Josef Bonnici: Strengthening economic resilience
Address by Professor Josef Bonnici, Governor of the Central Bank of Malta, at the Annual
Dinner of the Institute of Financial Services, Saint Julian's, 20 November 2015.
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Honourable Minister, members of the Institute, distinguished guests,
I would like to thank the President and Committee of ifs Malta for once again organising this
Annual Dinner and giving me the opportunity to share my thoughts with such a distinguished
audience.
Mr President, I am pleased to hear you speak about the Institute's commitment towards
raising the standards of financial services education, as this is exactly what we need for our
dynamic financial sector to remain successful and a key contributor to our economic
development.
Over the years, the Central Bank of Malta has worked closely with the Institute, and more
recently participated in the successful ifs Annual Conference on The Future of Pensions.
This national conference acted as a catalyst to rekindle the debate on private pensions in
Malta. I commend the Institute for this important initiative. I wish you success in all the
Institute's future endeavours.
Introduction
The current international economic environment poses a number of key challenges, including
the weak recovery in the euro area, the slowdown in emerging economies, the enduring
geopolitical tensions, and possible spill-overs from the US monetary policy that could affect
financial conditions on a global scale. Clearly, our economy is not immune from
developments beyond our shores. Against an uncertain economic and political landscape,
our vision should be to turn challenges into opportunities to sustain economic growth in the
long term.
Factors underpinning Malta's remarkable resilience
The Maltese economy has been vibrant, showing remarkable economic resilience in the face
of the unstable economic environment elsewhere. In fact, the theme "Vibrant Malta" has
been chosen for the European Cultural Days at the ECB in Frankfurt, which this year focus
on Malta. Earlier this month, we launched a cultural programme aimed to enhance
awareness of Malta's cultural heritage. The theme reflects not only the current cultural scene
but also our vibrant economy.
Malta is the most open economy in the euro area, having exports and imports of goods and
services each over 150% of GDP. Despite this challenging factor, the Maltese economy has
managed to outperform its peers, with GDP growth consistently above that of the euro area
average. A good perspective to this positive outcome is given in Chart 1, which is an update
of a Chart I used in last year's presentation; since the onset of the global financial crisis in
2008, Malta's GDP increased by 18%, whereas that of Germany and the United Kingdom
rose by just 5%, while that of the euro area as a whole contracted by 0.5%.
Chart 1: Real GDP growth by group of countries
Chart 2 shows the unemployment rate in the stressed and non-stressed euro area members
and Malta since 2005. Over this period, Malta's performance has been quite distinct,
outperforming the non-stressed countries, while having a declining trend since 2013. This
year, at 5.4%, it is the second lowest in the euro area, after Germany.
Chart 2: Unemployment rates by groups of countries
Chart 3 shows the employment performance. Since 2008 employment in Malta increased by
around 18%, compared with a rise of just under 3% in the non-stressed economies and a
contraction in employment in the stressed ones. In particular, the private sector employment
growth rate averaged above 3% per year over the past three years.
Chart 3: Employment growth by groups of countries
Of significant importance is the strong potential output growth, which has been supported by
the robust dynamics in the Maltese labour market. In its projections, the European
Commission had foreseen potential output growth in 2015 in excess of 3.5%, compared with
around 1% in the euro area as a whole, as shown in Chart 4. In fact, according to the
European Commission, Malta and Germany were the only two Member States in which
potential GDP in 2014 had already exceeded its pre-crisis growth rate.
Chart 4 - Potential GDP
Labour market participation is a critical factor supporting potential output, particularly the
steady increase in female participation. This is further reinforced by inward migration, mostly
from the European Union. In fact, we estimate that in the period 2010 to 2014, migrant
workers contributed to 0.6 percentage point of potential output growth. It is important to
recognise that the bulk of migrant workers are in managerial, professional and technical
occupations, although there is a growing number of foreign workers in elementary
occupations in the hotel and restaurant sector, and in clerical and other support duties.
These workers enhance the human capital stock, bringing new skills and knowledge, while
also helping to avoid bottlenecks in the labour supply in expanding sectors, including in
tourism related jobs.
The buoyant performance in output and employment has dampened concerns about
macroeconomic imbalances. The current account of the balance of payments turned positive
in 2012 and has remained in surplus on an annual basis since then, as shown in Chart 5.
The shift into surplus in recent years was driven by exports of services on the back of a
strong performance in tourism and the development of new areas of economic activity.
Chart 5: Current account
Imbalances in the public sector have also been narrowing. Malta has successfully emerged
from the European Commission's excessive deficit procedure, and this year Government is
aiming at a deficit of 1.6% and a declining national debt of 68.3% of GDP. Next year, the
deficit is targeted at 1.1% of GDP, while the national debt is forecast to decline to 65.2%.
Although the economy is small and highly dependent on foreign trade, resource flexibility and
ongoing structural change strengthened its ability to adjust to external shocks, so that Malta
emerged from the crisis with strong economic fundamentals.
The transformation in the exports profile of Malta, labour market developments, the modus
operandi of the banking sector and the prudent management of public finances have been
the main determinants of this resilience. The post-EU accession period witnessed a sharp
rise in export-oriented services. Liberalisation of various sectors, the higher availability of
better educated human resources and a targeted strategy to attract foreign direct investment
opened new service sectors.
The strong shift of the Maltese economy towards services could in fact explain the rising unit
labour costs observed in the past decade. The service sector engages higher quality
employees and is less capital intensive than the more traditional parts of the economy.
Although this could increase unit labour costs, it does not necessarily imply a loss of
competitiveness. The labour content per unit of output is higher in the changed composition
of output of the economy.
The resilience of the Maltese economy can also be attributed to its banking sector, which
operates in a sound and liquid framework and is profitable. The prudent business model
adopted by the core domestic banks is the backbone of our financial system's resilience.
Finally, the prudent management of public finances, and the stable funding of Maltese
government debt, have also contributed positively. Around 94% of local sovereign bonds are
held by residents, largely with a buy-to-hold mentality.
What are the challenges ahead of us? How to strengthen resilience further?
Internationally, the risk of deflation has been the primary concern from a central banking and
monetary policy perspective. In a low or negative inflation environment, consumption could
be postponed in the expectation of further price reductions, putting pressure on firm
revenues. Given the downward rigidity in wages, firms cannot easily adjust through lower
wages in a deflationary environment. So a deflationary environment could lead to higher
unemployment and stagnation. Also, low inflation increases the burden of servicing debt.
Indeed, with deflation the real interest rate starts rising. When nominal policy rates are close
to the zero lower bound, higher real rates cannot be corrected by reductions in policy rates.
The prolonged period of low inflation in the euro area since 2014 has prompted the ECB to
introduce unconventional monetary policy measures (See Chart 6).
Chart 6 - HICP inflation
These complement the reductions in the main policy rate so as to maintain an
accommodative monetary stance. In January 2015 the ECB announced the launch of the
Asset Purchase Programme (APP), first encompassing ABS and covered bonds, and later
extended to the purchase of sovereign bonds.
At the euro area level, the ECB's monetary policy strategy has gradually improved financial
and credit conditions, as well as the ongoing economic recovery.
The non-standard measures have resulted in higher equity and bond prices, higher liquidity
and improved lending conditions. Since June 2014 the transmission of policy rates to lending
rates has improved, with declines in lending rates becoming more pronounced and more
widely distributed across euro area countries. The bank lending survey confirms the
improvements in broader credit conditions since the introduction of the APP. As a result,
credit to the private sector in the euro area has shown signs of recovery and registered a
positive growth since May 2015, the first time in 36 months, as shown in Chart 7.
Chart 7 - M3 and main counterparts
On the inflation front, however, results continue to disappoint on the downside. The
harmonised index of consumer prices in the euro area is just 0.1% in October 2015, following
a period of negative or close-to-zero inflation. On the other hand, the latest inflation rate for
Malta, at 1.6%, is within reach of the ECB's below but close to 2% target; it attests to the
buoyancy of the economy. It also indicates that the APP has had positive effects on Malta's
economy. The main transmission channel has worked through the exchange rate. The
depreciation of the euro against other major currencies has kept inflation in Malta closer to
the ECB target and it also boosted competitiveness on the exports side. Countries with high
openness to trade with non-euro area countries have been more sensitive to the depreciation
of the euro. In Malta exports of goods towards non-euro area countries represent around
72% of total goods exports and around 87% in the case of service exports.
The wealth effect is another transmission channel of the APP that has been evident in Malta.
The Malta Stock Exchange has gained 32% since the beginning of the year, while the
property market continued to perform buoyantly. A higher level of wealth positively affects
consumption and general consumer confidence.
On other fronts, however, Malta can position itself better to reap more benefits from this
unprecedented scenario of accommodative monetary policy, particularly in the area of
access to finance. As just mentioned, the ECB's monetary policy has enabled significant
reductions in lending rates across the euro area. Bank lending rates in Malta did go down but
still remain higher than in other euro area countries, as shown in Chart 8.
Chart 8 Bank lending rates and ECB rates
The transmission of central bank policy rates to retail bank rates is an essential condition for
the monetary policy transmission mechanism. This is especially important in Malta where the
predominant types of businesses are SMEs, which use banks as a main source of financing.
In fact, although Malta outperformed the euro area on the main macroeconomic indicators,
credit to the non-financial corporate sector has remained subdued, although this partly
reflects deleveraging in certain sectors, particularly in construction and real estate.
Apart from the impaired transmission of ECB policy rates to retail rates, charges and
commissions of commercial banks are found to be relatively high. In a recent report, the
Malta Competition and Consumer Affairs Authority made a number of recommendations to
address issues primarily related to price transparency, barriers to expansion and consumer
mobility in view of improving competition and borrowing costs for SMEs. Bank charges on
SME loans and charges for credit transfers need to be revised downwards to facilitate
access to finance and also to encourage the use of electronic money, which would ultimately
result in lower processing costs to banks.
Chart 9 - Credit growth to households and businesses
In keeping constant focus on maintaining competitiveness, the Government took a significant
step by committing itself to set up the Malta Development Bank. Preparatory work on the
establishment of the Bank is well advanced. The development bank will strengthen and
diversify the local financial base and will contribute to economic growth by funding sectors
and projects that are not catered for by commercial banks on their own. It will provide
attractive wholesale financing and risk sharing facilities. It will be a powerful tool to bring to
realisation more economically feasible projects.
The delay in tackling non-performing loans (NPL) on the bank's books is another factor that
puts a drag on credit growth and reflects a dimension of credit risk that should be resolved.
An efficient judiciary system that deals with insolvency cases in a timely and cost efficient
manner facilitates credit risk management by bringing down the stock of NPLs. An improved
corporate insolvency regime facilitates the rehabilitation of viable firms and speeds up the
exit of non-viable ones. This would boost banks' profitability as a result of reduced
provisioning needs, while it would also generate gain of output for the real economy arising
from more efficient allocation of resources. The authorities have launched a comprehensive
review of the judicial system, which is expected to result in a reform that would benefit the
banking sector and the overall economy.
As I said earlier, the APP has had some positive effects on our economy. However, we need
to be vigilant to identify any arising risks from liquidity flows. Accordingly, the Central Bank of
Malta, through its participation with the Malta Financial Services Authority on the Joint
Financial Stability Board, is monitoring credit developments for any undue credit growth that
could potentially lead to the formation of asset bubbles. Should it be required, we will take
offsetting macro-prudential measures to safeguard financial stability and maintain the
resilience of the financial sector.
Given the limited depth of our capital market, the APP has somewhat tightened investment
options for the Maltese investor. In this context we need to diversify our capital market
further, with securities that are sufficiently backed by assets, such that the integrity of our
capital market and the stability of our investors' base remain intact.
During the Governing Council meeting held in Malta last October, President Mario Draghi
stated that "Monetary policy should not be the only game in town", indicating that monetary
policy could not solve the euro zone's economic problems alone, and that "...all countries
should strive for growth-friendly fiscal policies".
In the current state of affairs, an efficient budgetary policy must be built around structural
reforms, fiscal responsibility and productive public investment. With the Maltese economy
operating close to its potential output, it is the appropriate time to create fiscal buffers that
could act as a cushion against any future need.
Conclusion
The single currency has proved to be a challenge to various countries in the euro area.
Instead of exploiting the opportunities offered by the single market, some Member States
have been impacted by the fixed nominal exchange rate and their inability to correct
macroeconomic imbalances through internal adjustment. This made them more vulnerable in
times of crisis. One fundamental lesson to be learnt is that, with a fixed exchange rate, it is of
utmost importance that the rest of the economy is as flexible as possible to correct
imbalances.
In this regard, the Maltese economy has been nimble enough to adapt to the new realities of
the single currency. Yet, the challenges that lie ahead will require further structural changes
that increase flexibility and strengthen economic fundamentals. To this end, Government has
identified health and education as new sectors with growth potential that could be
transformed into exportable services. Malta has the ability to develop a regional cluster in
these areas, attracting students and patients from the region and beyond. This year we have
seen a significant correction in the exchange rate, which is expected to exert a positive
influence on economic growth in the year ahead.
There are other major elements that add to Malta's positive outlook. In addition to being an
efficient and profitable international business location, Malta is a meeting point of cultures
and languages at the centre of the Mediterranean. There is, therefore, potential for further
development of economic activities that exploit our location, our strengths in doing business
from Malta that add value to current activities, such as, for example, developing further
cultural niches in the tourism sector so as to maintain a vibrant and evolving economy.
Thank you