Michael C Bonello: Policy challenges beyond the euro
Speech by Mr Michael C Bonello, Governor of the Central Bank of Malta, at the Annual Dinner of the
Malta Institute of Financial Services, Saint Julian's, 17 November 2006.
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I should first of all like to thank you, Mr President, and your Council for the opportunity to share my
thoughts once again with such a distinguished audience. Before I do so, however, I would like to
commend the Institute of Financial Services (IFS) for its admirable capacity to reinvent itself in
response to the changing demands of the marketplace. This year, for example, the Institute has
renamed itself as the IFS School of Finance. I have discovered that this apparently cosmetic change
has a very significant meaning, in that the Institute in the UK is now empowered to award degrees. IFS
Malta, on its part, has extended its reach beyond our shores and is cooperating with the Romanian
Banking Institute in the delivery of one of its academic programmes in that soon-to-be EU member
country. I am sure all your other guests will join me in wishing you and your Council every success in
your continuing efforts to promote higher professional standards in the financial sector.
Since Malta joined the EU in 2004, and particularly since the Maltese lira entered ERM II last year, the
Central Bank of Malta has been making the case for an early adoption of the euro. That goal now
seems to be within reach, thanks in no small way to the Government's steadfast commitment to fiscal
consolidation. The achievement of a political consensus on the euro is also a welcome development.
The main remaining challenge is to meet the inflation criterion.
Tonight I shall argue that the euro is a necessary, but not a sufficient condition for faster growth. More
specifically, unless we establish limits on how much we consume and, within limits set by the
economy's earning capacity, allocate a greater proportion of the national income to investment, the
advantages of euro area membership cannot be fully realized. It is time for the country to disown an
unfortunate legacy of its colonial past that is best reflected in the notion that it is possible to spend
more without first producing more. To this day, political discourse contains frequent references to tax
reductions and subsidies, when it should be rallying popular support for the need to strengthen the
country's capacity to generate wealth on a sustainable basis.
The benefits of euro area membership
As I have said, the adoption of the euro should enhance the economy's potential to grow faster. The
elimination of exchange rate risk and currency conversion costs should result in increased trade, while
the lower interest rate and inflation environment of the euro area should make for reduced business
costs and greater macroeconomic stability. Combined with the fiscal discipline associated with
monetary union, this is expected to translate into higher credit ratings and better investment prospects.
From a central banker's viewpoint, moreover, a key benefit of euro area membership will be the
elimination of the costs inherent in managing a small, vulnerable currency like the Maltese lira and
their replacement by the greater security and credibility afforded by a strong international currency.
Euro adoption necessary but not sufficient
Viewed from this perspective, therefore, the euro is but one element in a continuum of changes
necessary to enhance the international competitiveness of the Maltese economy. The benefits of the
single currency will not suffice, especially in the presence of downside risks to global growth such as
higher oil prices, a potentially disorderly unwinding of current account imbalances and the rise of
protectionism. Although the ongoing preoccupation with the level of the external reserves will cease
once we join the euro area, moreover, any imbalance between what we buy and sell abroad will
continue to cause the depletion of assets or the accumulation of liabilities, and be reflected in the
country's international investment position. Any loss of competitiveness, therefore, will still result in
slower growth.
Raising productivity a key challenge
In setting out to overcome this challenge, a primary objective should be the correction of existing
macroeconomic imbalances. Output growth must, therefore, match spending growth more closely, and
a key element in bridging that gap is increased productivity.
Put differently, since we are price takers in the markets that matter, notably those for electronics and
tourism, we must have a cost structure that does not discourage investment. Domestic inputs,
particularly labour, must be competitively priced. And since the cost of labour in Malta is relatively
high, we must increase the value of output per employee. Once again, the only way forward is through
productivity growth.
In this regard, there is much room for improvement. The level of productivity has remained roughly
unchanged since 2001, while it is projected to increase at an annual rate of only 1% to 2% in 2007 and
2008. For a country that is highly dependent on exports, this is not good enough when many of our
competitors are achieving faster productivity growth.
Faced with this situation, we would do well to reflect on the experience of others. In France, a recent
McKinsey report showed how industrial productivity gains slowed sharply in the last five years, causing
the country to miss the opportunity to create an estimated 700,000 jobs. As for the reasons, a report
by the Camdessus expert group in 2005 identified two major obstacles to growth: first, not enough
people work, and those who do work, do not work long enough, due in part to the introduction of a
35-hour working week; second, the heavy State has become a costly drag on the economy.
Malta faces a similar predicament for much the same reasons. For example, the labour participation
rate is still low at 58% compared with an EU average of 70%; and the Maltese will have worked seven
fewer days this year than the Dutch, who work longest, and three days fewer than the EU average,
despite the abolition of the practice of compensation for a holiday that falls on the weekend. Since
independence, moreover, successive governments have bequeathed a legacy of welfare schemes
and free public services that have not only distorted incentives and encouraged waste and abuse, but
are also largely unsustainable. It is no wonder, therefore, that the Government absorbs almost half of
the GDP, the tenth highest percentage in the EU. The concept of value for money, moreover, does not
always prevail in public sector procurement1.
Let me mention just two examples of resource misallocation. The first is the absence of fees for
government-supplied health care. One can, for example, obtain expensive medicines or have a heart
by-pass operation for free, regardless of one's capacity to pay. Not surprisingly, the budgetary
allocation for medicines and surgical materials alone is forecast to increase by 13% next year to
Lm21.5 million. The sustainability of the public health system is imperiled by the very manner in which
it is financed. Sooner or later, the ability to provide free services to those who truly deserve them will
itself come under threat. In this context, the parallel commitments of the major political parties to the
continued provision of free health services for all and to prudent fiscal policies are not easy to
reconcile.
Much the same can be said of higher education, which is characterized by a student subsidy system
that is probably unique. The University of Malta and MCAST have together been allocated Lm15.5
million for 2007, compared with no less than Lm8 million budgeted for students' maintenance grants.
Funds that would permit these institutions to offer better quality programmes, and in the process
hopefully raise the number of science and technology graduates from its current inadequate level, are
instead paid to students regardless of their financial means.
Changes needed in the pattern of resource allocation
This generous approach to the management of public finances has meant that recurrent revenue,
although higher year after year, has often not been able to keep up with recurrent expenditure. For
example, in 2005 expenditure amounted to 41% of GDP, roughly matching revenue at 42%. As a
result, the 6% of GDP allocated to capital spending had to be funded almost entirely by additional
borrowing, which gives rise to further debt-servicing costs. Repeated year after year, this pattern
pushed the debt/GDP ratio steadily upwards to a peak of 75% in 2004.
This tendency for recurrent revenue to be matched by recurrent expenditure in the context of fiscal
retrenchment has had a crowding-out effect on investment, and partly explains why the country's
investment/GDP ratio has been static at best in recent years. A more telling indicator of the relatively
small investment in productivity-enhancing activities is the share of GDP devoted to R&D, 0.6% in
2004, compared with an average EU ratio of about 2%.
It is doubtful whether the existing pattern of resource allocation is conducive to the desired
improvement in Malta's international competitiveness. The latter can only be achieved by increasing
the size, flexibility and skill level of the labour force, while simultaneously creating an institutional and
physical infrastructure more likely to attract high value-added foreign direct investment. And since the
State must play a leading role in this effort, the question of financing arises spontaneously.
Now in the context of a fiscal consolidation process that has not yet run its full course, increasing
recurrent spending beyond the natural creep caused by existing commitments such as pensions is
clearly not an option. Such spending is already equivalent to 47% of GDP. The same applies to
taxation, which stands at 36% of GDP. The only way forward is to pursue the medium-term objective
of a balanced budget over the business cycle by reducing recurrent expenditure, by redistributing the
resources available and by making the most efficient use possible of both domestic and EU funds.
An additional advantage of lower spending commitments is that this would make further tax cuts
possible that would, in turn, stimulate private initiative and investment.
The course of action I am suggesting, therefore, would bring the country's spending priorities more
closely into line with its Lisbon Strategy goals. If Malta is to move up the value chain, it must
acknowledge global realities. It is clear, for example, that there are increasing rewards from
innovation; and that ICT has become a major driver of economic growth. A growing proportion of world
manufactured products, moreover, are in the high-tech category, 28% in 2000, double the percentage
twenty years earlier; and knowledge intensive services are the largest source of employment growth in
the EU15, with over 7 million new jobs created between 1997 and 20022. These trends should leave
us in no doubt as to the direction in which the wind is blowing.
Financing the necessary investment
So where is the money to be found to promote improved higher education and ICT-related skills,
entrepreneurship and innovation, or to be able to offer foreign investors custom-built premises at
relatively short notice and of the standard they have come to expect, when almost 80% of recurrent
Government expenditure goes on transfer payments and wages? As for the remainder, there is no
room for discretionary cuts either: almost 9% represent interest payments on the public debt, and the
balance is spent on essential supplies. Since EU funds alone will not be sufficient, the solution must
encompass a further contraction of the public sector and a rethinking of the philosophy behind social
spending programmes and other transfer payments.
Compensation of public sector employees has been stable at 36% of recurrent expenditure. As a
proportion of GDP, it peaked at just over 15% in 2004 and is projected to decline to 13% in 2008,
reflecting moderate wage increases and a declining workforce. It is important that these trends
continue.
As for transfer payments, these account for some 40% of total recurrent expenditure. Social spending
alone absorbs a third of the total. Growth in this area over time has been driven by the perceived need
to preserve the social fabric and by demographic pressures. In the process, however, sight has been
lost of the original objective. We have to ask whether today's blanket approach to welfare, higher
education and health is promoting a culture of reliance on the State rather than the encouragement of
private initiative. Our system does not focus exclusively on those who are truly in need, but also
provides a cushion for higher income earners, at the cost, however, of a heavier fiscal burden.
Social programmes must be sustainable
The time has, therefore, come for a radical reform that reconciles the objective of social cohesion with
financial sustainability. Non-essential transfer payments should be reduced, especially those that are
of a universal nature and do not address a proven need. The introduction of means testing must be
seriously considered, accompanied by continued efforts to reduce tax evasion. The criteria for the
granting of certain benefits should be tightened further. The underlying objective should be to promote
a culture of self-help and efficiency.
In the field of higher education, for example, since an academic qualification enhances the student's
income-earning potential, I believe a strong case can be made for at least the partial replacement of
grants with loans for students from a better-off financial background, with a repayment schedule that
provides for moratoria to suit the post-graduation realities of the particular student. What the typical
student expects from higher education in terms of quality will increase once he or she is contributing to
its financing, and higher expectations are known to be one of the drivers of an improvement in
standards.
Anyone who perceives something sinister in these proposals might look up a recent study by
economist Andre Sapir. Using a fairly well-established typology, Sapir grouped the EU15 into four
main social models, the Continentals, Nordics, Mediterraneans and the Anglo-Saxons, and then
estimated the efficiency and equity of each. He shows that there does not need to be a trade-off
between efficiency and equity. Just as importantly, however, he underlines that efficiency is always
necessary for sustainability3.
How do other countries approach this challenge? The experience of Singapore, which is twice as well
off as Malta on a per capita GDP basis, is instructive. There, undergraduate education is heavily
subsidized by the government, but the remaining cost is borne by the student. The student's annual
contribution ranges from the equivalent of Lm1,300 for an engineering degree to Lm3,800 for a
medical degree.
There are, however, means for the student to finance this co-payment through borrowing from the
Central Provident Fund. This is a social security savings plan funded by contributions from employers
and employees, and which go into three accounts. Let me mention two of them. One is the Ordinary
Account, which can be drawn upon to pay for the family's educational expenses, or to buy a house.
Another account, the Medisave Account, can be used for hospital and other medical expenses, or to
participate in the MediShield insurance programme. Under this scheme the patient pays a deductible
amount and is required to make a co-payment. The system encourages efficiency, because medical
practitioners and hospitals must compete for patients.
Other areas susceptible to reform
As these examples show, it only takes some imagination and a clear sense of purpose to devise
mechanisms that promote a more efficient use of resources. But it is not just in the areas of welfare,
higher education and health that a policy review is needed. Take transportation, for example.
Restrictive practices at the harbour raise costs by pushing up the price of imports and lower our
competitiveness by increasing the cost of exports. It is rather ironic that decades after the abolition of
hereditary titles, and at a time when the merits of free markets and competition are widely
acknowledged, Malta sanctions the inheritance of licences and protects monopolies not only in the
harbour, but throughout the public transport system.
More generally, if investment is to be channelled to productive activities that generate the highest
return, profit signals should not be distorted by monopolistic market structures, subsidies or protection.
The need for a consensual approach to reforms
Mr President, I am aware that the thrust of my remarks challenges the continued existence of what
have come to be perceived as acquired rights. They might have been acquired, but they are often
neither economically viable nor affordable. Trying to persuade public opinion to come to terms with
such economic realities is, however, a central bank governor's responsibility. My concern is not
without foundation, for the challenge to the sustainability of our current ways comes with a precise
timeline. It is likely that Malta's eligibility for EU structural funds will decline after 2013, and the burden
of an ageing population in terms of health and pension expenditures will be much heavier than it is
today. It will, therefore, be imperative to have invested massively and wisely in the meantime such that
the economy will be generating sufficient wealth and, therefore, tax revenues to bridge any budgetary
shortfall.
My conclusions are supported by both theory and experience. In the neo-classical growth model the
rates of saving and investment are the fundamental determinants of living standards in the long run. In
other words, countries that save or invest more than others will enjoy a higher per capita income.
Newer growth theories go beyond this and distinguish between two types of capital, physical and
human. Empirical evidence clearly shows that differences in living standards across countries can be
explained by differences in investment in human capital. Unfortunately, advice on the importance of
saving and investment often goes unheeded because higher saving entails lower consumption. In
other words, prosperity tomorrow can only be achieved by making sacrifices today.
Even if this lesson is not fully taken on board, the need for continued fiscal prudence will ensure that
choices between alternative uses of public funds will have to be made more frequently, and spending
cuts made in sensitive areas. Such decisions would be taken much faster and more effectively if a
bipartisan approach were adopted. Other countries in Europe have taken this road, but there are
precedents in Malta too. The financial services legislation, for example, was adopted unanimously by
Parliament. The impressive growth of the financial sector indeed testifies to what a bipartisan
approach to strategic economic choices can achieve. The national consensus on the adoption of the
euro is another example. It would greatly strengthen the economy's capacity to benefit from
membership of the euro area if this consensus were extended to a recognition of the need to increase
the share of government revenue devoted to investment in the country's future.
Mr President, I make no claim to originality in voicing these concerns. In a recent letter to a local
newspaper, a Mr V. Spiteri wrote,
"Vague promises and assurances that if we vote for one side instead of the other we can retain free
medical care, retire at 61, afford to eat out more often, take at least one holiday abroad and drive a
new car, is a dream we would do well to wake up from".
How very true! Higher living standards cannot be created by politicians out of thin air. As one of my
predecessors, Mr Lino Spiteri, wrote recently,
"They don't make magic wands that work any more."
In the real world, a key precondition for prosperity is higher productivity. It should, therefore, be our
common task, but particularly that of the political class, to promote policies and practices that are
conducive to a more efficient use of the nation's scarce resources.