SPEECH BY THE PRIME
MINISTER, THE HON LAWRENCE GONZI, AT CHATHAM HOUSE, LONDON, ENTITLED
“THE CHALLENGES OF CONVERGENCE”. – FRIDAY 2 JUNE 2006
Since it gained
independence in 1964, Malta’s economic development strategy has been
driven by the need to compensate for the country’s lack of natural
resources and its small size. The chosen path of diversification into
manufacturing and services, particularly tourism and, more recently,
financial services, has consequently had to depend heavily on inflows of
foreign direct investment and on securing access to larger overseas
markets. Economic openness and small size also entail exposure to
external shocks, a characteristic shared by other small economies.
In different parts of
the world, regional integration has proved a successful strategy as a
means of building up resilience to such shocks, while at the same time
providing exporters with new markets. This has been my country’s
experience too. For while Malta’s close economic ties to Europe owe
much to geography and history, they are to a large extent also the
product of a conscious policy that recognises the importance of closer
integration with major trading partners. In more recent times, this
awareness has manifested itself in the country’s decision to seek
participation in the European single market. This objective was
achieved in May 2004 when Malta became a member of the European Union (EU)
together with nine other countries.
Two years later it is
possible to begin to assess the impact of the wide-ranging changes and
reforms that membership has entailed, and also to evaluate the role that
the Economic and Monetary Union (EMU) plays in the process of economic
integration.
Malta’s economy is
today highly diversified. Until recently, export-oriented industries
coexisted with import-substituting, and mostly labour-intensive
enterprises, that sold their product in the protected domestic market.
Faced with foreign competition in the aftermath of EU accession,
domestically-oriented manufacturing and agricultural enterprises were
among the first to make the necessary adjustments to survive in the new,
liberalised environment. The impact was also felt in the public sector,
where the privatisation of a number of state-owned enterprises has
attracted considerable foreign direct investment. This adjustment was
made with no real disruptions in the economy, with the level of
unemployment remaining comparatively low.
The export-oriented
sectors of the Maltese economy have also adapted to the new realities in
an external environment that has not been particularly favourable.
Exporters of manufactured products have been facing intensified market
competition, particularly from Asia. There have lately been signs of a
rebound in the electronics sector, which is an important source of
employment and foreign exchange earnings, while rapid expansion in the
pharmaceuticals sector is filling the void left by the shrinkage in
labour-intensive export activities such as clothing and textiles. While
the tourist industry appears to be recovering slowly from the post-9/11
slowdown, other service activities, including financial services, are
growing steadily and have emerged as an important source of employment
creation.
As agreed during the
European Council held in December of 2005, Malta will be allocated a
total of €805 million under the EU’s Cohesion Policy for the period
2007-2013. These funds will be used to finance major capital projects,
mainly in the areas of transportation and environment. These projects
would have not been possible for the foreseeable future were it not for
EU funding which has also helped to soften the macroeconomic impact of a
less than benign international economic environment, characterised since
last year by sharply rising oil prices.
With Malta’s process of
deeper integration with the EU well under way, our next objective is to
join the European single currency area. Monetary union is a logical
complement to economic union. While the adoption of the Euro is an
obligatory next step for the new Member States, an expeditious entry is
doubly important for small and open economies like ours. It is hardly
surprising that the other new Member States are similarly eager to
secure, as soon as possible, the protection and benefits afforded by the
world’s second most important currency.
Upon adoption of the
Euro we expect to reap gains from the elimination of exchange rate risk
and reduced transaction costs across most of our external transactions.
If the experience of Austria – another small and open economy – is
anything to go by, such cost savings could amount to as much as 0.8% of
GDP annually. Indeed, given that Malta’s combined imports and exports
are almost twice as large as its GDP, the cost savings could be even
greater. In the product and resource markets, monetary union is also
likely to generate greater price transparency and increased competition.
Furthermore, the experience of other countries points to the prospect
of substantial output growth arising from increased external trade. It
is estimated that the additional annual GDP growth resulting from
participation in the Euro area could range between one and two per cent
over the next twenty years in the new Member States. As importantly,
the policy discipline that is synonymous with membership of a monetary
union will reduce the risk premium on interest rates, to the benefit of
both corporate and personal borrowers.
These benefits, of
course, do not accrue automatically. They are premised on a country’s
ability to make progress in achieving nominal and real convergence. In
this regard, Malta’s EU membership and the prospect of Euro adoption
already serve as catalysts for a series of reforms designed to raise
productivity and enhance the country’s attractiveness as a location for
foreign direct investment.
Malta’s candidacy for membership of the Euro area is based on the
grounds that it satisfies to a significant extent the conditions which a
country aspiring to join a single currency area must fulfil. The
Maltese economy is already closely integrated with its major trading
partner. It also has close similarities with the Euro area in the
sectoral composition of employment and GDP and in financial sector
integration. This would suggest a low probability of shocks that would
affect only Malta, that is shocks that could be more effectively
addressed by a separate monetary policy. A similar conclusion is
reached from a comparison of the degree of business cycle
synchronisation in the Maltese and Euro area economies. The case for
joining a monetary union is further supported by the degree of nominal
wage and price flexibility in Malta. Such flexibility, too, reduces the
likelihood that the European Central Bank’s (ECB) monetary policy would
not be appropriate for Malta.
Economic theory
suggests, and the experience of other countries has shown that, given
these characteristics, Malta should derive substantial gains by becoming
a full member of the European Monetary Union. The loss of monetary
policy autonomy that such membership entails should not prove costly
either. Indeed, by operating a fixed exchange rate regime in the
context of a liberalised capital account and in practice, therefore, we
would be exchanging an already limited degree of autonomy for the
greater credibility of the European Central Banks’s monetary policy.
For
a country to be able to live with a common monetary policy without undue
strains, its economy should have also achieved a high degree of nominal
convergence with that of the EU. We believe that Malta is well on the
way to satisfying this requirement. It is currently implementing a
Convergence Programme whose underlying rationale is precisely the
attainment of the so-called Maastricht criteria for membership of the
EMU.
One
of these criteria relates to exchange rate stability and entails the
participation of a country’s currency in the EU’s exchange rate
mechanism, known as ERM II, for two years without devaluing against the
Euro. The Maltese lira entered ERM II in May 2005, after three
decades on a fixed peg to a trade-weighted currency basket. Where we
differed from some of the other countries that have entered ERM II was
in eschewing the flexibility allowed by the mechanism’s 15% fluctuation
band. Thus while, like the other participants in the mechanism, the
Maltese lira was fully pegged to the Euro on joining ERM II, it entered
with a commitment on the part of our Central Bank to keep the rate
constant for the duration of ERM II. We recognise that the choice of a
fixed peg represents a major challenge. The decision, however, was
taken against the background of a three-decade long experience with a
fixed exchange rate regime, and the currency and price stability that
the economy has enjoyed as a result of this arrangement.
The decision to join
ERM II on the terms I have just described seems to have reassured the
financial markets about our resolve concerning the future of our
economy. Indeed, the period that immediately followed Malta’s entry to
ERM II saw sustained capital inflows. More recently, a decline in the
net foreign assets of the Central Bank, reflecting a combination of
cyclical and structural factors, has been followed by the Bank’s
decision to raise its key short-term interest rate; the first change in
the monetary policy stance since entry in ERM II.
Apart from exchange
rate stability, the nominal convergence criteria that have to be met as
a condition for adopting the Euro relate to fiscal discipline, inflation
and long-term interest rates.
Until recently, the
fiscal criteria, which specify maximum deficit-GDP and debt-GDP ratios,
represented a major challenge for my Government. Our determined efforts
to correct the existing imbalances, however, have begun to show results,
and the fiscal turnaround in the last three years has been quite
remarkable. The budget deficit has been reduced significantly during
this time, so that its ratio to GDP is scheduled to decline to below the
3 per cent benchmark this year from 10.2 per cent in 2003. The debt
ratio has meanwhile started to reflect the declining deficit trend, and
should also this year fall to around 71 per cent, a change of no less
than six percentage points since 2004.
The inflation criterion
is likely to prove more difficult to satisfy in the light of
unfavourable external developments. The criterion compares the national
inflation rate with the three lowest inflation rates in the EU. At
present, however, the rising price of oil is affecting Member States
differently, depending on their reliance on imports of fossil fuels and
on the availability of alternative energy sources. The three countries
with the lowest inflation rates at present, Sweden, Finland and Poland,
have a relatively low dependence in this respect compared to countries
like Malta. Although the second-round or ripple effects of higher oil
prices have not been substantial so far, world fuel and energy price
increases may, therefore, present a challenge for Malta’s convergence.
Our total dependence on oil imports is accentuated by the lack of
alternative energy sources, and by the major use of electricity for the
purpose of transforming sea water into drinking water.
Another challenge we
face is the current account deficit. While such deficits are typical of
open, developing economies, the imbalance in Malta’s case was
accentuated last year by the large increase in the import bill due to
the sharp rise in oil prices. The reforms related to EU accession have
also contributed to the deficit. For example, following the removal of
the remaining trade barriers upon accession, a marked shift was
experienced in consumption patterns towards imported goods.
Additionally, while the injection of foreign expertise and capital has
contributed to productivity growth, it has also been followed in the
course of time by an increased outflow of dividend payments to foreign
shareholders. The current account has also been burdened of late by the
implementation of a number of public sector capital projects, largely
financed by EU funds, which contain a substantial import content.
Staying on course is a
priority objective. According to our timetable, following a request for
a convergence assessment in early 2007, a positive response from the
European Commission and the European Council towards the middle of the
year would allow Malta to adopt the Euro in January 2008.
There have been calls from some quarters in Malta for delaying Euro
adoption until the economy is growing at a faster rate. These calls are
inspired by the prospect of relaxing the fiscal consolidation timetable.
Apart from sending the wrong signals to foreign investors, calls for
such a policy reversal ignore a fundamental truth: in an open economy
like Malta’s, not only does higher public expenditure not give rise to a
permanent boost to growth, but a large part of the stimulus will
extinguish itself through import leakages. It is no coincidence that
fiscal imbalances tend, in our experience, to be mirrored by imbalances
in external trade. We are, therefore, of the view that in the long run
the price to pay for fiscal laxity and for the failure to correct
structural imbalances by far exceeds any possible gains for the economy.
Slippage in the Euro
adoption timetable must, therefore, be avoided. Apart from postponing
the benefits of participation in monetary union, deferment of Euro
adoption would prolong the exposure of the Maltese lira to potentially
destabilising capital flows. The Euro is precisely the anchor that will
provide a small economy like Malta’s with protection from external
shocks. The European Central Bank’s policies succeeded in lowering
inflation in the Euro area and, equally important, in anchoring
inflation expectations at levels consistent with its definition of price
stability, that is lower than, but close to two per cent. Low and
stable inflation is essential for sustained growth in economic activity
and employment. Moreover, whereas in the past low inflation was
synonymous with high interest rates, this is no longer the case.
Because of the European Central Bank’s track record and its
credibility, borrowing costs have fallen sharply in the Euro area.
In conclusion, we have
embarked on a mission whose outcome we firmly believe will be of benefit
to our citizens. The coming months, however, will be a time during
which our resolve will be put to the test. It will require the courage
to place the long-term interests of our economy above considerations of
expediency. I am sure that an electorate which deliberated the case for
EU membership with such rigour, will be equally judicious in evaluating
the merits of the single currency and appreciating its likely future
benefits.
