Michael C Bonello: Time for a reality check
Speech by Mr Michael C Bonello, Governor of the Central Bank of Malta, at the annual
dinner of the Institute of Financial Services, Saint Julian's, Malta, 20 November 2010.
* * *
I would first of all like to thank the President and his Council for inviting me once again to
address their annual dinner. Before I do so, I would like to commend IFS Malta for its
unstinting efforts to promote higher levels of expertise in our financial community. The
success of the foundation degree programme at MCAST and the new training programmes
in Funds Administration, Anti-Money Laundering and Financial Crime Prevention are but two
examples. I would also like to congratulate the Institute's nominee, Mr Peter Calleya, for his
election to the EBTN Executive Committee.
The economic rebound should not give rise to complacency
Last year I said that an improving external environment could benefit the Maltese economy.
And indeed it has. The recession proved short and shallow, with a peak-to-trough decline in
GDP of 3.4%, as against 5.3% in the euro area, and the GDP contracted by just 2.1% in
2009. In the first half of 2010 the economy grew by 4%, which suggests that the outturn for
the full year could top 3%.
This encouraging performance has prompted manifestations of the "Malta is different"
syndrome, with suggestions that belt-tightening and structural reforms are for others, but not
for us. For a country that, with one exception, has not had a current account surplus or a
balanced budget for at least fifteen years, this attitude betrays a poor understanding of the
growth dynamics in a small, open economy and of current world realities.
A more balanced assessment of the facts would recognize that the extent and speed of the
turnaround demonstrate not only the undoubted resilience of the Maltese economy, but also
its vulnerability. More specifically, since the rebound in good part reflects a recovery in the
electronics and tourism industries, it underlines our dependence on the state of external
demand. We ignore this reality at our peril.
Medium-term prospects will be conditioned by slow growth abroad
Now, given the pervasiveness of the recession abroad and the considerable uncertainty that
still prevails today, we can expect only modest growth in export markets in the near future.
According to the IMF, real GDP in the advanced economies will expand by only 2.2% in 2011
compared with 2.7% this year.1 In Europe, the euro area is forecast to grow by just 1.5%.
Given these subdued global prospects, it would be naïve to assume that the current
economic upswing in Malta will continue spontaneously without determined efforts to achieve
faster growth. There is no other option if we aspire to converge to the higher living standards
enjoyed elsewhere in Europe. The key to a better quality of life are rising incomes. In this
respect, there is considerable potential for improvement. Malta's GDP per capita in PPS
terms has been stuck at around 77% of the EU average since 2003.2
The focus must be on productivity and competitiveness
Faster sustainable growth will not, however, be possible unless we produce goods and
services that meet the test of increasingly competitive and discerning markets. This, as the
recent Pre-Budget Document acknowledged, requires, among others, higher productivity
levels, which would then raise the rate of growth of potential output.
Productivity has been improving recently, but against the backdrop of a relatively poor
longterm record, which leaves Malta well behind the best performers in the euro area.3 Even
more worrying, compensation levels have risen much faster than productivity.
The explanation for this relatively poor outcome should be sought in the way we use
productive resources, principally labour and capital.
Malta's labour resources are underused...
To begin with, not enough people participate in the formal labour market. In 2009 the
employment rate stood at 55%, compared with a euro area average of nearly 65%.4 The
activity rate among women and older workers in particular is especially low.
Furthermore, long-term demographic projections suggest that, over time, the labour force will
shrink. According to the European Commission, the working-age population in Malta will
contract by more than 20% by 2060.5 In the light of these trends, raising participation rates
should be a priority. Several measures have already been taken, including in the Budget for
2011, such as incentives for women to re-enter the labour market, and trying to remove
"unemployment traps" that arise from the interaction of the tax and welfare system. The
gradual increase in the retirement age will also help. But this will not be enough.
Efforts to get more people to work must, moreover, be accompanied by measures to raise
their productivity. We need to invest more, and more efficiently. Malta's educational
attainment levels in particular, though improving, remain low. In 2009 just over one quarter of
adults aged between 25 and 64, much less than half the EU average, had completed at least
an upper secondary level of education.6
The solution here does not lie solely in allocating more resources. It is also a question of how
the money is spent. According to a recent study, public spending on education in Malta
amounts to around 5.5% of GDP, which is above the EU average.7 But the study also shows
that this spending is not very efficient, especially in the case of tertiary education. Despite the
significant amounts spent, Malta's tertiary educational attainment level, at 21.1%, is well
below the EU average of 32.3% and the Europe 2020 target of 40%.8
This situation must be reversed because well-remunerated jobs cannot be created in the
absence of high-quality post-secondary education. As the recent Browne report in the UK
3
Source: Eurostat.
4
Source: Eurostat.
5
European Commission, The 2009 Ageing Report: economic and budgetary projections for the EU-27 Member
States (2008-2060), European Economy 2/2009, page 47.
6
Source: Eurostat.
7
Ebejer, Ivan and Ulrike Mandl, The efficiency of public expenditure in Malta, ECFIN Country Focus Volume 6,
Issue 2. February 2009.
8
The tertiary educational attainment level is defined as the share of the population aged between 30-34 years
who have successfully completed university or university-like education with an International Standard
Classification of Education 1997 of 5-6.
BIS Review 156/2010
stresses, higher education drives innovation and economic transformation.9 The University of
Malta, however, is short of funds. One way of tackling this deficiency would be to limit stipend
support to students who are truly in need. This would ensure that access to a university
education remains open to everyone with the potential to benefit from it, while releasing
funds for improving its quality. It would also address an issue of equity: since a tertiary level
education is the key to better-paid jobs and higher lifetime incomes, it is appropriate that
those who benefit most from it should contribute at least part of the costs involved.
... while investment has not been sufficient
But enhancing the supply and quality of labour is still not enough. To produce output, labour
has to work with capital. Now a country's capital stock can only grow through investment.
The recent performance in this regard has been inadequate. As a share of GDP, private
investment amounted to 16% on average between 2000 and 2009, among the lowest ratios
in the euro area. Given Malta's track record in attracting foreign direct investment, this
shortfall is probably more a reflection of a relatively low level of domestic private investment.
The latter is unlikely to be related to the cost and availability of finance. Interest rates are at
historic lows and, contrary to the experience elsewhere, credit to the private sector continued
to expand during the recession. As for possible structural factors, the diversification of the
economy away from manufacturing towards services is also unlikely to have been a factor.
Similar sectoral shifts elsewhere did not result in a declining investment share.
Rather, the relatively low level of private investment could, in part, be a legacy of the past,
when firms in protected sectors could survive without the need to invest to face up to
competition. In addition, in key sectors such as tourism and the wholesale and retail trades,
the operating surplus has fallen, on average, over the past decade. Weak profitability, which
is partly due to labour costs rising faster than productivity, reduces both the incentive to
invest and the internal funds available to do so. Hence the emergence of a perverse cycle of
weak profitability, low investment, poor productivity growth and a loss of competitive strength.
These weaknesses are reflected in persistent current account...
These structural weaknesses show up in a persistent deficit on the current account of the
balance of payments. Shortfalls have been recorded in every year but one since at least
1995. The deficit widened again in 2009 to 6.9% of GDP from 5.7% the previous year.
A current account deficit indicates that we spend more than we produce. It also implies that
domestic savings are insufficient to finance investment, even though, as we have seen, the
rate of investment is relatively low. The only way in which current consumption levels can be
sustained, therefore, is by raising incomes. This, in Malta's case, requires a more dynamic
export performance.
For a start, this means that efforts to attract foreign direct investment, much improved in
recent years, need to become even more focussed and supported with a strengthened
infrastructure. The domestic private sector, meanwhile, needs an incentive to switch to
producing for markets abroad. This incentive is relative profit. Export-oriented activity must
become relatively more profitable than production for the domestic market alone.
In a small island economy, where transport costs impose natural barriers to trade, it is easier
to set up and defend monopolies. This was especially true before the liberalisation of product
markets at the time of EU accession. But this is not to say that elements of monopoly power
- and the attitudes this engenders - have not survived. For example, a survey carried out by
the Bank on price and wage setting in Malta shows that although just over half of
respondents would cut prices if their competitors did so, 36% would not. Unsurprisingly, the
most flexible firms were those in the manufacturing and tourism sectors, where foreign
competition is strong.
This suggests that there is still scope for increasing the degree of domestic market
competition. Sometimes, the connection between market liberalisation and exports may be
indirect. As the recent experience in the communications sector has shown, liberalisation
drove down costs and prices. This opened up new export opportunities outside the
communications sector itself, for example, in financial services and remote gaming.
The importance of keeping costs under control cannot be overemphasized. Malta's inflation
performance over the last ten years illustrates this point. Whereas the euro area inflation rate
averaged 2.1% between 2000 and 2009, domestic inflation averaged 2.5%. The record for
inflation excluding energy prices shows a similar unfavourable trend. It is an established fact
that in a currency union rates of inflation consistently above the average result in a loss of
competitiveness.
Apart from more competitive markets, containing domestic inflation implies a need for wage
moderation. For many years employee compensation has grown faster than real labour
productivity. Whereas the former increased by around 31% since 2000, productivity rose by
only 2.5%. The resulting rapid growth in unit labour costs, more than 28%, compares with an
average of 20% in the euro area.
In order to make up for this lost ground, the wage determination process needs to be
reformed. While wage bargaining at the enterprise level provides flexibility, the automatic
indexation mechanism through which current wages are adjusted to past inflation, even if
partially, increases the downward rigidity of real wages and thus represents a permanent
drag on Malta's competitive position.
...and government budget deficits
The current account deficit is mirrored not only in the shortfall in private savings but also in
the budget deficit. Government expenditure has exceeded revenue in every year at least
since 1995, resulting in a steady rise in the public debt from less than 40% of GDP in the
mid-1990s to 69% today.
The thrust of the recent Budget, and particularly the projected cut in the deficit ratio from
3.9% of GDP in 2010 to 2.8% next year, is therefore a welcome development. Continued
vigilance is, however, necessary. Given the uncertain prospects for Malta's export markets,
for example, the assumed nominal GDP growth rate of 5.6% on which the tax revenue
forecast for 2011 is based could turn out to be optimistic. The medium-term objective of a
balanced budget, moreover, must be kept well in mind.
EU rules stress the importance of achieving a balanced budget over the cycle precisely
because fiscal prudence responds to a clear economic logic. In the long run, a persistent
budget deficit contributes not only to a dangerous debt dynamic, but also to price pressures,
a loss of market share and a trade imbalance. Only through the achievement of surpluses
during a cyclical upswing can there be room for countercyclical deficits in a downturn. The
retrenchment currently being experienced in many countries highlights the consequences of
leaving fiscal imbalances unaddressed.
Fiscal consolidation is also necessary to bring the debt ratio below the 60% limit. For
example, if the deficit ratio does not shed one percentage point in 2011 as planned, the
deficit would be some EUR65 million higher than the projected amount. At current interest
rates, this would imply an addition of about EUR3.3 million to the annual interest charge on
the debt, which at EUR 198 million this year is considerably more than government
investment in the infrastructure; and the debt ratio would rise by an additional percentage
point to 70%.
Improving the long-term sustainability of public finances assumes additional importance in
view of the expected doubling of the share of the elderly in the Maltese population by 2060.
As a result, age-related spending is set to increase by more than 10% of GDP. Partly
because of these demographic trends, Malta is among the group of EU countries facing the
greatest challenge in terms of fiscal sustainability.10
Since this task can only be addressed gradually, we have to start now. Completing the
planned reform of the pension system must be part of the solution. In particular, introducing
funded pensions promises to deliver benefits on several fronts. First, by boosting incomes in
retirement it will help support a large share of the population as it ages, reducing the burden
that currently falls on the unfunded pay-as you-go system. Second, if individual contributions
are linked more closely to individual payouts, this will encourage private saving, which, as we
have seen, is necessary to close the saving/investment gap. Finally, if individuals perceive a
closer link between their contributions and their retirement income, this should help curb the
evasion of social security payments.
There is little room for tax increases
Fiscal consolidation, therefore, is desirable to help correct the economy's external imbalance;
to put public finances on a sound footing while coping with the costs of population ageing;
and, above all, to maintain credibility and investor confidence, which are prerequisites for
growing the economy.
Now deficit reduction is typically achieved through a combination of increased revenue and
expenditure cuts. As for the former, relying mainly on higher taxation cannot be an option at
this juncture; besides, it generally distorts the efficient allocation of resources. Higher indirect
taxation tends to push up the price level and, hence, harms competitiveness, while higher
taxes on income depress economic growth. Neither, of course, is this a time for cutting taxes.
An option which is at once fiscally beneficial and socially desirable is to close remaining tax
loopholes and to engage in a more aggressive pursuit of tax evasion and benefit fraud.
We need to cut spending, while rebalancing it
The only real alternative, however, is to cut public spending. There is a near-consensus in
the literature that expenditure cuts have a smaller adverse impact on the economy than
revenue increases.11 Fiscal consolidation, moreover, produces long-term benefits since a
smaller debt stock results in lower interest payments, and thus can eventually create room
for growth-enhancing tax cuts.12
General government expenditure amounted to EUR2.5 billion in 2009, or almost 44% of
GDP. The largest single item was the wage bill, equivalent to 14.5% of GDP. It was followed
by spending on benefits, mainly old age pensions, which amounted to some 13% of GDP.
Health care, excluding wages, absorbed a further 2%. These three items together account
for more than two-thirds of government spending. In contrast, an amount equal to only 2.2%
of GDP was dedicated to investment. A substantial increase in productive investment,
particularly in physical and human capital, is clearly necessary.
The Budget for 2011 recognizes this need, projecting a marked increase of 15% in capital
spending. This is encouraging because in recent years growth has mainly occurred in
recurrent spending. Between 2004 and 2009, this expanded at an annual average of 5.3%.
On the other hand, government investment remained broadly unchanged during this period
and declined in the last two years, in part because actual outlays often fell short of targets.
The dual challenge of maintaining a high level of investment spending while reducing the
budget deficit, therefore, implies that it is recurrent expenditures that must be cut. Progress
has already been made by reducing subsidies, through the privatisation of the shipyard and
by aligning utility rates more closely to production costs. For next year, however, while an
increase of less than 1% in recurrent spending is planned, few specific cuts have been
identified. In this context, the latest Annual Report of the National Audit Office suggests there
is ample scope for controlling expenditures more effectively and for improving revenue
collection.13
While taxpayers have every right to expect value for their money, a substantial, durable fiscal
correction requires a fundamental reappraisal of the role of the state in providing services.
The need to prioritize expenditure programmes has not been fully addressed. As a result, the
most difficult challenges, such as how to ensure sustainable funding for tertiary education,
pensions and health services, remain to be tackled.14
Domestic consumption must return to a sustainable level. It is an inevitable adjustment for
economies like ours that have lived beyond their means for far too long. Fortunately, we
need to adopt much less drastic measures than those countries that have had to make deep
cuts in public sector staffing levels, wages and social benefits in order to stave off the
financial collapse of the state itself.
And yet, people in Malta continue to expect the Government to hand out money it does not
have. This attitude must change, for not only can it lead to bankruptcy, but it is also
indefensible on moral grounds. Politicians, trade unions, NGOs and other opinion shapers
must explain that we do not have money for everything and that you cannot have gain
without pain. The intelligent thing to do is to work together so as to minimize the pain and
then ensure that it is equitably shared.
In my view, the priority of the welfare state should be to provide equal opportunities for all,
but a safety net only for those who need it most. Universality - dispensing free goods and
services to all irrespective of income - is a wasteful and unaffordable principle. In the words
of the renowned economist, Jeffrey Sachs, "Even playgrounds should collect tolls, when it is
billionaires who are playing in the sandpit."
The social welfare system, including health care, has long been identified, including by the
European Commission and the IMF, as offering the greatest potential for savings. Effective
measures implemented elsewhere which could be adopted range from user fees for certain
public services to policies designed to make work pay. We should also reassess the scope of
social benefits, to distinguish between those that truly help to combat poverty and social ills
and others that are not so effective in achieving the desired outcomes.
Finally, I believe the time has also come to consider how to strengthen the budget process,
drawing on models tested successfully abroad. These typically involve fiscal rules providing
for limits on supplementary budgets, multi-annual expenditure ceilings and more
transparency in fiscal policy making, as well as an independent monitoring agency. The
pursuit of fiscal sustainability along such lines requires a broad political consensus.
Conclusion
Mr. President, this evening I have argued that while the Maltese economy is headed in the
right direction - a fact that has been recently confirmed by its 33rd place in the Human
Development Index -, we must look beyond the current upturn to examine structural
weaknesses that are preventing the economy from exploiting its full potential, and thus from
closing the income gap with our European peers.
I have therefore suggested that we need to raise labour force participation, improve the
quality of the work force and increase the efficiency of public spending, particularly in
education. We also need to invest more, to upgrade the capital stock. Here, monetary policy
is playing an important role: interest rates are at historic lows and bank credit continues to
flow. The Eurosystem's commitment to deliver price stability in the medium term is also a key
factor in sustaining investor confidence and supporting economic expansion.
Market mechanisms, underpinned by appropriate legal frameworks, must be allowed to work
better. In general, we need to open up domestic markets to an even greater degree of
competition.
In addition, fiscal tightening is necessary to correct current imbalances and begin to reverse
the trend increase in public debt. This objective acquires added importance in the context of
population ageing. Above all, durable consolidation requires a reappraisal of the role of the
state and the tightening of fiscal rules.
Finally, we need to further improve the economy's resilience to external shocks. Over the
past decade unit labour costs and prices have shown a marked tendency to deviate from the
euro area average, thereby eroding competitiveness. It is a law of economics that the
adjustment necessary to regain competitiveness inside a monetary union must take place in
the real economy by ensuring that prices, wages and profit margins fall, or at least increase
by less than the average, for a number of years. This requires the introduction of
productivityenhancing measures and a wage-setting process in which wage increases reflect efficiency
gains at the enterprise level rather than past inflation.
In concluding, let me emphasize that what I am advocating is not austerity but enlightened
self-interest. It is a commonsense appeal for a closer alignment of our priorities with the
economy's strategic objectives and for a more efficient allocation of resources. Against a
backdrop of weak and uncertain global growth prospects, the policy focus must be on
releasing resources to make the long-term investments needed for sustainable growth. There
is indeed not much that economic policy can do to create well paid jobs in the short term.
These are the combined outcome of high education standards, modern technology and an
efficient infrastructure. This, in turn, depends on farsighted policies and years of wise
investment by both the public and private sectors. That, I believe, is the path we should
follow.