The Central Bank of Malta Annual Report 2008, released today, includes an analysis of economic and financial developments in Malta and abroad, a review of the Bank’s policies and operations and the financial statements of the Bank for 2008. The Report also carries an introductory statement by the Governor in which he assesses the recent performance of the Maltese economy in the broader context of the global financial crisis.

Governor’s Statement

The Governor first refers to the adoption of the euro, which he describes as a major milestone in Malta’s economic integration with the European Union and a turning point in the history of the Central Bank of Malta. He notes that the country’s first year as a member of the euro area coincided with a global financial crisis of unprecedented proportions. This crisis spread rapidly, particularly in the last quarter of the year after the collapse of a major American financial institution, and subsequently major economies were pushed into recession as private consumption and investment contracted and world trade declined sharply. Central banks and governments tried to contain the systemic risk posed by these developments, but at the turn of the year the situation remained tense and volatile.

Against this background the Governor highlights the fact that membership of the euro area has meant that the economy has not been exposed to the risks inherent in managing a small, vulnerable currency, such as the Maltese lira, at a time of severe financial market turbulence. The Governor further points out that the danger posed by the global financial crisis for the Maltese economy was also mitigated by the existence of a sound financial system. He cautions, however, that risks to the banking system are likely to develop, emanating from an expected weaker performance of key economic sectors, particularly the property market and those which are highly dependent on foreign demand such as tourism and manufacturing.

The Governor then notes that while the sharp deceleration in international economic activity was accompanied by a reversal in global inflation trends, price movements in Malta did not fully mirror this pattern. This was due to the delayed pass-through of higher international energy costs to consumer charges and also because food prices failed to decline in response to trends abroad. This, the Governor states, is a source of concern as it could reflect market imperfections.

Meanwhile, as the threat of inflation receded, central banks worldwide adopted an easier monetary policy stance. The ECB lowered the interest rate on its main refinancing operations on several occasions. These rate reductions were largely passed on to bank borrowers in Malta, implying a considerable easing of domestic monetary conditions.

The Governor then recalls that several EU governments have announced large financial packages designed to bolster ailing financial institutions and to stimulate consumption and investment, but adds that room for similar manoeuvres in Malta is limited by the relatively high budget deficit and debt levels. Subject to this caveat, an increased stimulus in the form of lower taxation or higher social benefits is not as cost effective as a rise in public investment expenditure. The only instance where a case could be made for higher discretionary public outlays, the Governor concludes, is in those sectors, such as manufacturing and tourism, which are being negatively impacted by the sharp contraction in foreign demand. Any measures should, however, be targeted and be of a temporary nature.

The Governor goes on to stress that sustainable economic expansion can only be based on a greater role of exports, thus allowing the economy to benefit from scale economies and keeping the current account deficit to reasonable proportions. This requires a process of continuous investment, particularly FDI in view of the associated technology transfer and access to markets.

The Governor concludes his statement by emphasising that it is essential that economic operators prepare themselves with the products of tomorrow and at prices that the market will bear, so that when the economic recovery arrives they will be in a stronger position to compete in overseas markets. The current period of economic dislocation, therefore, may well be the right time to re-examine certain features of the domestic market with a view to removing remaining rigidities and increasing competition, as well as the working of certain labour market institutions and cost structures generally. An investment strategy more focused on products and markets where demand promises to grow faster in the years ahead should also prove beneficial.

Economic and financial developments

In its review of global and domestic economic developments in 2008 the Report notes that activity in the major industrialised countries slowed down significantly, as the negative impact of the financial crisis spilled over rapidly onto the real economy. The main emerging market economies initially remained relatively buoyant, but later also experienced a deceleration in economic growth, underscoring the strength of global interdependence. Inflationary pressures remained elevated in the first half of the year, but then eased thereafter in response to lower commodity prices and falling global demand.

Malta’s trade-dependent economy was not spared. The Report observes that the pace of economic activity moderated as the year progressed, as both investment and exports contracted substantially. As a result, the annual growth rate fell to 1.6% in 2008 from 3.6% in 2007, as growth turned negative in the final quarter. Employment continued to rise in the first three quarters of the year, but in last quarter labour market conditions, too, started to weaken. Thus, after falling to a low of 5.9%, according to the Labour Force Survey, there were general indications of a rising trend in unemployment in the final quarter.

As noted in the Governor’s statement, inflation trends in Malta did not mirror those abroad as the economy slowed down. The annual average rate of HICP inflation, in fact, rose to 4.7% in 2008, well above the rate of 0.7% recorded in 2007. The sharp increase was mainly attributable to the food and energy components of the overall index.

Reflecting a weaker export sector, the current account deficit of the balance of payments rose to 6.5% of GDP in the twelve-month period to September 2008. At the same time net inflows on the capital and financial account fell by nearly two percentage points to 4.7%. This was mainly attributable to developments on the capital account, which posted a smaller surplus, as official transfers declined. At the same time, net inflows on the financial account also fell.

Turning to fiscal developments the Report notes that on the basis of official estimates the general government deficit was expected to rise to 3.3% of GDP in 2008 from 1.8% in 2007, mainly because of one-off expenditure items related to early retirement schemes for shipyard workers and increased subsidies to the energy utility. As a result, government debt is estimated to have edged up to 63% of GDP.

The Report then comments on monetary developments and notes that, following euro adoption, it was no longer possible to compile data for broad money (M3) for Malta alone. This notwithstanding, it was observed that during 2008 growth in residents’ deposits slowed down considerably while credit to residents accelerated further. Reflecting developments abroad, yields on Treasury bills and Malta Government Stocks fell, as did equity prices.

In line with past practice, the Annual Report carries the Bank’s projections for GDP growth. Reflecting the current economic downturn, the Bank expects GDP growth in 2009 to range between 0.5% and 1.1%, driven by domestic demand, and then to recover to between 1.0% and 1.6% in 2010. The Report points out that the degree of uncertainty surrounding the projections is exceptionally high and that risks to GDP growth are expected to be on the downside. HICP inflation is forecast to ease significantly during 2009, largely reflecting the base effect of past increases in commodity prices, but also lower locally-generated inflation. In 2010 inflation is projected to be slightly higher, mainly as a result of an expected rebound in commodity prices.

The Bank’s operations and activities

This section of the Report reflects the marked impact that the adoption of the euro had on the Bank as an institution, and on its policies and operations. The Bank now forms an integral part of the Eurosystem and is represented on the ECB’s Governing Council. Bank officials also contribute to the Eurosystem through their participation in the work of the various committees and working groups.

As the institution responsible for the implementation in Malta of the Governing Council’s monetary policy decisions, the Bank regularly conducted open market operations during 2008, in which domestic banks participated actively.

The Bank also enhanced the smooth functioning of local payment systems through links with TARGET2, the payment system used by the Eurosystem. At the beginning of the year, the Bank was involved in the preparations leading to the launch of the Single Euro Payments Area (SEPA). The use of SEPA payments in Malta is spreading rapidly with the cooperation of the banks and the public sector.

The Bank was also responsible for the withdrawal and disposal of Maltese lira banknotes and coins and for ensuring that the supply of euro banknotes and coins met the needs of the public. The euro changeover proceeded smoothly, supported by an intensive communications campaign. By the end of the year, euro banknotes and coins for a total of more than EUR 715 million had been issued, while MTL 38.8 million worth of banknotes and coins were still outstanding.

In January the Bank transferred a portion of its US dollar and gold reserves to the ECB in line with Eurosystem requirements. Moreover, together with the Central Bank and Financial Services Authority of Ireland, the Bank took responsibility for managing a part of the ECB’s reserves.

The Bank’s statutory responsibility for financial stability was actively pursued through continuous monitoring of the domestic financial system. It also maintained regular contact with the Malta Financial Services Authority and the Ministry of Finance, the Economy and Investment, particularly in the second half of the year as the global financial crisis intensified.

In 2008 the Bank’s operating profit amounted to EUR 48.6 million, as against EUR 28.7 million in 2007.

The Annual Report 2008 is available on the Central Bank of Malta’s website at http://www.centralbankmalta.org.

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