Michael C Bonello: The challenges faced by the Maltese economy ahead of
euro adoption and their implications for monetary policy
Interview with Mr Michael C Bonello, Governor of the Central Bank of Malta, by The Times,
2 March 2006.
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1. It has been reported that Malta needs a real growth rate of 4 per cent per annum if it is to
reach the EU average per capita GDP in 20 years. Growth, in fact, only averaged about 0.5 per
cent in real terms in the five years to 2005. Are you preoccupied?
More important than expressing concern is the need to understand the reasons for this slow growth.
Since the turn of the century the economy has faced challenges of both external and domestic origin,
and the recent period of weakness reflects the size of the task ahead.
The slowdown began in 2001 with external shocks to the key sectors of tourism and semi-conductors.
Since then the relatively slow growth in Malta's main trading partners has been compounded by the
competitive pressures unleashed by globalization and by our integration in the single European
market, all of which has forced an acceleration in the pace of restructuring of the manufacturing sector.
At the same time that we were opening up our markets, low-cost producers were undercutting our
competitiveness, particularly in labour intensive sectors. These, along with the sharply higher price of
imported oil since last year, are among the factors that have contributed to the slow down. In the long
run the changes brought about by globalization and by the correction of the economy's structural
imbalances should enhance growth prospects, but the coincidence of the same two events has made
for a difficult transition.
It is also true that the economy could have been better prepared to cope with such shocks. That,
however, would have required a greater degree of foresight and a timely reordering of priorities in the
allocation of scarce resources. Regrettably, our national governance system is not conducive to the
achievement of consensual solutions to issues having longterm implications. This explains why the
process of reform tends to be rather slow and the outcome often less than ideal.
The persistence of rigidities in product and labour markets, a partial wage indexation system, failure to
anticipate the consequences of demographic trends and insufficient investment in physical
infrastructure and in human resources in earlier years are some of the reasons why the economy lacks
the flexibility to react to external developments as successfully as some of its competitors.
This does not mean that the economy is not headed in the right direction. Appropriate policies are
indeed in place in several key areas, policy coherence is improving and financing is available to
implement the national reform programme. This much has been acknowledged by the EU Commission
and the IMF. As the restructuring process moves on, moreover, the industrial sector is increasingly
composed of more resilient firms producing higher value added products, while new, important
sources of output growth are emerging, such as financial and ICT-related services. I, therefore, believe
that there are grounds for cautious optimism, provided we persevere. It will, however, take time; there
are no easy short cuts to faster growth.
2. EU accession was meant to boost our trade. In fact, exports were down by 11.3 per cent in
2005, although the EU's share edged up slightly to 51.5 per cent. Don't tell me the problem is
the EU economy, not ours ...
First, let's get the facts right. While Malta's exports did fall by 11.3% last year, exports to the EU were
only 5.2% lower. The drop, moreover, was entirely due to reduced sales of electronic goods and
clothes. Sales of some other product categories to the EU increased. And do not forget that Malta is
also increasingly an exporter of services, which are not included in these numbers.
Second, in the real world it is hardly ever the case that things are either black or white. For a start, it is
a proven fact that membership of a single market, particularly in the presence of a monetary union,
results in a marked expansion of intra-market trade. That has been the experience of existing EU and
euro area members. It is not reasonable, however, to expect that to happen in the first full year after
membership! Exploiting the new market opportunities takes time because institutional structures and
operating practices need to be adapted. Some of the funds Malta is getting from the EU are being
used precisely to strengthen the economy's export potential.
At the same time, it is also true that the EU economy did not grow as rapidly as anticipated in 2005. It
expanded by 1.6 per cent, compared with 2.3 per cent in 2004. A higher proportion than ever of
consumer demand, moreover, was satisfied by imports from more competitive producers at the
expense of established suppliers.
Finally, as I have already observed, the persistence of sluggish growth in the Maltese economy cannot
be explained exclusively in terms of a cyclical downturn. Delays in implementing effective
competitiveness-enhancing reforms were also a factor. As a result, the economy was not fully
prepared to exploit the single market.
3. In these circumstances, isn't this the worst time to be strait-jacketed by the conditions for
euro adoption? Wouldn't a fiscal boost speed up economic growth, now that your already
limited monetary policy tools have been put in the shed?
Allow me first to correct two misconceptions implicit in your second question. For a start, our monetary
policy tools have not been put away but are available for use if needed, as was the case in April last
year when the Bank's central intervention rate was raised by 25 basis points. The primary objective of
our monetary policy, moreover, is not to influence the level of economic activity. It is to maintain price
stability, which we pursue through the operation of a fixed exchange rate. We, therefore, use our
monetary policy tools in the first instance to provide support for the currency.
Now your question echoes the view of those who argue that if only we were to delay adopting the
euro, the government would be able to spend more and run a higher budget deficit because it would
not have to meet the deficit criterion this year, and thereby help the economy grow faster. It sounds
very attractive, but would it work?
First, the argument is based on the premise that increased government spending produces jobs and
growth. In a small, open economy, things are not that simple. If more money is spent on infrastructure
projects, there will be increased imports of raw materials and other inputs; and of the money that
remains in Malta in the form of wages, a high proportion will also be spent on imports. These leakages
will diminish the benefit to the economy from the multiplier effect of the increased spending.
Thus, for example, our calculations suggest that had the government invested Lm18.5 million more in
2005, keeping the deficit at the 2004 level, the GDP would have been around Lm14.5 million higher
last year.
Against this benefit, moreover, one would have to set off the costs. For example, a higher deficit
means an increase in the public debt of equal amount, and thus more annual interest to be paid out of
recurrent revenue. Besides, for the reasons I gave earlier, a higher deficit translates into a wider trade
gap (by an estimated Lm7.5 million in the above example).
Proponents of more government spending should also bear in mind that even in the absence of the
euro adoption factor, Malta would still have to abide by the Stability and Growth Pact (SGP). You
might recall that even the British Government, which has no immediate plans to adopt the euro, was
called to order by the EU Council some time ago because of its growing budget deficit.
Then again, sound public finances are fundamentally a matter of economic common sense and
prudence. So much so that in recent years there have been repeated calls on the government from all
quarters to reduce the deficit and the public debt. Is it not strange, therefore, that just when headway
is finally being made in this very direction, we hear calls for a reversal of this policy and for engineering
what would at best be a short-term boost to growth?
One should also bear in mind that Malta's main challenge is to become more internationally
competitive. In this respect, an increased fiscal deficit will not solve anything. Malta needs quality
growth, preferably resulting from foreign direct investment, which brings with it capital, technology and
markets. And that kind of investment tends to go to countries with sound economic fundamentals,
including a budget that is balanced over the course of the business cycle.
More immediately, if we renege on the Convergence Programme targets, there would be a real risk of
a drop in investor confidence. This is confirmed by recent developments in interest rates and in bond
markets in central Europe, where markets have started to punish countries who risk delaying euro
adoption. It is indeed relevant to point out that Malta's current 'A' rating is predicated upon the
continued pursuit of fiscal consolidation.
There is an additional short-term gain from staying on course. As I have mentioned, fiscal restraint
also helps to reduce the country's external imbalance, and this, in turn, could allow a cut in the interest
premium that investors require in order to hold Maltese lira assets. This would mean lower interest
rates.
On balance, therefore, the outcome of a u-turn on fiscal policy is unlikely to be positive.
4. Last year's entry in ERM II has been described as hasty and premature. Why the rush to join
the euro? Does it not rule out any possible adjustments to the value of the lira?
One of the arguments made in support of this view is that our euro adoption calendar does not allow
government to run a higher deficit and thus promote faster growth. I have just explained why I am not
convinced by this argument.
As for the claim that the decision to enter ERM II was hasty and premature, that suggests
recklessness! No, there was no rush. The decision was made after thorough consultations with the EU
Commission and the European Central Bank (ECB) in the light of the progress achieved by Malta in
fiscal consolidation and structural reforms. Their agreement was contingent on a firm undertaking by
the Maltese authorities to continue to implement the Convergence Programme.
A related objection is that before adopting the euro Malta should first satisfy tests similar to those set
for the British economy by Chancellor Brown. This argument betrays an insufficient familiarity with the
Chancellor's five tests. They are, in fact, not so different from the Maastricht criteria, which Malta,
together with the six other new Member States currently in ERM II, is seeking to satisfy.
The five tests relate to convergence (like the Maastricht criteria); flexibility of labour, product and
capital markets (being addressed in Malta's Convergence Programme); investment, i.e. whether euro
will encourage more inward FDI (the British Treasury's 2003 report suggests that it does); financial
services (this applies to the special case of the City of London); and growth, stability and employment.
Malta's strategy document, published jointly by the Government and the Bank last year, argues that
the euro would be beneficial in this respect (and so does the Treasury report).
The case for adopting the euro sooner rather than later is set out in the strategy document. I shall only
reiterate here that for a small, open economy like ours with no trade or capital controls, keeping a
separate currency leaves us exposed to external shocks and volatile capital flows. We are thus
obliged to maintain a large amount of external reserves. These are financial assets that could perhaps
earn higher rates of return if invested domestically. Instead, we invest them abroad, in effect promoting
foreign, rather than domestic growth. That is the price we pay to have an independent currency.
This vulnerability is indeed one of the main reasons why some leading academics in this field believe
that the small new Member States should have been allowed to lock themselves into the relatively
greater security of the euro area as quickly as possible. The validity of this view was underscored by
Malta's experience in late 2004/early 2005 when the Bank's external reserves declined as a result of
uncertainty created by speculative comments on the exchange rate.
Your second question reflects the view that the fixed nature of the exchange rate as well as the level
at which the lira was pegged to the euro in ERM II are both inappropriate and are stifling Malta's
competitiveness.
Let me first address the issue of the fixed peg. This has been a mainstay of our monetary policy for
over three decades. It is what Maltese traders and investors, and the public at large, have become
accustomed to. The resulting exchange rate and price stability have made a vital contribution to the
country's economic development. Opting for a new and unfamiliar regime, which is what the 15 per
cent band arrangement amounts to, in the midst of the uncertainty prevailing early last year would not
have been prudent.
The decision to opt for continuity by pegging the lira to the euro at the central parity rate, moreover,
was also supported by our study on the equilibrium exchange rate, available on the Bank's website,
which did not produce evidence of a significant misalignment; and by our conviction - which is shared
by expert opinion in Malta and abroad - that given the openness of the economy and the speed of the
nominal exchange rate pass-through to prices, a possible devaluation is anyway unlikely to have
lasting beneficial effects. The 1992 experience proved that devaluation is not the correct antidote for
structural problems. In less than three years, the inflationary pressures resulting from that decision
wiped out whatever competitiveness gain had been achieved.
In the event, the commitment to keep the lira/euro peg at the central parity rate - which was also
welcomed by the IMF - seems to have reassured both the business community and investors as calm
returned to the financial markets. The downward trend in the reserves was first interrupted and then
reversed, as capital inflows resumed, including a considerable amount resulting from the
redenomination of domestic loans into euro to take advantage of the lower interest rate.
In these circumstances, had we allowed the exchange rate to adjust to market pressures within the 15
per cent band, the currency would have appreciated.
5. You seem to be playing down the efficacy of the fiscal deficit and of exchange rate
adjustment as a means of jump starting the economy. What would you suggest instead?
As I have already pointed out, the domestic factors which are contributing to the economy's anaemic
growth record are largely microeconomic in nature. I have also explained why deficit financing and
changes in the nominal exchange rate cannot correct these weaknesses, still less produce sustainable
growth. Policy orientation must eschew short-term palliatives. Like our competitors we must learn to
come to terms with globalization. Reflecting on one simple fact should help in understanding what this
means: the hourly cost of labour of an electronics operative in Malta is around $11, compared with $7
in Singapore and $2 in China. Neither more government spending nor a devaluation can narrow that
gap.
Against this background, maintaining external competitiveness in the long run depends on continued
moderation in wage growth, faster increases in labour productivity and sustainable budget positions. I
make no claim to originality in proposing this prescription; it is shared by the EU Commission, the ECB
and the IMF.
I shall first address the last objective. Given that taxation levels are already high, fiscal consolidation
should be achieved by cutting recurrent spending. Here I would focus on reducing the public sector
wage bill, mainly by lowering employment levels, as government is currently doing; reforming the
provision of pensions and health care; rationalizing social welfare schemes, including by eliminating
benefits that have outlived their usefulness and extending means testing; and transforming the
unemployment benefit system into an effective instrument of employment creation rather than of social
dependence.
With regard to competitiveness-related problems, there is a need to address remaining rigidities in the
labour market - including by ensuring that wage costs reflect productivity levels; investing more in
education and providing suitable incentives to unleash the potential inherent in the country's human
resources; and improving the business environment, in particular by lowering the costs of operating in
Malta.
While it is beyond dispute that the country has undergone significant change for the better in these
first years of the new century, it is equally true that the world around us has become a much more
dynamic place in the meantime, and competitive pressures are such that unless we adapt to them
rapidly, we will have to accept lower living standards.
6. Euro yields have risen yet you have left the central intervention rate unchanged...
This proves that our limited monetary policy tools have not been put in the shed, as you put it in an
earlier question! We still have a degree of autonomy. As I said earlier, the exchange rate is the
nominal anchor of our monetary policy. The rationale of our regime, i.e., providing support to the
currency, does indeed require us to mirror interest rates offered by other currencies - primarily the
euro since we moved to a full peg last May - , but in addition we also need to offer a premium to
holders of Maltese lira assets to compensate for the small size and vulnerability of our economy. Our
judgement on the appropriate size of that premium at any point in time, complemented by
considerations relating to financial market sentiment and economic conditions generally, determines
our decisions on the Bank's central intervention rate. The markets have so far judged the interest rate
premium on the lira as being appropriate.
7. It would be ironic if the government were to meet the fiscal criterion for euro adoption, but
fail because of the inflation rate. What interest rate policy will the Bank adopt in this regard?
I have already explained that the focus of monetary policy in a fixed peg regime is the exchange rate.
Unlike most countries with a floating regime, we are not inflation targeters. The Bank's ability to
influence price levels directly through its power to change short-term interest rates in the money
market is, therefore, rather limited. To the extent, however, that a rise in inflation is associated with
developments that are putting pressure on the exchange rate in the shape of a persistent loss of
external reserves, such as a surge in consumer imports financed by credit creation, then a higher
interest rate could have a cooling effect.
In Malta's open trading environment, one would expect prices to respond more effectively to market
forces than seems to be the case. The relatively small number of importers of essential commodities
and of providers of some services that have a significant weight in the retail price index is a
disadvantage in this respect. There are governmental agencies whose responsibility it is to ensure that
competition and price transparency prevail. Containing local costs, including government-induced
costs, should also be a priority in this crucial ERM II phase. In its capacity as advisor to the
government, the Bank takes every opportunity to express any concerns that it may have in this regard.
8. In addition to the short-term pressure of the Maastricht criteria, there is the longterm reality
of the welfare gap. Are you frustrated with the pace of pension reform?
A sense of disappointment best sums up my feelings. I am all for consultation and consensus building,
but the time comes when decisions need to be taken if further damage is to be avoided. This applies
equally to the social welfare and health systems as it does to pensions. Last year the first cohorts of
the baby-boom generation reached retirement age. This produced an acceleration of some Lm7
million in the rate of increase of pension expenditures.
Pension reform, which is vital for the long-term sustainability of public finances, should be
implemented this year. Everybody has had a say and there is now a comprehensive, balanced set of
proposals which answer to the widest possible range of concerns compatibly with having a viable
system. It is time to move on to other pressing issues.
9. Property values continue to increase against a background of a rising volume of bank credit
that is being channeled into construction and house purchase. Are there grounds for concern?
Property values are estimated to have increased by about 9% in 2005. Although this represents a
slowdown from previous years, it is still in excess of recent inflation and occurred despite a continuing
high vacancy rate.
The ready availability of credit contributes to rising property prices. While the volume of bank credit to
the construction industry was more or less flat last year, borrowing to finance the construction or
purchase of housing went up by 21% to Lm653 million. These numbers, moreover, must be viewed in
the context of total household borrowing. Consumer credit, including through credit cards, increased
by 13% in 2005 to Lm91 million. This is an area where the banks are marketing their products rather
aggressively, encouraging borrowing for consumption rather than for investment purposes.
One has to be concerned about this, particularly at a time of slow growth in household disposable
income, and about the resulting increase in the consumer debt burden. For while the default rate of
household borrowing, particularly mortgage loans, remains low, much lower in fact than that of the
corporate sector, existing and prospective borrowers may not be factoring into calculations of their
repayment capacity the possibility that interest rates might not remain at their current low levels
indefinitely.
While the exuberance which took hold of the property market in recent years appears to have
moderated somewhat, a similar phenomenon has emerged in the equity market. The optimism that is
driving up share prices is supported by strong corporate profitability in a few cases. Current trends,
however, are taking prices into territory where the connection with intrinsic values becomes less
obvious, and suggest caution.
10. Economic analysts can sound gloomy warnings to keep pushing the authorities in the right
direction, or ring the bells proclaiming good news and risk undermining the sense of
determination needed. Which approach would you advocate?
Neither of the two. There is already so much spin created by purveyors of pessimism and optimism
alike that it is becoming increasingly difficult to get a balanced reading of the economic situation.
Independent economic analysts, therefore, shoulder a heavy responsibility. It is to bring together all
the relevant information, subject it to a critical but objective assessment, and be prepared to support
their conclusions with well documented arguments. This is a role the Bank has endeavoured to play
consistently, and for good reason. The more people understand how our economy works, the
challenges it is facing and the limited options available to overcome them, the greater the likelihood
that policymakers will feel comfortable to take the required decisions promptly, leading to a faster pace
of wealth creation, which is one thing we all want.
11. The adoption of the euro will greatly reduce the role of the Central Bank of Malta. What will
you be doing in January 2008?
Your question reflects a perception that is commonly held but which is not borne out by the experience
of the current members of the euro area. It would be more correct to say that the Bank's role will be
greatly changed rather than reduced. Some existing functions will become less important, others more
so, and yet others created.
On the institutional level, the transfer of responsibility for monetary policy to the ECB would be
replaced by the Governor's participation in the Governing Council where interest rates are set for the
euro area. For this purpose, we will need to strengthen our capacity in the areas of economic
research, forecasting and statistics and redirect its focus. This also applies to our activities in support
of monetary policy, such as open market operations, which would be conducted within the parameters
set by the ECB.
In the area of foreign exchange, there would no longer be a need to provide marketmaking facilities
once the euro becomes our domestic currency, or to retain the current foreign exchange facilities
offered to government at their existing level. Our reserve management role, however, would remain;
not only to manage our own reserves, but also to manage part of the ECB's portfolio.
Likewise, the Bank would retain its function as issuer of notes and coins and would thus have to meet
the local demand for euro. It would also need to analyse suspected counterfeit euro notes and coins.
Particularly important will be the Bank's role in providing a channel for both domestic and cross border,
high value payments by linking our payment system with the Eurosystem's TARGET, as well as in
operating a mechanism for the cross border delivery of assets for collateralisation purposes.
The adoption of the euro will also integrate further Malta's financial system with that of the euro area,
so that the Bank's financial stability and internal audit responsibilities will assume a cross border
dimension because weaknesses in any one Member State could impact directly on the stability of the
entire system. For example, we will have to cooperate closely with other central banks and the ECB to
prevent the emergence of systemic crises. This will involve strengthening our institutional and
analytical capacities to detect potential vulnerabilities in our own financial system. As for the audit role,
we will have to provide internal control assurances to the ECB on all the functions we will be carrying
out on their behalf.
All of this, of course, has important implications for essential support functions such as information
technology and human resources. I need only mention the fact that euro area membership entails
considerable electronic reporting obligations and the maintenance of several statistical databases.
The Bank is gearing up to take on these new, more specialized functions, and I would like to note that
it is only able to do so with confidence because it has a substantial core of qualified and dedicated
professionals in all these areas.