Commission Staff Working Document:Accompanying document to the Report from the Commission - Convergence Report 2007 on Malta (prepared in accordance with Article 122(2) of the Treaty at the request of Malta) - Montesquieu Instituut

 

COUNCIL OFBrussels, 22 May 2007

THE EUROPEAN UNION

9696/07 ADD 1

UEM 103 ECOFIN 209

COVER NOTE

from:

Secretary-General of the European Commission, signed by Mr Jordi AYET PUIGARNAU, Director

date of receipt: 22 May 2007

to: Mr Javier SOLANA, Secretary-General/High Representative

Subject: Commission Staff Working Document: Accompanying document to the Report from the Commission - Convergence Report 2007 on Malta (prepared in accordance with Article 122(2) of the Treaty at the request of Malta)

Delegations will find attached Commission document SEC(2007) 622.

________________________

Encl.: SEC(2007) 622

 

ENCOMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 16.5.2007 SEC(2007) 622

COMMISSION STAFF WORKING DOCUMENT

Accompanying document to the

REPORT FROM THE COMMISSION

CONVERGENCE REPORT 2007 ON MALTA

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

{COM(2007) 258 final}

LIMITED

European Economy

Convergence Report 2007 on Malta Technical Annex

A Commission services working paper

SEC(2007) 622

Aknowledgements

The Convergence Report and its Technical Annex were prepared in the Directorate-General for Economic and Financial Affairs. The main contributors were Pavlína Záková and Paul Kutos.

Other contributors to the paper were Sean Berrigan, Ivan Ebejer, Christine Gerstberger, Fabienne Ilzkovitz, Baudouin Lamine, Claudia Lindemann, Lucio R. Pench, Nuno Sousa, Andreas Trokkos, Charlotte Van Hooydonk and Johan Verhaeven.

Statistical assistance was provided by André Verbanck and Gerda Symens.

The paper was coordinated by Massimo Suardi, and approved by Servaas Deroose, Director, and Klaus Regling, Director-General.

Contents

• 1. 

  Introduction .................................................................................................................. 2

1.1. Role of the report ......................................................................................................... 2

1.2. Application of the criteria ............................................................................................ 3

• 2. 

  Legal compatibility .................................................................................................... 12

2.1. Legal situation............................................................................................................ 12

2.2. Assessment of compatibility ...................................................................................... 14

• 3. 

  Price stability.............................................................................................................. 15

3.1. Respect of the reference value ................................................................................... 15

3.2. Recent inflation developments................................................................................... 15

3.3. Underlying factors and sustainability of inflation...................................................... 16

• 4. 

  Government budgetary position................................................................................. 20

4.1. The excessive deficit procedure for Malta ................................................................. 20

4.2. Developments until 2006 ........................................................................................... 20

List of Tables

Table 1. Inflation reference value in previous and current Convergence Reports

Table 2. Malta: Components of inflation

Table 3. Malta: Other inflation and cost indicators

Table 4. Malta: Budgetary developments and projections

Table 5. Malta: Product market integration

Table 6. Malta: Balance of payments

List of Charts

Chart 1. Malta: Inflation criterion since May 2004

Chart 2. Malta: HICP inflation

Chart 3. Malta: Inflation, productivity and wage trends

Chart 4. Nominal effective exchange rate: MTL

Chart 5. MTL: Spread vs central rate

Chart 6. Exchange rates: MTL/EUR

Chart 7. Malta: 3-M Mibor spread to 3-M Euribor

Box 1. Article 122(2) of the Treaty

Box 2. Article 121(1) of the Treaty

Box 3. Assessment of price stability and the reference value

Box 4. The excessive deficit procedure

Abbreviations and symbols used

Member States

BE Belgium

BG Bulgaria

CZ Czech Republic

DK Denmark

DE Germany

EE Estonia

EL Greece

ES Spain

FR France

IE Ireland

RO Romania

SI Slovenia

SK Slovakia

FI Finland

SE Sweden

UK United Kingdom

EU10 European Union Member States that joined the EU on 1 May 2004 (CZ, EE, CY, LT, LV, HU, MT, PL, SI, SK)

EUR13 European Union Member States having adopted the single currency (BE, DE, EL, ES, FR, IE, IT, LU,

NL, AT, PT, SI, FI)

EU15 European Union, 15 Member States before 1 May 2004 (EUR-12 plus DK, SE and UK)

EU25 European Union, 25 Member States before 1 January 2007

EU27 European Union, 27 Member States

Currencies

EUR euro

ECU European currency unit

USD US dollar

MTL Maltese lira

Eurostat Statistical Office of the European Communities

FDI foreign direct investment

GDP gross domestic product

GFCF gross fixed capital formation

HICP harmonised index of consumer prices

ICT information and communications technology

MTO medium-term objective

MFSA Malta Financial Services Authority

PPS Purchasing Power Standard

SGP Stability and Growth Pact

ULC unit labour costs

VAT value added tax

• 1. 

  INTRODUCTION

1.1. Role of the report

Box 1: Article 122(2) of the Treaty

The euro was introduced on 1 January 1999 by eleven Member States, following several years of successful adjustment efforts to achieve a high degree of sustainable convergence. The decision

"At least once every two years, or at the request of a Member State with a derogation, the Commission and the ECB shall report to the Council in accordance with the procedure laid down in Article 121(1). After consulting the European Parliament and after discussion in the Council, meeting in the composition of the Heads of State or Government, the Council shall, acting by a qualified majority on a proposal from the Commission, decide which Member States with a derogation fulfil the necessary conditions on the basis of the criteria set out in Article 121(1), and abrogate the derogations of the Member States concerned."

1 by the

Council (meeting in the composition of the Heads of State or Government) on 3 May 1998 in Brussels on the eleven Member States deemed ready to participate in the single currency (from the beginning) had, in accordance with the Treaty (Article 121(4)), been prepared by the Ecofin Council on a recommendation from the Commission. The decision was based on the two Convergence Reports made by the Commission

2

and the European Monetary Institute (EMI), respectively.

3 These reports, prepared in accordance

with Article 121(1) of the Treaty, examined in considerable detail whether the Member States satisfied the convergence criteria and met the legal requirements.

Those Member States which are assessed as not fulfilling the necessary conditions for the adoption of the single currency are referred to as "Member States with a derogation". Article 122(2) of the Treaty lays down provisions and procedures for examining the situation of Member States with a derogation (Box 1).

At least once every two years, or at the request of a Member State with a derogation, the Commission and the European Central Bank (ECB) are required to prepare Convergence Reports on such Member States.

Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht Treaty

4 and do not participate in the third stage of

EMU. Until these Member States indicate that they wish to participate in the third stage and join the single currency, they are not the subject of an assessment by the Council as to whether they fulfil the necessary conditions.

Greece submitted a request on 9 March 2000 for its convergence situation to be re-examined. The Ecofin Council adopted the decision

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Technical annex

the ECB7, which covered both Greece and Sweden. 2006.11 None of the countries assessed was deemed to

Greece adopted the single currency with effect from 1 January 2001. Sweden was assessed in 2000 as not fulfilling the necessary conditions for the adoption of the single currency.meet the necessary conditions for adopting the single currency.

On 27 February 2007, Malta submitted a request for a convergence assessment. As a response to this request, the Commission and the ECB prepared Convergence Reports for Malta.

This Commission services working paper is a technical annex to the Convergence Report on Malta and includes a detailed assessment of the progress with convergence. The remainder of the first chapter presents the methodology used for application of the assessment criteria. Chapters 2 to 7 examine fulfilment of each of the convergence criteria and other requirements in the order as they appear in Article 121(1). The cut-off date for the statistical data included in the convergence report and in this technical annex is 26 April 2007.

In 2002, the convergence assessment covered only Sweden and concluded that Sweden was not fulfilling the necessary conditions for the adoption of the single currency and continued to be referred to as a "Member State with a derogation".

8

In 2004, Sweden was examined together with the ten countries that joined the EU on 1 May 2004. In accordance with Article 4 of the Act of Accession, the ten countries became upon entry "Member States with a derogation". Although the maximum period referred to in Article 122(2) of the Treaty had not elapsed for these countries in 2004, the re-assessment of Sweden was seized as an opportunity to analyse also the state of convergence in the new Member States. None of the eleven assessed countries was considered to have fulfilled the necessary conditions for the adoption of the single currency.

1.2. Application of the criteria

9

In 2006, two convergence assessments have been carried out. In May, the Commission and the ECB presented reports on Lithuania and Slovenia, prepared at the request of the national authorities.In accordance with Article 121(1), the convergence reports shall examine the compatibility of national legislation with the Treaty and the Statute of the European System of Central Banks (ESCB) and of the European Central Bank. The reports shall also examine the achievement of a high degree of sustainable convergence by reference to the fulfilment of the four convergence criteria dealing with price stability,

10 While

Slovenia was deemed to fulfil all the convergence criteria and to be ready to adopt the euro in January 2007, the report on Lithuania suggested that there should be no change in the status of Lithuania as a Member State with the derogation. The remaining nine Member States with a derogation were assessed in regular Convergence Reports issued in December

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Box 2: Article 121(1) of the Treaty

"1. The Commission and the EMI shall report to the Council on the progress made in the fulfilment by the Member States of their obligations regarding the achievement of economic and monetary union. These reports shall include an examination of the compatibility between each Member State's national legislation, including the statutes of its national central bank, and Articles 108 and 109 of this Treaty and the Statute of the ESCB. The reports shall also examine the achievement of a high degree of sustainable convergence by reference to the fulfilment by each Member State of the following criteria:

• - 

  the achievement of a high degree of price stability; this 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;

• - 

  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);

• - 

  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;

• - 

  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.

The four criteria mentioned in this paragraph and the relevant periods over which they are to be respected are developed further in a Protocol annexed to this Treaty. The reports of the Commission and the EMI shall also take account of the development of the ECU, the results of the integration of markets, the situation and development of the balances of payments on current account and an examination of the development of unit labour costs and other price indices."

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Member States in terms of price stability". period. The reference value is calculated as the arithmetic average of the average rate of inflation of the three best-performing Member States in terms of price stability plus 1.5 percentage points (Box 3).

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".

Since national consumer price indices (CPIs) diverge substantially in terms of concepts, methods and practices, they do not constitute the appropriate means to meet the Treaty requirement that inflation must be measured on a comparable basis. To this end, the Council adopted on 23 October 1995 a framework regulation

12 setting the legal basis for the

establishment of a harmonised methodology for compiling consumer price indices in the Member States. This process resulted in the production of the Harmonised Indices of Consumer Prices (HICPs), which have been used for assessing the fulfilment of the price stability criterion. Until December 2005, HICP series had been based on 1996 as the reference period. A Commission Regulation (EC) No 1708/2005

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Over the 12 month period covering April 2006-March 2007, the three best-performing Member States in terms of price stability were Finland, (1.3%), Poland (1.5%) and Sweden (1.6%) yielding a reference value

of 3.0%.

The Protocol on the convergence criteria not only requires Member States to have achieved a high degree of price stability but also calls for a price performance that is sustainable. The requirement of sustainability aims at ensuring that the degree of price stability and inflation convergence achieved in previous years will be maintained after adoption of the euro. This implies that the satisfactory inflation performance must essentially be due to the adequate behaviour of input costs and other factors influencing price developments in a structural manner, rather than reflecting the influence of temporary factors. Therefore, this technical annex examines also developments in unit labour costs as a result of trends in labour productivity and nominal compensation per head, and developments in import prices to assess whether and how external price developments have impacted on domestic inflation. From a forward- looking perspective, the report includes an assessment of medium-term prospects for inflation. The analysis of factors that have an impact on the inflation outlook, such as credit developments and cyclical conditions, is complemented by a reference to the most recent Commission forecast of inflation. That forecast can subsequently be used to assess whether the country is likely to meet the reference value also in the months ahead.

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Box 3: Assessment of price stability and the reference value

The numerical part of the price stability criterion implies a comparison between a Member State's average price performance and a reference value.

A Member State's average rate of inflation is measured by the percentage change in the unweighted average of the last 12 monthly indices relative to the unweighted average of the 12 monthly indices of the previous period, rounded to one decimal.

This measure captures inflation trends over a period of one year as requested by the provisions of the Treaty. Using the commonly used inflation rate calculated as the percentage change in the consumer price index of the latest month over the index for the equivalent month of the previous year would not meet the one year requirement. The latter measure may also vary importantly from month to month because of exceptional factors.

The reference value is calculated as the unweighted average of the average rates of inflation of, at most, the three best-performing Member States in terms of price stability plus 1.5 percentage points. The outcome is rounded to one decimal. While in principle the reference value could also be calculated on the basis of the price performance of only one or two best performing Member States in terms of price stability, it has been existing practice to select the three best performers.

The reference value has been defined in the Maastricht Treaty in a relative way. An absolute reference value could, depending on the overall economic circumstances at the time of the assessment, be considered to be unduly harsh or too loose. Alternatively, using the average of the inflation rates of all Member States as a basis for the reference value would imply that high inflation rates of a few countries could increase the average to undesired levels. These problems are avoided in the Treaty by requiring convergence towards the best performing Member States within a margin of 1.5 percentage points. As the reference value is a relative concept based on the Member States with the lowest rate of inflation, a margin of 1.5 percentage points is added.

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Table 1.

Inflation reference value in previous and current Convergence Reports 1)

Convergence ReportCut-off monthThree bestReferenceEuro area average

adoption dateperformers 2)valueinflation rate 2)

1998January 1998Austria, France, Ireland2.71.5

2000March 2000Sweden, France, Austria2.41.4

2002April 2002United Kingdom, Germany, France3.32.4

2004August 2004Finland, Denmark, Sweden2.42.1

2006 May March 2006Sweden, Finland, Poland2.62.3

2006 DecemberOctober 2006Poland, Finland, Sweden2.82.2

2007March 2007Finland, Poland, Sweden3.02.1

• 1) 

  EU15 until April 2004; EU25 between May 2004 and December 2006; EU27 from January 2007 onwards.
• 2) 

  Measured by the percentage change in the arthmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly

indices of the previous period.

Source: Commission services.

Government budgetary position relation to the two criteria for budgetary discipline set in Article 104(2), namely on the government deficit and the government debt. Failure by a Member State to fulfil the requirements under either of these criteria can lead to a decision by the Council on the existence of an excessive deficit, in which case the Member State concerned does not comply with the budgetary convergence criterion (for further information on this procedure, see Box 4).

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".

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Box 4: The excessive deficit procedure 16

The excessive deficit procedure (EDP) is specified in Article 104 of the Treaty, the associated Protocol on the EDP and Council Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the EDP

17,

which is the "dissuasive arm" of the Stability and Growth Pact (SGP). Together, they determine the steps to be followed to reach a Council decision on the existence of an excessive deficit, which forms the basis for the assessment of compliance with the convergence criterion on the government budgetary position, and the steps to be followed to correct a situation of excessive deficit. According to Article 104(2), compliance with budgetary discipline is to be examined by the Commission on the basis of the following two criteria:

"(a) whether the ratio of the planned or actual government deficit to gross domestic product exceeds a reference

value [specified in the Protocol as 3%], unless:

-- either the ratio has declined substantially and continuously and reached a level that comes close to the reference value;

-- or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value;

(b) whether the ratio of government debt to gross domestic product exceeds a reference value [specified in the

Protocol as 60%], unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace".

According to the Protocol, the Commission provides the statistical data for the implementation of the procedure.

As part of the application of this Protocol, Member States have to notify data on government deficits, government debt and nominal GDP and other associated variables twice a year, namely before 1 April and before 1 October

• 18. 

  After each reporting date, Eurostat examines whether the data are in conformity with

ESA9519 rules and related Eurostat decisions and, if they are, validates them.

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The next step in the procedure is the formulation by the Economic and Financial Committee of an opinion on this report within two weeks of its adoption by the Commission (Article 104(4)). If it considers that an excessive deficit exists or may occur, the Commission then addresses an opinion to the Council (Article 104(5)). On the basis of a Commission recommendation, the Council decides, after an overall assessment, whether an excessive deficit exists (Article 104(6)). Any such decision has to be adopted as a rule within four months of the reporting dates (1 April, 1 October).

When it decides that an excessive deficit exists, the Council has to issue a recommendation to the Member State concerned with a view to bringing that situation to an end within a given period, also on the basis of a Commission recommendation (Article 104(7)). The Council recommendation has to specify when the correction of the excessive deficit should be completed, namely in the year following its identification unless there are special circumstances, and has to include a deadline of six months at most for effective action to be taken by the Member State concerned. The recommendation should also specify that the Member State concerned has to achieve a minimum annual improvement of at least 0.5% of GDP as a benchmark in its cyclically-adjusted balance net of one-off and temporary measures.

If effective action has been taken in compliance with a recommendation under Article 104(7) and, compared with the economic forecasts in this recommendation, unexpected adverse economic events with major unfavourable consequences for government finances occur subsequent to its adoption, the Council may decide, on a recommendation from the Commission, to adopt a revised recommendation under the same article, which may notably extend the deadline for the correction of the excessive deficit by one year. Where it establishes that there has been no effective action in response to its recommendations, the Council adopts a decision under Article 104(8) on the basis of a Commission recommendation immediately after the expiry of the deadline for taking action (or at any time thereafter when monitoring of the action taken by the Member State indicates that action is not being implemented or is proving to be inadequate). The provisions of Article 104(9 and 11), on enhanced Council surveillance and ultimately sanctions in case of non-compliance, are not applicable to Member States with a derogation (that is, those that have not yet adopted the euro), which is the case of the Member States considered in this report.

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the establishment of the ERM II20, the European Additional factors

Monetary System has been replaced by the Exchange Rate Mechanism II upon the introduction of the euro, and the euro has become the centre of the mechanism.

The Treaty in Article 121 also requires an examination of other factors relevant to economic integration and convergence. These additional factors include financial and product market integration and the development of the balance of payments. The examination of the development of unit labour costs and other price indices, which is also prescribed by Article 121 of the Treaty, is covered in the chapter on price stability.

As in previous reports, the assessment of this criterion verifies the participation in ERM II and examines exchange rate behaviour within the mechanism. The relevant period for assessing exchange rate stability in this technical annex is 27 April 2005 to 26 April 2007.

Long-term interest rates

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".

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Technical annex

The additional factors are an important indicator that the integration of a Member State into the euro area would proceed without major difficulties. As regards the integration of financial markets, the focus is on compliance with the acquis communautaire in respect of the financial sector, on main characteristics, structures and trends of the financial sector and on progress in financial integration. Integration of product markets is assessed through trade, foreign direct investment and a smooth functioning of the internal

market. Finally, the situation and

development of the current account of the balance of payments is examined to ensure that the Member States joining the euro area are not subject to unsustainable external imbalances.

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• 2. 

  LEGAL COMPATIBILITY

2.1. Legal situation (Article 4(1)) has been amended and fully reflects the ESCB's secondary objective.

Following Malta's independence in 1964, the Central Bank of Malta (CBM) was established in April 1968 on the basis of the Central Bank of Malta Act (1967).

It is a corporate body with a distinct legal personality. The CBM became an independent central bank pursuing price stability as its primary objective following amendments to the Act adopted in October 2002. The CBM Act was amended twice in 2005. A further Act (Act n° I of 2007) amending the CBM Act was adopted by Parliament on 28 February 2007, entering into force on the date to be established by the Minister of Finance. This date should be the date of the introduction of the euro in Malta.

Independence

According to Article 108 of the Treaty neither a national central bank nor any member of its decision- making bodies shall, when exercising the powers and carrying out the tasks and duties conferred upon them by the EC Treaty and the ESCB Statute, seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body. Inversely, the Community institutions and bodies and the governments of the Member States have to respect this principle and may not seek to influence the members of the decision-making bodies of the national central banks in the performance of their tasks. The different features which make up independence may be grouped into three categories: institutional, personal and financial independence.

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The CBM Act was already considered compatible with the Treaty as regards independence in the 2006 Convergence Report.

Integration in the ESCB

The incompatibilities raised in the 2006 Convergence Report have been removed. The Act on the amendments to the Central Bank of Malta Act notably repeals Articles 4(2)a, 17A, 17D, 19, 37(2) and (3), 39, 40, 41 as well as Article 43(3) and (4) of the initial Act. Moreover, a series of articles have been amended so as to take account of the respective roles and competences assigned by the EC Treaty to the ECB, ESCB and the EC Council. This concerns in particular Articles 15(2) on the holding and managing of foreign reserves, Articles 42 and 43(1) and (2) on the right to authorise the issue of banknotes and the volume of coins, Articles 15(1) and 37(1) on the monetary functions, operations and instruments of the ESCB, Article 52a on the imposition of sanctions and Article 22 on the financial provisions related to the ESCB.

Prohibition of monetary financing

In line with the prohibition of monetary financing (Article 101(1) of the Treaty), the CBM shall not grant overdrafts or any other type of credit facility to Community institutions or bodies, to the government or any public authority, to bodies governed by public law, public undertakings or government-owned corporations of any Member State. Moreover, the CBM shall not directly purchase debt instruments of such entities (Article 27(1)).

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2.2. Assessment of compatibility

Legislation in Malta is compatible with the requirements of the EC Treaty and the ESCB Statute.

One residual imperfection subsists in the Central Bank of Malta Act with respect to the prohibition of monetary financing.

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• 3. 

  PRICE STABILITY

3.1. Respect of the reference value fluctuations. Having stayed close to 2% since 2002, inflation picked up in 2004, mainly due to indirect tax increases, but it returned to around 2% at the beginning of 2005. In autumn 2005, inflation increased again and more considerably, reflecting a strong rise in energy prices related to higher oil prices. Between October 2005 and September 2006, headline inflation hovered around 3.5%. When the impact of higher oil prices ebbed away, inflation dropped markedly to below 1% at the end of 2006 and it has stayed close to that level since then. Since November 2006, Malta has been the EU Member State with the lowest HICP inflation rate. Apart from the significant base effects in energy inflation, the decline reflects a drop in prices of clothing and footwear and air transport (following the arrival of low-cost airlines in November 2006).

The 12-month average inflation rate for Malta, which is used for the convergence assessment, has fluctuated around the reference value for the past years.

12-month average inflation has been at or slightly below the reference value since July 2005 except for the period May October 2006. In March 2007, the reference value was 3.0%, calculated as the average of the 12-month average inflation rates in the three best- performing Member States (Finland, Poland and Sweden)

plus 1.5 percentage points. The

corresponding inflation rate in Malta was 2.2%, i.e.

0.8 percentage point below the reference value.

3.2. Recent inflation developments

22

Convergence Report 2007 on Malta

Technical annex

Chart 1. Malta: Inflation criterion since May 2004

6 (percent, 12-month moving average)

5

4

3

2

1Malta

Reference value

2004200520062007

Sources: Eurost at , Commission services' Spring 2007 Forecast

Table 2.

Malta: Components of inflation1)weights

(percentage change)in total

200120022003200420052006Mar-072007

HICP2.52.61.92.72.52.62.21000

Non-energy industrial goods0.20.4-1.31.51.71.71.4321

Energy0.33.72.25.915.917.19.656

Unprocessed food 6.60.62.3-1.02.22.22.879

Processed food3.05.11.54.51.51.61.8143

Services3.73.64.63.22.31.41.4401

HICP excl. energy and unproc. food2.32.71.92.82.01.61.5865

• 1) 

  Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices in the previous period.

Sources: Eurostat, Commission services.

Core inflation (measured as HICP inflation excluding energy and unprocessed food) has remained contained at an average of 2% in 2005 and 1.6% in 2006, though this masks considerable intra-year volatility amid fluctuations in sub-items such as food, clothing, accommodation and administered prices (water). At the end of 2006, this measure of core inflation fell to historically low levels below 1% before rebounding to 1.2% in the first quarter of 2007. Moderate core inflation Macroeconomic policy-mix and cyclical stance

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Technical annex

tightened in 2004 and 2005 and was roughly neutral in 2006. Fiscal impulses have thus not been a driver of inflation. A moderate decline of the cyclically- adjusted primary surplus is expected for 2007, though against the background of a still negative output gap. Exchange rate stability and a credible monetary policy have also contributed to keep inflation at relatively low levels. employment) around a low trend rate. Productivity fell alongside real GDP in 2003 and grew at around 1.2% annually in the following two years. A slight pick-up to around 2% is estimated for 2006 and 2007. Together, wage and

Chart 3. Malta: Inflation, productivity and wage trends

10y-o-y % change

Wages and labour costs 8

6

4

Inflationary pressures from the labour cost side appear contained at present, amid slow growth of both wages and labour productivity. Following a few years of deceleration (from 5.8% in 2001 to slightly above 1%

in 2005 and 2006), annual growth of nominal compensation per employee is expected to recover moderately to some 1.6% this year. Labour productivity has recorded strong cyclical fluctuations (as GDP volatility was not directly translated into 2

-2

-4

19992000200120022003200420052006

P roductivity (real GDP per person employed) Nominal compensation per employee Nominal unit labour costs

P rice deflator private consumption

Source: Commission services

Table 3.

Malta: Other inflation and cost indicators (annual percentage change)

20012002200320042005200620071)

Private consumption deflator

Malta2.42.10.62.42.62.01.4

Euro area2.31.82.12.02.02.01.8

Nominal compensation per employee

Malta5.82.83.92.51.11.21.6

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suggests that no second-round effects from recent energy price increases through the wage-setting process have materialised so far. Public sector wage discipline has been fostered through a multi-year collective agreement concluded in late 2005. Wage agreements in private sector reflect a need to regain competitiveness. Flexibility of the wage setting process in Malta is somewhat diminished by partial wage indexation (cost-of-living adjustment based on the "social wage", which is lower than the average wage), although indexation can be waived at firm level. Preserving wage discipline in both the public and private sector will be important to contain spillover risks from temporary factors affecting headline inflation. exchange rate of the lira, measured against a group of 40 trade partners, appreciated steadily by around 10% between 2000 and 2004, dampening import price dynamics. The effective exchange rate broadly stabilised in 2005 and 2006, thus remaining roughly neutral with regard to import prices.

Chart 4. Nominal effective exchange rate: MTL *

115(monthly averages, index 1999 = 100)

110

105

100

Import prices

95

Given Malta's small size and high degree of openness, imported goods account for a large share of the consumer basket. Import price developments, as measured by the import of goods deflator in the national * vs. 40 t rading partners

90

2000200120022003200420052006

Source: Commission services

accounts, have been favourable to

disinflation in 2003 and 2004, with decreases of 5.7 and 3.3%, respectively. Import price inflation strengthened to around 3% in 2005 and is estimated to have increased further in 2006, thus generating upward pressure on headline inflation.

Administered prices and taxes

The share of administered prices in the Maltese HICP basket is relatively low, reflecting inter alia a comparatively small share of energy products in the basket. Still, Malta's inflation profile in the last years has been strongly shaped by developments in regulated prices for energy and related products, as pent-up price pressures have been released. In particular, electricity and water supply prices were increased significantly in January 2005 through the imposition of a "surcharge"

23

Convergence Report 2007 on Malta

Technical annex

lower share of energy in the HICP basket (at some 6%, compared to around 9% in the euro area). During the first 10 months of 2006, electricity prices were 37% higher than one year before and energy accounted for around 1.5 percentage points of Malta's HICP inflation. A 30-percent increase in the administered price of water supply in November 2005, which added another 0.2 percentage point to headline inflation, was also related to higher oil prices, given the energy-intensive desalination process used to generate drinking water. The combined impact of a drop in energy and water inflation resulting from both strong base effects and falling prices of fuel in autumn 2006 - contributed by almost 2 percentage points to the sharp decline in headline inflation in October and November 2006. In the first quarter of 2007, energy and water contributed to inflation negatively, by about -0.3 percentage point. Consumer prices in Malta are some 70-75% of the EU average. This suggests some potential for some gradual further price level convergence in the long- term, as income levels (currently abut 70% of the EU25 average in PPS) rise towards the EU average.

Medium-term inflation prospects will also depend strongly on wage and productivity developments as well as the competitive environment. Measures should be taken (including in the field of education and labour market regulation) in order to prevent labour shortages and skill mismatches, in particular in the light of some upcoming large investment projects (e.g. "Smart City Malta"). Advancing structural reforms to improve the functioning of product markets (in particular utilities) is warranted with a view to price developments. Fiscal discipline will also be important to stem inflationary risks as cyclical conditions improve.

VAT and excise increases, partly related to EU accession, had a relatively strong impact on inflation in Malta in 2004, but Malta's inflation profile since 2005 has not been appreciably influenced by changes

in indirect taxes.

Medium-term prospects

Inflation performance in 2007 will mainly reflect the path of prices for energy and related products. As base effects related to strong price increases in these categories in late-2005 subside towards the end of 2007, headline inflation is expected to move back towards rates more consistent with medium-term trends. The Commission 2007 Spring Forecast projects a deceleration of annual average HICP inflation from 2.6% in 2006 to 1.4% in 2007 and an increase in 2008 to 2.1%.

Convergence Report 2007 on Malta

Technical annex

• 4. 

  GOVERNMENT BUDGETARY POSITION

4.1. The excessive deficit procedure for Malta4.2. Developments until 2006

25

Over the 2000-2006 period, the general government deficit averaged around 5.5% of GDP reaching a high of 10% of GDP in 2003, when a one-off expenditure- increasing transaction amounting to some 3% of GDP in relation to the restructuring of the shipyards took place. Since then, the deficit-to-GDP ratio has progressively declined, reaching 2.6% of GDP in 2006. The 2006 outcome is 0.1 percentage points better than the official target of 2.7% of GDP set in the January 2006 update of the convergence programme. The primary balance, after reaching a through of -6.5% of GDP in 2003, turned into a surplus in 2005 and stood at 1.1% in 2006. Interest expenditure was relatively stable in a range between 3.4% and 3.8% of GDP during this period.

In July 2004, the Council decided that Malta was in excessive deficit, based on a deficit of 9.7% of GDP in 2003 and a rising debt ratio, which stood at 72% of GDP in 2003. At the same time, the Council issued a recommendation to correct the excessive deficit. In particular, Malta was recommended to take action in a medium-term framework in order to bring the deficit below 3% of GDP by 2006 in a credible and sustainable manner, in line with the Council Opinion on the May 2004 Convergence Programme. The Council endorsed the following intermediate targets for the general government deficit: 5.2% of GDP in 2004, 3.7% in 2005 and 2.3% in 2006. Malta was also recommended to bring the rise in the debt ratio to a halt in 2005.

The revenue-to-GDP ratio followed an upward trend between 2000 and 2005, increasing by 8 percentage points, on account of both new and higher taxes and in response to the government's drive to achieve a more efficient tax collection. In 2006, total revenue declined marginally in relation to GDP and stood at 42.7% mainly reflecting a fall in both social contributions and capital transfers. Nevertheless, capital transfers rose substantially in 2004 and 2005, supported by financial inflows from the Italian financial protocol

Convergence Report 2007 on Malta

Technical annex

Mater Dei hospital. The decline in total expenditure in 2004 occurred on the back of a fall in capital outlays as current expenditure continued to rise. In 2005, the fall in the general government expenditure ratio to GDP was due to a decline in current spending which more than offset higher total capital expenditure. In 2006, the further decline in total expenditure ratio reflected both lower current spending and public investment, the latter mainly reflecting constraints in the capacity to absorb EU funds. categories of part-time employment, tax deductions for parents utilising the services of childcare facilities, a reduction in the airport tax, an energy benefit aimed at alleviating the cost of energy to low-income households and improvements in certain social benefits.

The Budget also announced the

securitisation of certain government property

(estimated at around 1 percentage point of GDP) to finance payment for expropriated land. The 2007 Budget targets a further decline in the general government deficit to 2.3% of GDP in 2007, which was subsequently improved to 1.9% of GDP in the April 2007 fiscal notification. Compared to the April 2007 fiscal notification, the Commission services' Spring 2007 forecast projects a slightly more cautious adjustment to 2.1% of GDP in 2007, primarily due to lower revenue from social contributions as compared to the projections of the Maltese authorities.

Recourse to one-off and other temporary measures was substantial since 2003. Apart from 2003, one-off measures in the other years under consideration were deficit-reducing operations consisting mainly of sale of land averaging around 1% of GDP each year. The structural deficit (i.e. cyclically-adjusted deficit net of one-off and other temporary measures) improved from a high of 6.4% of GDP in 2003 to 3.8% in 2005.

In 2006, the structural deficit declined further to 2.7%

of GDP.

The structural deficit is projected to improve marginally from 2.7% of GDP in 2006 to 2.6% of GDP in 2007. This suggests that the relatively high economic growth and the progressive closing of the output gap anticipated for 2007 are not being utilised fully to speed up the pace of adjustment.

As a result of the deficit recorded in successive years, the general government debt moved from a position below 60% of GDP in 2000 to one substantially above the reference value. Specifically, the debt ratio increased from around 56% of GDP in 2000 to slightly below 74% of GDP in 2004. The acceleration in debt accumulation which occurred in 2003 reflects a one-off transaction as government took over debt incurred in the past by the shipyards as part of restructuring this sector. However, starting from 2005 the debt ratio followed a downward path reaching around 66.5% of GDP in 2006. During these years, stock-flow adjustments specifically, proceeds from privatisation - dampened the rise in debt. In particular, the decline in the general government debt in 2006 was to a large extent due to substantial privatisation proceeds amounting to around 3.5% of GDP.

The December 2006 update of the convergence programme covers the period from 2006 to 2009. The budgetary strategy outlined in the update aims at reducing the deficit below the 3% of GDP reference value in 2006 and at pursuing fiscal consolidation thereafter, to a broadly balanced budget by 2009.

Convergence Report 2007 on Malta

Technical annex

previous year. According to the December 2006 convergence programme, the debt ratio is foreseen to follow a downward path between 2007 and 2009, when it is expected to reach 59.4% of GDP. adjustment towards the MTO implied by the programme was broadly in line with the Stability and Growth Pact, there were some 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 its Opinion of 27 February 2007 on the December 2006 update of the Convergence Programme, the Council noted that, in a context of strong growth prospects, the programme envisaged adequate progress towards the MTO but that there were risks to the achievement of the budgetary targets after 2007.

In particular, while in the years following the correction of the excessive deficit, the pace of

Table 4.

Malta: Budgetary developments and projections (as percentage of GDP unless otherwise indicated)

Outturn and forecast (1)20002001200220032004200520062007

General government balance-6.2-6.4-5.5-10.0-4.9-3.1-2.6-2.1

• - 

  Total revenues34.936.738.238.641.942.942.742.2
• - 

  Total expenditure41.043.143.848.646.846.045.244.3

Of which: - Interest expenditure3.63.43.63.53.73.83.73.3

• - 

  Current primary expenditure33.636.436.537.839.037.937.636.6
• - 

  Gross fixed capital formation4.23.74.55.12.15.34.65.2

Primary balance-2.5-3.1-1.9-6.5-1.20.71.11.2

p.m. Tax burden28.230.431.931.833.834.534.935.2

Cyclically-adjusted balance-7.8-6.9-6.2-9.2-3.6-2.2-2.0-1.9

One-off and temporary measures----2.90.71.70.70.6

Structural balance (2)----6.4-4.3-3.8-2.7-2.6

Structural primary balance----2.9-0.6 1.00.8

Government gross debt56.062.160.870.473.972.466.565.9

p.m. Real GDP (% change)6.4-1.11.9-2.30.43.02.93.0

Convergence Report 2007 on Malta

Technical annex

• 5. 

  EXCHANGE RATE STABILITY

On 2 May 2005, the Maltese lira entered ERM II at the previous trading day's ECB reference rate of 0.4293 MTL/EUR, with a standard fluctuation band of ±15%. Upon joining ERM II, the Maltese authorities unilaterally committed to maintain the lira exchange rate at the central rate. At the time of the adoption of this report, the lira has been participating in ERM II for 24 months. has consistently exceeded 100% of liabilities. At the end of February 2007, reserves stood at 103% of currency and deposit liabilities, equivalent to around 132% of the monetary base.

Before ERM II entry, Malta had followed a basket peg since the 1970s. Within this regime, the only exchange rate realignment occurred in 1992, when the lira was devalued by 10% against the basket, in response to devaluations by major trade partners and competitors in the context of the ERM crisis. The last basket adjustment occurred in August 2002, raising the share of the euro in the basket to 70%, with the US dollar and British pound accounting for the remaining share at 10 and 20%, respectively. At the time of ERM II entry, the lira was re-pegged to the euro. This step did not affect the external value of the lira. Chart 5. MTL: Spread vs central rate

0.2

(as percent, daily values)

0.1

May-05Sep-05Jan-06May-06Sep-06Jan-07

Convergence Report 2007 on Malta

Technical annex

Chart 7. Malta : 3-M Mibor spread

to 3-M Euribor

300(monthly values, basis points)

250

200

150

100

50

-50

-100

19992000200120022003200420052006

Source: Eurostat

The CBM closely monitors reserve developments in setting policy interest rates. Following significant monetary easing between 2001 and 2003, mirroring developments in the countries represented in the pegging basket, the CBM left its main policy rate on hold between September 2003 and April 2005 at a level of 3%, i.e. 100 basis points above euro area rates. In view of adverse reserve developments since late-2004, reflecting pressures on the current account as well as portfolio shifts by investors, the CBM raised rates by 25 basis points in April 2005. Together with ERM II entry in May, this served to underpin investor sentiment and restore reserve stability. Since the start of monetary tightening by the ECB in late- 2005, the policy interest rate differential between Malta and the euro area has narrowed significantly, from 125 to currently 25 basis points. The CBM slowed the pace of policy rate convergence through three 25 basis point rate hikes in May and October 2006 and in January 2007 with a view to ensuring stable foreign reserves and providing sufficient support to the exchange rate peg. Spreads on Maltese money market rates vis-à-vis the euro area, which had hovered around 80-90 basis points until spring 2005, widened in line with the interest rate hike in April 2005, but have narrowed to about 30 basis points currently in tandem with policy rate convergence.

Convergence Report 2007 on Malta

Technical annex

• 6. 

  LONG-TERM INTEREST RATES

Long-term interest rates in Malta used for the convergence examination reflect secondary market yields on a basket of benchmark government bonds.

Chart 8. Malta: Long-term interest rate criterion

7 (percent, 12-month moving averages)

6

The Maltese 12-month moving average long-term interest rate relevant for the assessment of the Treaty criterion has progressively declined over the whole assessment period, reflecting a global decline in bond yields as well as a decreasing country risk premium.

In March 2007, the reference value, given by the average of long-term interest rates in Finland, Poland and Sweden plus 2 percentage points stood at 6.4%. The 12-month moving average of the yield on ten- year Maltese benchmark bond stood at 4.3%, 2.1 percentage points below the reference value. 5

4

Malta

Reference value

3

200420052006

Sources: ECB, Eurostat, Commission services

Chart 9. Malta : Long-term interest rates

At the beginning of 2001, Malta had the lowest long- term interest rate among the new Member States. Since then, Maltese long-term interest rates have declined further towards euro area levels, albeit not on a continuous path. Maltese long-term interest rates decreased by around 150 basis points during the period of monetary easing between 2001 and autumn 2003, and subsequently remained stable at a level of 4.7% through mid-2005. This has implied some fluctuation in spreads vis-à-vis the euro area, with spreads dropping to a low of around 25 basis points in mid-2004 and widening to around 135 basis points by mid-2005. Spreads recorded a broad narrowing trend since then, reflecting both a moderate decrease in Maltese long-term rates and rising yields in the euro area. Having dropped to around 4.4% in August 2005, Maltese long-term rates recorded a further slight decrease in spring 2006, but increased at the beginning of 2007. Yield spreads vis-à-vis the euro area narrowed to a low of around 20 basis points in spring 2006, widened moderately to around 50 basis points in late 2006 and narrowed back to around 30 basis points in the first quarter of 2007. (percent, monthly values)

7

6

5

Convergence Report 2007 on Malta

Technical annex

• 7. 

  ADDITIONAL FACTORS

7.1. Financial market integration

The banking sector expanded considerably in 2005, as new licences were issued to a number of credit and financial institutions and 29 banks from other Member States were authorised to provide cross- border services in Malta. While the market share of foreign owned credit institutions is still a bit lower than for the EU10 average, and the degree of concentration in terms of CR5 ratio

Reflecting its history as a regional financial centre, Malta's financial system is substantially inter-linked with the financial systems of other countries, both in and outside of the EU, via the establishment of financial intermediaries and the provision of cross- border services. Over the past decade, Malta has moved from being an offshore to an onshore jurisdiction by reforming its finance sector legislation in line with international best practice. All offshore licences terminated in 2004. Compliance with the acquis communautaire in the field of financial services was already broadly achieved on accession and the transposition process of legislation adopted under the Financial Services Action Plan is close to completion.

30 of 75% would

not be unusual in such a small market, domestic lending is de facto dominated by only two institutions. There was also an increase in the number of licensed insurance companies, insurance managers and affiliated insurance companies as well as a rapid growth of investment funds in 2005. However, insurance and investment funds are still of minor importance when compared to the banking system and private pension funds are just developing.

28

The growth rate in domestic credit picked up to 9% over 2006, as negative net lending to the central government compensated only partly a significant 15% rise in claims on other residents, which reflected mainly an increase in household borrowing for house purchases

Malta's financial sector is well-developed in relation to its stage of economic development.

Convergence Report 2007 on Malta

Technical annex

traded corporate bonds was also very limited. Secondary market turnover fell also for government bonds, which dominate the fixed income market, and for which the central bank acts as market maker. Services Authority (MFSA) since 2002. The MFSA supervises the banking, securities and insurance sectors,

but the central bank retains responsibility for

monitoring the financial system's overall stability. These institutional changes have been accompanied by measures to facilitate cross-border co-operation between Malta and foreign supervisory bodies, and the MFSA has continued to increase the number of bilateral

The importance of adequate supervisory structures is heightened by Malta's role as a regional financial centre and the activity of foreign banks within the system. Regulatory and supervisory responsibilities have been consolidated in the Malta Financial

and multilateral Memoranda of

Understanding with other regulators over 2006.

Chart 10a. Malta: Structure of financial system Chart 10b. Malta: Foreign ownership and

relative to EU-10 and Euro areaconcentration in the banking sector in 2005

250(in percentage of GDP)CR5 ratio (in % of total assets)

80

200Debt securities (end-2005)Share of foreign institutions as % of total assets of domestic credit institutions

Stock market capitalisation (end-2006) Total bank loans (end-2005)70

60

150

50

10040

30

5020

10

MaltaEU10Euro area

Sources : European Banking Federation, Eurostat, ECB (including own calculations and estimates)MaltaEU10Euro area

Source : ECB: EU Banking Structures (2006) (including estimates)

Convergence Report 2007 on Malta

Technical annex

that firms are given the right incentives to improve their level of efficiency. However, the small size of the Maltese economy hampers the scope for the diversification of production activities and leads to a high degree of trade specialisation in a small number of sectors, notably electronics (in particular semiconductors) and tourism. Such dependence on a few sectors increases the exposure of the economy to asymmetric shocks determined by the evolution of international markets. Nonetheless, there is evidence of progress in terms of the diversification of economic activities, namely with the expansion of other services sectors like financial services and ICT and the build- up of clusters in manufacturing sectors like pharmaceuticals. technology sectors (largely due to the semiconductors sector), the other sectors where the country has comparative advantage are mostly of low and medium-low technology, like for example clothing. The relatively high transport costs contribute to explaining the importance of the services sectors in trade flows, namely tourism and financial services. In 2005, the share of services in total trade was around 30% compared to 22% in the EU25.

FDI has also been an important channel for economic integration with the EU. The evolution of FDI inflows in recent years has been volatile but on average the ratio of FDI inflows to GDP remained above the EU25 average over the period 2001-2006. FDI outflows remain very limited. In 2004, the ratio of inward FDI stock to GDP reached 67.5% in 2004 which is among the highest in the EU25. The EU25 is by far the main investor in Malta and investment flows overwhelmingly target services sectors, in particular financial services.

Malta is among the most open economies in the EU25 and in the euro-area. The trade openness ratio has decreased during the first half of the decade but this evolution is largely driven by cyclical developments, namely the downturn at the beginning of the decade in the tourism industry and in the semiconductors sectors, which dominate Malta's trade. Over time the EU25 has been reinforcing its position as Malta's main trading partner. In 2005, the weight of extra-EU trade in Malta's total trade (around 32%) was lower than the weight of extra-EU trade in the total trade of the EU25 (36%). Moreover, trade integration with the euro-area is particularly well advanced. In 2005, 77%

of Malta's intra-EU trade flows were with euro-area Member States.

33

Despite the increasing market integration with the EU25, the price level of goods and services remained around 25% below the EU25 average in 2005. The remaining price gap is mainly driven by services as the price level of goods was already around 91% of the EU25 level. In contrast, price levels remain particularly low in services sectors such as recreational and cultural services and energy where prices are still administered (41% of the EU25 average price level in 2005).

Convergence Report 2007 on Malta

Technical annex

fluctuations of these sectors and to prevent competitiveness

strains from the increasing

competition pressure in low technology sectors from lower-cost economies is underway. However, the conditions for such a successful and sustained transition are not yet fully in place.

Malta's innovation performance remains well below the EU average.

35 Recent survey data show that while

42% of EU27 enterprises are actively engaged in innovation, only 21% of Maltese enterprises do so.

36

R&D spending is still well below the EU average level, despite the ongoing efforts led by the authorities to promote research and innovation performance across the business sector. Efforts to foster the adoption and diffusion of ICT are also underway which could have an important impact on the prevalent services sectors. There is already evidence of good progress for example regarding ICT diffusion as the rate of broadband penetration approaches the EU25 average.

The promotion of a market-based adjustment is facilitated by improvements in the business environment, namely regarding the speeding up of the process for starting up a company and the increase of the quality of the regulatory framework. However, barriers to further restructuring remain as many activities, namely in professional services, are still heavily regulated. Competition pressure is also not yet fully ensured in some sectors such as importation and distribution of fuel products, retail, transport and construction. Sectoral state aids also remain relatively high and their redirection towards horizontal objectives in particular R&D is also lagging.

Convergence Report 2007 on Malta

Technical annex

Table 5.

Malta: Product market integration

MaltaEU25

200120022003200420052006200120022003200420052006

Trade openness 1) (%)---79.573.1---35.436.738.3-

Extra-EU trade in goods GDP ratio 2) (%)22.922.822.220.417.421.39.99.49.19.610.411.1

Intra-EU trade in goods GDP ratio 3) (%)33.632.933.535.733.632.819.018.518.419.019.621.0

Intra-EU trade in services GDP ratio 4) (%)---16.215.6---4.64.74.9-

Intra-EU trade balance in goods 5)-0.8-0.9-1.0-1.1-1.2-1.189.496.290.777.972.681.4

Intra-EU trade balance in services 6)---0.40.4---1.917.015.9-

Intra-EU trade balance GDP ratio 7) (%)----15.8-17.0---0.90.90.8-

Total FDI inflows GDP ratio 8) (%)7.3-10.219.57.311.0-5.85.03.62.24.6-

Intra-EU FDI inflows GDP ratio 9) (%)---5.31.1-4.33.72.31.63.7-

FDI intensity 10)---2.30.2-3.93.72.51.93.8-

Internal Market Directives 11)---6.01.21.0---3.61.61.2

Price levels 12)75.573.771.271.872.5-100100100100100100

• 1) 

  (Imports + Exports of goods and services/2xGDP at current prices)*100. (Foreign trade statistics/ Balance of payments).
• 2) 

  (Extra-EU Imports+Exports/2xGDP at current prices)*100. (Foreign trade statistics).
• 3) 

  (Intra-EU Imports+Exports/2xGDP at current prices)*100. (Foreign trade statistics).
• 4) 

  Intra-EU25 trade in services (average credit and debit in % of GDP at current prices). (Balance of payments).
• 5) 

  Difference between export and imports of goods (credit minus debit) in bn euros. (Foreign trade statistics).
• 6) 

  Difference between export and imports of services (credit minus debit) in bn euros. (Balance of payments).
• 7) 

  Difference between export and imports of goods and services as a % of GDP. (Foreign trade statistics/ Balance of payments).
• 8) 

  Total FDI inflows as a % of GDP (at current prices).
• 9) 

  Intra-EU total FDI inflows as a % of GDP (at current prices).
• 10) 

  Average value of Intra-EU25 inward and outward FDI flows, divided by GDP and multiplied by 100.
• 11) 

  Percentage of Internal Market directives not yet communicated as having been transposed in relation to the total number.
• 12) 

  Comparative price levels of final consumption by private households including direct taxes (EU25=100).

Sources: Eurostat, Commission services.

Convergence Report 2007 on Malta

Technical annex

7.3. Development of the balance of payments well over half of total goods exports, with one large semi-conductor firm dominating the market. The sector's performance has reflected difficult global market conditions after 2001, thus underscoring the vulnerability associated with a narrow sectoral base in a small economy. At the same time, Malta's tourism industry has performed sluggishly during the past years, reflecting both a fallout from geopolitical concerns and intensified competitive pressure. Imports were underpinned by strong investment activity, including by the public sector, while the oil bill increased strongly in line with global market developments.

Malta's current account balance has been in deficit since 1998 (except for 2002), averaging -5% of GDP, with large merchandise trade deficits not fully compensated by sizeable surpluses in the services balance. Year-on-year swings were large, partly reflecting one-off factors that disproportionately affect the aggregate in an economy of Malta's size. After having recorded a surplus in 2002, the current account balance worsened sharply to -8.2% of GDP in 2005. This was primarily due to a marked worsening of the trade balance, whose deficit increased from 8 to 20% of GDP between 2002 and 2005, while the services balance remained stable in that period. The adverse trend was compounded by a steady deterioration of the income balance. As a mitigating influence, net current transfers picked up strongly in 2005, following several years of marginal increases.

In 2006, the current account balance improved to 6.3% of GDP on account of a significant increase in current transfers due to increased receipts from the booming

online gaming industry. A slight

deterioration in trade balance was triggered by higher imports of capital goods (such as cranes, ships) which masked a strong recovery in exports (especially pharmaceuticals,

scientific instruments and

electronics). The deterioration in surplus of services trade reflected mainly a weak performance of the tourism industry. There is however a revival in this sector following the arrival of low-cost airlines in November 2006.

Over the last years, the Maltese current account balance has been strongly affected by swings in the tourism and electronics sectors, as well as stronger exposure to import competition in previously well- protected manufacturing sectors, partly related to EU accession. The electronics sector alone accounts for

Convergence Report 2007 on Malta

Technical annex

Table 6.

Malta: Balance of payments (percentage of GDP)

200120022003200420052006

Current account-3.82.4-3.2-6.4-8.2-6.3

Of which: Balance of trade in goods-14.3-8.1-13.1-16.0-19.6-19.8

Balance of trade in services8.99.49.89.88.06.2

Income balance 1.00.7-0.5-1.2-2.8-1.5

Balance of current transfers0.60.50.61.06.28.8

Financial and capital accounts-2.9-1.02.65.18.29.2

Of which: Net FDI6.4-10.08.57.410.527.4

Net portfolio inflows-12.6-8.6-32.3-38.2-46.1-39.6

Net other inflows (1)9.924.228.930.844.520.0

Net capital account 0.20.41.53.43.1

Change in reserves (+ is a decrease)-6.7-6.7-2.93.6-4.1-1.7

Errors and omissions6.7-1.50.61.3 -2.9

Gross capital formation18.714.317.517.021.619.8

Gross saving14.917.014.710.613.313.5

(1) Including financial derivatives

Sources: Eurostat and Commission services.

Convergence Report 2007 on Malta

Technical annex

So far, the financing of the current account deficits has been largely unproblematic, but the external position reflects substantial financing needs. While in 2004 net capital inflows did not fully match the current account deficit, leading to a drop in external reserves, this was reversed again in 2005 in line with longer-term trends. Net FDI inflows constituted the dominant category of external financing over the past years, generally exceeding the current account shortfall, though with some large year-to-year volatility. Reflecting sizeable capital transfers from the EU and Italy, the capital account improved to a surplus of 3.4% of GDP in 2005 and 3.1% in 2006.

As a result, the deficit in the combined current and capital account decreased from slightly below 5% of GDP in 2004-2005 to 3.2% of GDP in 2006. Extensive restructuring has taken place in the last few years, with activity in shrinking sectors (such as clothing) being progressively replaced by sectors with competitive edge (pharmaceuticals, remote gaming, aircraft maintenance, financial services, auditing), and with product upgrading in the main exporting industry (electronics). Increased openness to the world trade after EU accession has contributed significantly to this process.

A narrowing of the current account deficit to some 3- 4% of GDP is expected in the coming years. The main factors behind this improvement should be exports of manufacturing

goods (pharmaceuticals), higher

revenues from travel industry and tourism and higher current transfers (as a result of the buoyant remote gaming industry).

Some caution is warranted in interpreting Malta's balance of payments data, as in recent years the residual "net errors and omissions" were consistently strongly positive, implying an overestimation of the current account deficit and/or an underestimation of net inflows on the capital and financial account in the order of 2-3% of GDP.

A sustained improvement in Malta's external balance will need to be supported by strengthened efforts to maintain external competitiveness, including through policies fostering productivity growth, appropriate wage developments, and further progress in diversifying the sectoral export structure. A prudent fiscal stance is important to underpin domestic savings. On the financial account side, ensuring a positive investment climate is vital to underpin FDI inflows.

The outlook for Malta's balance of payments is influenced by external factors (such as developments on global energy and electronics markets), but also crucially depends on prospects to improve the competitive position of the Maltese economy.