Boosting output 'the only remedy' for high oil prices

The only remedy in the long run to counteract the effects of higher oil prices is to expand productivity and output, and therefore incomes, according to Central Bank Governor Michael Bonello.

Noting that the rise in Malta's fuel bill is roughly equivalent to the reduction in the fiscal deficit achieved over the past seven years, Mr Bonello underlined the importance of avoiding cushioning the increase in oil prices through borrowing.

Speaking at the annual dinner of the Institute of Financial Services last night, Mr Bonello said that growth next year would have to come primarily from an acceleration in the pace of underlying economic activity.

Mr Bonello insisted on the need to return the economy to a path of faster and sustainable growth as the country's primary objective.

In the meantime, he said, the economy is facing three major challenges: Globalisation, the sharp increase in fuel prices and changes in Malta's demographic profile.

While he recognised the progress achieved through fiscal consolidation and a monetary strategy that delivered exchange rate stability, he stressed that much remains to be done in addressing structural problems at the microeconomic and sectoral levels.

He called for further efficiency gains in the services and public sectors, more flexibility in the product and labour markets, and more investment in people and in the country's scientific and technological base.

Speaking about the ageing population, Mr Bonello insisted on the importance of not delaying further pension reform. He warned that further postponement would result in the burden of supporting the growing number of dependents, and their healthcare needs.

The Governor quoted indicative growth rates necessary for the economy to deal with such challenges. To make up for the increased dependency ratio associated with the ageing population, for example, the economy would have to grow by around one per cent per annum over the next 20 years. At this rate of growth, however, there would be no improvement in living standards.

Next, lifting the activity rate by 10 percentage points to around 70 per cent over 20 years requires an average of three per cent growth each year.

Finally, convergence with the average EU per capita income in 20 years would need an estimated growth rate of some four per cent.

Stressing the need for decisive action that will deliver early results, Mr Bonello appealed to the social partners to cooperate in the pursuit of faster growth.

He suggested that the way forward is to strive to maintain the competitive advantage of the traditional sectors while promoting the development of new activities that exploit Malta's competitive advantages.

The Governor observed that fiscal consolidation in 2004 and 2005 had proceeded in line with the convergence programme targets and that the 2006 budget continues in this direction. He cautioned, however, that reaching the targeted deficit of less than three per cent of GDP depends on a rigorous implementation of all budgeted measures.

Referring to monetary policy, Mr Bonello noted that the financial markets have so far judged the level of interest rates as appropriate.

Inflation remains moderate while participation in ERM II is proceeding smoothly. The Central Bank, he said, had found no evidence of significant exchange rate misalignment, a finding that had not been contested by the relevant EU institutions.

Moreover, reductions in the value of the currency are typically followed by a rapid pass-through in the form of higher prices of imports and wages, as the 1992 experience showed. On the other hand, due to downward price rigidity, a strengthening of the Maltese lira is not likely to be followed by parallel reductions in prices and wages.

With regard to the commitment to maintain the peg to the euro, the governor observed that since ERM II entry in May there had been a steady market demand for the lira, and the external reserves had increased substantially. Had the bank opted for flexibility within a band, therefore, market forces would have exerted upward pressure on the exchange rate.

In the light of these considerations, the governor appealed for better-informed public pronouncements on this subject, recalling that negative perceptions towards the end of 2004 led the bank to raise interest rates. Mr Bonello stressed that defending the currency is a responsibility that the bank will not abdicate.

The governor noted that there was still an insufficient appreciation of the finite nature of available resources, so that lifetime employment continues to be taken for granted regardless of performance or need, while free and universal welfare services are expected irrespective of their sustainability and in spite of equity considerations.

Mr Bonello pointed out that the simultaneous achievement of economic growth and a high degree of social protection can only be achieved if there is greater flexibility in both product and labour markets and further investment in the technological base and in people.

The country, the Governor concluded, is facing an unprecedented challenge. Its vulnerability to external events is compounded by a large state apparatus that subsidises inefficient public corporations and offers its citizens notionally free services irrespective of income levels.

He called for an end to the ambivalent attitude towards reform: While the status quo is recognised as being unsustainable, it is also comfortable, and so there is a reluctance to bear the cost of change.

Observing that time was running out, he suggested that people should stop shifting the blame on others and instead work together to build on past achievements in order to secure the objective of greater material well-being and social cohesion which all profess to share.