The Central Bank of Malta has just released its Annual Report for 2011. The Report carries a review of the Bank’s policies and operations during that year together with detailed financial statements. It commences with an introductory statement by the Governor, Josef Bonnici, which is then followed by an analysis of economic and financial developments in Malta and abroad.

In his statement, the Governor assesses the recent performance of the Maltese economy in 2011 against the background of a global economic recovery that remained weak throughout the year. He notes that economic activity in most major industrial and emerging economies grew at a slower pace than in 2010 and some even registered a contraction.

“Thus, following a fairly strong start to the year, economic activity in the euro area moderated. The euro area economy grew by 1.4% in 2011, down from 1.9% a year earlier. The intensification of the sovereign debt crisis, tightening financial conditions and fiscal consolidation measures all had a dampening impact on demand. As a result, unemployment in the euro area increased over the year. Meanwhile, inflation followed an upward trend for most of the year, before decelerating to 2.7% in December.”

“In the light of positive underlying momentum in economic activity at the beginning of the year and stronger upside risks to price stability, the Governing Council of the European Central Bank (ECB) raised key interest rates in April and July. Thus, the rate on the main refinancing operations was increased to 1.50%. Nonetheless, the economic environment remained highly uncertain. Over the summer, tensions in debts markets intensified further in various euro area countries. The subsequent deterioration in the economic outlook led the ECB to bring the rate on the main refinancing operations back down to 1.00% by the end of 2011.”

“Throughout the year, the Eurosystem implemented a range of measures to provide liquidity to the financial system. In the last quarter of the year, the Council took additional measures, including the introduction of three-year long-term refinancing operations and a reduction of minimum reserve requirements.”

In his statement the Governor also observes that EU governments took a number of initiatives to address the debt crisis, including fiscal consolidation and structural reforms. Tighter rules for the surveillance of economic imbalances were introduced and financial support continued to be available for stressed countries.

Turning to the domestic scene, the Governor notes that the Maltese economy continued to expand during 2011. At 2.1%, real GDP growth was slightly below the 2.3% registered in 2010. Employment growth maintained a steady pace while annual HICP inflation moderated over the course of the year, dropping to 1.3% by December.

“This positive economic performance attests to the resilience that the Maltese economy has built over the years through a gradual process of structural reforms that began before EU accession. These contributed to a process of economic diversification towards new areas of activity largely backed by foreign direct investment, as reflected in a significant increase in the share of services exports in GDP.”

“The manufacturing sector has also expanded into new areas of activity, although its share in GDP had continued to decline. To a large extent, the narrowing of the current account imbalance in recent years was attributed to the growth of the new export-oriented sectors. The deficit continued to decline in the first three quarters of 2011 and was lower than in the corresponding period of 2010.”

The Governor emphasised that the financial sector had also contributed to the economy’s resilience. The Maltese financial system emerged from the international financial crisis relatively unscathed with generally robust performance, especially with regard to the systemically important banks. Capital and liquidity ratios remained well above the regulatory minima. The health of the domestic banking system was also reflected in its uninterrupted ability to respond to the demand for credit by extending loans to the private sector.

On fiscal developments, the Governor notes that the general government deficit for 2011 is expected to be lower than in 2010 at 2.7% of GDP.

The Governor’s statement then focuses on the economic outlook, which for the current year is rather subdued given the expected weakness in key foreign markets. The latest ECB projections suggest that the euro area economy is expected to contract slightly in 2012, before recovering in the following year. This is expected to have negative repercussions for the Maltese economy. According to the Bank’s latest projections, which are presented in the Annual Report, real GDP is forecast to grow by 1.6% in 2012, before picking up slightly to 2.0% in 2013. Inflation is expected to ease in both years.

The Governor highlights the need for further structural reforms that will enable the economy to exploit the opportunities that will arise as the recovery gathers momentum and external conditions improve. These include measures that raise labour force participation.

He stresses the importance of wage increases being supported by productivity gains. To this end, consideration should be given to measures that would permit greater flexibility in the application of the COLA mechanism.

The Governor notes that the sustainability of wage increases must also be fully recognised in the debate surrounding the recent proposal to raise the minimum wage. Wages provide compensation for work carried out. To be sustainable, they must be linked to the value of the work carried out and hence to the productivity of the person involved. This aspect in the debate needs to be fully taken into account, through a careful assessment of the wider impact on the economy.

Upward pressure on unit labour costs is likely to lead to a loss in competitiveness and a fall in growth potential and consequently higher unemployment, especially among the low skilled income earners. The key to higher living standards lies in the provision of further skill-enhancing programmes and sustained and better targeted investment at all levels of education.

Other possible reforms include measures to improve competition in the domestically-oriented sectors of the economy, and where this is not feasible, to strive to achieve efficiency gains.

As regards public finances, the Governor welcomes the recently announced measures to curtail growth in current expenditure and the strengthening of domestic fiscal rules. The long-term sustainability of public finances, however, also requires solutions to the more permanent challenges of prioritising expenditure programmes and ensuring that all items of recurrent expenditure are funded in a sustainable manner.

Focusing on the financial sector, the Governor urges the banks to continue to strengthen their capital buffers in order to mitigate risks associated with non-performing loans, the concentration of property-related lending as well as the use of property as collateral. He also encourages the banking sector to adopt more prudent policies, including as regards dividends and loan-loss provisioning.

The Governor finally stresses that the local economy remains highly open and exposed to external developments. At the same time, he notes that the sovereign debt crisis has prompted structural reforms in a number of competitor countries, which should therefore result in more intense competitive pressures. He warns that unless matched by similar efforts locally, the resilience of the Maltese economy could be gradually eroded.

In reviewing the Bank’s operations during 2011, the Governor highlights the Bank’s responsibilities in relation to the formulation and implementation of monetary policy in the euro area. In this context, he recalls that the Bank conducted market operations with eligible counterparties in Malta worth an aggregate of EUR20.5 billion.

The Bank also continued to monitor the domestic financial system to assess potential risks to which the system could be exposed. In this regard, it maintained close contacts with the Malta Financial Services Authority (MFSA) and with the Ministry of Finance, the Economy and Investment. The Bank also participated in the work of the European Systemic Risk Board and, with the MFSA, played a key role in a stress test on a Maltese credit institution as part of an EU-wide exercise.

The Bank also continued to regulate and oversee the payment and securities settlement system, to provide banking services to the public sector and to issue euro banknotes and coins to satisfy public demand.

The Bank’s operating profit for 2011 amounted to EUR52.5 million, as against EUR57.6 million in 2010.

The Annual Report 2011 is available on the Central Bank of Malta’s website at http://www.centralbankmalta.org.

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