Fitch affirms Malta at ‘A’; Outlook stable

Fitch Ratings has affirmed Malta's Long-term foreign and local currency Issuer Default Rating at 'A' with Stable Outlooks. The issue ratings on Malta's senior unsecured foreign and local currency bonds have also been affirmed at 'A'. Fitch has also affirmed the Country Ceiling at 'AAA' and the Short-term foreign currency IDR at 'F1'.

KEY RATING DRIVERS

The affirmation and Stable Outlook reflect the following key rating drivers:

Malta's public finances continue to improve gradually, helped by strong economic growth and lower nominal interest expenditure. Fitch expects the headline fiscal deficit to fall to 1.8% of GDP in 2015, with total revenue/GDP reaching a record high of 42.8%. As in previous years, expenditure growth will be driven by a higher public wage bill (reflecting in part a rise in the number of health and education workers) and social transfers.

The authorities expect fiscal consolidation to gather pace in 2016-18, primarily driven by lower current expenditure. However, meeting these targets will prove challenging, as the risk of expenditure slippage is high. On the upside, fiscal management is set to improve following the implementation of the Fiscal Responsibility Act and the eurozone fiscal rules. The establishment of a fiscal council could also help guarantee confidence in fiscal targets.

General government gross debt is expected to fall modestly in the medium term, but remain well above the 'A' median of 47.2% of GDP. In our baseline, nominal GDP growth of 5.3% and a primary surplus of 0.7% of GDP will help bring public debt/GDP to around 65% in 2017, from a high of almost 70% in 2013. There are some downside risks to our debt outlook, primarily related to lower than projected growth and higher budget deficits.

At 16.9% of GDP at end-2014, government-guaranteed liabilities are among the highest in the EU and continue to weigh on creditworthiness. Most are related to state-owned enterprises, in particular the utility company, Enemalta. Nevertheless, after the recent purchase of 33% of its assets by a Chinese firm, Enemalta's financial position has started to improve, thanks in part to lower energy imports and new infrastructure investment. This has reduced the risk that contingent liabilities will crystallise.

Private consumption growth retained momentum in 1Q15, helped by falling unemployment, lower energy costs and steady credit growth. Although gross fixed capital formation contracted in year-on-year terms in 1Q15, investment is expected to pick up in the short term, helped by the construction of a new power plant and the completion of EUfunded projects (the funds have to be spent by end-2015). In this context, Fitch forecasts the economy to expand by around 3.6% this year, above the 'A' and ' AA' medians.

The Maltese economy will continue to outperform eurozone peers in the medium term, even as GDP growth is set to moderate slightly from 2016 onwards. The country's services sectors will remain the most dynamic, led by higher tourist arrivals and expansion of the gaming industry. There are some risks from rising unit labour costs, but at present there are few signs of a loss of price competitiveness, highlighting a structural shift in the economy to higher value-added services. However, failure to improve productivity could create growth bottlenecks in the longer term.

Inflation has started to pick-up since our last rating review, reaching 1.1% in June (from 0.4% in December 2014). This reflects both sturdy domestic demand growth and the diminishing effects of the 2014 energy price cut for households. An upcoming reduction in industrial energy prices is unlikely to have significant pass-through effects on consumer prices, with Fitch forecasting inflation to rise to around 2% in 2016-17.

Malta's capital markets remains very liquid, with the loan to deposit ratio of domestic banks at 63% in 1Q15. The core banks, which have a balance sheet of around 260% of GDP, are well capitalised and delinquency portfolios have stabilised over the past year, while provisions for NPLs have increased. However, financial institutions are likely to face challenges in boosting profitability, partly due to high non-interest expenses. The regulatory environment has continued to evolve in the past six months, with a singlesupervisory framework now in place and the establishment of a resolution fund. This should help underpin financial stability.

External data has been revised significantly, in line with new guideline's under the IMF's BOP and IIP manuals. The inclusion of special purpose entities as Maltese residents has substantially increased the size of the financial sector and boosted Malta's net external creditor position relative to all rating categories. The country has also maintained its strong positive international investment position.

RATING SENSITIVITIES

The Outlook is Stable. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a rating change. However, future developments that could individually or collectively, result in a positive rating action are: • An improved track record in consolidating the public finances that leads to a lower government debt/GDP ratio. • A significant decline in contingent liabilities. The main factors that individually or collectively could trigger negative rating action are: • Significant slippage from fiscal targets leading to deteriorating public debt dynamics. • Crystallisation of material contingent liabilities or a shock to the banking sector that requires fiscal support.

KEY ASSUMPTIONS

Fitch assumes that in case of need, the government of Malta would only be predisposed towards supporting the core domestic banks within the framework of the EU's Bank Recovery and Resolution Directive. For HSBC, Fitch assumes that any necessary support would come from its parent company. In Fitch's view, the Maltese government would be very unlikely to support international banks (415% of GDP at 1Q15) and would probably not support non-core banks (28% of GDP at 1Q15) either.

Fitch assumes that the incumbent government will maintain its legislative majority and advance its agenda gradually until the next general elections scheduled for 2018.

The European Central Bank's asset purchase programme should help underpin inflation expectations, and supports our base case that the eurozone will avoid prolonged deflation. Nevertheless, deflation risks could re-intensify in case of adverse shocks.

In the event of a Greek exit from the eurozone, Fitch assumes this would be unlikely to trigger a systemic crisis like that seen in 2012 or another country's rapid exit. However, it would increase financial volatility and dent economic confidence.