COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances – Malta 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: Euro Group (euro area), Malta, competitiveness, economic growth, financial services, indebtedness, macroeconomics, public debt, stability pact, trade balance













EUR-Lex - 52014SC0086 - EN











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52014SC0086

COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances – Malta 2014 /* SWD/2014/086 final */









Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances
The macroeconomic challenges in Malta
no longer constitute substantial macroeconomic risks and are no longer identified
as imbalances in the sense of the MIP. Although indebtedness remains high,
risks to the sustainability of private and public sector debt and the stability
of the financial sector appear contained, even if they deserve continued
monitoring. 
More specifically,
the analysis in the IDR finds that financial stability indicators remain sound.
Still, in light of the structural nature of the risks in the sector, a
continuation of the current prudent supervisory and risk-taking practices is
key. The housing market has stabilised and thus risks arising from
over-exposure to property are limited. Private debt is on the decrease; the
corporate deleveraging is taking place in an orderly manner and credit market
pressures are limited. As regards public finances, Malta is expected to meet
its nominal deficit targets in 2013 and 2014. As regards external
sustainability, trade performance has been positive, thanks to product and
geographical market orientation and non-cost competitiveness factors; the
current account balance is in surplus. Still, external competitiveness could
benefit from active policy response to cost-adjustments in competitor
countries.
Excerpt of country-specific findings on Malta, COM(2014) 150 final,
5.3.2014
Executive Summary and Conclusions 5
1.       Introduction  7
2.       Macroeconomic
Developments 9
3.       Imbalances
and Risks 15
3.1.     Indebtedness 15
3.1.1.  Private sector
debt 15
3.1.2.  Government
debt 18
3.2.     Financial
stability  21
3.2.1.  The core
domestic banks 22
3.2.2.  The non-core
domestic banks 27
3.2.3.  The
non-banking financial sector 28
3.3.     External
trade and competitiveness 29
3.3.1.  Export
performance  29
3.3.2.  Competitiveness
drivers 33
4.       Policy
Challenges 37
References 39
LIST OF Tables
2.1. Key
economic, financial and social indicators 13
3.1.     Core
Financial Stability Indicators by bank groups 22
LIST OF Graphs
2.1.     Real GDP
growth, 2000=100  9
2.2.     Total
employment rate, age 15-74 years, 2006=100  9
2.3.     Breakdown
of HICP differential between Malta and Euro area   10
2.4.     Non-cyclical
current accounts 10
2.5.     Geographical
breakdown of portfolio investments held by Maltese residents 11
2.6.     Wage and
productivity levels 11
3.1.     Decomposition
of y-o-y changes in debt-to-GDP ratios, non-financial corporations 15
3.2.     Financing
cost for companies (1) 15
3.3.     Cost of
bank funding for businesses in euro area countries 16
3.4.     Decomposition
of change in debt-to-GDP ratio, households 17
3.5.     Debt
service to income ratio (households with debt payments) by income  17
3.6.     Credit
Supply and Demand Deleveraging Pressures 17
3.7.     Stress Map
of Credit Demand Conditions (1) 17
3.8.     Stress Map
of Credit Supply Conditions (1) 18
3.9.     Maturity
structure of government debt 20
3.10.   Structure of
contingent government liabilities 2012, % of total 21
3.11.   Financial
sector liabilities by residence  22
3.12.   Total loss
provisions 23
3.13.   Provisioning
policies in EU countries, 2008q4 - 2013q3  25
3.14.   HHI index of
banking sector concentration  26
3.15.   Intermediation
margin  26
3.16.   Interest
margin on loans 26
3.17.   Income
ratios, 2008-12 average  27
3.18.   Geographical
and sectoral composition of nominal (USD) rate of change of goods exports 29
3.19.   Export market
shares, services 30
3.20.   Market Share
Growth in Services 32
3.21.   Market Share
Growth in Goods 32
3.22.   Global
Competitiveness Index  33
3.23.   Malta's
distance to frontier (frontier = 100, result over 100 means better than
frontier) 33
3.24.   Unit labour
costs relative to a country aggregate  34
3.25.   Growth in
nominal compensation per employee  34
3.26.   FDI flows 35
LIST OF Boxes
3.1.     Debt
sustainability analysis. 20
3.2.     The housing
market 24
3.3.     Regulatory
treatment of real estate collateral 25
3.4.     External
competitiveness of the tourism sector. 31
LIST OF Maps
No table of contents
entries found.
In April 2013, the Commission concluded
that Malta was experiencing macroeconomic imbalances arising from the
significant exposure of the financial sector to the property market and the
risks for the long-term sustainability of public finances. In the Alert
Mechanism Report (AMR) published on 13 November, the Commission found it
useful, also taking into account the identification of imbalances in April, to
examine further the persistence of imbalances or their unwinding. To this end,
this in-depth review (IDR) provides an economic analysis of the Maltese economy
with the scope of the surveillance under the Macroeconomic Imbalances Procedure
(MIP). The main observations and findings from this analysis are:
·       The financial sector does not appear to pose imminent risks to
macro-financial stability. Maltese banks generally
benefit from high liquidity and solvency ratios and have remained profitable.
Risk-management and supervisory practices also appear prudent. The nature of
the main risks is structural and as such will likely remain a characteristic of
the sector in the future. So far, the authorities are managing these risks in
an effective way, as evidenced by the robust performance and soundness
indicators.
·       The high private sector indebtedness appears to be correcting in an
orderly fashion. There is no evidence of
significant deleveraging pressures in the corporate sector. The ongoing decline
in corporate debt seems to result from lower demand for loans, combined with a
high cost of credit. Despite growing mortgage debt, the debt servicing burden
of households does not appear to be problematic.
·       Public debt is still on an upward path, but short-term risks are
contained. The government continues to be able to
finance the budget deficit without constraints and the treasury department has
been successful in extending the average maturity of the debt stock. In
response to the deterioration in public finances in 2012, the Council requested
that Malta puts the government debt on a sufficiently decreasing path by 2014.
Long-term sustainability, however, remains a concern due to rising age-related
budgetary costs. High contingent liabilities pose an additional burden.
·       The export performance of the Maltese economy has been successful and the economy has been able to attract new, growing industries
while the core, traditional ones have continued expanding. This appears to have
been supported by favourable non-cost factors, which lower the transaction
costs of doing business. The robustness of external competitiveness and the
attractiveness to FDI, however, need to be preserved.
The IDR also discusses policy elements
stemming from these areas and possible avenues for the way forward. A number of
elements can be considered:
·       With a view to maintaining financial stability, tight
risk-taking and supervisory practices as well as ensuring the robustness of the
real estate market are key in managing the inherent structural risks related to
the limited size of the economy. Moreover, maintaining an efficient supervisory
approach would be instrumental in managing the future growth of the sector.
Finally, indications of anti-competitive behaviour in the core banking segment
warrant closer attention.
·       In order to preserve external competitiveness, which is key for
the growth of the domestic economy, as well as its attractiveness for FDI, it
would be beneficial to keep both labour and transaction costs in check. This is
particularly valid in an environment where some competitors are undergoing
accelerated cost-adjustment.
·       Meeting the fiscal targets set by the Council under the Excessive
Deficit Procedure would put government debt on a more sustainable
footing in the short-term, but tackling sustainability in the long-term remains
a challenge.
On 13 November 2013, the European
Commission presented its second Alert Mechanism Report (AMR), prepared in
accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention
and correction of macroeconomic imbalances. The AMR serves as an initial
screening device helping to identify Member States that warrant further in
depth analysis to determine whether imbalances exist or risk emerging.
According to Article 5 of Regulation No. 1176/2011, these country-specific
“in-depth reviews” (IDR) should examine the nature, origin and severity of
macroeconomic developments in the Member State concerned, which constitute, or
could lead to, imbalances. On the basis of this analysis, the Commission will
establish whether it considers that an imbalance exists in the sense of the
legislation and what type of follow-up in terms it will recommend to the
Council.
This is the second IDR for Malta. The
previous IDR was published on April 10 2013 on the basis of which the
Commission concluded that Malta was experiencing macroeconomic imbalances
arising from the significant exposure of the financial sector to the property
market and the risks for the long-term sustainability of public finances. In
the AMR the Commission found it useful, also taking into account the
identification of imbalances in April, to examine further the persistence of
imbalances or their unwinding. To this end this IDR takes a broad
view of the Maltese economy in line with the scope of the surveillance under
the Macroeconomic Imbalance Procedure (MIP).
Against this background, Section 2 presents
an overview of the general macroeconomic developments, while section 3 looks
more in detail into the main imbalances and risks. Section [4] discusses policy
considerations.
Growth, inflation and unemployment
The Maltese economy continues to
outperform the euro area. Since 2007-8, real GDP
growth has been higher than the average for the euro-area and in particular
other Mediterranean EU Member States (see Graph 2.1). This has been primarily the result of
improving external trade, thanks to a more favourable product and geographical
orientation (see Section 3.3), and higher private consumption. Following a
two-year period of moderation, the economic activity regained pace in 2013.
Growth is projected to remain at roughly the same level in 2014-15, remaining
below the pre-crisis average. 
Recovery from the 2009 downturn has been
rather job rich. Driven mainly by the services
sector, job creation has been vibrant and employment grew by over 7% between
2009 and 2012. Thus, Malta performed better than the average for the EU and the
Mediterranean countries (see Graph 2.2) and its employment rate has been
steadily converging with the EU average. This has been particularly thanks to
rising female employment. Nonetheless, the overall employment rate of
52.1% ([1]) remained
five percentage points below the EU average, particularly due a still very low
employment rate among women ([2]). The positive dynamic is expected to persist, although Malta's
employment rate is not projected to catch up with the EU average in the medium
term.
The social consequences from the crisis
have thus been milder than the average for the EU.
Total and youth unemployment have remained stable, well below the euro-area
average and the increase in labour market activity lead to a decline in the
number of people living in low-work-intensity households. In addition, the
share of the population at risk of poverty ([3]) has remained broadly unchanged between 2009 and 2012 at around
15%, while in the EU as a whole it increased by 0.5 pp. to 16.9%. The share of
the population living in material deprivation, however, went up notably since
2009, suggesting that social pressure has increased. As a result, the share of
the population living at risk of poverty or social exclusion ([4]) increased in 2009-12, particularly for young people (age below 24
years). Still, the total at-risk-of-poverty-or-social-exclusion rate in Malta
remained lower than the EU average.
The Harmonised Index of Consumer Prices
(HICP) has moved closer to the euro-area average.
Price inflation tended to be higher than the euro area, but the differential
has narrowed in 2010-13 (see Graph 2.3). The persistently higher inflation
observed in Malta in the past can be explained mainly with the structural
characteristics of the domestic economy, such as smaller size, limited
competition and higher product mark-ups and transport costs. Evidence indicates
that prices in Malta are thus more sensitive to shocks on international
markets, due also to the higher import intensity of domestic consumption (see
CBM 2013). Narrower inflation differential in recent years has been mainly due
to less dynamic energy inflation, in particular reflecting the enacted freeze
in electricity tariffs ([5]) and prices
of liquid fuels. Looking forward, the government decision to lower electricity
tariffs as of the spring of 2014 is expected to contribute to price inflation
staying in line with that in the euro area, at least in the short term. 
The sustainability of the external position
has strengthened
The current account deficit has
corrected and is now in surplus. The current
account deficit reached around 9% of GDP in the years following EU accession as
a result of rapid deterioration of the balance of goods and increasing income
outflows. This trend was reversed after 2009 as a weakening of domestic demand
and particularly lower investment resulted in lower demand for imports, while exports
rebounded quickly and income outflows stabilised. At the same time, the rate of
increase of the surplus in the services balance moderated slightly but remained
sizeable. As a result, the current account is estimated to have posted a
surplus for the second consecutive year in 2013. Estimations by the Commission
Services of the underlying current account balance, net of income flows and
adjusted for the real effective exchange rate (see Graph 2.5), indicate that
the upward trend is even stronger than the headline figures suggest. Looking
forward, the current account balance is projected to remain positive in the
short term, also likely to benefit from government plans to reform the energy
generation system, shifting it away from imported oil. A stronger rebound in
investment, driven by a resumption of FDI inflows, might drag it down, but in
general the restructuring of the economy towards less import-intensive services
is expected to structurally improve the overall balance.
The sustainability of the external
position is reinforced by a positive net international investment position. Malta has traditionally enjoyed a comfortable net international
investment position (NIIP). The NIIP stood at 24.9% of GDP at the end of 2012,
which was the highest balance since end-2006. A high domestic savings rate and
less-diversified investment opportunities inside Malta have contributed to a
large, positive net portfolio investment position (holdings of equity and debt
securities). Funding takes place mainly through other foreign investments, in
the form of bank loans and deposits, and a significant stock of foreign direct
investments (FDI). It should be noted that the stock of portfolio investments
is significantly inflated by the presence of large internationally-oriented
foreign banks in Malta. Namely, around half of the total portfolio investments
abroad, totalling €19.1 billion at end-2012, is into Turkish securities, due to
the presence of two large branches of Turkish banks (see Graph 2.5), which get their funding from abroad
and thus have a little impact on the domestic economy. Therefore, the headline
stock positions should be interpreted with caution.
Despite eroding cost competitiveness,
external competitiveness appears to have been maintained. Nominal unit labour costs have grown faster than the average for
the euro area. In particular, while the nominal level of compensation per
employee has been converging with the euro-area average, labour productivity
has actually moved away from it (see Graph 2.7).([6]) Despite this, Malta's exports have been performing well,
suggesting that there have been other factors at play, supporting its
competitive position (see Section 3.3). Moreover, the economy registered gains
in price competitiveness reflected in a depreciating real effective exchange
rate, mainly due to the nominal depreciation of the euro in 2010 and 2012.
The financial system has remained stable
The financial soundness indicators
remained stable. Profitability and solvency ratios
in the core domestic banks remained high, while a low loan-to-deposit ratio
meant that exposure to the volatility of the wholesale market was limited. The
ratios improved in the first half of 2013, with rising non-interest income,
thanks to trading profits, compensating for the drop in interest income thus
allowing for retained earnings to further boost capital buffers. Liquidity also
remained stable and resort to liquidity operations by the central bank was
limited. The non-performing loans ratio increased somewhat in the first half of
2013 due to a worsening of the corporate portfolio, but appears to have
stabilised in the second half of the year. Overall, the banking sector was able
to withstand the slowdown of economic activity in Malta and the euro area as
well as shocks on the international financial markets without suffering a
marked decline in its performance indicators (see Section 3.2).
The stock market has been showing gains
since the beginning of 2012. Malta's stock market
lost some 50% of its capitalisation in 2008-9, but since then has stabilised
and has been gradually gaining since early 2012. Developments have been largely
in line with the markets in other EU countries in the Mediterranean region,
failing to match the faster recoveries recorded by the indices in Germany and
the US.
3.1.      Indebtedness
High public and private debt levels make
economic actors more vulnerable to asset price shocks or interest rate
fluctuations. In addition, a high debt servicing burden can reduce profits for
firms, thus restraining investment capacity and economic activity. These
effects can be exacerbated in case deleveraging takes place simultaneously in
more than one economic sector.
3.1.1.   Private
sector debt
The process of deleveraging in the
corporate sector is picking up speed. Following
years of relatively strong lending growth, the flow of credit to the corporate
sector turned negative in 2012 (see Graph 3.1). As a result, the debt-to-GDP ratio of
non-financial companies in consolidated terms decreased to 156.3% in 2012, down
from its peak at 170.9% in 2009. ([7]) Deleveraging picked up speed in 2013, spreading across the entire
sector and as of December 2013 the year-on-year credit flow was positive only
in the utilities sector. The contraction is strongest in construction and real
estate activities. The sharp correction in credit to corporates is also partly
due to a statistical effect – an outstanding loan to a company in the energy
sector was reclassified to the financial sector at the end of 2012, thus
leading to a lower stock of corporate loans and affecting the y-o-y rate of change
in 2013. The correction does not appear to have been driven by government
action as the tax treatment of corporate financing has remained unchanged in
recent years and continues to be characterised by a relatively high
debt-bias. ([8]) However, the
leverage ratio (debt-to-equity), although gradually declining, remains elevated
and significantly exceeds the euro-area average. Higher leverage means that
companies have relatively low loss-absorbing buffers, thus increasing the risk
of delays in servicing bank credits or even going into bankruptcy. 
Deleveraging appears to be driven by a
mix of both supply and demand factors. According to
the ECB's Bank Lending Survey, lending standards were tightened significantly
in response to the crisis, particularly for the construction sector, and have
remained largely unchanged since then. At the same time, interest rates on
loans in Malta are relatively high, exceeding the euro-area average (see Graph3.2), which to some extent discourages
credit demand. Moreover, the aforementioned structural shift in the economy to
some extent lowers the capital intensity of the economy, resulting in lower
need for new investment, thus also lowering the demand for credit. The Bank
Lending Survey does not point to expectations for a change in credit demand in
the near-term, with the exception of indications of some recovery in demand
among SMEs, also supported by the availability of initiatives co-funded by the
EU, such as JEREMIE ([9]).
Evidence at SME level seems to indicate
prevalence of supply-side factors. The European
Commission's 2013 Access to Finance of Small and Medium-Sized Enterprises
(SAFE) survey shows that over 75% of the participating SMEs did not apply for
financing in the preceding six months, because of sufficient funds or other
factors, which exceeds the corresponding ratios for the EU and the euro area.
However, the ratio of SMEs that applied for financing, particularly bank loans
and trade credit, increased, confirming that there is increasing appetite. At
the same time, supply appears to have tightened – the ratio of SMEs that
successfully applied for bank overdraft and trade credits dropped significantly
compared to the results of the 2011 SAFE. This points to tighter
risk-assessment practices by lenders, while at the same time participants in
the survey indicate that the overall conditions, such as availability of
instruments, collateral requirements, interest rates and other costs, have
improved.
To facilitate the access to credit of
SMEs, the authorities are considering setting up a development bank. The project is still at an early stage and no concrete plan has
been made public. Negative credit flows in a relatively high-interest-rate
environment might indeed indicate inefficiencies in the financial
intermediation role of the banking sector in channelling the ample liquidity in
the financial system into higher lending. High lending rates, however, need to
also be seen in a context of a highly-leveraged corporate sector, and in
particular the SMEs, as there appears to be a strong correlation between the
two indicators in the euro area (see Graph 3.3) ([10]) . In fact, countries with similar corporate leverage are charging
even higher interest rates, which, however, could be explained also by the more
difficult economic conditions these countries are experiencing. While a
development bank could have a role to play in improving the efficiency of
financial intermediation, it would be crucial that it does not compete with the
commercial banks and that it is equipped with sufficient risk assessment
capabilities to prevent it from mopping up lower-quality projects that could
end up burdening the government's balance sheet.
Household balance sheets remain healthy
and the debt-servicing burden appears manageable.
The flow of credit to households, and in particular credit for housing
purchase, remained positive even as lending to companies contracted. The
indebtedness of households, however, has remained broadly unchanged since 2011
as the increase in nominal credit on the nominator side has been offset by GDP
growth and inflation (see Graph 3.4).  While household debt remains close to
the euro-area average, total financial assets stand well above it and thus
Maltese households enjoy a relatively sound net financial wealth position. The
debt servicing capacity also compares relatively well with other euro-area
countries as the debt service-to-income ratio is relatively low across all
income quintiles (see Graph 3.5). Even though financing costs for
Maltese companies appear elevated compared to the euro-area average, those for
households are competitive. In addition, household balance sheets have
benefitted from the increasing role of the second earner due to the significant
gains in female labour market participation in recent years.
Overall, private sector deleveraging
pressures in Malta are less pronounced than in other Member States. The Commission Services' composite indicator for supply and demand
deleveraging pressures suggests that Malta positions relatively well with
respect to the other Member States in terms of both demand and supply pressures
(see Graph 3.6). Moreover, the assessment of both
supply and demand pressures has abated since 2011. In particular, a closer look
at the demand (Graph 3.7) and supply (Graph 3.8) factors driving deleveraging reveals
that Malta's corporates compare favourably across-the-board. The only
exceptions are the levels of sovereign credit default swaps and the capital
adequacy in banks on the supply side and the economic sentiment on the demand
side, but even in these cases, Malta does not score worse than the EU average.
Low deleveraging pressures translate into a lower risk for economic growth
resulting from the high stock of private debt. ([11]) ([12]) 
3.1.2.   Government
debt
Government debt exceeded 70% of GDP in
2012. The government debt ratio in Malta is lower
than the euro-area average but it has been rising continuously since 2008 and
exceeded 70% of GDP in 2012. The debt is projected to reach 71.2% of GDP in
2015 according to the Commission services' 2014 winter forecast. The failure to
ensure a sufficient pace of debt reduction towards the 60%-of-GDP threshold in
the Stability and Growth Pact was a key reason for the reopening of an
Excessive Deficit Procedure against the country in June 2013. The European
Council thus requested that Malta achieve a nominal budget deficit of 2.7% of
GDP by 2014, which corresponds to a cumulative improvement in the structural
balance of 1.4 pps. of GDP in 2013 and 2014, while also ensuring that the gross
debt ratio declines at a satisfactory pace.([13]) After correction of the excessive deficit, the Council recommended
that Malta pursue the structural adjustment effort at an appropriate pace so as
to reach the medium-term objective (MTO) of a balanced budget in structural
terms by 2019.([14]) 
A public debt above the Treaty threshold
and an ageing population ([15]) pose risks to the long-term sustainability of Malta’s public
finances. While Malta does not appear to face
sustainability risks in the short term, risks increase in the medium and long
term (see Box 3.1). In particular, the projected growth in
age-related expenditure is well above the EU average, with the increase in pension
expenditure – including the impact of the 2006 pension reform – accounting for
more than half of it([16]).
Sustainability pressures could also arise from health-related spending, as
Malta records one of the highest projected increases in the EU for healthcare.
The ongoing fiscal incentives and a pension reform, enacted in 2006 have helped
to increase the labour market participation of older workers. 
Debt sustainability in the near term has
benefited from efficient debt management. Spreads
on Maltese sovereign bonds have not been significantly affected by the tensions
in financial markets generated by the sovereign debt crisis. The apparent cost
of debt (interest expenditure over total nominal debt) decreased to 4.4% in
2012 (from 5.3% over the period 2004-2008), in spite of a large increase in the
debt ratio (around 10 pps. in the last 4 years). The lengthening of the
maturity structure of government debt since EU accession has resulted in a high
share of debt with maturity between fifteen and thirty years (38.5% in 2012, up
from 18.9% in 2004) while short-term debt has decreased significantly and, in
2012, it accounted for 4.8% of total government debt (from 20.2% in 2004). This
is expected to further reduce the impact of fluctuations in the interest rate
on government in case of changes market sentiment. In addition, government debt
is almost entirely held by residents (with non-residents accounting for only 3%
of the outstanding debt stock). This has further protected the sovereign
against the tensions on international markets and indeed debt financing has not
posed problems so far. At the same time, the high interconnectedness between
the government sector and the domestic economy, in particular the financial
sector and households ([17]), implies
that adverse developments in one of these sectors can have negative spillovers
on the others.  
The high level of contingent liabilities
represents an additional risk for Malta's public finances. Government-guaranteed debt in Malta is high, following a
substantial increase since the start of the crisis, from 11.5% of GDP in 2008
to 17.4% of GDP in 2012 (which would imply a total public guaranteed debt of
around 88.7% of GDP in 2012). Around 9% of these liabilities are accounted for
by the Water Service Corporation, 20% for by the Malta Freeport Corporation,
while the bulk of these guarantees, around 60%, is accounted for by the public
energy utility corporation (Enemalta). The difficult financial situation of
Enemalta, reflecting the company's exposure to fluctuations in oil prices, the
lack of timely and cost-effective adjustment in electricity tariffs and
inefficiency costs([18]), thus
continues to pose a challenge for the public finances. The government has
embarked on a large-scale energy reform plan, an essential part of which is
restructuring ([19]) Enemalta's
debt. The agenda of the government, indeed, sees to lower the cost of electricity
generation by reducing the dependence on oil and the costs emanating from
operational inefficiencies. In particular, in order to be able to reduce of
households' electricity tariffs by 25%, starting from March 2014, Enemalta is
pursuing various projects which will be financed through public private
partnerships.
Debt financing in both the public and
the private sector does not appear to be a burden and there is no evidence of
the presence of strong deleveraging pressures. Despite decreasing indebtedness,
however, high leverage in the corporate sector could be a source of
vulnerability should economic conditions deteriorate significantly. The
government's reliance on domestic sources of funding shielded it from the
stress on international financial markets, but this can also be a source of
vulnerability in case of shocks to the balance sheets of the households or the
financial sector. Compliance with the Stability and Growth Pact rules would
help put the gross government debt on a more sustainable path.
3.2.      Financial
stability 
Maintaining financial stability is of
crucial importance for the channelling of savings into investment opportunities
and the overall efficient functioning of the economy. The financial sector also
plays an important role in financing the government deficit, which reinforces
its role in ensuring macro-financial stability.
Risks related to the headline size of
the banking system should not be overstated as it masks a very fragmented
system. Maltese banks can be split into three
distinct groups of banks depending on their relation to the domestic economy:
(i) the core domestic ones, with assets of 220% of GDP, are closest to the
Maltese economy; (ii) the non-core domestic banks with assets of 80% of GDP do
business mainly outside Malta, but they offer products to residents as well,
albeit mostly corporate; and finally (iii) the international banks, the largest
segment with total assets of over 500% of GDP, who have no material links with
the domestic economy. Table 3.1 reviews the main financial soundness
indicators for each of the three groups.
Contingent liabilities for the state in
case of disruptions to financial stability remain limited. The only major institution where the government has an ownership
stake is the universal Bank of Valletta (BOV), which is the largest core
domestic bank with a total balance sheet of over 100% of GDP. Despite the large
headline size of the financial sector (banking, insurance and investment funds'
liabilities stand at 875% of GDP ([20])) a significant proportion of it is foreign-owned. Indeed, most
large financial institutions operating in Malta are subsidiaries or branches of
international financial groups (for example HSBC UK, Akbank T.A.C. and Turkiye
Garanti Bankasi AS (Turkey), Deutsche Bank (Germany)) that would be expected to
intervene in case of a potential capital or liquidity shortfall. Risks
associated with the international banks are low due to the nature of their
activities, consisting largely of intra-group transactions, and their funding
profile. ([21])  Thus, the
categories of banks of relevance for domestic financial stability are the core
domestic banks and, to a smaller extent, the non-core domestic banks. The
banking sector is a major tax payer and contributes around 18% of the total
amount of direct taxes.
3.2.1.   The
core domestic banks
The core domestic banks are those
focused on servicing the domestic economy. The
group consists of five banks with total liabilities of over EUR 13 billion
(190% of GDP), out of which over 80% represents resident retail deposits. The
core banks generally operate a conservative business model with limited
reliance on wholesale funding, a low loan-to-deposit ratio and an investment
portfolio that consists largely of held-to-maturity securities, thus shielding
their balance sheets from market volatility. These banks are the main deposit
takers and lenders to the private sector. They also play an important role in
financing the government as they held around 25% of GDP of Malta Government
Stocks in 2012, which is over one third of the total government debt stock
(excluding any holdings of state-guaranteed debt).
The nature of the financial stability
risks of the core domestic banks has remained unchanged. The main risks remain credit and concentration risks, particularly
related to the construction sector in the loan book and the domestic sovereign
in the investment portfolio. In terms of exposure to the domestic sovereign,
securities issued by the Government of Malta amounted to around 12% of their aggregate
balance sheet and 150% of the aggregate equity. ([22]) Property market-related loans represented over half of the entire
stock of loans to the private sector as of the end of 2013. A somewhat
mitigating factor is the fact that nearly three-quarters of those correspond to
lending for housing purchase by households, which, continue to have generally
healthy balance sheets. Construction was among the most hit segments of the
economy, losing about 15% of its net operating surplus between 2009 and 2012. This
has had a correspondingly negative impact on asset quality with non-performing
loans rising by two-thirds between the end of 2009 and the second half of 2013.
After a period of correction in 2008-9, the housing market appears to have
stabilised (see Box 3.2). The link with the property market is
further strengthened by high reliance on real estate collateral (see Box 3.3).
Banks have increased provisions in
response to the increasing bad loans. As loans tend
to be well-collateralised, the coverage of doubtful and non-performing loans by
specific provisions in Malta was historically low. Indeed the coverage ratio is
among the lower ones in the euro area (see Graph 3.12). Still, the core banks, most notably
the BOV, increased their loan-loss provisions over the past year. This increase
was offset by additional non-performing loans resulting in a slight decline in
the coverage ratio. Nevertheless, the gross value of non-performing loans is
more than fully covered by collateral and provisions, including interest in
suspense – the interest that is accrued on assets classified as non-performing.
Overall, low loan-to-value ratios (LTV) ([23]) and a conservative valuation of the underlying collateral point to
relatively prudent risk-management practices so far. This provisioning
practice, linked also to the standard of high collateralisation, has limited
the impact of the persistently high stock of bad loans on profitability and
allowed banks to remain profitable even in an environment of deteriorating
asset quality. Reflecting the structural nature of the relatively higher credit
risk, the Maltese banking system has operated with even worse asset quality
ratios in the past – the NPL ratio stood at well over 10% in the beginning of
the 2000s – without a significant impact on macro-financial stability. Still,
it is crucial that the workout practices for bad loans are efficient and the
legislative framework provides for the timely recovery of collateral in case a
client enters into default.
The authorities have taken steps to
strengthen provisioning practices. In line with the
recommendation made by the European Council, the financial sector supervisor
MFSA, together with the Central Bank, has adopted a revision to the Banking
Rule 9 – the legislation governing banks' provisioning policies. The new BR09
has been in force since the beginning of 2014. Its implementation is expected
to contribute to an increase in the coverage ratio by some further 3-4
percentage points. Moreover, banks have often been encouraged to use profit
retention in order to strengthen their capital buffers. As a result, the ratio
of NPLs net of provisions to capital in Malta does not stand out in comparison
with the other EU Member States (see Graph 3.13). Still, it is in the low end of the
spectrum and the ratio in Malta is among the highest for a given level of NPLs
suggesting that there is room to further increase either specific provisions or
capital buffers.
The market structure of the core
domestic segment is very heavily concentrated, which may give rise to
inefficiencies in the channelling of savings to investment. The two biggest banks, BOV and HSBC Malta, hold nearly 90% of the
total assets of the core domestic banks. As a result, the Herfindahl-Hirschman
concentration index by assets of the core domestic banking system is the
highest in the euro area (see Graph 3.14). ([24]) In 2013, the non-core Mediterranean bank has increased its
exposure to the domestic economy, but its market share is still too small for
it to be a real competitor to BOV and HSBC in the retail products market. Lack
of competition could create inefficiencies in financial intermediation,
particularly in the pricing of products such as loans, deposits and the fees
and commissions that commercial banks charge. Indeed the intermediation margin,
the difference between reference interest rates on loans and deposits, ([25]) in Malta has been well above that in the euro area since end-2008
due to higher loan rates while the deposit rates have been at roughly similar
levels (see Graph 3.15). Thus, a closer examination of the
drivers of the high intermediation margin appears warranted. 
Higher interest rates on loans could
reflect lack of competitive pressure. A higher
intermediation margin could reflect a number of factors, such as different
funding costs, higher price of risk or lower cost-efficiency. On the funding
side, a sticky deposit base and low reliance on wholesale funding have shielded
Maltese banks from fluctuations on international markets and prevented
competition for retail deposits. This could explain the stable and low deposit
rates. On the asset side, concentration risk in Malta is higher than in most
euro-area Member States, which may have been a factor in banks' risk-taking and
pricing policies. The core banks, however, appear to be more cost-effective
than banks in most other euro-area countries as their cost-to-income ratio is
generally low. Overall, the persistently higher intermediation margin is
indicative of slow and partial transmission of the ECB's monetary policy in
Malta and could indicate that banks have pricing power. 
A look at the structure of income of the
core banks suggests some indications that there could be anti-competitive
behaviour. Divergence in the income ratios across
the sector usually reflects differences in the asset portfolios. Even though
there have been divergences in the past, the interest margin([26]) on loans in the core banks appears to be converging (see Graph 3.16). One bank is an outlier and charges
higher rates on average, which can be explained by the higher level of credit
and concentration risk on its books that is eventually passed on the prices of
its products. Converging interest margins could reflect the broadly similar
loan books across the institutions. On the other hand, however, it could be
indicative of collusive behaviour as, excluding the one outlier, banks charge
broadly similar interest margins despite possible differences in the risk
profile of their assets. Moreover, there is notable divergence in the levels of
fees and commissions, particularly fees related to retail services, between the
top two banks and some smaller domestic banks (see Graph 3.17). The former thus appear to have been
able to exercise their market power and charge higher fees than their peers.
3.2.2.   The
non-core domestic banks
The non-core domestic banks are the
smallest category of banks in Malta. The group
consists of nine banks with gross liabilities of around 60% of GDP, out of
which less than 16% are raised from residents. The category is dominated by two
institutions – Mediterranean Bank and FIMBank, that together account for
two-thirds of total liabilities of this group. In particular, Mediterranean
Bank has gross liabilities of over 30% of GDP, out of which 10% of GDP are
resident. This makes it the fourth biggest bank in the country by exposure to
the domestic economy. The resident liabilities in the non-core banks consist
largely of deposits from corporate clients and thus pose little burden on the
Deposit Compensation Scheme (DCS). ([27]) The financial services regulator is putting in place measures to
ensure that liabilities to the DCS are sufficiently secured. There is no state
ownership in any of the banks. 
The non-core banks carry out a very
diverse range of activities with a limited link to the domestic economy. The non-core domestic banks are generally not typical retail banks.
Since they lack the extensive branch network of the larger core domestic banks,
they are not in a position to compete for resident retail deposits, nor to
expand their asset portfolios inside Malta. Therefore, their activities are
largely focused abroad, including syndicated corporate lending or intra-group
activities and specialising in niche activities like trade financing and
factoring. A limited branch network also implies that these banks are not major
employers on the island – the top two banks of this category directly employ
around 400 people, which represents just 0.3% of the gainfully occupied
employees.
Non-interest income is the main source
of profit. On aggregate, around 60% of the gross
income of the non-core banks comes from the non-interest component of the
profit and loss account. This reflects their larger reliance on investment
activities – investment securities represent over 40% of total assets, which is
nearly twice as high as the ratio in the core banks. The sources of
non-interest income vary across banks with some relying more on fees and
commissions, while others registering gains on held-to-maturity investment
securities. On the expenditure side, the non-core banks are generally more
cost-effective, largely on account of lower personnel expenses and impairment
costs.
Profitability remains high. On aggregate, the non-core banks posted profits for the fourth
consecutive year in 2012 and data for the first half of 2013 indicates that the
trend continues. As a result, the non-core banks have continuously been able to
strengthen their capital levels through retained earnings.  The return on
assets is generally similar to that of the core domestic banks. It improved to
1.9% in 2012 before moderating somewhat to 1.5%. Due to the higher capital
levels that the non-core banks are required to maintain, their return on equity
is generally lower than that of the core banks.
The non-core banks are generally
healthy, but high reliance on wholesale funding increases their vulnerability
to any potential future liquidity shock. The
non-core banks maintain high solvency ratios – the ratio of aggregate Tier 1
capital to risk-weighted assets was just under 24% as at June 2013, well above
the statutory minimum. Higher capital adequacy reflects to some extent the
supervisory approach of the MFSA, which may request that banks with more
specialised and riskier asset and funding profiles or which fund themselves to
some extent with retail deposits to maintain a higher level of capital. The
aggregate loan quality is good and the ratio of non-performing loans to total
loans stood at just over 4% in June 2013. The liquidity ratio was also very
sound as liquid assets represented 74% of the short-term liabilities on
aggregate, well above the statutory minimum of 30%. Ample liquidity is
essential given the high reliance on wholesale funding and the business model
of some banks that consist of maturity transformation – using short-term
borrowing on the interbank market to invest in longer-term assets. This,
however, implies that banks could be susceptible to a liquidity crunch if a
significant tightening of the interbank market occurred. The successful
operations even during the challenging conditions on international financial
markets in 2008-9 suggest that banks and supervisors have been able to manage
this risk successfully. However, the size of the non-core banks has
substantially increased since then.  The high level of diversity may also imply
different levels of performance of the individual banks within the group.
Ultimately bank level data would be required to make a definitive assessment
which is not available for all non-core banks.
Potential risks to financial stability
are limited. Potential failure of a bank in this
category would have a limited direct impact on the balance sheets of the
government, private sector or the rest of the banking system. Such an event
could impact financial stability rather through a contagion effect – reducing
investor confidence in Maltese assets and increasing the risk spread on them as
well as tightening access to the international financing. The direct effect of
such a scenario would be mitigated by the fact that government, banks and firms
get most of their financing from domestic sources.
3.2.3.   The
non-banking financial sector
Besides banking, the Maltese financial
sector offers a range of other activities. These
include insurance, investment funds, payment and electronic institutions and
providers for a range of other services including trustees, fiduciary services
and fund administrators. While the banking sector is by far the largest in
terms of assets, insurance and collective investment schemes have seen very
rapid development over the past several years and their aggregate assets stood
at around EUR 19 billion at end-2012 (over 250% of GDP), up from around EUR 13
billion at end-2010. The nature of activities in the non-banking financial
sector is generally not very complex and a shadow banking sector appears not to
exist at the moment.
While growth slowed down in 2013, the
sector is expected to continue expanding. The
implementation of several international directives in 2013, such as the
Alternative Investment Fund Managers Directive (AIFMD) and work ahead of the
introduction of SOLVENCY II, created some uncertainty on the market and halted
the growth rates observed in the past. Still, the authorities expect
non-banking sector to continue growing in the future related, including into
new types of activities. The setting up of a voluntary third pension pillar
might also incentivise the development of pension funds in Malta.
The financial sector has managed to
successfully navigate an environment of heightened risk and reduced confidence
in the aftermath of the Cypriot crisis. With tensions on international markets
abating and confidence returning, also in view of the planned establishment of
the Single Supervisory Mechanism under the ECB, risks to macro-financial
stability appear contained. The nature of the main risks facing the sector, namely
credit and concentration, is structural and as such will likely continue to
characterise it in the future. So far, the authorities are managing these risks
in an effective way, as evidenced by the robust performance and soundness
indicators.
3.3.      External
trade and competitiveness
External trade and competitiveness are
of particular importance to the Maltese economy due to its high degree of
openness. Relative export performance, measured as the evolution of export
market shares, is thus a key indicator for the robustness of the economy. An
analysis of cost and non-cost competitiveness factors offers an explanation of
its drivers and potential obstacles.
3.3.1.   Export
performance
The exporting sector has been
successful, as evidenced by the positive external trade performance. National accounts data show that exports of goods and services
expanded by over 40% between 2009 and 2012, after a relatively moderate
contraction in 2009, which was one of the fastest recoveries in the euro area,
after Estonia, Latvia and the Slovak republic. The recovery was most pronounced
in the export of goods, particularly to non-EU countries, although intra-EU
goods exports and overall services exports also registered significant growth.
At the same time, imports grew at a more moderate rate, largely due to weaker
domestic demand, but also pointing to a structural lowering of the import
content of exports. As a result, the trade balance improved and net exports
have been the main driver of economic growth in 2009-12.
Goods exports have been boosted by
strong performance in the main sectors. Goods
exports have been boosted mainly by the traditional semi-conductors industry
and the emerging trans-shipment of oil. In 2012, these sectors accounted for
over half of the total value of goods exports. Malta continued to gain export
market shares in particular in its main product markets (largely in the oil
trans-shipment market) and in the main geographical destinations (mainly Turkey
and Egypt, but also in Hong Kong and Libya). Moreover, exports have also
benefitted from a favourable geographical and product orientation, where high
market dynamism provided more opportunities for Maltese exporters (see Graph
3.9). Malta's export performance compares favourably with the rest of the EU
Member States, most of which lost world market shares in the trade of goods in
2008-12.
Trade in services has also performed
well, thanks to Malta's main sectors of specialisation. Malta's main services exports remain tourism (see Box 3.4) and other personal, cultural and
recreational services (mainly remote and digital gaming) as well as, more
recently, financial services. The growth of the remote gaming industry has been
particularly impressive and over the past ten years Malta has become the
largest exporter of such services worldwide, overtaking Malaysia and Turkey.
Together, tourism and remote gaming accounted for some 70% of the total
services exports in 2012, which puts Malta among the more concentrated
economies in the euro area in this respect. The exports of services slowed down
in 2012, particularly in the personal and recreational services sector, which
appears to be reaching maturity. ([28])  This was partially offset by financial services, which have seen
significant gains since 2011, but remain relatively small in absolute terms. As
a result, despite still growing in nominal terms, Malta lost export market
shares in 2012 (see Graph 3.10). This loss, however, comes after a prolonged
period of significant gains. 
 (Continued on the next page) 
 Box (continued) 
The overall external trade performance
points to a favourable competitive position in comparison with other EU Member
States. Malta's export performance compares well
with the rest of the EU Member States. In terms of services exports, the growth
in export market shares has been among the highest in the EU and moreover Malta
was among the few Member States that has been able to consistently expand its
world market shares (see Graph 3.20). In the trade of goods, the domestic
economy has successfully been able to recover from the decline of the textiles
industry in the beginning of the past decade and gain market shares (see Graph 3.21). 
3.3.2.   Competitiveness
drivers
Competitiveness indicators paint a
relatively favourable picture. Apart from natural
shortcomings arising from the small size of the domestic market, which limits
the opportunity to exploit economies of scale, making export the only
possibility for growth, the institutional and regulatory features of the
Maltese economy are generally in line with, or in some cases better than,
competitor euro-area economies in the Mediterranean region. In particular,
survey data points to a better perception of the efficiency of the goods and
labour markets, technological readiness and the development of the financial
market, supported by a more favourable macroeconomic environment (see Graph 3.22). Still, room for improvement remains
to allow Malta to exploit its competitive advantages with its competitors and
compensate for inherent disadvantages. The most problematic factors for doing
business are perceived to be the inefficiency of public administration, related
to a still high regulatory burden, as well as the access to financing and the
inadequate supply of infrastructure, particularly related to the quality of
roads and of electricity supply.
The environment for doing business
appears in line with that in the main competitors, but gaps in some important
areas remain. Malta compares well with other EU
Mediterranean countries in most indicators examined by the World Bank's Doing
Business survey (see Graph 3.23). Particular strengths include a
simplified system of paying taxes, where more payments can take place online,
while relatively low costs facilitate external trade. Still, while the total
cost to import and export is relatively low, ports and terminal handling costs
are elevated, particularly when importing. Given the high import-intensity of
domestic demand, tackling this inefficiency would further boost the economy's
competitiveness. At the same time, a high number of associated procedures and
the long time needed to complete them can burden the start-up and every-day
operations of businesses. Some procedures, such as getting electricity and
enforcing contracts, are associated with high accompanying costs. Resolving
insolvency appears to be a particularly problematic area, due to the long time
the procedures take and the low recovery rate for claimants.
Labour cost competitiveness has recently
showed signs of erosion. The evolution of nominal
unit labour costs (ULCs) relative to the EU Member States has been quite
unfavourable as ULCs in Malta increased faster than the reference group. This
has been to a large extent due to the job-rich growth in Malta as employment
increased faster than in most other industrialised countries, particularly in
recent years, also reflecting some element of labour hoarding. As a result, the
growth of productivity per person employed has been more subdued, particularly
since 2009. It is useful to gauge Malta's performance in terms of labour cost
competitiveness against direct competitor countries. Graph 3.24 illustrates the evolution of nominal
ULCs relative to EU MS in the Mediterranean region that are the main
competitors on the tourist services market, but also for other activities.
Between 2000 and 2012, Malta's relative nominal unit labour costs have remained
largely unchanged as initial gains in the beginning of the decade were lost
after 2008. The erosion of cost competitiveness with respect to the EU
Mediterranean region is projected to continue in 2013-15, also due to sharp
cost-adjustment in these countries, which could put pressure on the external
trade performance of the Maltese economy.
Still, wage developments have been in
line with fundamentals. Commission estimates assess
actual wage developments until 2012 against domestic wage determinants, taking
into account domestic price inflation and the terms of trade, productivity
developments, unemployment and education attainment (benchmark 1). In addition,
wage developments are assessed against price competitiveness, benchmarking them
against a constant value of the ULC-adjusted real effective exchange rate
(benchmark 2). Results show that after a period of misalignment particularly with
respect to benchmark 2, wage increases since 2010 have been in line with or
even below the benchmarks (see Graph 3.25). ([29]) This has been facilitated by a flexible wage setting environment
where wage bargaining takes place at company level (see Aumayr-Pintar, Cabrita,
Foden 2013).  Nevertheless, the existence of an automatic wage indexation
mechanism (cost-of-living adjustment or COLA), which is often added on top of
the wage increase coming out of collective agreements (see IMF 2013), could
result in real wage rigidity and trigger wage-inflation spirals.
Labour cost levels and skills are among
the main FDI attractiveness factors. Labour costs
in Malta remain well below the average for the euro area as well as most
countries in the Mediterranean region. Most foreign investors in Malta indeed
indicate that labour costs are among the main factors attracting foreign
investment to the island. ([30]) The lowest
implicit tax rate on labour in the euro area contributes to the low level of
labour costs. Commission services estimates ([31])  show that the level of nominal compensation per employee in
purchasing power standards (thus eliminating the effect of different price
levels) has actually been lower than the levels predicted on the basis of the
two benchmarks above. Low labour costs, however, reflect also the relatively
low skill level of the domestic labour force, which exhibits the second highest
ratio of low-skilled workers in total employment in the euro area and the EU28
as a whole. Nevertheless, there appears to be an effective training framework
in place and particular sectors, such as pharmaceutical production and aviation
repair, have been able to benefit and train their staff for specific activities
at the Malta College of Arts, Science and Technology. Furthermore, E&Y's
2013 Attractiveness Survey points to the stability of social climate and the
political, legal and regulatory environment, corporate taxation and the growth
potential as other key factors attracting FDI.   
Despite a favourable competitive
position, foreign direct investment inflows have dried up in recent years. The stock of foreign direct investment (FDI) as a share of GDP in
Malta is among the highest in the EU and significantly exceeds those in the
other Mediterranean EU Member States. The majority of the stock is into
financial and insurance activities, reflecting the presence of subsidiaries and
branches of large international banking groups. In recent years, however, FDI
inflows have decreased significantly, more so than in other Member States from
the Mediterranean region. Since 2009, FDI inflows not related to financial or
insurance activities have been negative or just above zero. Given the small
size of the domestic economy, FDI is an important source of innovation.
Therefore, lack of foreign investment flows, combined with the observed decline
in investment,   limit the future growth potential of the economy.
The export performance of the Maltese
economy has been strong. It has been able to expand into new niche areas such
as the remote gaming industry and, more recently, the trans-shipment of oil
while establishing a solid base for further development in the more traditional
activities. This seems to be confirmed by an analysis of cost and non-cost
factors, which indicate that the Maltese economy enjoys a relatively healthy
competitive position. Maintaining external competitiveness and attracting FDI,
however, is a continuous challenge.
The analysis in sections 2 and 3 indicates
that macroeconomic developments in the areas of financial stability, external
competitiveness and public indebtedness may warrant some policy attention in
Malta. It should be recalled that these challenges were identified under the
MIP in the first IDR and relevant policy responses were reflected and
integrated in the country-specific recommendations issued for Malta in July
2013. The assessment of progress in the implementation of those recommendations
will take place in the context of the assessment of the National Reform
Programme and Stability programme under the European Semester. Against this
background, this section discusses different avenues that could be envisaged to
address the above challenges. 
Public debt sustainability
Improving the quality of public finances
is crucial for ensuring debt sustainability.
Numerical fiscal rules and credible institutions have an important role to play
in improving the quality of public finances, in particular to limit fiscal
slippages and strengthen fiscal monitoring and planning. In this respect, Malta
has not yet implemented the Treaty on Stability Coordination and Governance and
the deadline of end-2013 was missed. The expenditure review undertaken by the
authorities is a positive development. It would be important that any
expenditure savings, resulting from the findings of the review, are used to
reinforce fiscal consolidation and reduce the debt stock.
Medium-term debt sustainability would
benefit from compliance with the Stability and Growth Pact. Meeting the EDP headline government deficit target of 2.7% of GDP
in 2014 and, thereafter, progress towards the MTO, as recommended by the
Council, are expected to contribute to the medium-term sustainability of
government debt.
In the long-run, the budgetary costs of
ageing need to be contained. Despite the observed
improvement in labour market participation, the demographic trends and the
characteristics of the welfare system suggest that the budgetary impact of
ageing in Malta are projected to be higher than the EU average in the medium to
long-term. Thus, policy action to improve the sustainability of the pension
system, while also ensuring its adequacy, and of the healthcare system appears
warranted.
Financial stability
Maintaining and in some cases
strengthening the current prudent supervisory framework would be beneficial for
financial sector stability. Low loan-to-value
ratios, coupled with high capital buffers point to prudent supervisory
practices, as also confirmed by the 2011 independent assessment of the MFSA.
Supervision was further reinforced by the strengthening of provisioning
practices undertaken in 2013 with the implementation of a revised Banking Rule
9. Faced with concentration risk of structural nature, due to the relatively
small size of the domestic market, it is crucial that the supervisor and the
commercial banks remain vigilant and their risk-management practices remain
prudent. Further supervisory action, such as introducing a cap on the
loan-to-value ratio for new lending or further encouraging banks to use profit
retention as a counter-cyclical buffer to strengthen their capital positions
could be beneficial in reinforcing confidence in domestic financial stability.
The consolidation of prudential oversight into the Single Supervisory Mechanism
in 2014 will also contribute to strengthening confidence in the stability of
the banking sector. 
While the MFSA is up-to-date with the
regulatory framework for banking and non-banking financial services, keeping up
with the evolving framework will pose a continuous challenge. Thus, it will be
important that the MFSA has sufficient resources to cope with the task. In
light of this, the strengthening of the staff capacity in the past year is a
positive development.
Managing credit risk would benefit from
an efficient judiciary system. A persistently high
stock of NPLs implies reduced profitability for the banks as a result of
increased provisioning needs as well as loss of output for the real economy due
arising from inefficient allocation of resources. Bringing down the stock
requires an efficient judiciary system that deals with insolvency cases in a
timely and cost-efficient manner. The authorities have launched a comprehensive
review of the judicial system, which is expected to result in a three-year
reform process starting in the beginning of 2014. Targeted measures to raise
the overall efficiency of the judiciary, followed by timely and efficient
implementation, would thus benefit the banking sector and the overall economy.
Efficient real estate market monitoring
is also important. The significant link between the
core domestic banks and the real estate market calls for attention to property
market developments in order to limit boom/bust episodes. Strengthening the
provision of statistical data would be beneficial such as by developing series
on property market transactions.
Low levels of competition among the core
domestic banks could result in inefficiencies.
Although not posing a direct risk for macro-financial stability,
anti-competitive behaviour in the banking system could result in higher costs
for businesses and consumers and present a drag on growth. The interest rates
charged by the core domestic banks segment on corporate loans appear relatively
high, while retail banking fees in the two dominant banks appear higher than in
the rest of the sector. A closer look at the drivers of the high intermediation
margin and fee and commission income could, thus, be warranted. 
External competitiveness
External competitiveness benefits from
keeping labour costs in check. Foreign investors
identify competitive labour costs as one of Malta's key advantages. The
importance of labour cost is increasing in view of the rising
labour-intensiveness of the economy.  Thus, authorities and stakeholders need
to continue monitoring wage developments and stand ready to introduce
cost-adjustment reforms if required in order to stay in line with competitor
countries.
Strengthening the business environment
would reflect positively on competitiveness, FDI attractiveness and growth. Keeping transaction costs at minimal levels boosts the
attractiveness of Malta to foreign investors, thus enhancing the prospects for
growth and jobs. To that end, ongoing efforts to restructure the energy sector
and lower costs to industry and households would have a positive impact.  In
addition, the authorities have implemented reforms aimed at reducing
administrative burdens on businesses. Strengthening the reform momentum in this
area and addressing procedural shortcomings, such as the relatively long time
required to start a business, would be beneficial. In view of the possibly
negative impact on competitiveness, collective bargaining could be enhanced in
a way that any cost of living adjustment is incorporated into the negotiated
wage agreements so as to ensure that wages are more closely aligned with
productivity developments. Education policies also have an important role to
play, particularly in ensuring that the labour force has the necessary basic
skills to attract investment and offer services of sufficient quality at
competitive prices.
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Differentials in a Monetary Union: the Case of Malta, Central Bank of
Malta, May 2013
World Bank (WB 2013), Doing Business
report, 2013
World Economic Forum (WEF 2013a), The
global competitiveness report 2013-2014, 2013
World Economic Forum (WEF 2013b), J.
Blanke, T. Chiesa, The Travel & Tourism Competitiveness Report 2013 -
Reducing Barriers to Economic Growth and Job Creation, 2013 
([1])  The figure refers to the 15-74 age
group
([2])  Despite the gains in recent years,
Malta's female employment rate was the second lowest in the EU in 2012.
([3])  This rate is defined as the share of
the total population living with income less than 60% of the median equivalised
income after social transfers.
([4])  This measure refers to people living in
either at risk of poverty, severe material deprivation or in a household with
very low work intensity.
([5])  The government decided to freeze
electricity tariffs in 2011-13.
([6])  Productivity developments in Malta need
to be interpreted with caution. The negative trend in labour productivity
observed over the past decade and in particular since 2008-9 reflects the
significant employment growth during this period. In turn, this reflects the
structural change in the economy towards more labour-intensive activities in
the services sector.
([7])  Debt is defined as the sum of securities
other than shares and loans, including also inter-company loans from abroad.
([8])  The debt-equity bias in corporate
financing indicates the difference between the effective marginal tax rate on
new equity and new debt. A high debt bias means that companies might find it
cheaper to finance themselves through loans rather than equity. Conclusions
based on this indicator, however, need to be treated with caution.
([9])  Joint European Resources for Micro and
Medium Enterprises Initiative
([10]) Corporate leverage is defined as the
ratio of debt to equity. The financing cost for new businesses is proxied by
the interest rates on loans of over EUR 1mn amount and with original maturity
of up to one year.
([11]) It should be kept in mind that this
Graph offers a comparative analysis and thus should not be interpreted in
absolute terms.
([12]) See details on the methodology in EC
2013a
([13])  See http://ec.europa.eu/economy_finance/economic_governance/sgp/pdf/30_edps/126-07_council/2013-06-21_mt_126-7_council_en.pdf
([14]) See http://register.consilium.europa.eu/doc/srv?l=EN&t=PDF&gc=true&sc=false&f=ST%2010645%202013%20REV%201
([15]) See EC 2012a
([16]) Age-related expenditure in Malta is
projected to increase by 8.2 pps. of GDP between 2010 and 2060, more than
double the increase projected for the EU as a whole.
([17]) About 30% of the outstanding stock of
government debt is held by retail investors.
([18]) Enemalta has accumulated debts to the
level of EUR 702 million, thus representing a significant contingent liability
for the public finances. 
([19]) A debt restructuring plan for Enemalta,
adopted by the authorities in December 2012, covers about half of the company's
current debt (which, at end-2011 and including only bank and other borrowings,
stood at EUR 702 million or EUR 867 million when adding also trade-related and
other payables).
([20]) Preparation for the balance sheet
assessment and stress test exercise by the ECB in 2014 can be expected to
result in a decrease in the aggregate balance sheet of the Maltese banking
system.
([21]) See also findings in EC 2013b
([22]) The aggregate concentration figures in
both the loan and investment portfolios mask significant differences across the
individual banks.
([23]) At June 2013, the LTV for loans backed
by residential property was 73.6% and 63.1% for loans backed by commercial
property.
([24]) The index is calculated by adding the
squared values of the market shares of all banks in the respective countries.
For Malta, only the core domestic banking segment is considered. It should be
taken into account that the data for the other countries is on consolidated
level. Therefore, it may include also institutions that are not entirely geared
towards the respective domestic economies, making it not entirely comparable
with the sample of banks for Malta.
([25]) For this chart, the intermediation
margin is the difference between interest rates on new business lending to
non-financial corporations of up to 1 year initial rate fixation and over EUR 1
million amount, and the interest rates on new household deposits with up to 3
months period of notice. 
([26]) The interest margin is calculated as
the ratio of interest income on loans and advances to customers to gross loans
and advances to customers. For BOV, the financial year is October – September,
while for the rest of the sector it is January – December. 
([27]) The non-core domestic banks held 6.2%
of the total deposits eligible for the DCS as at end-2012 (CBM 2013a)
([28]) Following the so-called "VAT
package" adopted by the council in Council Directive 2008/8/EC of 12
February 2008, Malta's attractiveness as a location for remote gaming could
diminish. Malta currently exempts from VAT such activities. The new Council
Directive stipulates that as of 2015 VAT must be charged on the basis of where
the customer is located. Since several Member States do not apply a blanket
exemption to gaming, service suppliers established in Malta will have to charge
and account for VAT where this is applicable. Any VAT advantage gained by
choosing Malta as a location for remote gaming will thus disappear.
([29]) See details on methodology in EC 2013d
([30]) See E&Y 2013
([31]) See EC 2013d