit this development.

Wage growth in excess of HICP inflation is also foreseen up to 2010, boosted by negotiated rises in public sector pay. Despite a deceleration from the peak reached in 2008, HICP inflation is projected to stay above the euro-area average.

Food prices are expected to remain dynamic over the forecast horizon. Notwithstanding increased competition in the distribution trade and lower global prices, domestic food prices have proved sticky.

New high value-added services activities boosted productivity during 2004-07. Thereafter, productivity receded with the turn of the cycle, as the slowing output was accompanied by a still relatively strong employment growth in 2008, led by ICT and remote gaming.

It is anticipated that productivity will remain weak in 2009, as firms continue to hoard labour in sectors that have benefited from public financial support to retain workers, as well as those sectors with a high incidence of skilled workers. As a result, job growth will be low in the subsequent years.

Although it will benefit from the expected turnaround in output growth, productivity gains are set to remain weak. Against this background, unit labour cost growth in Malta over the forecast horizon is projected to be above the euro-area average. This, coupled with the projected weakening of the dollar, which is the transaction currency used by the electronics sector, may harm Malta’s competitiveness.

Restoring public finances

Following years of fiscal consolidation, the general government deficit increased to 4.7 per cent of GDP in 2008 due to one-off early retirement payments to shipyards’ employees, the reclassification of the yards in the general government sector and lower tax receipts.

For 2009, the deficit is estimated to decline slightly to 4.5 per cent of GDP. The worsening economic situation is expected to depress the tax intake.

Indirect taxes are projected to decline by 0.7per cent on the back of weak private consumption, while social contributions are set to fall as a result of softer labour market conditions.

Similarly, tax receipts on property transactions are expected to decline, reflecting the cooling real estate market. In line with developments in cash data for the first eight months of 2009, revenue from direct taxes is projected to show some resilience for the year as a whole, supported by an amnesty on past income tax dues and the part-recuperation of delayed tax payments owed by companies in 2008.

Helped by favourable base effects related to the higher remuneration for health sector employees in 2008 and the liquidation of the shipyards, the growth in government consumption expenditure is set to decelerate in 2009. Social transfers are projected to rise further amid higher healthcare running costs, rising age-related spending and higher demand for unemployment benefits.

Subsidies, on the other hand, are foreseen to fall significantly, mostly due to the withdrawal of aid to the water and energy providers. Capital spending is set to increase significantly, as the government embarks on environment and infrastructure investment projects and provides support to manufacturing as part of the economic recovery measures.

Based on the no-policy-change assumption, which does not include the forthcoming 2010 budget, the general government deficit is projected to decline marginally to 4.4per cent of GDP in 2010. Revenue is set to recover in line with the incipient economic turnaround, and to grow at a faster pace than expenditure. Receipts are anticipated to be buoyant primarily due to direct taxes as it is assumed that the delayed income tax owed by companies will be recuperated. Social contributions are also expected to increase, as employment growth resumes.

Expenditure is projected to grow steadily, partly stemming from more dynamic developments in the public sector wage bill and health and age-related costs. In 2011, assuming no policy change, the deficit is foreseen to decline further to 4.3 per cent of GDP. Revenue is expected to continue to recover as tax-rich domestic demand improves.

Expenditure growth is assumed to stabilise, partly reflecting the authorities’ stated objective of following an expenditure-based fiscal consolidation. Moreover, with the expiration of the current public service collective agreement in 2010, compensation of employees is assumed to grow in line with inflation in 2011.

However, in the absence of concrete measures to tackle the spending pressures from healthcare and pensions, intermediate consumption and social benefits will increase at a sustained pace. Public investment is assumed to remain constant as a ratio to GDP.

The general government debt is projected to continue on an upward path over the forecast horizon, increasing to around 72.5 per cent of GDP by 2011.