Deficit could be as high as 3.5% of GDP – EY

The autumn Ernst & Young Eurozone Forecast on Malta forecasts a 1% GDP growth in 2013, revised up from 0.5% in the June report, with ongoing growth in tourism - up by nearly 10% in January-June compared with the same period last year - contributing 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.

But the domestic economy remains weak and unless there is a very large turnaround in the second half of 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," EY's country managing partner Ronald Attard said.

The 2013 budget deficit will most likely be larger than planned by the government. "We estimate that it will reach 3.5% of GDP, compared with a 2.7% official target. This means that meeting the medium-term objective of a balanced budget will require additional tightening measures," Attrd said.

The EU's excessive deficit procedure requires by October, a programme to reduce the headline deficit to 3.4% of GDP this year and 2.7% in 2014, staying below 3% thereafter. There is little room for flexibility over the targets or timespan, because public debt (72% of GDP at end-2012) is above the 60% ceiling. This will require further plans for administrative savings and revenue enhancement aimed at meeting the EU targets.

"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."

Consumer spending will benefit from a sharp slowdown in inflation to 0.5% in June from 4% a year earlier, thanks to lower energy price inflation and expectations of cuts in the price of energy.

At 6.1% in June, on the International Labour Organization measure, the unemployment rate was close to pre-crisis record lows.

"We assume companies will take advantage of the recovery to recoup the productivity losses experienced during the 2008-09 recession," Attard said. "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% 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. ""Ongoing strong increases in deposits (up 7.6% year-on-year in June 2013) are a testament of the general trust in Malta's banking sector," Attard said.

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

With IMF data showing that around 40% of total loans extended to the residential real estate market and a further 30% 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% a year in 2014-17. 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.