Dy­namic but vig­i­lant

Ad­dress by Dr Mario Vella, Gover­nor, Cen­tral Bank of Malta de­liv­ered dur­ing the ifs Malta An­nual din­ner

The Malta Business Weekly - - NEWS -

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

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