Dynamic but vigilant
Address by Dr Mario Vella, Governor, Central Bank of Malta delivered during the ifs Malta Annual dinner
Last year, I highlighted the fact that the performance of the Maltese economy had exceeded the bank’s expectations and those of other institutions. Key economic indicators were among the best in Europe, with the European Commission at the time projecting continued, though moderating, strong GDP growth through 2019.
This assessment can be broadly confirmed at the current juncture. GDP growth in the first half of 2018 averaged 5.4%, which is in line with the latest projections that the Central Bank published over the summer. The unemployment rate fell to a new record low of 3.8% in the second quarter of this year. Labour market participation, previously on the low side, now slightly exceeds the euro area average.
In the area of public finances, the general government balance remains in surplus, the debt-toGDP ratio extended its downward path, and contingent liabilities, while still elevated, are now within the range observed in other countries. The external balance remains in surplus and inflationary pressures remain contained.
When compared with the information available a year ago, the economic record is even more impressive. Then, GDP growth in 2017 was recorded at 5.6%, now the latest vintage of data puts last year’s growth rate at 6.7%. Growth in 2018 is also expected to be higher than previously expected. The European Commission’s latest projections foresee growth this year at 5.4%, the second highest rate at the European Union after that of Ireland. This compares with a projection of 4.9% in November 2017.
According to the European Commission, fast growth rates are expected to prevail through 2020, although as one might expect, the pace of expansion is set to moderate from recent highs, with annual growth reckoned to stand at 4.4% in 2020.
All this is positive news, but there is also some not so good news.
While the outlook for the Maltese economy remains bright, we have to acknowledge that the external environment is becoming less supportive than we expected a year ago, or even three months ago. Some of the external downside risks flagged by the bank in recent projection rounds have started to materialise. Global economic growth has become more diverse across regions, with soft indicators suggesting that global trade is losing the buoyancy seen in 2017. Partly in response to the less benign economic conditions abroad, activity has also softened in the euro area.
The less favourable international environment partly reflects new restrictions on trade and the response of businesses’ capital spending plans. In late 2017 and also in the course of 2018, the United States introduced additional trade protectionist measures, which have been followed by a degree of retaliation. Although these actions mostly concern trade between the United States and China, the overall impact may be considerably broader once global value chains and the effects of uncertainty on private spending are taken into account. This assessment is broadly confirmed by the latest assessments published by the IMF in October, and by the OECD a week ago. Indeed, yearon-year growth in world trade has slowed to 3.2% in the first half of this year, from the relatively fast growth of 5% recorded in 2017, while growth in container port traffic averaged 3.9% in the first nine months of this year, down from 6.5% in 2017.
Notwithstanding the deal reached during the special meeting of the European Council held on 25 November, the uncertainty surrounding the UK’s future relations with the European Union continues. Should the deal be rejected, the immediate effect would be an amplification of the loss of momentum.
The European Central Bank continued to pursue an accommodative monetary policy throughout 2018, against the backdrop of a continued recovery in economic activity in the euro area as a whole, to ensure that inflation would converge sustainably to the target of below, but close to, 2% in the medium-term.
Following very strong growth in 2017, real GDP in the euro area continued to expand during the first three quarters of this year, albeit at a slower pace, with an annual growth rate of 1.7% being registered in the third quarter. The latest information, while being somewhat weaker than expected, remains consistent with an ongoing economic expansion.
In turn, with the economy growing at rates above potential, and with the unemployment rate declining steadily, inflation should gain momentum. Indeed, the euro area inflation rate stood at 2.2% in October, up from 2.1% in September and from 1.4% a year earlier. That having been said, measures of underlying inflation, which strip out the contributions of volatile items such as energy and food, remain muted.
The situation in international financial markets during 2018 remained very challenging. Most asset classes today are in negative territory when compared to the start of the year, which is a very unusual phenomenon.
Over the past year, developments in financial markets have been largely dominated by several political events, while generally positive economic news seemed to matter much less. These political events ranged from trade tensions, especially between the US and China, to Brexit-related developments, a slowdown in emerging market economies, most notably in Argentina and Turkey, and also the rise of populist movements in some European countries that have led to tensions, particularly between Italy and the European Commission. All this led to volatility in financial markets, with a constant turn in Risk-On/Risk-Off sentiment, which has made it more challenging for investment strategies.
As a Central Bank, financial market developments are of a direct interest to us as these have an impact on both the domestic banking system and the Central Bank itself. While such volatility in financial markets and persistence of interest rates at a relatively low level in Europe have continued to exert pressure on interest income flows and potential on capital gains, and hence impinge on profitability, nevertheless domestic banks have absorbed such turbulence relatively well. For the year ahead, the situation is likely to remain equally challenging on interest income and profitability, as signs are emerging that world economic growth, including in Europe, is losing momentum. This could be also particularly challenging for the process of the normalization of the monetary policy stance in Europe, which is likely to be very gradual.
As you are all well aware, during 2018, the European Central Bank gradually scaled back the nonstandard monetary policy measures that it had introduced to combat the risks of a long period of low inflation and possible deflation. In January, the monthly purchases in terms of the Asset Purchase Programme were halved from €60bn to €30bn. They were halved again, to €15bn, from October. The Governing Council currently anticipates that, subject to incoming data confirming the medium-term inflation outlook, the net purchases will cease altogether in December.
Indeed, even after net asset purchases have ended, monetary policy will continue to provide support to the euro area economy as the stock on Central Banks’ balance sheets will be maintained with the re-investment of maturing bonds. The ECB’s key interest rates remain very low, with the overnight deposit rate standing at -0.4%. The Governing Council expects them to remain unchanged at least through the summer of 2019.
At the same time, the Governing Council will ensure that ample liquidity conditions will continue to prevail for as long as needed by reinvesting principal payments from maturing securities for an extended period of time. This combination of very low interest rates and ample liquidity should ensure favourable financial conditions for firms and households, underpinning economic activity and should strengthen the sustained convergence of inflation to the target.
Looking ahead, domestic demand will play an important role in economic growth. The prospects in this regard remain favourable. The still very low unemployment rate and the low interest rate environment should continue to shore up private consumption, while investment should benefit from increased public spending on infrastructure as well as new projects in education and health. Certain capital intensive sectors look set for further expansion. The continued strong growth in permits for residential dwellings should also lead to further growth in dwelling investment.
It is also evident, however, that maintaining the momentum registered in recent years is becoming an increasingly challenging feat, as a number of internal constraints already identified last year persist.
The rapid economic expansion and population growth have put pressure on the country’s physical infrastructure, in particular as regards road transport and health and education facilities. Given the adverse effects of infrastructure gaps on business investment, productivity and social welfare, it should not be surprising that one of the key recommendations which IMF staff issued in January was to boost public investment, to address infrastructure bottlenecks and support medium-term growth in a budget-neutral manner. This need to boost investment in infrastructure was also acknowledged by the European Commission in its assessment of the Stability Programme and National Reform Programme. In this regard, government’s announcement of a seven-year capital investment programme focusing on the road network is an encouraging step forward. However, given that this additional investment coincides with a booming construction sector and more stringent procedures as regards the utilisation of EU funds, the possibility of slippages should not be overlooked.
Government’s efforts need to be complemented with a better utilisation of savings accumulated by the private sector. The Malta Development Bank can help in this regard, by identifying gaps in the financing of viable projects and partnering with financial intermediaries and other stakeholders to develop financial instruments that can finance them.
Apart from infrastructure bottlenecks, international institutions that monitor the business environment flag other areas that warrant immediate attention. While we have significant reservations on a number of methodological aspects underlying such surveys, we also share the view that in some areas we do need to step up our efforts very considerably. This is notably the case as regards the efficiency of court proceedings. Although the time it takes to resolve court cases has more or less halved since 2010, it is still among the longest in the European Union.
Other challenges that we need to address concern the length of procedures to set up a business, the low educational attainment level relative to our peers and a limited capacity to innovate. These are essential elements that support investment and productivity. The development of an intelligent online business portal which ties all government business-related services into a one solid platform should put businesses in a better position to do business.
The new legislation in the area of digital innovation provides the legal framework for business to embrace disruptive technologies. The private sector is encouraged to exploit the opportunities that these technologies entail in terms of efficiency gains, adaptability and overcoming labour shortages which remain widespread across sectors and skill levels.
So far we have managed to address these gaps partly through labour activation policies targeting nationals and partly through foreign labour. However, one has to acknowledge that the national working age population is what it is. With the male participation rate already around the euro area average, a better utilisation of the domestic component of the labour supply can only be achieved if more women take up employment or if the labour force works longer. Alternatively, production processes would need to rely on upgraded technology, such as automation and artificial intelligence.
While further gains in the female participation rate are possible, these will likely materialise only gradually, as the participation rate of younger females already exceeds that in the euro area as a whole, while that of older females does not adjust upwards easily, as these tend to have fewer skills and experience or have to care for dependants. Longer hours are probably not compatible with a better quality of life. Technology upgrades through, for example, automation and artificial intelligence offer a promising avenue, but can be very costly for small firms and also require skills and financing that are not immediately available. Their effectiveness rests on a more active participation in training and re-skilling programmes as well as entrepreneurial willingness to support innovative activities.
The private sector is likely to maintain a high dependence on foreign workers. The latter, however, tend to stay for a relatively short period in Malta, which does not augur well for firms’ return on investment in human capital and productivity. It may also put at risk the competitiveness of our exports and job prospects to the extent that wages begin to increase faster than productivity.
From this point of view, there is an urgent need to understand the factors behind the relatively short stay of foreign workers in Malta and devise solutions to this problem. A key factor that has been cited by firms and foreign workers alike is the recent rapid increase in rent in the private market, but