The autumn EY Eurozone Forecast (EEF) on Malta forecasts a one per cent GDP growth in 2013, revised up from 0.5 per cent in the June report.

Ongoing strong growth in the tourism sector, with the number of visitors up by nearly 10 per cent in January-June compared with the same period last year, has contributed significantly to the brighter short-term outlook.

The rise in the average length of stay is also an encouraging sign for the profitability of the sector.

The domestic economy remains weak, however.

In particular, unless there is a very large turnaround in H2 2013, consumer spending and business investment will fall this year. Concerns about the eurozone’s prospects have probably affected households’ and businesses’ willingness to spend.

In this context, it is positive that the eurozone now seems much more resilient than in the past couple of years.

Economic activity and especially consumer spending, will also benefit from the fall in inflation in 2013.

Inflation slowed to 0.5 per cent in June from four per cent a year earlier. This was a much sharper fall than we expected.

Lower energy price inflation has contributed to this but inflation has also come down swiftly for non-energy goods and services sector.

A promise to reduce electricity prices and build a new gas power station that is operational by March 2015 was prominent in the new Government’s election campaign. The tendering process of the new power station has already been launched.

Conversion of domestic generation to gas will also help to meet EU emissions reduction targets and could allow a lasting reduction in the import bill – enhancing the current account surplus – if shale gas expansion continues to hold down European gas prices.

Together with a new inter­connector to southern Italy and power station construction, the renewal of generation should deliver a significant real reduction in industrial and domestic energy costs over the forecast period.

Overall, although we expect inflation to rise to 1.3 per cent next year, nominal wages should increase faster.

With higher purchasing power and improved confidence about the general economic environ­ment, consumption is forecast to bounce back.

Households’ ability and willingness to spend will also be supported by favorable labour market conditions.

At 6.1 per cent in June (on the International Labour Organi­sation measure), the unem­ployment rate was close to pre-crisis record lows.

As the economy strengthens, demand for labour should remain robust. According to the Euro­pean Commission (EC) survey, employment expectations are particularly well-oriented in the services sector.

The EY Malta forecast assumes that companies will take advantage of the recovery to recoup the productivity losses experienced during the 2008-09 recession. As a result, employ­ment will rise more slowly than output. Nonetheless, moderate growth in employment will be enough to lower the jobless rate to 5.5 per cent in 2017, one of the lowest in the eurozone.

One source of downside risk to the forecast relates to the banking sector.

The sector is generally sound and has managed to dispel doubts that it could be engulfed in a similar crisis to the one that hit Cyprus’s banks.

Ronald Attard, EY Country Managing Partner for Malta commented: “Ongoing strong increases in deposits (up 7.6 per cent year-on-year in June 2013) are a testament of the general trust in Malta’s banking sector.”

With IMF data showing that around 40 per cent of total loans were extended to the residential real estate market and a further 30 per cent to the commercial real estate market, the domestic banking sector is exposed to a downturn in the construction and housing market

And while large parts of the sector consist of foreign banks dealing with foreign residents and therefore pose no risk to the economy, NPLs for domestic banks are relatively high, at 8.5 per cent of total loans in Q1 2013 according to the International Monetary Fund (IMF) and pro­visions low at 22 per cent of NPLs.

With IMF data showing that around 40 per cent of total loans were extended to the residential real estate market and a further 30 per cent to the commercial real estate market, the domestic banking sector is exposed to a downturn in the construction and housing market.

While a slump in property prices is unlikely, banks’ balance sheets and lending capability could be undermined by further increases in NPLs and losses on these loans. More active provisioning of NPLs would help mitigate the risk of unforeseen losses in the next few years.

Malta should continue to outperform the eurozone over the next five years, although growth will remain relatively low by historical standards. We forecast GDP will grow by 1.6 per cent a year in 2014-2017.

Chris Meilak, economist at EY Malta, com­mented: “Significant constraints on GDP growth in the medium term arise from the ageing population, comparatively high external transport costs, which restrict manufacturing export growth to high value-added products, and fiscal consolidation.”

One key uncertainty for the medium-term outlook relates to ongoing changes in the tax and regulatory environment at the European level, to which Malta will need to adjust.

Parts of the financial sector and Malta’s gaming industry, for instance, may have to adapt to new regulation.

Investment in education and infrastructure is essential to gain the flexibility that is necessary to respond to change. With govern­ment spending in education at around 5.5 per cent of GDP, Malta is in line with the EU average. But that investment seems to have been less efficient than elsewhere given the relatively high rate of school leavers.

A highly educated workforce is better able to retrain or transfer across sectors should prospects in one of the key sectors currently supporting Malta’s economy be dampened by new regulation.

Finding resources to invest in education will be challenging in the context of ongoing fiscal consolidation.

The 2013 budget deficit will most likely be larger than planned by the Government.

We estimate that it will reach 3.5 per cent of GDP, compared with a 2.7 per cent official target.

This means that meeting the medium-term objective of a balanced budget will require additional tightening measures.

With the EC having reopened the “excessive deficit” procedure (EDP), there will be pressure to implement such measures.

The EDP requires, by October, a program to reduce the headline deficit to 3.4 per cent of GDP this year and 2.7 per cent in 2014, staying below three per cent thereafter. There is little room for flexibility over the targets or timespan, because public debt (72 per cent of GDP at end-2012) is above the 60 per cent ceiling.

This will require further plans for administrative savings and revenue enhancement aimed at meeting the EU targets.

However, the experience of other countries shows that it would be counter-productive to try to achieve such deficit targets at all costs.

Moreover, it is essential that fiscal consolidation happens in a way that is least damaging to growth in the medium term.

In particular, investment in infrastructure and education should be preserved, or indeed increased, in order to maintain the economy’s competitiveness.

Savings can be found on current expenditure.

In particular, Malta has one of the highest public sector wage bills in the EU.

Overall, Malta is set to continue to outperform the eurozone, although growth will be relatively low by historical standards.

Over the medium term, Malta’s challenge will be to gain flexibility to adjust to a changing regulatory and tax environment.

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