'BBB+/A-2' ratings affirmed

Overview

• In our view, Malta's economic growth prospects remain strong relative to
• its EU and 'BBB' rating category peers.

• We expect budgetary consolidation to continue, leading net general
• government debt to decline to 55% of GDP in 2018, from 59% in 2014.

• We are therefore revising our outlook on Malta to positive from stable and
• affirming our 'BBB+/A-2' ratings.

• We do not believe events in Greece will have a material bearing on Malta's
• credit profile.

• The positive outlook reflects a one-in-three likelihood of an upgrade
• within the next 24 months if medium-term economic growth prospects are
• maintained and fiscal consolidation continues, while no bank- or
• nonfinancial public enterprise-related contingent liabilities or external
• risks materialize.

Rating Action

On July 10, Standard & Poor's Ratings Services revised its outlook on Malta to positive from stable. At the same time, we affirmed our 'BBB+/A-2'  long- and short-term foreign and local currency sovereign credit ratings.

Rationale

Malta's real GDP grew by 3.5% in 2014, and we project that it will expand by  close to 3% annually on average in 2015 2018.

We believe Malta's economy will  continue to outpace the eurozone as a whole, notably because of investments in the energy sector.

Investments include the laying of an interconnector cable  to Sicily (currently in a testing phase), as well as the building of a  liquefied natural gas terminal, a natural gas plant, and the conversion of an  oil-fired plant to gas, all expected to be finalized in 2016.

Beyond 2016, further diversification of the economy--particularly into  information and communication technology and medical tourism--could boost  investment.

Moreover, we expect domestic demand to be backed by stronger  private consumption, resulting from government-mandated cuts to utility  tariffs that have reduced electricity prices by 25%.

Lastly, consumption  trends are being supported by rising real wages and, more importantly, broader female participation in the labor market.

On the external side, we view Malta as an open, services-oriented economy.

We  expect the tourism sector will continue to perform well on the back of a  favorable euro/pounds sterling exchange rate, the increased perception of  terrorism-related risks in some other Southern Mediterranean countries, and  the current turmoil in Greece.

The low corporate tax rate has attracted significant foreign investment into  Malta's banking, insurance, and gaming industries, implying that the economy  would be sensitive to potential pressure for a eurozone-wide standardization  of corporate tax regimes.

We expect that Malta will run a small current account surplus over our  2015-2018 forecast horizon, and remain in a narrow net external asset position of about 16% of current account receipts (CARs) on average during 2015-2018.

Nevertheless, we note that gross external financing needs are high, at about  255% of CARs plus usable reserves on average during 2015-2018, mainly  reflecting the large financial sector.

Indeed, offshore banks dominate Malta's international investment position. We understand that foreign banks use Malta  as a booking center for their own financing needs.

We believe that Malta's favourable economic growth prospects support further  budgetary consolidation.

We forecast general government consolidation to  progress gradually through 2018, primarily owing to increased tax receipts  from strengthening domestic demand and the expected decline in current  expenditure from 2016 onward.

We expect net general government debt to decrease to 55% of GDP by 2018, from  59% in 2014.

We forecast general government gross debt to be 68% of GDP in  2015, excluding the guarantees related to the European Financial Stability  Facility.

We forecast general government interest payments will average 7.1% of general  government revenues per year over 2015-2018.

Malta's contingent fiscal  liabilities stemming from NFPEs derive mostly from Enemalta's government  guaranteed debt (9.7% of GDP as of end-March 2015).

Enemalta will likely not  generate profits until 2017. We note that the current drop in international  oil prices is helping Enemalta's expected return on investments.

Nevertheless, other state-owned enterprises also represent fiscal risks, as exemplified by  this year's government financial support to Air Malta, estimated at 0.5% of  GDP.

Government guarantees of NFPE debt totaled 16% of GDP at year-end 2014.

Moreover, we note that without further reforms in the pension and health care

systems, public finances will become strained in the medium term.

Under our criteria, we see contingent fiscal risks to public finances coming  from the banking sector.

Malta's domestic banking sector operates alongside a  large offshore sector which, we believe, the government would not support in  case of financial distress. However, dislocations in their funding could  affect the island's reputation as a financial center.

Assets of the total  banking sector are nearly 7x GDP while assets of core domestic banks amounted  to about 2x GDP.

As of end March 2015, domestic systemically important banks  include 25% state-owned Bank of Valleta (total assets €9.3 billion) and HSBC  Malta Bank (total assets €5.9 billion). To this list, we would add  fast-growing Mediterranean Bank (total assets €2.9 billion), which we expect  to join the other two under ECB supervision soon.

Among core domestic banks,  the increase in nonperforming loans (NPLs) to 9.1% of total loans as of March  2015 remains a challenge for the economy, with almost half of NPLs in the  construction and commercial real estate sectors.

Banks' aggregate loan loss  provisioning rose to 43.9% as of March 2015, which we still consider low.

Indeed, banks take a while to realize collateral in Malta, a characteristic  that we regard as common to small jurisdictions.

Membership in the eurozone anchors Malta's monetary policy and provides its  banks access to funding at low nominal interest rates.

Nevertheless, we  believe that membership in a monetary union increases the onus on member  governments to support competitiveness through fluid labor, product, and  services markets, and to build up fiscal buffers against future shocks.

This  is more the case now than a year ago, given that the ECB is undershooting its  medium-term price stability target of close to, but lower than, 2% for the  eurozone as a whole.

We note that nominal unit labor costs have been  increasing at one of the fastest rates in the euro area, posing risks for  competitiveness when many euro area neighbors are undertaking structural  reforms and internal devaluations.

We do not believe events in Greece will have a material bearing on Malta's  credit profile. Like all Eurozone members, Malta is exposed through common  monetary, fiscal, and development institutions such as the European Central

Bank, the European Financial Stability Facility, and the European Investment  Bank.

Apart from contingent liabilities associated with those institutions,  Malta's exposure to Greece is limited. Malta's trade with Greece is small and  direct financial links are few.

We assess the external debt of Malta's  domestic banks as sufficiently contained such that Malta would cope with a  permanent real increase in external funding costs spilling over to eurozone  markets from Greece.

Overall, the ratings on Malta are supported by our assessment of Malta's  economic growth prospects, solid external position although with data  discrepancies, and gradual budgetary consolidation, which we expect will place the government's debt-to-GDP trajectory on a steady downward course.

Sizable  government debt and contingent liabilities continue to constrain the ratings,  however.

Outlook

The positive outlook reflects our opinion of at least a one-in-three  likelihood that we could upgrade Malta within the next 24 months if  medium-term growth continues without a return to significant current account  deficits.

We could also raise the ratings if fiscal consolidation advances  faster than we currently expect while no contingent liabilities or external  risks materialize for the government.