IMF outlook mainly positive

- 2000’s external account imbalance set to largely reverse during 2001.

In the first of a two part series on the International Monetary Funds’ latest report on Malta, the Malta Financial and Business Times carries the IMF’s analysis on the Maltese economy. Here the focus is on the IMF’s discussions held in April with Finance Minister John Dalli, Central Bank Governor Michael Bonello, senior officials from government ministries and the Central Bank, and representatives of financial institutions. Also discussed are the macroeconomic outlook for 2001 and the medium term and fiscal and structural policy for 2001 and the medium term

Report on discussions
Discussions focused initially on whether immediate policy action was required to address the external current account imbalance. The authorities and staff agreed that the deterioration during 2000 was largely due to temporary factors and was set to largely reverse during 2001.
Nevertheless, the current account deficit could remain high and thus fiscal policy should remain focused on ensuring a sustainable path for the external balance over the medium term. This would build on the reduction in the fiscal deficit of four percentage points of GDP achieved since 1998. This ongoing consolidation, in conjunction with trade liberalisation, privatisation, and public sector restructuring underway since 1998 would support the exchange rate peg. And the combination of fiscal and structural reform was expected to continue to yield dividends in terms of efficiency of public services, employment in the private sector, and activity. These policies would constitute an appropriate response to any deterioration in external demand in 2001 and provide impetus to the administration's ambitions to secure early accession the European Union.
Malta would also, however, remain exposed to "investment shocks" and to short-term capital flows-with consequent potential volatility of the current account balance and international reserves. These characteristics of economic behaviour put a high premium on strong policies. This motivated discussion of the nature of prospective fiscal reforms and the appropriate role of monetary policy and two sets of trade-offs were highlighted. First, though further fiscal consolidation is necessary, anticipated, and rightly expected to focus on spending, the authorities are reluctant to commit to tighter policies even though they anticipate them. This reflects the desire to avoid appearing to move the "goalposts," and to strike a balance between maintaining appropriate room for fiscal manoeuvre and avoiding undue uncertainty about fiscal prospects. Second, the authorities place a high premium on maintaining the stability of interest rates. But the opening of the capital account regime alongside the conventional pegged exchange rate regime sharpens the trade-off between the stability of interest rates and that of international reserves.

Macroeconomic outlook for 2001 and the medium term
For 2001, the authorities and staff anticipated a sharp reduction in the current account deficit. The current fixed investment program of the microchip manufacturer had been largely completed during 2000, and further expansion would likely await an upturn in international microchip markets. This decline would only partly be offset by the initiation of several tourist-related projects in 2001. There was also no prospect of the sizeable dividend payment that had occurred in late 2000. There was also some prospect of a stabilisation or partial easing of international oil prices and at least a partial recovery in household savings rates after the decline in 2000 as household incomes rose the result of increased civil service salaries in the context of an unchanged personal income tax regime. Nevertheless, the authorities anticipated that household responses to continued fiscal consolidation in 2001 as well as longer term factors affecting savings propensities, including financial deepening and increasing "consumerism," would likely prevent a return to household savings rates recorded in 1999 The authorities also target a fiscal consolidation of 0.7 percentage points of GDP in 2001, which would boost public savings.
However, the staff was more concerned than the authorities about the risks for activity posed by weakening external market growth. WEO projections indicated that export market growth would drop to 8 percent. The authorities were nevertheless confident, on the basis of soundings of their major exporters, that r6bust export market growth would continue in 2001 as in 2000. Staff agreed that the binding constraint on Malta's export growth was likely not export market growth but the growth in competitive export capacity. But it seemed unlikely that even hitherto capacity constrained exporters would be completely insulated from a deceleration of external demand. The staff therefore was more concerned about possible downside risks to real activity and employment growth than were the authorities.
Over the medium term, the private sector savings investment balance was likely to deteriorate, requiring offsetting fiscal policy actions to secure external sustainability. Given that the likely sizeable external current account deficit even after the temporary factors in 2000 had unwound, the authorities agreed with staff that medium-term external sustainability was a key issue. They also agreed that declines in household savings from 1999 levels were likely in the context of a strong policy framework, the steady deepening of financial markets, the ageing of the population, and increased confidence in medium-term income growth. Fixed investment ratios would likely remain around levels attained in 1999 as major tourist investment projects came on stream alongside investment implemented in the restructuring process. These assessments, broadly shared by the authorities and staff, suggested that in the absence of further fiscal consolidation, projected FDI inflows would be insufficient to secure a sustainable path for external debt-associated with a current account balance in the order of 4-5 percent of GDP in the medium term.
This prospective underlying trend deterioration in the private savings-investment balance underlies the need for medium-term fiscal consolidation. The authorities target a consolidation of 0.7 percentage points of GDP in 2001. Given the prospective self-correction of much of the current account deficit seen in 2000, the staff welcomed the authorities 2001 fiscal deficit target as an appropriate step towards medium-term consolidation. The latter goal remains defined by the 1998 fiscal framework for 1999-2004. This projected a decline in the officially defined fiscal deficit to 4 percent of GDP in 2004 from 11 percent of GDP in 1998, though the authorities expect to secure a deficit of around 3 percent of GDP in 2004. The latter expectation would imply a consolidation of 2- percentage points of GDP from the 2000 outturn. Staff suggested that a consolidation of some 34 percentage points of GDP from the 2000 outturn would be needed by 2004 in order to maintain a sustainable underlying current account balance. This would be consistent with output growth at or around Malta's estimated potential of 44_ percent in the medium term. With the exchange rate peg supported by fiscal and structural policies, inflation would remain close to EU rates.

Fiscal and structural policy for 2001 and the medium term
The government budget for 2001 anticipates a consolidation of 0.7 percentage points of GDP. The adjustment is anticipated to occur on the revenue side. The taxation of fringe benefits under the personal income tax is tightened, and the brackets in that tax are again unchanged, implying further fiscal drag. The VAT base is extended in various ways, excises are raised, and a further round of reductions of import tariffs is implemented in accord with the three-year liberalisation program. On the spending side, current spending is projected to rise by 0.3 percentage points of GDP, partly offset by a similar decline in net lending. However, the composition of spending changes markedly: personnel expenditure rises by 0.8 percentage points due to implementation of the 1998 civil service wage agreement, offset by declines in operations, and interest spending-the latter presuming strong privatisation receipts.
The official data exclude off-budget fiscal operations conducted through the TCF. These activities-consisting largely of transfers and loans to public enterprises, notably the shipyards-summed to 1 percent of GDP in 2000, up from 0.9 percent of GDP in 1999. The increase in 2000 largely reflects unanticipated funding for the shipyards and for the Freeport. The authorities expected that activity in the TCF in 2001 could be at or below levels seen in 2000 relative to GDP. Thus, on the staff definition of the fiscal balance, assuming unchanged operations in the TCF relative to GDP, the fiscal deficit is expected to decline from 6.9 percent of GDP in 2000 to 6.2 percent in 2001.
The authorities emphasised that fiscal adjustment in 2001 at least as great as indicated in the headline fiscal deficit measure would be secured, even allowing for off-budget transactions. They were confident that the budget estimates contained adequate cushions and that an adjustment of 0.7 percent of GDP would be secured even on the staff measure of the deficit. Such an adjustment was necessary to support the external current account balance and to continue progress towards the medium-term fiscal goal. Staff noted several concerns, however: the estimates for VAT could be high if the rate at which arrears are cleared declines relative to 2000; spending on free medicines might again overrun the estimates in 2001; and cash flow projections for public enterprises consistent with the budget and TCF estimates were, as in earlier years, not available to underpin those estimates. The authorities argued that arrears accumulation in VAT since its reintroduction in 1999 had been minimal but acknowledged difficulties in projecting spending on medicines. Nevertheless, this risk was offset by some cushions in the revenue estimates, notably in the estimates for the yield on further tax administration measures.
While underscoring the continued need to increase tax compliance, the authorities acknowledged that further increases in the tax burden were undesirable.
They noted that the priority of fiscal deficit reduction, the difficulty of effecting spending rationalisation, and the scope to combat tax evasion, meant that increases in the tax burden had, until now, inevitably been the focus of deficit reduction. This pattern would remain during 2001 when taxes on benefits paid in kind would be fully applied and through the introduction of benchmarking exercises for small firms. But increases in tax rates had further stimulated evasion and increases in the overall tax burden had weakened incentives for private investment. Staff welcomed the strengthened tax administration and enhancements to the tax system more generally-notably through the effective reintroduction of VAT in 1999 and the steady widening of its base and endorsed the view that the tax burden had likely approached if not exceeded efficient levels.Continues on page 14
The authorities noted that the emphasis in deficit reduction would therefore increasingly shift to expenditure rationalisation, though further tax increases could not be ruled out They noted three initiatives of spending reform already underway:
The Commission on Welfare Reform, set up in 2000, was examining options to reform the current PAYG pension system and was due to report soon. Issues to be addressed include: the automatic links between individual pension levels and current wages; nominal caps on individual contributions and pension payouts; and demographic challenges as the population ages. All the social partners are represented and all options for reform are on the table. Prior to the report, there is no outline timetable for implementation.
A privatisation program is underway, the proceeds of which will be used to lower public debt and hence, debt services. The program focuses on sales of high quality assets and builds on the flagship sale of Mid-Med Bank in 1999. Legal and technical obstacles, which impeded the sale of the Freeport in 2000, have been addressed. This sale, alongside others including the government holdings in a major bank, is on track
for completion before end-2001. The aim is to sell mainly to strategic investors on the basis of price, the quality of the business plan, and employment guarantees. Efforts are also being made to increase the implementation capacity of the unit responsible for preparing the sales, and the authorities remain committed to transparency in the sales processes, guided by the 2000 White Paper on privatisation.
Flows of public funds to public enterprises will be curbed through two actions.
First, fuel prices will be tied to international oil prices from end-2001 though the details of the new pricing arrangement have yet to be worked out. Consideration is being given to similar treatment for other energy prices. Second, central control over public enterprise multi-year wage agreements is being strengthened, with every agreement now being individually centrally vetted in advance.
The staff welcomed the intention to prioritise spending rationalisation. They strongly encouraged early completion of the work of the pension's commission and agreed that the privatisation of Mid-Med bank in 1999 had yielded significant benefits in terms of productivity and the robustness of the financial sector. Further gains would likely accrue in the context of the sale of the government's remaining stake in the second major commercial bank. Staff also noted that privatisation could help by bringing the largely consensual character of industrial relations in the private sector into hitherto public operations. Steps to overcome technical obstacles that had impeded the privatisation process during 2001 were welcome, as were those to provide the privatisation task force with personnel resources commensurate with its task.
However, staff urged a more ambitious reform agenda. They expressed concern at the absence of plans to curb the public sector wage bill, despite considerable evidence of scope for savings there. In addition, uniform lump sum wage increases should be replaced by percentage increases to maintain the wage structure over time, thereby avoiding the need for periodic major adjustments to restore an appropriate wage structure as occurred in 2001. Staff also suggested that consideration be given to defining multi-year wage agreements on the wage bill, rather than on wage rates, to encourage rationalisation of the public sector workforce at a socially acceptable pace. These steps could contribute to reducing the flow of subsidies to public enterprises, which would not only yield fiscal benefits, but would also relieve labour shortages in the private sector.
In implementing their medium-term fiscal objectives, the authorities remain committed to the content and the form of the projections made in their l998-2004 fiscal framework. While recognising that Malta's officially defined fiscal deficit in 2000 was already lower than had been projected in late 1998, the authorities were reluctant to alter their official fiscal balance projections to 2004 in this light, lest this should confuse the public. They were confident that the fiscal outturns in the future would be stronger than projected, as in the past, and argued that reflecting this expectation in official projections or in recasting the fiscal balance projections into targets or ceilings would add little of substance while curtailing flexibility. On similar grounds, they were sceptical of the case to strengthen the accounting standards used in the official fiscal framework. Even though flows through the TCF should be included in the headline fiscal deficit outturn and historical data showing this would soon be regularly published. by the EU-commission on an ESA-95 basis, the authorities argued that the public would be confused by changes to the accounting standards used in the medium-term fiscal framework.
Staff welcomed the authorities' expectation that the fiscal balance would be stronger than projected between 2000 and 2004, given the need to rein in the external current account deficit and support the exchange rate peg. But staff noted that greater transparency in the fiscal framework-by revising the official projections and accounting standards in line with the authorities' actual expectations and intentions could help to anchor investor's expectations and help to co-ordinate efforts within the government to ensure that the authorities’ expectations were realised. Both of these benefits could be significant in the context of a de facto open capital account, a fixed exchange rate peg, and of a likely deterioration in external market conditions in 2001. Staff recommended that the authorities should undertake a self-assessment against the Code of Fiscal Transparency to highlight key areas where improvements could be made.
Malta is midway through a phased program of tariff reductions for non-agricultural products. Beginning in 1999, so-called "levies" on non-agricultural imports have been lowered in conformity with a three-year program: various levies were abolished in October 1999 and January 2000, and the remaining levies were lowered by 20 percent in January 2001, will be further lowered in January 2002, and abolished in January 2003. The schedule of adjustments was announced in advance so as to encourage adjustment in advance of the reductions and, on that basis, it was decided to leave the greatest reductions until 2003. The authorities confirmed that the program remained on track and that the reductions scheduled for 2002 and 2003 would be fully implemented at that time.