Bomb site warning

There are two time bombs in the making. The first time bomb lies in the government's commitment, if the EU accepts that Malta is on track towards the convergence benchmarks, to adopt the euro in January 2008. Unless the transition to the eventual changeover and the early aftermath are tightly managed and monitored inflation will rise. Management preparations began with setting up a euro changeover committee.

The finance parliamentary secretary has now announced that there will be a precautionary transitional period during which both the euro and the Malta lira can be used in domestic transactions. A Euro Adoption Bill will be presented early in 2006. (The Times, November 19)

Committee, legislation and all, some will still attempt to mark euro-denominated prices up to confused consumers. If the inflation time bomb is not defused, the impact and embedded effect will impose fresh social burdens and maim the economy. That is why the banks must shore up the euro committee's smoothing work by making it clear they are applying the established central parity (one euro=Lm0.4293) to switches between the two currencies.

The second time bomb lies in the stance the Leader of the Opposition has taken over the issue. He insists that economic recovery must take place before the euro can be adopted. That statement requires elaboration. The Opposition leader wants Malta not to become part of the EU monetary union at this stage because the economy has hardly grown at all over the past five years, and growth in the foreseeable future is forecast under the EU's own low average, and far below the average four per cent per annum the island requires to start catching up with the Union. In what way might adopting the euro run against the economic recovery and growth objective? Theoretically because, with euro adoption, monetary policy will be transferred to the European Central Bank.

The Maltese authorities will no longer be able to lower interest rates or to devalue the Malta lira to try to influence economic activity. Dissect that reality and the time bomb inherent in the Opposition leader's stance starts ticking away.

At times of weak economic activity, compounded by rising costs, economic operators call on the monetary authorities to reduce interest rates.

Rates in the eurozone are below those in Malta. Were Malta to adopt the euro today, domestic interest rates would fall. The Opposition leader, therefore, cannot be warning against that. What he is targeting is the Malta lira central rate against euro.

The government hopes that on January 1, 2008 Malta will adopt the euro at the rate set when we joined the Exchange Rate Mechanism. Thereby the Lm was linked fully to the euro, instead of by 70 per cent as hitherto. Should adoption not take place on that date, Malta cannot adopt the euro by the time the general election is held.

In that scenario no one will need much financial advice to reason out the implications of the Opposition leader's view about the euro, in the context of implied failure to meet convergence targets. The conclusion will spread like wildfire that, if he wins the election, one of the first decisions the incoming Labour government will take will be whether to let the Malta lira fall from the central parity against the euro.

An effective devaluation would also lower the value of the Lm against other foreign currencies (beyond the way the euro moves any way, as it is doing at present against the US$).

In synthesis, the warning on the bomb site is this. Should it be clear that Malta will not adopt the euro in January 2008 the first time bomb (the threat of an inflationary push) will fizzle out. But the second time bomb will explode. There will be a rush to convert Malta liri into foreign currencies, and so a depletion of the official foreign exchange reserves.

The effects of the explosion will be felt by the new government. If that government is indeed a Labour one, as looks very likely, that part of its thorny inheritance would be political dramatic irony like no one has ever scripted.