The recovery underway since the second half of 2009 is expected to gradually gain strength, according to a European Commission economic forecast for Malta.

Real GDP is anticipated to expand by just above 1 per cent in 2010 and to accelerate in 2011 to 1.7 per cent, well below the average over the last decade. Still, Malta continues to outperform the euro area as a whole, albeit less markedly than in recent years, the report says.

Domestic demand is projected to recover gradually over the forecast horizon, mainly driven by a marked pick-up in investment already in 2010. This owes to a significant increase in public capital spending in environment and construction. In 2011, a stronger and more broad-based recovery in private investment is projected as capacity utilisation returns to its historical average and the profitability of foreign-owned companies improves due to the assumed global economic turnaround.

Private consumption is expected to weaken slightly in 2010 given subdued consumer confidence from still weak labour market conditions, but the improved economic outlook more generally, together with continued real wage growth, should boost it in 2011.

Benefitting from the assumed expansion of world trade, specifically in non-EU markets, exports growth is anticipated to gradually gain strength in 2010 and to stabilise in 2011. Imports are set to outperform exports, supported by the pick-up in investment, thus leading to a negative contribution of net exports to output growth. The external balance of goods and services is projected to remain slightly positive over the forecast period.

The main downside risk to the macroeconomic outlook stems from uncertainties surrounding Malta's ability to benefit from the global upturn.

The private sector will need to respond flexibly to counteract the erosion in competitiveness witnessed in recent years and to possible changes in the composition of external demand for goods and services produced in Malta.

Unit labour cost growth decelerates somewhat

After averaging almost 3 per cent in the period 2005-08, somewhat above the euro area average, per capita wage growth moderated markedly in 2009, the report says. This also reflects the slightly negative development of public wages following the exceptional increases in 2008 related to the voluntary redundancy schemes provided to the workers of Malta Shipyards Ltd ahead of its liquidation. From 2010, wage growth per capita is projected to pick up again, to a level above the euro area average, reflecting inflation trends rather than productivity gains, thus putting some pressure on Malta's competitiveness.

Though decelerating from the peak reached in 2008, HICP inflation is projected to stay above the euro area average but close to 2 per cent. In line with recent experience demonstrating sticky domestic food prices in spite of increased competition in the distribution trade, food inflation is expected to remain relatively firm over the forecast horizon.

Core inflation is projected to increase only marginally (from 1.5 per cent in 2009 to 1.6 per cent in 2011) mainly thanks to the expected stabilisation in prices of non-energy industrial goods. Services inflation is set to remain below overall HICP inflation, also reflecting increased competition in the tourism sector.

After a relatively strong performance in the years preceding the international crisis, labour productivity declined in 2008 as slowing output was accompanied by relatively strong employment growth and in 2009 as the scale of the output contraction exceeded the fall in employment.

The latter reflects support measures to retain workers and labour hoarding, especially in those sectors characterised by a high incidence of skilled workers. Employment is projected to improve only moderately over the forecast period, with some lag compared to the expected turnaround in output growth. As a result, productivity gains are set to reappear but at a lower pace than witnessed in the pre-crisis period.

Against this background, unit labour cost growth is projected to moderate somewhat over the forecast horizon, but to remain well above the euro area average. Although these developments would weigh on Malta's competitive position, some gains might arise from the recent appreciation of the US dollar, which is the transaction currency used by the important electronics sector.

Public finances under stress

Following several years of fiscal consolidation, the general government deficit increased to 4.5 per cent of GDP in 2008 mainly due to some exceptional expenditure-increasing items, such as the voluntary redundancy schemes for shipyards employees, the reclassification of the yards into the general government sector and temporary subsidies to the energy provider.

The deficit declined to 3.8 per cent of GDP in 2009. The improvement relative to 2008 is explained to a large extent by the non-recurrent nature of the exceptional expenditure items weighing on the 2008 outcome (although some further exceptional outlays for shipyards workers were recorded in 2009). In addition, public investment contracted significantly compared with 2008. Finally, while direct taxes were supported by the one-off proceeds of a tax amnesty on penalties for unpaid taxes and a relatively strong performance of income tax from international companies registered in Malta, the economic downturn hit revenue from indirect taxation, including taxes on property transactions.

In 2010, the deficit is expected to widen to 4.3 per cent of GDP, also because of lower deficit-reducing one-offs. Helped by favourable base effects related to the liquidation of the shipyards and the measures adopted with the 2010 budget to restrict recruitment, compensation of employees is set to fall further in 2010. Intermediate consumption is projected to increase markedly, mainly because of the additional recovery measures in the 2010 budget, including funds to enhance the quality of health-care services. Social transfers other than in kind are projected to keep increasing significantly due to the dynamics of age-related entitlements.

Capital spending is also expected to increase substantially mainly thanks to public investment projects in environment and infrastructure and support to private investment in part financed with EU funds. Overall revenue is projected to rise very strongly reflecting primarily the assumed buoyant absorption of EU funds. Tax revenue is expected to remain more subdued: indirect taxes are affected by moderate consumption dynamics (but at the same time benefit from some revenue enhancing measures), while the one-off effect of the 2009 tax amnesty weighs on direct taxes.

Finally, social contributions are set to increase broadly in line with the economy-wide wage bill.

Based on the no-policy-change assumption, the deficit is projected to narrow to 3.6 per cent of GDP in 2011, mainly thanks to the expiry of some temporary support measures adopted with the 2010 budget. More specifically, current expenditure is set to increase by just above 3 per cent relative to 2010, while capital expenditure is expected to stabilize after the strong increase expected in 2010.

Overall, the expenditure-to-GDP ratio is projected to fall by around ½ pp. to 45.5 per cent. On the revenue side the projected economic upturn and improved employment outlook are likely to entail an acceleration in revenue growth from tax collection as well as social contributions. As a result, current revenue is set to increase by close to 5 per cent relative to 2010, while capital transfers received are expected to broadly stabilise at a high level mainly due to the assumed support from EU funds. The overall revenue-to-GDP ratio is projected to increase slightly, to some 42 per cent.General government debt is expected to continue on an upward path over the forecast horizon, increasing on a no-policy-change assumption to around 72½ per cent of GDP by 2011 as the primary balance remains negative.