Ratings agency applauds attempts to curb deficit

International rating agency Fitch has hailed the government's attempts to get a grip on the budget even if it underlined that the prospect of an eventual rating upgrade could still be remote.

With continued resolve, the government should be able to cut its deficit to less than three per cent of the gross domestic product in 2006 and privatisation revenue should help initiate a decline in the government to debt ratio, according to the rating agency. Inflation was also running low so Malta has a "good chance" of meeting the Maastricht criteria in time to adopt the euro in January 2008.

Fitch affirmed Malta's long-term foreign currency rating at A with a positive outlook. The long-term local currency rating has been affirmed at AA minus with a stable outlook.

Malta's foreign currency rating has had a positive outlook since November 2003 in the expectation that the country will join the euro area at the start of 2008. Fitch said the government looks on course to achieve this objective, having made successful efforts to curb its previously large deficit.

But the performance of the economy has continued to be disappointing. Real GDP last year was still a little smaller than in 2000 and the current annual growth rate is only about one per cent.

"There are signs that resources are starting to shift into more efficient industries and business services and activity could now start to pick up. But if this fails to happen and growth remains slow, it would be difficult for the government to reverse the climb in its debt-to-GDP ratio seen in recent years and the prospect of an eventual rating upgrade would become more remote," Fitch's chief economist, Lionel Price said.

Malta joined ERMII at the beginning of May and pegs the lira to the euro with no margins. Fitch said that in view of the country's long history of a pegged exchange rate, it should have no difficulty meeting the exchange rate and interest rate criteria for adopting the euro and inflation is close to the rate likely to be needed to satisfy the Maastricht criterion.

The fiscal criteria have presented a greater challenge and the large budget deficit and government debt remain constraints bearing down on the credit rating.

Fitch said that since 2003, the government has got a better control of its finances. In 2004, the fiscal deficit was cut to 5.2 per cent and this year the deficit should be within striking distance of the government's convergence programme aim of 3.7 per cent of GDP.

In Fitch's view, it is realistic to expect next year's deficit to be within the Maastricht three per cent limit. However, with anaemic nominal GDP growth, this would not be sufficient to cut the ratio of government debt to GDP from the 76 per cent to which it had climbed by the end of last year. To cut its debt ratio this year and next, the government will need to use the revenues from its planned privatisations.

The other main constraint on a rating upgrade is Malta's lack of growth since 2000. The sudden ending of the five per cent annual growth of the previous decade appeared at the time to owe much to weak global demand in two of the country's key industries: tourism and micro-electronics.

However, cost factors also played a role. Public sector pay increased sharply in 2000 and this spread into the private sector, partly through market forces but also through the cost-of-living adjustment that applies to nearly all workers.

Malta's rating strengths include a long history of low inflation and exchange rate stability and a large net external creditor position. Malta's banking system, one of the largest in the world in terms of GDP, is well managed and supervised and poses limited contingent risk to the sovereign, the ratings agency said.

Fixed investment has strengthened but consumption is scarcely rising and exports, notably of electronics, dipped sharply at the start of the year. Tourism is slowly recovering but numbers are still below their 2000 peak. Malta has regained some of the cost competitiveness it lost at the turn of the decade vis-à-vis other EU countries. However, when measured against a wider group of countries. that also includes the US and other major economies, the real exchange rate suggests Malta has continued to lose ground.

"The incentive to the government to put its fiscal house in order has clearly been beneficial. Now the key question is whether the smaller deficits will be maintained as the next election approaches in 2008 - and indeed thereafter," the agency said.