Report from the Commission - convergence Report 2007 on Malta (prepared in accordance with Article 122(2) of the Treaty at the request of Malta) {SEC(2007) 622}
Date: 2007-05-16
Institutions: European Commission
Subjects: Economic and Monetary Union, European Commission, Malta, convergence criteria, economic convergence, report

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 16.5.2007 
COM(2007) 258 final 

REPORT FROM THE COMMISSION 

CONVERGENCE REPORT 2007 ON MALTA 

(prepared in accordance with Article 122(2) of the Treaty at the request of Malta) 

{SEC(2007) 622} 

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1. 

PURPOSE OF THE REPORT 

Article 122(2) of the Treaty requires the Commission  and the ECB to report to the 
Council,  at  least  once  every  two  years,  or  at  the  request  of  a  Member  State  with  a 
derogation, on the progress made by the Member States in fulfilling their obligations 
regarding the achievement of economic and monetary union. 

This  report  has been  prepared  in  response to the request submitted  by Malta  on  27 
February 2007. A more detailed assessment of the state of convergence in Malta is 
provided in a technical annex to this report (SEC(2007) 622). 

The content of the reports prepared by the Commission and the ECB is governed by 
Article  121(1)  of  the  Treaty.  This  Article  requires  the  reports  to  include  an 
examination of the compatibility of national legislation, including the statutes of its 
national central bank, and Articles 108 and 109 of the Treaty and the Statute of the 
ESCB  and  of  the  ECB  (ESCB  Statute).  The  reports  must  also  examine  whether  a 
high  degree  of  sustainable  convergence  has  been  achieved  in  the  Member  State 
concerned by reference to the fulfilment of the convergence criteria (price stability, 
government budgetary position, exchange rate stability, long-term interest rates), and 
by  taking  account  of  several  other  factors  mentioned  in  the  final  sub-paragraph  of 
Article  121(1).  The  four  convergence  criteria  are  developed  further  in  a  Protocol 
annexed to the Treaty (Protocol No 21 on the convergence criteria). 

The examination of the compatibility of national legislation, including the statutes of 
the  national  central  banks,  with  Articles  108  and  109  of  the  Treaty  and  the  ESCB 
Statute  requires  an  assessment  of  compliance  with  the  prohibition  of  monetary 
financing (Article 101 EC) and the prohibition of privileged access (Article 102 EC); 
consistency  with  the  ESCB's  objectives  (Article  105(1)  EC);  central  bank 
independence  (Article  108  EC);  and  integration  of  national  central  banks  into  the 
ESCB (several EC Treaty and ESCB Statute articles). 

The  price  stability  criterion  is  defined  in  the  first  indent  of  Article  121(1)  of  the 
Treaty:  “the  achievement  of  a  high  degree  of  price  stability  […]  will  be  apparent 
from a rate of inflation which is close to that of, at most, the three best performing 
Member States in terms of price stability”. 

Article  1  of  the  Protocol  on  the  convergence  criteria  further  stipulates  that  “the 
criterion  on  price  stability  […]  shall  mean  that  a  Member  State  has  a  price 
performance  that  is  sustainable  and  an  average  rate  of  inflation,  observed  over  a 
period  of  one  year  before  the  examination,  that  does  not  exceed  by  more  than  1.5 
percentage points that of, at most, the three best-performing Member States in terms 
of price stability. Inflation shall be measured by means of the consumer price index 
on a comparable basis, taking into account differences in national definitions”. The 
requirement of sustainability implies that the satisfactory inflation performance must 
essentially  be  attributable  to  the  behaviour  of  input  costs  and  other  factors 
influencing  price  developments  in  a  structural  manner,  rather  than  the  influence  of 
temporary  factors.  Therefore,  the  convergence  examination  includes  an  assessment 

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of  the  factors  underlying  inflation  and  of  medium-term  prospects.  It  also  assesses 
whether the country is likely to meet the reference value in the months ahead1. 

The  inflation  reference  value  was  calculated  to  be  3.0%  in  March  20072,  with 
Finland, Poland and Sweden as the three best-performing Member States. 

The Treaty refers to the exchange rate criterion in the third indent of Article 121 as 
“the observance of the normal fluctuation margins provided for by the exchange-rate 
mechanism  of  the  European  Monetary  System,  for  at  least  two  years,  without 
devaluing against the currency of any other Member State”. 

Article  3  of  the  Protocol  on  the  convergence  criteria  stipulates:  “The  criterion  on 
participation in the exchange rate mechanism of the European Monetary System (…) 
shall  mean  that  a  Member  State  has  respected  the  normal  fluctuation  margins 
provided  for  by  the  exchange-rate  mechanism  of  the  European  Monetary  System 
without  severe  tensions  for  at  least  the  last  two  years  before  the  examination.  In 
particular, the Member State shall not have devalued its currency’s bilateral central 
rate  against  any  other  Member  State’s  currency  on  its  own  initiative  for  the  same 
period”. 

The relevant two-year period for assessing exchange rate stability in this report is 27 
April 2005 to 26 April 2007. 

The  convergence  criterion  dealing  with  the  government  budgetary  position  is 
defined in the second indent of Article 121(1) of the Treaty as “the sustainability of 
the  government  financial  position:  this  will  be  apparent  from  having  achieved  a 
government  budgetary  position  without  a  deficit  that  is  excessive  as  determined  in 
accordance  with  Article  104(6)”.  Furthermore,  Article  2  of  the  Protocol  on  the 
convergence  criteria  states  that  this  criterion  means  that  “at  the  time  of  the 
examination the Member State is not the subject of a Council decision under Article 
104(6) of this Treaty that an excessive deficit exists”. 

The  fourth  indent  of  Article  121(1)  of  the  Treaty  requires  “the  durability  of 
convergence achieved by the Member State and of its participation in the exchange 
rate mechanism of the European Monetary System being reflected in the long-term 
interest  rate  levels”.  Article  4  of  the  Protocol  on  the  convergence  criteria  further 
stipulates that “the criterion on the convergence of interest rates (…) shall mean that, 
observed over a period of one year before the examination, a Member State has had 
an  average  nominal  long-term  interest  rate  that  does  not  exceed  by  more  than  2 
percentage points that of, at most, the three best-performing Member States in terms 
of  price  stability.  Interest  rates  shall  be  measured  on  the  basis  of  long-term 
government  bonds  or  comparable  securities,  taking  into  account  differences  in 
national definitions”. 

The interest rate reference value was calculated to be 6.4% in March 2007. 

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The forecast of the reference value is subject to significant uncertainties given that it is calculated on the 
basis of the inflation forecasts for the three Member States projected to have the lowest inflation in the 
forecast period, thereby increasing the possible margin of error. 
The cut-off date for the data used in this report is 26 April 2007. 

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Article 121  of  the  Treaty  also  requires  an  examination  of  other  factors  relevant  to 
economic integration and convergence. These additional factors include financial and 
product  market integration, the development of the balance of payments on current 
account and the development of unit labour costs and other price indices. The latter 
are covered within the assessment of price stability. 

In  the  December  2006  Convergence  Report,  the  Commission  assessment  was  that 
Malta fulfilled one of the convergence criteria (on long-term interest rates). Pending 
the adoption of the draft law amending the Central Bank of Malta Act, legislation in 
Malta  was  considered  not  fully  compatible  with  Article  109  of  the  Treaty  and  the 
ESCB  Statute  as  regards  central  bank  integration  into  the  ESCB  at  the  time  of  the 
adoption of the euro. 

2. 

LEGAL COMPATIBILITY 

All  outstanding  incompatibilities  have  been  addressed  in  an  Act  amending  the 
Central Bank of Malta Act that was adopted by Parliament on 28 February 2007 and 
should  enter  into  force  on  the  date  of  the  introduction  of  the  euro  in  Malta.  In 
particular, the Act has repealed or amended a series of articles so as to take account 
of  the  respective  roles  and  competences  assigned  by  the  EC  Treaty  to  the  ECB, 
ESCB and EC Council. This concerns notably provisions on the monetary functions, 
operations  and  instruments  of  the  ESCB,  on  the  holding  and  managing  of  foreign 
reserves and on the right to authorise the issue of banknotes and the volume of coins. 

Legislation in Malta, in particular the Central Bank of Malta Act, is compatible with 
the requirements of the EC Treaty and the ESCB Statute. 

3. 

PRICE STABILITY 

Respect of the reference value 

12-month average inflation in Malta has been at or below the reference value since 
July 2005 except for the period May –  October 2006. The average inflation rate in 
Malta during the 12 months to March 2007 was 2.2%, below the reference value of 
3.0%, and is likely to remain below the reference value in the months ahead3. 

Underlying factors and sustainability 

HICP  inflation  in  Malta  has  fluctuated  around  2.5%  over  recent  years.  There  has 
been  some  volatility,  primarily  due  to  the  fact  that  Malta  is  a  small  and  open 
economy vulnerable to external shocks (particularly in food and energy prices), and 
to changes in indirect taxes. Inflation picked up considerably in autumn 2005, mainly 
reflecting a sharp rise in regulated prices for energy and related products in response 
to higher oil prices. When the impact of the energy price shock ebbed away, inflation 
dropped markedly at the end of 2006 to below 1%. In addition to the significant base 

3 

According to the Commission Spring 2007 Forecast, 12-month average inflation in Malta will decrease 
to 1.4% in December 2007, while the reference value is forecast to stand at 2.8%. 

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effects  in  energy  inflation,  the  decline  reflected  a  drop  in  prices  of  clothing  and 
footwear and air transport. 

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underlying 

Chart 1.  Malta: Inflation criterion since May 2004
 (percent, 12-month moving average)

HICP  inflation  excluding  energy 
and  unprocessed  food  declined  to 
1.6%  in  2006,  from  2%  in  2005. 
Moderate  core  inflation  suggests 
that 
inflationary 
pressures  have  remained  limited, 
against 
the  background  of  a 
negative output gap and low wage 
pressures.  Unit  labour  costs  have 
since  2005, 
been  decreasing 
reflecting  strong  wage  discipline 
both  in  the  private  and  public 
sector. There have been no signs of second-round effects from energy prices so far, 
suggesting  that  inflationary  expectations  remain  well-anchored.  The  effective 
exchange  rate  broadly  stabilised  in  2005  and  2006,  thus  remaining  roughly  neutral 
with regard to import prices 

2006
Sources:  Eurostat, Commission services' Spring 2007 Forecast

Reference value

Malta

2004

2005

2007

0

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2

Looking  ahead,  headline  inflation  is  expected  to  remain  on  a  moderate  path  in  the 
medium  term,  although  it  is  projected  to  increase  somewhat  from  the  current  low 
levels as favourable base effects in energy prices subside. Risks to the outlook appear 
broadly  balanced.  The  main  risks  are  related  to  oil  prices  and  are  two-sided. 
Otherdownward  risks  include  the  on-going  liberalisation  of  the  energy  sector  in 
Malta  and  the  other  structural  reforms  improving  functioning  of  product  markets. 
Upward  risks  could  stem  from  the  tightening  of  the  labour  market  as  cyclical 
conditions improve.  

Malta fulfils the criterion on price stability. 

4. 

GOVERNMENT BUDGETARY POSITION 

Malta  is  at  present  the 
subject  of 
a  Council 
Decision  on  the  existence 
of  an  excessive  deficit 
(Council  Decision  of  5 
July 2004)4.  

Inverted s cale

Chart 2 . Malta: Government budget balance and debt
(in percent of GDP)

-12

-10

-8

-6

-4

80

70

60

50

40

30

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general 
Malta's 
government  deficit  was 
relatively  high  at 
the 
beginning  of  the  2000s, 
reaching  a  high  of  around 
10%  of  GDP 
in  2003 
(mainly  due  to  a  significant  one-off  operation).  Since  then,  the  budget  deficit  has 

2003
2004
Government balance (lhs)
Cyclically-adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' Spring 2007 Forecast

Sources : Eurostat and Commission services

2007(*)

2001

2002

2005

2006

10

20

0

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4 

Decision 2005/186/EC (OJ L 62, 9.3.2005, p. 21). 

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considerably  decreased  in  the  context  of  the  government's  fiscal  consolidation 
programme.  The  deficit-to-GDP  ratio  reached  2.6%  in  2006  and  according  to  the 
Commission  services'  Spring  2007  Forecast  will  amount  to  2.1%  of  GDP  in  2007. 
The  revenue  ratio  has  followed  an  upward  trend,  whilst  expenditure  as  a  share  of 
GDP increased until 2003 but decreased thereafter. 

General  government  debt  increased  significantly  in  the  first  half  of  the  decade, 
peaking at around 74% in 2004. However, starting from 2005 the debt ratio followed 
a downward path reaching around 66.5% of GDP in 2006. The Commission services' 
spring 2007 forecast projects a general government debt of 65.9% of GDP for 2007. 

In  its  Opinion  of  27  February  2007  on  the  December  2006  update  of  the 
Convergence  Programme,  the  Council  noted  that  the  debt  ratio  appeared  to  be 
diminishing at a satisfactory pace towards the 60% of GDP reference value and that 
the programme was consistent with a correction of the excessive deficit by 2006. At 
the same time, the Council noted that there were risks to the budgetary projections in 
the  programme,  especially  with  regard  to  the  assumed  favourable  macroeconomic 
assumptions  in  2008  and  2009.  The  Council  invited  Malta  to  pursue  the  planned 
progress  towards  the  MTO,  ensure  that  the  debt-to-GDP  ratio  was  reduced 
accordingly  and  to  make  further  progress  in  the  design  and  implementation  of  the 
healthcare reform in order to improve the long-term sustainability of public finances. 

In view of these developments and the Commission services' Spring 2007 Forecast, 
the  Commission  considers  that  the  excessive  deficit  has  been  corrected  with  a 
credible  and  sustainable  reduction  of  the  budget  deficit  below  3%  of  GDP  and  the 
debt-to-GDP ratio diminishing towards the reference value of 60%. The Commission 
is therefore recommending that the Council abrogate the decision on the existence of 
an  excessive  deficit  for  Malta  (SEC(2007)  621).  If  the  Council  decides  to  abrogate 
the  excessive  deficit  procedure  for  Malta,  Malta  will  fulfil  the  criterion  on  the 
government budgetary position. 

5. 

EXCHANGE RATE STABILITY 

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0.1

Chart 3.  MTL: Spread vs central rate
 (as percent, daily values)

The  Maltese  lira  has  participated 
in  ERM  II  since  2  May  2005,  i.e. 
for  24  months  at  the  time  of 
adoption  of  this  report.  Before 
entering  ERM  II,  the  lira  was 
pegged  to  a  euro-dollar-sterling 
basket.  During  the  period  of  the 
assessment not covered by ERM II 
participation  (27  April  –  1  May 
2005),  the  lira  stayed  close  to  the 
future  central  rate.  Upon  ERM  II 
the  Maltese  authorities 
entry, 
unilaterally  committed  to  maintain  the  lira  at  the  central  rate.  During  ERM  II 
participation,  the  lira  has  remained  stable  vis-à-vis  the  central  rate  and  has  not 
experienced  severe  tensions.  Additional  indicators,  such  as  developments  in  short-
term  interest  rates  and  foreign  exchange  reserves,  do  not  point  to  pressures  on  the 
exchange rate.  

Sources:  ECB, Commission services

0.0
May-05

Jan-06 May-06

Sep-05

Sep-06

Jan-07

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Malta fulfils the exchange rate criterion. 

6. 

LONG-TERM INTEREST RATES 

Chart 4.  Malta: Long-term interest rate criterion
 (percent, 12-month moving averages)

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The  average  long-term  interest 
rate in Malta in the year to March 
2007  was  4.3%,  below 
the 
reference value of 6.4%. Average 
long-term  interest  rates  in  Malta 
have  been  below  the  reference 
value  since  EU  accession.  Long-
term  yield  spreads  vis-à-vis  the 
euro  area  have  fluctuated  at 
relatively  moderate  levels  over 
the  past  years,  hovering  around 
30 basis points in the first quarter 
of  2007.  Contained  yield  spreads 
indicate that the residual country risk priced in by markets is limited.  

Reference value

Malta

2005

2004

3

4

5

Sources:  ECB, Eurostat, Commission services

2006

Malta fulfils the criterion on the convergence of long-term interest rates. 

7. 

ADDITIONAL FACTORS 

Additional factors have also been examined, including product and financial market 
integration and balance of payments developments. The Maltese economy is highly 
integrated  with  the  EU.  In  particular,  trade  and  FDI  relations  with  other  Member 
States  are  extensive  and  Malta’s  financial  system  is  substantially  inter-linked  with 
the  financial  systems  of  other  countries,  both  in  and  outside  the  EU,  via  the 
establishment of financial intermediaries and the provision of cross-border services. 
Malta's current account balance has been rather volatile over the past years, reflecting 
the small size and narrow sectoral base of the economy. The external position shows 
large disparities in net trade in goods and services, with a high deficit in goods trade 
being partly compensated for by a substantial services surplus. The current account 
deficit has increased significantly in recent years, reaching a level of 8.2% of GDP in 
2005. This increase reflected difficult market conditions in the dominant electronics 
and tourism sectors and, in 2005, a strong increase in the oil bill. In 2006, the current 
account  deficit  fell  to  6.3%  of  GDP  on  account  of  a  significant  increase  in  current 
transfers  due  to  increased  receipts  from  the  booming  online  services  industry.  The 
deficit in the combined current and capital account decreased from around 4.9% of 
GDP in 2004-2005 to 3.2% of GDP in 2006. On the financing side, net FDI inflows 
have largely covered the current account deficits. 

* * * 

In  the  light  of  its  assessment  on  the  fulfilment  of  the  convergence  criteria  and 
assuming  that  the  Council  will  follow  the  Commission's  recommendation  for  the 
abrogation  of  the  excessive  deficit,  the  Commission  considers  that  Malta  has 
achieved a high degree of sustainable convergence. 

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