Fitch upgrades Malta to A+; Outlook stable

Fitch Ratings has upgraded Malta’s long-term foreign- and local-currency issuer default ratings to A+ from A. The outlooks are stable. The issue ratings on Malta’s senior unsecured foreignand local-currency bonds have also been upgraded to A+ from A. The Country Ceiling has been affirmed at AAA and the ShortTerm Foreign-and Local-Currency IDRs have been upgraded to F1+ from F1. The issue ratings on Malta’s short-term foreign-and local-currency bonds have also been upgraded to F1+ from F1.

Key Rating Drivers

The upgrade of Malta’s IDRs reflects the following key rating drivers and their relative weights:

High

Malta’s public debt dynamics are improving, as reflected by the fast declining gross general government debt. Fitch forecasts Malta GGGD to decrease to 50% of GDP in 2019, slightly higher than the ‘A’ median of 48.8% and supported by strong nominal GDP growth and recurrent primary surpluses. Government-guaranteed liabilities are set to decline to 9.7% of GDP by the end of 2017 from 14.2% of GDP in 1Q17 when the temporary guarantee granted to ElectroGas for the construction of a new power station expires. No additional capital injections for Air Malta are currently provisioned for in the 2017 Stability Programme Update.

Medium

Malta’s fiscal balance turned into a surplus of 1% of GDP in 2016 from a deficit of 1.3% in 2015 and compared with an initial deficit target of 0.7% of GDP in last year’s Stability Programme Update. We expect the general government balance to remain in a surplus of 0.5% of GDP over 2017-2019. The fiscal surplus reflects both struc- tural consolidation and cyclical trends. Buoyant fiscal receipts fuelled by strong nominal growth and high revenues from the International Investor Programme will compensate for increased wage and pension expenditure following the introduction of the new collective agreement for the public service and guaranteed national minimum pension.

Efforts to improve tax collection, increase excise duties and reduce expenditure on social benefits should support a positive fiscal structural adjustment in 20172019. Government’s recent pension reforms, namely the lengthening of the contribution period and measures to incentivise late retirement, should ease pressures on pension spending, while the proportion of GDP spent on social benefits has been reduced by nearly 2pp since 2013. Government is aiming for a fiscal surplus of 0.5% of GDP over 2017-2019 and forecasts an average structural balance of 0.4% of GDP over the next three years. Fitch expects fiscal policy continuity following the re-election in June of the Labour government led by Prime Minister Joseph Muscat.

We expect the economy to continue to grow at a faster pace than its similarly rated peers with real GDP growth forecast at 4.3% in 2017, 3.7% in 2018 and 3.5% in 2019 compared with 2.9% for the ‘A’ median. Sustained external demand will support solid performance of Maltese exports notably in the services sector, including tourism, financial services and gaming, and pharmaceutical sectors. A dynamic labour market, with employment set to grow by an average 2.9% per year, and rising compensation per employee will support private consumption. Investment will pick up in 2019, boosted by the gradual absorption of new EU funds and the launch of large transport, health and education projects.

The Central Bank of Malta estimates potential growth at 3.25% over the medium-term, reflecting the positive impact of labour market reforms and structural improvements in the energy sector in recent years. The employment rate grew to 65.8% in 1Q17, from 64.3% in 1Q16, supported by higher participation rates notably for women and high net immigration. The labour market is tightening, with emerging labour shortages and pressures on wages, but labour productivity gains will contain pressures on unit labour costs. Upcoming investments in transportation and education and ongoing reform of the judiciary system are likely to further improve the business environment.

Malta’s ‘A+’ IDRs also reflect the following key rating drivers:

Malta’s ratings reflect its high national income per head compared with the ‘A’ median, robust economic growth, a large net external creditor position and strong governance indicators. Unemployment is low compared with ‘A’ rated peers at a forecast 4.6% in 2017 and household net worth is high. Malta’s Ease of Doing Business World Bank indicator has improved in 2017 with the country now ranking 76th out of 190, up from 83rd a year ago, although this is significantly lower than the ‘A’ median.

The Maltese banking sector remains sound with improved profitability, non-performing loans on a declining trend, improved capitalisation and conservative lending standards. However, the sector remains highly concentrated and core banks account for 220% of GDP, international banks 223% and noncore banks 25%. Mortgage loans are increasing, pushing up banks’ exposure to the real estate sector, although household debt has remained fairly stable in recent years as a share of GDP at 111.2% of GDP at end-2016 from 110.1% a year earlier. House prices increased by 4.8% over 1Q17 but the Central Bank estimates prices to be in line with fundamentals and the rise is likely to moderate as supply comes on stream.

We expect Malta’s external position will remain strong with a forecast current account surplus of 7.7% of GDP over 2017-2019. The improvement of the current account balance mirrors the structural change in the economy towards the less import-intensive and high value-added service sector. Improved energy efficiency supported by the completion of the connector with Italy, upgrade of energy infrastructure and the conversion of oil power plants to gas also helped reduce the import bill. Malta is a large net external creditor with a net international investment position at 48% of GDP in 2017, higher than the ‘A’ median’s 27% of GDP debtor position. However, the highly open nature of the Maltese economy makes it vulnerable to external developments.

Sovereign Rating Model and Qualitative Overlay

Fitch’s proprietary SRM assigns Malta a score equivalent to a rating of AA- on the Long-Term FC IDR scale.

Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows: • External Finances: -1 notch, to reflect that the euro’s reserve currency status, for which the SRM provides a +2-notches enhancement, would likely offer Malta only limited protection in case of a global or domestic financial crisis. Fitch’s SRM is the agency’s pro- prietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

Rating Sensitivities

Future developments that could individually or collectively result in positive rating action include: • Further fiscal consolidation leading to lower than forecast government debt/GDP. • Faster growth in GDP per capita, for example supported by progress in addressing key weaknesses in the business environment.

Future developments that could individually or collectively, result in negative rating action include: • Significant fiscal slippages 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 Maltese government would only be predisposed towards supporting the core domestic banks that are systemically important, in particular Bank of Valletta (115% of GDP at-end 2016). For HSBC Bank Malta (59% of GDP), Fitch believes that any necessary support would come from its parent company. In Fitch’s view, the Maltese government would be very unlikely to support the international banks and would probably not support non-core banks either.