Malta receives first-time credit rating of A+ with stable outlook

Euro area membership, high economic growth, prudent fiscal management and a strong external position are credit strengths. Elevated contingent liabilities, unfavourable demographics, external vulnerabilities, and regulatory shortcomings remain challenges.

Scope Ratings GmbH has assigned the Republic of Malta a first-time A+ long-term issuer and senior unsecured local- and foreign-currency rating, along with a shortterm issuer rating of S-1+ in both local and foreign currency. All Outlooks are Stable.

Rating drivers

Scope's first-time assignment of Malta's A+ rating reflects the country's euro area membership, high economic growth, prudent fiscal management and strong external position. The rating is challenged by contingent liabilities, unfavourable demographics, external vulnerabilities, and regulatory shortcomings of the financial sector.

Malta has shown buoyant growth rates during the recent decade with an average expansion of 4.3% since 2007, outperforming the EU average behind only Ireland. The main drivers of Malta's growing economy are high service exports (tourism, transport and gaming), and robust private consumption.

For 2018 and 2019, Scope anticipates annual growth to reach 5.4% and 5% respectively on the back of record-low unemployment of 4%, strong employment growth due to migration and recovering investment, especially on the housing market. Growth is expected to continue to be driven by private consumption and higher investment, whereas the external sector provides less support compared to previous years.

The A+ rating is further underpinned by Malta's strengthened fiscal framework, together with a combination of faster fiscal consolidation, low interest payments and stronger GDP growth. The government has achieved consistent fiscal surpluses, supported by a broadening tax base, reflecting better monitoring compliance and increasing female labour participation.

Expenditures are below the euro area average but have picked up recently. Capital expenditures have increased strongly due to the acquisition of landing rights from Air Malta. Going forward, the Maltese government targets a general fiscal surplus of 1.3% of GDP for 2019, net of revenues from the Individual Investment Program and including gross fixed capital formation of 3.5% of GDP. Fiscal expenditures in 2019 are expected to decline slightly from 38.4% to 37.8% of GDP, based on the onetime capital transfer to Air Malta in 2018 (€57mn).

Malta's strong fiscal performance has led to a steady decline in its debt to GDP ratio from 2012 onwards, falling below the 60% Maastricht threshold in 2015. The last two years brought a further decline by almost 8 percentage points, thanks to exceptionally strong growth and a slightly positive fiscal balance.

For 2018, government projections foresee a decline of the debt to GDP ratio to 46.9%, equal to 4 percentage points. Going forward, the government expects another 3 percentage points decline towards 2019 by assuming that the primary surplus of 2.7% exceeds interest rate expenditure (1.5%) and stockflow adjustment (1.6% of GDP). Our baseline scenario, in line with the IMF forecast, foresees a continued, albeit less pronounced decline in debt over the projection horizon to around 30% of GDP, supported by positive primary balances and high growth.

Malta's A+ rating is further supported by the economy's robust external sector. Continuous current account surpluses led to a net international investment position of 62.6% at year-end 2017. This development is dominated by a boost in services exports, comprising transport, tourism and gaming. Although the country shows a negative balance on goods exports, the quality of exported manufacturing goods is above the EU average with 40% of the export value related to top quality. Going forward, we expect Malta to retain its current account surplus, albeit with lower surpluses towards 2019 but supported by rising import shares and its role as a financial centre.

Despite the relative strengths of Malta's rating, challenges remain. Malta's rapidly declining public debt ratio is still facing additional burden from elevated contingent liabilities of 9.6% of GDP (in 2017), resulting from financially weak state-owned enterprises. These risks have decreased in line with higher growth but remain a credit risk over the forecast horizon.

Over the medium-term term, the country also faces supply side constraints, induced by the tighter labour market. Although the government initiated reforms of the labour market to reduce low skill attainment among young people and low tertiary education, the economy still faces a large gender employment gap and educational outcomes remain closely linked to socio-economic background. Infrastructure investment is projected to increase strongly with higher absorption of EU funds and expected investment in healthrelated projects.

With only 0.5m inhabitants, Malta's small open economy remains especially vulnerable to external shocks, in particular with its reliance on the export of business-cycle relevant services. Also, Malta is vulnerable to policy harmonisation risks and changes in EU corporate tax law. Finally, infrastructure bottlenecks and skills shortages are expected to weigh on the country's long-term growth potential.

Malta's economic strength is partly related to a booming gaming sector and large revenues from the IIP, which attracts foreigners who seek European citizenship. Financial inflows are more than tenfold the country's GDP, thereby remaining a source of uncertainty despite being mostly decoupled from domestic economic activity. Despite the implementation of several Anti-Money Laundering Directives to improve due diligence and transparency, the European Commission asked the government to take a stand on anti-money laundering measures following allegations related to Pilatus Bank whose banking license was revoked in November by the European Central Bank.

In July, the European Banking Authority pointed out that the measures taken by the Maltese Financial Intelligence Analysis Unit were not sufficient to satisfy the identified shortcomings, requesting further action to comply with the Anti-Money Laundering and Countering Terrorism Financing Directive. The Maltese authorities have responded by launching the AML/CFT Strategy, which includes an improvement of the supervisory framework and an increase of resources to strengthen legal enforcement. Scope recognizes that the recent events have no likely impact on public finances but may affect Malta's reputation of an emerging financial centre.

Core Variable Scorecard and Qualitative Scorecard

Scope's Core Variable Scorecard, which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative 'AA' rating range for the Republic of Malta. This indicative rating range can be adjusted by the Qualitative Scorecard by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.

For the Republic of Malta, the QS signalled credit weaknesses for the following analytical categories: i. economic policy framework; ii. macro-economic stability and

sustainability; iii. market access and funding

sources; iv. external debt sustainability; v. vulnerability to short-term

external shocks; vi. recent events and policy deci

sions; vii. banking sector oversight and

governance; viii. financial imbalances and

financial fragility.

The combined relative credit strengths and weaknesses generate a 2-notch negative adjustment and signal a sovereign rating of A+ for Malta. A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance

Scope considers ESG sustainability issues during the rating process as reflected in its sovereign methodology. Governancerelated factors are explicitly captured in Scope's assessment of 'Institutional and Political Risk', for which Malta scores high according to the World Bank's Worldwide Governance Indicators. Qualitative governance-related assessments in Scope's 'geo-political risk' category of its QS are assessed as 'neutral' compared with Malta's sovereign peers. Socially related factors are captured in Scope's CVS in Malta's rapidly growing GDP per capita ($27,326 in 2017) and record-low level of unemployment but increasing old-age dependency ratio. Qualitative assessments of social factors are reflected in Scope's 'macroeconomic stability and sustainability', for which Scope assesses Malta as 'weak'. Finally, environmental factors are considered during the rating process but did not have an impact on this rating action.

Outlook and rating-change drivers

The Stable Outlook reflects Scope's assessment that the risks faced by Malta remain balanced at this stage. The rating could be downgraded in the event of: i) a significant slowing of growth; and/or ii) failure to increase investment spending. The rating could be upgraded if i) the government implements structural reforms, which raise the growth potential; ii) if there is continued fiscal consolidation; and/or iii) reforms to strengthen financial supervision are effectively completed.

Rating committee

The main points discussed were: i) growth potential; ii) economic policy framework; iii) macroeconomic stability and sustainability; iv) fiscal policy framework; v) public debt sustainability, debt structure and market access; vi) external debt sustainability and vulnerabilities; vii) banking sector oversight and governance; viii) political developments; and ix) peers.