November 17, 2017

Malta’s economic growth remains one of the strongest in Europe, reflected by rapid income convergence towards the European Union (EU) average. Prudent policies advanced structural reforms and contributed to the strengthening of private and public-sector balance sheets, while steady job creation drove unemployment to historically low levels. Growth prospects remain favorable, yet the mounting pressure on infrastructure, rising housing prices, as well as shortages of labor and skills pose a challenge. Reducing the infrastructure gap and improving labor supply remain the key policy priorities to sustain high growth and promote inclusiveness. Attention should also be given to enhancing the economy’s resilience to shocks by further reducing fiscal risks and building larger fiscal buffers, safeguarding financial stability, and ensuring that property market imbalances will not emerge.

1. Malta’s robust economic performance is set to continue. Aided by favorable domestic and external conditions, real GDP growth is projected at 5.8 percent in 2017 and 5.1 percent in 2018, and to gradually converge towards a potential rate of about 3 percent over the medium term. Growth will be driven largely by domestic demand in the coming years backed by rising incomes and historically-low unemployment while buoyant services exports will continue to sustain current account surpluses. Inflation is expected to pick up gradually, reflecting an increase in import prices and tighter labor market conditions.

2. Risks to the outlook are broadly balanced. As a small and highly open economy, Malta is vulnerable to growth fluctuations and policy uncertainty in key trading partners. An increase in inward-looking policies abroad and possible international corporate taxation reforms could adversely affect the economy. Domestically, wage pressures could boost private consumption above projections while a robust implementation of infrastructure plans and improved SMEs’ access to credit—including due to the new Malta Development Bank—could result in higher-than-projected investment growth. Yet, slow progress in addressing the remaining structural weaknesses could undermine growth prospects and erode competitiveness. Strong increases in housing prices may raise financial stability risks and deter the inflow of foreign workers.

Build fiscal buffers and tackle fiscal risks

3. The mission welcomes the progress made in improving public finances . Malta achieved its medium-term objective (MTO) of a structural balance in 2016, three years ahead of schedule, owing to buoyant tax revenues, proceeds from the Individual Investor Program (IIP), and contained expenditure growth. Public debt fell to below 60 percent of GDP. The 2017 overall balance is expected to reach 1.3 percent of GDP, exceeding the budget target, as economic conditions and IIP proceeds remain robust.

4. Remaining fiscal risks need to be carefully addressed. Possible international corporate taxation reforms may affect Malta’s fiscal position unfavorably due to the high share of corporate tax revenues in total revenues, thus calling for broadening the tax base and strengthening revenue collection. Recent measures to combat tax evasion and increase Value-Added Tax compliance are steps in the right direction. Contingent liabilities from state-owned enterprises (SOEs), although receding, remain high and require close monitoring. Advancing the restructuring of financially weak SOEs would help contain these risks. Lastly, age-related spending pressures remain significant, requiring a better alignment of the contributory period with life expectancy and pensionable income with life-time earnings. Ongoing efforts to delay retirement and encourage voluntary savings will help to ensure socially sustainable pensions.

5. Building larger buffers would add strength to Malta’s fiscal position. The government’s plan to continue lowering public debt by keeping a medium-term surplus of 0.5 percent of GDP in 2018-20 and comply with the MTO is appropriate given the economy’s favorable cyclical position and remaining fiscal risks. However, the attainment of these targets depends partly on IIP revenues, which are temporary and hard to predict. Hence, identifying further structural measures would put the fiscal position on a stronger footing.

6. A budget-neutral public investment push would buttress Malta’s competitiveness. The government’s plans to upgrade the road network and encourage higher utilization of public transportation will help to mitigate endemic congestion, thereby improving the population’s well-being and fostering business productivity. To contain fiscal risks, higher public investment should be well-prioritized in a budget-neutral manner. Consideration should be given to strengthening revenue collection, making best use of public-private partnerships and EU funds, as well as increasing public spending efficiency, including through extension of the in-depth reviews to the broader public sector.

Safeguard financial stability

7. Domestic banks remain well-capitalized and profitable, but face several challenges. Bank profitability remains subject to headwinds from subdued lending to the non-financial corporate sector, low interest rates, and upcoming regulatory changes, which may require higher loan-loss provisions and lead to higher funding costs. Additional challenges for the banking sector include elevated, albeit declining, legacy corporate non-performing loans (NPLs) and a high concentration of property-related loans.

8. The mission commends the continued reduction in impaired loans, although further efforts are warranted. Favorable economic conditions as well as banks’ write-offs and loan restructuring have sustained the downward trend in NPLs, which stood at 4.6 percent for core domestic banks in the second quarter of 2017. However, at about 10 percent, corporate NPLs remained elevated, thus weighing on bank balance sheets. Continued resolution efforts and enhanced supervisory oversight, supported by the recent regulatory changes, would strengthen the monetary policy transmission mechanism and improve the economy’s resilience to shocks. The expected increase in the provision coverage ratio and further improvements of the insolvency process could support these efforts. With persistent real estate appreciation, it is important to maintain prudent collateral valuation practices.

9. Diversification of corporate financing may foster resilience, but adequate safeguards are needed to contain risks. Intercompany loans have become the main funding source for firms, as bank lending to corporates continued to decline. Moreover, direct issuance of debt securities and credit from nonbank financial institutions have grown rapidly, albeit from a low base. While the diversification of funding sources has served Maltese firms well, the authorities should address data gaps and enhance the oversight of nonbank lending to mitigate potential financial stability risks. SMEs’ access to finance could be further improved by the Malta Development Bank, for which robust governance and well-designed origination rules will help to contain contingent liability risks to public finances.

10. The growing size and complexity of the financial sector represent a challenge for supervision. The increasing number of financial firms under supervision, the rapid development of new products, and the evolving regulatory environment have put the Malta Financial Services Authority (MFSA) under strain despite its recent expansion. Further pressure emanates from tight labor market conditions, which have contributed to high MFSA staff turnover. Ensuring that the MFSA has adequate resources is critical to preserve its operational independence, improve its capacity to retain experienced staff, and maintain effective supervision.

11. Sustained efforts are needed to safeguard the financial system’s integrity. Robust implementation and effective enforcement of the Anti-Money Laundering (AML) framework is critical given the fast-growing remote gaming activity and the high demand for the IIP. Finalizing the related National Risk Assessment and transposing the EU’s 4^th AML Directive into national law would support efforts in this area.

Address housing market pressures

12. The strong momentum in the housing market calls for pre-emptive measures. Household balance sheets are generally sound, yet persistent strength in mortgage lending and demand for properties may lead to imbalances and potential macro-financial repercussions. While the mission does not see immediate financial stability risks, housing prices appear to have entered a modest overvaluation territory by several metrics. Steps to reduce the buildup of risks are therefore warranted, including by:

• Deploying targeted macroprudential limits for mortgages to enhance the resilience of bank and household balance sheets to possible housing price corrections and increases in interest rates. Closing data gaps on borrower characteristics would help to calibrate these measures effectively.
• Ensuring that fiscal incentives do not amplify the housing cycle by aligning the tax rate on rental income with tax rates on other sources of income. Introducing periodic reviews of the scope and parameters of the IIP, including the minimum real estate investment or leasing values, could help curb the housing demand pressure and may improve the predictability of fiscal revenues.
• Reducing supply bottlenecks by accelerating corporate balance sheet repair in the construction sector.

13. Accelerated delivery of social housing would mitigate the impact of rising housing prices on the poor. Efforts to expand social housing, such as providing financial incentives for homeowners that make their property available to low-income households, are welcome. Steps to relax eligibility requirements for rent subsidies and social loans would help improve housing affordability, yet ensuring that eligibility criteria are prudently assessed and means-tested is important.

Sustain high growth and make it more inclusive

14. Closing the infrastructure gap and strengthening labor supply would promote high and inclusive growth. Safeguarding the reform momentum and addressing the remaining structural impediments would foster future development. Attention should be given to:

• Addressing infrastructure gaps . Malta’s public capital stock per capita is the lowest in the EU, and the high density of car ownership coupled with weak road quality have led to severe congestion. The government’s medium-term strategy to improve road quality and increase the utilization of alternative means of transport is a step in the right direction.
• Upskilling and reskilling the labor force and increasing female labor force participation . Scarcity of skilled staff has become a key problem for firms. Recent government initiatives to enhance the training and education systems will help contain the skill gap. This, together with continued steps to boost the incentives to work and delay retirement, would also sustain the upward trend in female labor force participation.
• Strengthening innovation . Innovation in Malta continues to lag its peers. The implementation of the National Research & Innovation Action Plan could enhance productivity and medium-term growth prospects by developing research infrastructure, upscaling the financial support for innovation activities, and improving the links between academia and the private sector.

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The mission would like to thank the authorities, private sector participants, and other interlocutors for the open and productive discussions and warm hospitality.