Opening up an economy

Addressing last Friday’s Central Bank of Malta seminar on ‘World Economic Prospects and Financial Stability’, Finance Minister John Dalli asserts that Malta’s small size and outward orientation has made the Maltese economy one of the most open in the world, while highlighting several local macro and micro economic issues

To put the discussion in a local perspective, I propose to focus my remarks on some pertinent features of the Maltese economy. Malta’s small size and outward orientation have combined to make it one of the most open economies in the world. As we continue to remove barriers to international trade and the cross-border movement of factors of production, this remarkable degree of openness can be expected to grow even further. Openness has been a major factor behind Malta’s positive track record of sustained economic growth and considerable human development. However, it also means that our economy is vulnerable to international economic shocks. This fact of economic life was clearly brought home last year in the context of a hostile international environment.

But the performance of the domestic economy does not only depend on developments abroad. The Maltese Government is fully aware of this and is actively pursuing macroeconomic stability, which, together with structural reforms in the context of our policy of seeking membership of the European Union, is expected to provide a platform for sustainable economic growth and rising living standards. Our fiscal consolidation programme aims at reducing the budget deficit to around 3% of GDP by 2004, through a combination of improved revenue collection and curbs on expenditure growth. Meanwhile, monetary policy focuses on maintaining price stability through an exchange rate peg to a basket of currencies consisting of the euro, the dollar and sterling.

At the microeconomic level, economic activity has been stimulated in recent years by a phased reduction in barriers to international trade and capital flows, the promotion of competition in domestic markets and the withdrawal of the State from direct intervention in the economy, mainly through privatisation and the removal of administrative controls on prices. Nowhere has the reform process been more far-reaching than in the financial sector.

Over the past ten years, the Maltese authorities have completely removed controls on interest rates, eased restrictions on international capital movements and sold the State’s equity holdings in banks and other financial services firms. Maltese law governing the financial sector was thoroughly overhauled in the mid-1990s, when a package of legislation covering areas including banking, insurance and investment services was enacted. Company law was also reformed. This legal framework continues to be upgraded as Malta aligns all its legislation with European Union law as part of the accession process.

At the same time, Malta has been careful to ensure that the development of its financial sector has not taken place at the expense of its integrity and reputation. In fact, key parts of the legal package are designed at combating insider dealing and money laundering. More recently, Malta set up a Financial Intelligence and Analysis Unit to strengthen the authorities’ technical capabilities in the fight against international crime and terrorism, and is co-operating with the OECD to combat harmful tax competition. In this same context, a self-assessment exercise has been recently carried out on the level of adherence of the Maltese financial sector to international standards in preparation for undergoing a Financial Sector Assessment Programme (FSAP) as part of the next IMF Article IV consultations.

The establishment of the Malta Stock Exchange and the Malta Financial Services Centre in the 1990s allowed non-bank financial intermediaries and a capital market to develop in Malta. In response to this competitive challenge, the major domestic banks extended their operations beyond traditional banking business to cover a wider range of financial products. This year, in recognition of the increasing complexity of financial services firms, the Maltese Government has transferred the responsibility for regulating and supervising banks to the Malta Financial Services Centre. It is also our intention for the Centre to assume the regulatory responsibilities currently vested in the Malta Stock Exchange and thus become the sole regulator for the entire financial system.

The Central Bank of Malta will remain responsible for overall financial stability, however, and will retain the capability to act as lender of last resort if necessary. The lender of last resort function gives central banks a key role in resolving episodes of financial instability.

Financial liberalisation spurred the growth of the Maltese financial sector and attracted a range of firms that use Malta as a base from which to provide financial services internationally. It has increased the efficiency of the financial system in providing payments services and in channelling surplus funds towards their most productive uses. In these roles, the financial system has acted as a catalyst for broader economic development.

However, financial liberalisation, and especially capital account liberalisation, is a double-edged sword. By injecting a dose of competition in domestic financial markets, liberalisation promotes efficiency in the allocation of capital. However, greater competition may also lead to increased risk-taking as financial services firms strive to maximise profits. At the same time, while capital account liberalisation allows the domestic economy to benefit from access to international finance, it may also expose the economy to sudden capital movements. This is a particularly relevant consideration in the case of a small island economy such as ours.

Global financial market integration has indeed made it easier for financial crises to be transmitted swiftly across national borders. Although international investors may have become more sophisticated in their assessment of emerging markets, the possibility of contagion implies that the health of national financial systems can affect global economic prospects. The reverse may also be true, in that expectations of poor global economic performance may heighten awareness of risk, leading to a flight to quality among investors that may precipitate financial instability in emerging markets. Thus, financial liberalisation may trigger behaviour that that may ultimately lead to full-blown banking and currency crises. In turn, as recent experience in a number of countries has shown, episodes of severe financial instability can have a considerable negative impact on economic performance.

We are indeed honoured that Mr Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, has accepted to deliver the keynote speech to conclude the programme this afternoon. Mr Volcker promises to bring all the diverse strands of a rich discussion together by putting forward proposals to address economic, financial and exchange rate instability in the world today.

In conclusion, I would like once again to extend a warm welcome to Malta to our foreign guests. I thank the panelists for their contributions to what should prove to be a fruitful discussion and thank you all for your attention.