Mission Concluding Statement 

Malta: Staff Concluding Statement of the 2020 Article IV Mission

February 14, 2020

Malta has enjoyed very rapid economic growth in recent years as the economy rebalanced towards high value-added services. Prudent fiscal policy and timely structural reforms have helped boost employment and build fiscal buffers while promoting social cohesion. However, sustaining such strong performance will require addressing key challenges. First, if not tackled in a timely manner, deficiencies in Malta’s anti-money laundering and countering the financing of terrorism (AML/CFT) framework could result in further pressures on correspondent banking relationships (CBRs), damage the country’s attractiveness for investment and threaten financial stability. Second, economic growth has relied on large inflows of foreign labor, exacerbating pressures on housing, infrastructure and natural resource management. Third, while the public debt burden has decreased markedly, fiscal risks associated with contingent liabilities and long-term age-related spending pressures remain.

Key policy recommendations

• Financial sector. Continue the reforms by prioritizing efforts to address identified shortcomings in the implementation of the AML/CFT framework. Guarantee the long-term financial independence of the supervisor and further enhance its capacity. Address limitations in the crisis management framework. Further strengthen the analysis of financial risks outside of the banking sector and close remaining data gaps.
• Fiscal policy. Maintain gradual structural consolidation excluding proceeds from the Individual Investor Program (IIP). Continue to address infrastructure needs while improving public investment efficiency and contain current expenditures. Diminish fiscal risks by enhancing risk management related to government guarantees and state-owned enterprises, and by addressing long-term age-related spending pressures. Continue to strengthen tax revenues and explore ways to diversify beyond corporate income tax (CIT) proceeds.
• Structural reforms. Further encourage labor force participation of elderly workers and women, close skills-gaps, foster innovation and improve access to affordable housing to help relieve bottlenecks and ensure sustainable and inclusive growth. Improving governance would safeguard Malta’s business climate and its attractiveness for foreign investment.

While still strong, growth is gradually reaching cruising speed

1. Economic activity, although still above its long-term average, is moderating, and is increasingly dependent on domestic demand. Real GDP growth is expected to have dropped to about 5 percent in 2019, from 7 percent in 2018, primarily reflecting weaker foreign demand; and is projected to moderate further to around 4 percent in 2020 as business investment is affected by global uncertainty and as private consumption moderates. While the labor market remained tight in 2019, large inflows of foreign workers in many sectors helped contain aggregate wage and price inflation. Going forward, domestic demand is expected to remain the main engine of growth, with a gradual decline of the large current account surplus.

2. Risks to the outlook are skewed to the downside. Malta’s high degree of openness makes it vulnerable to a further deterioration in the external environment, including rising protectionism and a limited deal Brexit, and possible changes in international corporate taxation. Domestically, slow progress in addressing structural weaknesses, including in the AML/CFT framework, may undermine long-term growth prospects and potentially threaten financial stability. On the upside, Malta could attract more firms from the U.K. seeking to serve the European Union market.

Tackle financial integrity risks and upgrade risk analysis and supervision

3. It is of critical importance to continue to reform the AML/CFT system and ensure its effective implementation. Failure to address identified shortcomings in the AML/CFT framework, as laid out by the Council of Europe’s AML body (MONEYVAL) ^[1] , could expose Malta’s financial system to financial integrity and reputational risks, threaten financial stability and magnify existing pressures on CBRs. As a result, difficulties in processing payments could potentially arise as well as pressures on related sectors of the economy. The focus should be on improving and demonstrating the effectiveness of the AML/CFT framework. In particular, the understanding of risks and the monitoring and supervision of banks and other high-risk sectors and programs—such as remote gaming, virtual financial assets, and the IIP—should continue to be strengthened. It is also key that AML/CFT enforcement actions are enhanced.

4. Supervisory capacity should be further enhanced, and the crisis management framework improved. Despite commendable progress, the Malta Financial Services Authority (MFSA) remains under strain due to the large number of financial institutions under supervision, the evolving regulatory environment and challenges associated with new and complex products. Data management should be improved and considering the scarcity of seasoned specialists, the MFSA’s resources should be kept in line with hiring requirements and its long-term financial independence should be assured. It is also important to address a number of gaps in the crisis management framework. In particular, the legal framework for bank insolvency should be updated and streamlined and an administrative regime for the orderly closure and liquidation of a failing bank should be introduced.

5. The banking system remains well-capitalized and liquid but faces challenges. Profitability has suffered from the low interest rate environment, heightened compliance costs and provisioning, and greater competition from non-banks. In this context, the recent introduction of borrower-based macroprudential measures was appropriate and should help address the build-up of vulnerabilities in the real estate market and improve resilience. Further refining these measures—by reducing exemptions in the most speculative part of the market—should be considered once enough evidence on their effect has been collected.

6. Safeguarding long-term financial stability will require a more comprehensive assessment of potential risks developing outside of the banking sector. Inter-company lending is gradually displacing bank lending as the main source of corporate funding, posing new challenges to supervision. A better understanding of the flow of funds between corporates and of their risk-management practices could help identify potential emerging financial risks and contagion channels to the financial system. At the same time, it is important to avoid over-exposure to large, indebted and interconnected corporates.

Maintain prudent fiscal policy, enhance public investment management and address fiscal risks

7. Prudent fiscal policies need to be maintained. A fourth consecutive year of fiscal surplus is expected for 2019, and the structural balance is estimated to continue exceeding the government’s medium-term objective of a balanced budget in structural terms; public debt is projected to drop below 45 percent of GDP. Maintaining gradual consolidation excluding proceeds from the IIP is warranted due to fiscal vulnerabilities from contingent liabilities, age-related spending pressures, and heavy reliance on corporate income tax revenues. Current-expenditure growth needs to remain contained in order to preserve healthy public finances, while support for social inclusion should continue through well-targeted measures.

8. As public investment has increased, enhancing its management should be a priority. Ongoing and new projects should help fill infrastructure gaps in transport, health and education. To upgrade environmental outcomes, continued focus in other areas—such as waste and natural resource management, renewable energy, and public transportation—is important. However, with these increased outlays it is critical to enhance public investment management to secure greater efficiency. Efforts should focus on adopting general guidelines for project appraisal and selection as well as implementing cost-benefit analysis for major projects, and address any weaknesses in the public procurement system.

9. Continued efforts are needed to reduce fiscal risks in several areas. Government guarantees and liabilities of nonfinancial public corporations have declined in recent years, but contingent liability risks are still substantial. Improving transparency of fiscal risk analysis and management in this area is therefore warranted. The new legal framework for managing government guarantees should be implemented, ongoing work to release statements on financial performance of public corporations should be completed, and sound strategies to put financially vulnerable public corporations on a stronger footing need to be adopted. To address long-term age-related spending pressures, the ongoing periodic review of the pension system should comprise new measures to increase the effective retirement age and further encourage enrollment in voluntary savings schemes. To identify saving opportunities in healthcare spending, it is important to complete the institutionalization of the comprehensive spending reviews (CSRs) and adopt the new planned system to monitor the implementation of CSRs’ recommendations.

10. On the revenue side, Malta’s high reliance on CIT proceeds makes it vulnerable to potential international regime changes. To increase tax revenues in a sustainable way, options to diversify beyond CIT proceeds should be explored. Estimating foregone revenues from tax expenditures is another key priority. Finally, revenue administration reforms should be pursued as they are likely to help improve tax collection and compliance.

Growth-enhancing structural reforms

11. Addressing remaining structural weaknesses will help sustain Malta’s growth performance, while promoting social inclusion. Key priorities include:

• Sustain commitments to increase labor force participation, upskill workers, and invest in innovation. Labor shortages and lack of skilled workers remain pressing problems for Maltese firms. Measures taken to boost female and elderly labor force participation continue to bear fruit and should be sustained. Recent initiatives to update and broaden the learning curriculum and increase participation in apprenticeship and vocational training have the potential to improve educational outcomes and further reduce early school leaving. Recent partnerships between the Malta Development Bank and commercial banks aim to support entrepreneurship and innovation, but continuous monitoring is needed to ensure strong risk management and governance.
• Address governance shortcomings without delay to safeguard the business climate. Stepping up the fight against corruption and increasing the efficiency of the judicial system while ensuring its independence, as stressed by the Council of Europe (MONEYVAL, Venice Commission and the Group of States Against Corruption) are necessary to safeguard Malta’s business climate and its attractiveness for foreign investment.
• Continue to improve access to affordable housing to support greater inclusion. Housing benefits and transfers should continue to be complemented by policies to expand the supply of affordable and social housing.

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