DBRS Morningstar confirms Malta at A (high), Stable trend

DBRS Ratings GmbH confirmed the Republic of Malta’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS Morningstar confirmed the Republic of Malta’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (midd

The Central Bank of Malta estimates that the fiscal surplus stood at 1.5% of GDP and the debt-to-GDPratio was 42.8% of GDP in 2019. Despite a weaker external backdrop and the recent political turbulence, DBRS Morningstar expects Malta to continue to grow at a solid pace and continue to post fiscal surpluses in coming years.

Key rating considerations

Malta’s economic performance has been extremely strong between 2013 and 2019, with average GDP growth at an estimated 7% and its economy becoming increasingly diversified. This has attracted both foreign labour and capital to Malta, complementing its favourable tax environment and reinforcing the positive economic dynamic. On the back of a buoyant economy and fiscal prudence, Malta’s public finances have improved.

The Central Bank of Malta estimates that the fiscal surplus stood at 1.5% of GDP and the debt-toGDP-ratio was 42.8% of GDP in 2019. Despite a weaker external backdrop and the recent political turbulence, DBRS Morningstar expects Malta to continue to grow at a solid pace and continue to post fiscal surpluses in coming years.

On the other hand, given its size and the openness of the Maltese economy, with sectors such as tourism, gaming and financial services highly reliant on external demand and foreign capital, Malta remains exposed to external demand or confidence shocks. In the medium-term, potential changes in international corporate taxation, changes to the EU regulatory framework, or weakening perception of the governance framework could reduce Malta’s attractiveness to foreign companies. Malta’s contingent liabilities, stemming from its large non-financial state-owned enterprises and concentrated financial sector and rising age-related costs are potential sources of vulnerability for public finances.

Rating drivers

Upward rating drivers include one or a combination of the following: (1) a sustained material reduction in the public debt ratio to low levels driven by sound fiscal management and economic performance; (2) effective implementation of reforms to enhance Malta’s governance framework, including the financial and judicial sector or (3) further evidence of increased economic and fiscal resiliency to external shocks, including changes to the international tax or regulatory environment.

While DBRS Morningstar’s baseline factors in a relatively positive economic and fiscal outlook, a deterioration in the trajectory for public debt in the medium-term could exert downward pressure on

Malta’s ratings. This could derive from: (1) a deterioration in growth prospects; (2) a sustained worsening of fiscal and debt indicators or (3) the materialisation of contingent liabilities.

Rating rationale

Malta continues to outperform EU average growth rates

Malta’s economic performance has been remarkable in recent years, with estimated 7% annual average GDP growth from 2013 to 2019, well above the 2.1% average rate between 2004 and 2012. This has allowed Malta to reduce the GDP per capita gap with the EU. Maltese GDP per capita is estimated to represent 84% of the EU average in 2019 from 54% in 2004, when the country joined the EU. Growth has been broad-based with outward-facing sectors such as tourism, gaming, financial and business services being key to the expansion. A highly elastic foreign labour supply, increasing female and older worker participation rates, and a rising share of less capital-intensive service sectors have prevented overheating pressures. Higher investment, a larger labour supply and enduring benefits from the energy reform will continue to support potential output.

Despite increasing weakness and uncertainty externally, Malta’s still buoyant labour market has underpinned domestic demand in 2019. The International Monetary Fund projects annual average growth of 3.6% between 2020 and 2024. Nevertheless, Malta’s openness and small size exposes it to swings in external demand and lower foreign direct investment. Although some external risks appear to be diminishing, such as US-China trade disputes and a hard Brexit, they remain significant and could both worsen external and domestic conditions for Malta. In the mediumterm, changes in international corporate taxation, changes to the EU regulatory framework or slow progress in enhancing its governance framework could reduce Malta’s attractiveness as a financial and business location.

Malta accumulates fiscal surpluses, benefitting from buoyant macroeconomic environment

Malta’s fiscal performance has improved significantly over the last two decades, allowing the country to be fully compliant with the EU’s Stability and Growth Pact. The general government budget balance as a percentage of GDP switched to an average surplus of 2.1% in 20162018 from an average deficit of 2.7% for 2004-2015. Since 2016, Malta’s budgetary surpluses have been both in nominal and structural terms. Key factors underpinning this trend have been stronger underlying economic fundamentals boosting revenue growth, improved spending efficiency, lower interest payments and the proceeds from the Individual Investor Programme since its introduction in 2014.

On the back of economic momentum that remains very strong, government projects a headline surplus of 1.4% for 2019 and 2020. Encouragingly, government aims to sustain the fiscal surplus above 1% of GDP until at least 2022, while sustaining high levels of public investment to deal with increasing infrastructure bottlenecks. Given the difficulty in predicting proceeds from the IIP, DBRS Morningstar considers the authorities’ intention to comply with government’s Medium-Term Objective, net of the IIP, to be appropriate.

Proceeds from corporate taxation, which represented 17.1% of total revenues in 2018, could be eroded if international tax changes were to significantly reduce Malta’s attractiveness to multinationals relative to other jurisdictions. Although Malta’s fiscal performance has been strong in recent years, uncertainties over future revenues from the IIP, its relatively high reliance on corporate taxation and the risk of fiscal revenues underperforming in a less buoyant scenario led DBRS Morningstar to make a negative qualitative assessment of the “Fiscal Management and Policy” building block.

The public debt ratio is expected to continue falling in coming years

Following a substantial drop of close to 25 percentage points over the last decade, the Central Bank of Malta estimated the debt-to-GDP ratio at 42.8% of GDP in 2019, one of the lowest in the EU. In the absence of material shocks, this steep downward trend is projected to continue in coming years, explained by solid primary surpluses and favourable nominal growthinterest expenditure differential. The projections from the Central Bank of Malta of 35.6% by 2022 and by the IMF of 28.3% of GDP by 2024 point in this direction.

Malta’s current public finance position and debt dynamics provide government with valuable room to support the economy in the event of a negative shock without materially jeopardising debt sustainability. DBRS Morningstar views the main sources of risks as coming from a sharp deterioration in Malta’s growth outlook, a weakening primary balance or the materialisation of a contingent liability.

In addition to its large and concentrated financial system, another source of contingent liabilities could come from vulnerabilities in its state-owned enterprises outside of the general government, with liabilities of 18% of GDP in 2017 and accounting for most of the 8.2% of GDP of outstanding guarantees in

Q3 2019.

On a positive note, government plans to continue lowering the stock of outstanding guarantees as a share of GDP in coming years.

In the long term, age-related costs are projected to increase by 6.8 percentage points from 2016 to 2070, according to the European Commission’s 2018 Ageing Report. Government initiatives, such as the gradual lengthening of retirement ages, longer contribution periods and incentives to deter retirement, appear to have contributed to longer working lives. Nevertheless, additional measures may be required to improve the long-term sustainability of the healthcare and pension systems.

Financial system remains sound but AML/CT identified shortcomings need addressing

The Maltese financial system remains sound, underpinned by its conservative core banks’ healthy levels of capitalisation, liquidity and profitability. Core domestic banks, with assets of around 190% of GDP in Q2 2019, mostly follow a traditional business model based on retail deposits for funding. Core banks’ nonperforming loans as a share of total loans, which stood at 3.2% in Q3 2019, continue to decline, driven by the overall improved economic and housing market conditions as well as tighter regulatory requirements. International banks, with assets of 122.5% of GDP in Q2, and domestic noncore banks, with assets of around 21% of GDP, have limited or no linkages to the domestic economy. Therefore, potential spillovers to the rest of the system should be contained.

Core banks’ high exposure to the real estate market and rapid house price growth since 2014 is a source of risk. While valuation in the housing market is becoming stretched, strong demand has largely been driven by fundamental factors such as rising disposable income, substantial net migration and low interest rates. An increasingly responsive housing supply, households’ high levels of financial wealth and liquid assets and banks’ conservative lending practices mitigate the risks to the banks’ mortgage loan book.

New borrower-based macro-prudential measures became effective in July 2019, broadening the authorities’ ability to counter mounting pressures in the housing market, especially in the buy-to-let segment.

Moneyval, the Council of Europe’s anti-money laundering body, found shortfalls in Malta’s money laundering and combating the financing of terrorism (AML/CFT) framework and enforcement, especially in the areas of supervision capabilities, money laundering investigation and prosecution and confiscation of criminal proceeds.

The report was published in July 2019, considering measures in place by November 2018. Malta has been implementing the measures included in its AML/CFT strategic plan (2018-2020), such as strengthening the financial supervisors (for example, functions, resources, risk analysis capabilities), establishing a new asset recovery unit and boosting its investigation and prosecution of financial crimes efforts. Malta’s financial system could suffer from a reputational loss should Moneyval or the Financial Action Task Force consider insufficient progress has been made in addressing their recommendations.

DBRS Morningstar made a negative qualitative assessment of the “Monetary Policy and Financial Stability” building block to reflect the potential impact of this on banks’ intermediation and economic activity.

Malta’s external remains strong

position

Malta’s external position continues to strengthen, led by fast-growing service sector exports. The current account shifted from an average 6.2% deficit during 20052009 to an average surplus of 2.8% of GDP during 2010-2018, chiefly driven by the enlargement of the trade services balance.

The marked improvement in the external accounts since 2009 can be mostly explained by structural factors, such as improving energy intensity, lower import content, the increasing role of the gaming industry, as well as the expansion of sectors such as aviation.

Although gross external indebtedness is very high at 715.9% of GDP in Q3 2019, it poses limited risks to the domestic economy as it is mainly reflective of stable flows of intercompany lending and Malta’s role as an international financial centre. Furthermore, on the back of strong current account surpluses Malta has built up a large positive net international investment position of 62.8% of GDP by Q3 2019.

A stable policy environment is credit positive but further steps to strengthen governance are needed

Malta’s public institutions are broadly sound. The adoption of European procedures over time has resulted in a stable macroeconomic, fiscal and monetary policy framework. Looking at the World Bank’s governance indicators, Malta compares favourably with the EU average scores, except on corruption and government effectiveness.

Despite recent political events in Malta, DBRS Morningstar expects a broad continuation of macroeconomic policies. This January, a new Labour Party government was appointed led by Robert Abela, who has pledged economic policy continuity and further steps to strengthen governance in the country. This followed former Prime Minister Joseph Muscat’s resignation amid increasing pressure from Maltese civil society over its handling of the investigation of the death of a Maltese journalist who was investigating alleged corruption cases involving senior government officials.

A report published by the Venice Commission, Council of Europe’s advisory body on constitutional matters, in December 2018 points to the need to further strengthen Malta’s institutional setting and its checks and balances. Some measures have already been implemented to improve the separation of powers and the independence of the judiciary (for example, separating the dual role of Attorney General); however, deeper institutional changes will need cross-party support.

The presence of these shortcomings has led to a negative qualitative assessment of the Political Environment building block.