Mission Concluding Statement 

Malta—Concluding Statement of the 2019 Article IV Mission

January 16, 2019

Malta’s economic growth continues to be one of the strongest in Europe, resulting in rapid income convergence towards the European Union (EU) average. Prudent policies and reform efforts have contributed to the strengthening of private and public-sector balance sheets, while steady job creation has driven unemployment to historically low levels. Growth prospects remain favorable, yet mounting pressure on infrastructure, rapidly rising housing costs, as well as shortages of labor and skills increasingly pose challenges. Improving infrastructure, reducing fiscal risks and enhancing labor supply are key policy priorities to sustain high growth and promote inclusiveness. Attention should also be given to safeguarding financial stability and integrity, including against the risks attached to new activities involving virtual financial assets.

Key policy recommendations

• Financial sector. Safeguard financial integrity by continuing the reforms and swiftly remedying identified deficiencies in the implementation of the anti-money laundering and countering the financing of terrorism (AML/CFT) framework. Guarantee the long-term independence of the supervisor and increase supervisory capacity. Enhance monitoring of the non-bank financial sector and close remaining data gaps.
• Housing market. Consider gradually narrowing the exemptions to the envisaged new borrower-based macroprudential measures and ensure that fiscal incentives do not amplify house price cycles. Ensure that measures to make housing more affordable remain targeted on low-income families and consider stepping up the provision of social housing.
• Fiscal policy. Continue with prudent policy that aims at fiscal balance excluding proceeds from the Individual Investor Program (IIP) in the medium term. Shift the balance of expenditure towards infrastructure and contain long-term fiscal risks by addressing age-related spending pressures and further restructuring financially vulnerable state-owned enterprises (SOE). Improve public investment management and risk analysis. Continue to strengthen revenue collection and broaden the tax base.
• Structural reforms. Support strong and inclusive growth by encouraging further participation of women and elderly workers in the labor market and strengthening human capital. Increase productivity by fostering innovation, including through more spending on research and development (R&D) and easier access to financing for small and medium enterprises (SMEs).

While the outlook remains strong, the economy faces capacity constraints

1. Growth remains strong but the economy may be approaching its cyclical peak. Real GDP growth was very high in the first three quarters of 2018, accompanied by robust employment growth supported by strong inflows of foreign workers. Growth is projected at close to 6.5 percent in 2018, slightly lower than the previous year, and at above 5 percent in 2019, mainly driven by buoyant domestic demand. Despite tight labor market conditions, generalized wage and price pressures are yet to materialize. As global demand slows and imports recover, growth will continue to be largely driven by domestic demand in coming years, backed by rising incomes, low unemployment, and planned investment projects. The current account surplus likely peaked in 2017 but it is expected to remain large, reflecting continued trade surplus in services.

2. Risks to the outlook are broadly balanced. Malta is potentially vulnerable to a deterioration in the external environment, including through a disruptive Brexit, rising global protectionism, a sharp tightening in global financial conditions, or possible changes in international corporate taxation. Slow progress in closing infrastructure gaps could likewise undermine growth prospects. A failure to effectively implement the AML/CFT framework could affect the business and financial environment and potentially imperil financial stability, as could a sharp correction in housing prices. On the upside, employment growth and private consumption could continue to surprise, and the execution of investment plans could be faster and stronger than expected.

Safeguard financial stability and integrity

3. The banking system remains well-capitalized, liquid, profitable and resilient, but faces some challenges . As interest rates remain low, profitability could suffer from increased competition from non-bank finance and heightened compliance costs associated with ongoing regulatory transformations. At the same time, enduring inefficiencies in the corporate insolvency process inhibit faster progress in the resolution of non-performing loans (NPLs).

4. Rapid diversification of corporate financing calls for more comprehensive risk monitoring. Intercompany loans have become the main source of funding for firms in recent years. Direct issuance of debt securities and credit from non-bank financial institutions have also grown rapidly, albeit from a low base. While the diversification of funding sources has served Maltese firms well, this development calls for strengthening data quality and management to enable an in-depth monitoring of contagion risks. Enhancing the analytical tools for risk assessment of the non-bank financial sector would help further mitigate financial stability risks.

5. The planned introduction of housing-related macroprudential instruments is appropriate given the rising exposure of banks to real estate risks. The new measures – which comprise loan-to-value (LTV), and debt-service-to-income (DSTI) limits, as well as amortization requirements – are expected to proactively address the build-up of vulnerabilities in the residential real estate market and improve the resilience of balance sheets to a reversal in housing market conditions. However, to improve their effectiveness, these measures could be refined in due course, including by narrowing the exemptions from the LTV and DSTI limits for loans against secondary and buy-to-let properties. The tax treatment of rental income should also be aligned with that of other sources of income to avoid amplifying house price cycles.

6. Capacity constraints and deficiencies in the regulatory framework undermine the effectiveness of financial supervision and crisis management. The increasing number of financial entities under supervision, the rapid development of new products, the evolving regulatory environment and the tightening of the labor market have put the Malta Financial Services Authority (MFSA) under considerable strain. To improve the effectiveness of the supervisory and crisis management frameworks, the authorities need to ensure that the long-term financial and operational independence of the MFSA is guaranteed. Resources must be kept in line with MFSA’s hiring requirements. Moreover, supervisory actions should not be delayed through judicial appeals and an administrative insolvency regime for banks should be adopted.

7. The effective implementation of AML/CFT requirements is critical to safeguard financial integrity and stability, and Malta’s role as a financial center. The large and internationally connected financial and remote gaming sectors, the strong demand for the IIP and the envisaged expansion of blockchain-related activities create significant ML/TF risks. The measures taken to implement the recently-enacted 50-point action plan (based on the latest National Risk Assessment) are steps in the right direction, and the mission supports its full implementation without delay. Immediate action is required to close existing gaps in supervisory and enforcement capacity, while steps should be taken to improve the understanding of risks and enhance their identification through intrusive, risk-based supervision. It is also crucial to ensure that timely and adequate sanctions are applied in case of breaches. The authorities should guarantee that virtual asset service providers implement AML/CFT requirements in an effective manner and are monitored in line with the Financial Action Task Force standards.

Maintain prudent, growth-enhancing fiscal policy, while fostering social inclusion

8. The government’s plan to balance the budget excluding IIP proceeds in the medium term is appropriate. Outturns as of November 2018 suggest another year of fiscal surplus – above the initial government target of 0.5 percent of GDP – owing to buoyant tax revenues and IIP proceeds. Public debt is declining fast and is projected to drop below 40 percent of GDP by 2021. In the short to medium term, the government aims for a positive structural balance, which seems appropriate given the favorable cyclical position, still significant contingent liabilities related to financially vulnerable SOEs and large expected age-related spending.

9. Reducing fiscal risks and shifting the balance of expenditure towards growth-enhancing public investment should remain priorities. To ensure space for much needed investment in infrastructure, it is important to identify structural measures that would put the fiscal position on a stronger long-term footing. The restructuring of financially vulnerable SOEs should be pursued, and public investment management and risk analysis should be strengthened, notably by introducing a cost-benefit analysis and publishing annual fiscal risk statements. The planned institutionalization of the comprehensive spending reviews should help identify further saving opportunities. Moreover, given large projected demographic pressures, further incentives to deter early retirement and increase the take-up of private pension schemes should be explored. On the revenue side, Malta’s high reliance on the IIP and corporate tax makes it vulnerable to possible regime changes. Recent measures to combat tax evasion and avoidance and increase VAT compliance are steps in the right direction, but further avenues for broadening the tax base should be explored.

Promote high and inclusive growth

10. Addressing remaining structural weaknesses will help sustain Malta’s growth performance, while promoting social inclusion.

Particular attention should be given to:

• Addressing infrastructure gaps. The authorities’ recent focus on upgrading road infrastructure is appropriate to alleviate severe traffic congestion and its impact on productivity and the environment. Continued efforts to avoid overlapping responsibilities and improve planning would lead to enhanced implementation of projects co-financed by EU funds or the private sector through public-private partnerships.

• Upskilling and reskilling the labor force and encouraging female and elderly participation. Labor shortages and the availability of skilled staff remain pressing problems for firms. Recent initiatives to strengthen the vocational and training system and make it more inclusive should help bridge the skills gap, but continuous monitoring and evaluation of these programs is warranted. Sustained efforts to “make work pay” and delay retirement, including through lifelong learning, should help support the rising trend in female labor force participation and increase the effective retirement age.

• Easing SME’s access to financing and stimulating innovation. Malta’s spending on R&D remains low compared to other EU countries. Continued efforts are needed to increase financial support for startups and strengthen links between academia and the private sector. The Malta Development Bank’s (MDB) planned financing schemes for SMEs and education infrastructure could importantly contribute towards enhancing lending for investment and boosting innovation. At the same time, it is critical to ensure prudent risk assessment and robust governance for the MDB’s operations.

• Improving housing affordability. Rapidly rising housing costs are increasingly affecting vulnerable households. The recent relaxation of eligibility requirements for rents subsidies is a step in the right direction, but the scheme should be periodically reviewed to ensure it remains targeted on low-income households. Further efforts should be envisaged to accelerate the provision of social housing.

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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 their warm hospitality.