Malta 'A-/A-2' Ratings Affirmed; Outlook Remains Positive

  • We expect Malta's economic growth will average about 4% in 2019-2022, while general government debt to GDP will decline.
  • As a small and open economy with a financial sector several times GDP, Malta is more vulnerable to financial market volatility as well as other idiosyncratic external shocks (including Brexit) compared to peers.
  • We are affirming our 'A-/A-2' long- and short-term ratings on Malta.
  • The outlook remains positive.
RATING ACTION
On March 15, 2019, S&P Global Ratings affirmed its 'A-/A-2' long- and 
short-term sovereign credit ratings on Malta. The outlook remains positive.


OUTLOOK
The positive outlook indicates that we could raise the ratings on Malta over 
the next six months if:
  • Economic growth and the government's fiscal and debt metrics perform in line with our expectations; and
  • The authorities strengthen supervisory standards with respect to the country's financial sector.
We could revise the outlook to stable if risks to financial stability 
increased, or if there were a substantial slippage in Malta's fiscal 
performance, or if external demand from Malta's key economic partners 
deteriorated significantly.


RATIONALE
Our ratings on Malta are supported by its strong growth performance, recurring 
current account surpluses driven by its large services exports, and the 
improving government budgetary and debt positions, and fiscal management. 

The ratings are constrained by Malta's relative vulnerability to changing 
international financial conditions in light of its small open economy, and by 
our limited visibility on external risks given the presence of large flows 
into and out of the country, particularly in the financial sector. Due to 
linkages between Malta and the U.K., we also think Brexit presents a potential 
negative shock to Malta's economic performance. In our opinion, the ECB's 
monetary policy stance is not necessarily appropriate in light of the recent 
strength of Maltese growth, and significant asset price inflation in the 
property market. The high spread of bank lending rates, particularly to the 
Maltese corporate sector, relative to eurozone averages also suggests that the 
transmission of ECB monetary policy to Malta is only partial.

Institutional and Economic Profile: Economic growth will remain robust, but 
weaknesses in the transparency and accountability of Malta's institutions 
persist 
  • We expect Malta's economic growth will average about 4% in 2019-2022.
  • Evolving global tax regulation and rapid house price growth pose risks to our growth expectations.
  • While policymaking in recent years has promoted a reduction of fiscal imbalances, we believe weaknesses in the transparency and accountability of Malta's institutions persist.
We expect growth will decelerate in 2019-2022 to a still-solid average of 4.3% 
as services activity decelerates, also reflecting capacity constraints in the 
economy. Furthermore, several projects that contributed to growth in the past 
few years, particularly in the energy sector, have reached completion. 
Nevertheless, we anticipate Malta's headline GDP growth performance will 
likely exceed that of peers at similar income levels and stages of 
development, reflecting the authorities' commitment to policies incentivizing 
investment and hiring. Over the next few years, we anticipate that domestic 
demand will become the main driver of growth as an increasing foreign labor 
supply supports private consumption. Exports will moderate on the back of 
slower services growth.

The structure of Malta's economy has changed significantly over the past 
half-decade, with real GDP growth accelerating to 7.6% on average in 
2014-2018. The contribution of traditional manufacturing and financial service 
exports to growth has been moderate, and the economy has instead been 
dominated by tourism and the proliferation of new services exports such as 
logistics and e-gaming. In our opinion, these new sectors may prove subject to 
significant cyclical swings, as well as potentially large GDP accounting 
effects. Malta's National Statistics Office estimates that tourism directly 
contributes 6% to gross value added, and 17% if all establishments whose 
principal activity is related to the supply of a tourism-related product are 
considered. The arts, entertainment, and the recreation sector--of which 
e-gaming is a major part--increased its share in Maltese gross value added to 
15% in 2018 from under 3% in 2000. The sector grew by about 20% annually over 
2013-2018. Despite a marked deceleration over the past three years, we note 
that the sector still grew by about 11% in 2018.

In a high-growth environment, the government has consolidated its finances, 
reduced general government debt relative to GDP, and undertaken several 
structural reforms, notably those that have reduced the country's energy bill 
and increased female participation in the labor market. We anticipate 
macroeconomic policymaking will remain geared toward further fiscal 
consolidation. We expect additional efforts to further reduce skill 
mismatches, and improve the long-term sustainability of public finances in the 
context of an aging population will be implemented gradually, alongside public 
investment to plug infrastructure gaps.

Structural shifts in the economy have created new employment opportunities, 
and the unemployment rate declined further to 3.8% in 2018, the lowest in two 
decades. Labor market participation has traditionally been low, but reforms in 
recent years have improved this, particularly among younger women. Eurostat 
data indicate that the participation rate increased to over 70% in 2018 from 
58% in 2000. Malta has also been successful in attracting labor from abroad 
across a wide range of industries and skill levels. The country's population 
increased by around 2% on average between 2013 and 2018, up from 0.7% between 
2008 and 2012. These factors have so far prevented wage pressures from 
forming, despite the tight labor market. Skills shortages in some areas could 
prompt wage increases. We do not anticipate that any potential future 
increases are likely to hamper Malta's external competitiveness over the 
medium term, given other non-cost factors such as regulation, which might be 
more relevant for Malta, particularly for sectors such as e-gaming. We note 
that at €13.8 per hour in 2017, Malta's labor costs were about 55% lower than 
the eurozone average.

However, the higher pace of growth, immigration inflows, and tourism activity 
have also led to higher house price inflation in recent years, bolstered by 
fiscal incentives such as government schemes for first-home buyers. Another 
factor could stem from the eligibility criteria for the Individual Investor 
Program (IIP; the citizenship program), which requires the purchase or lease 
of property. House prices have increased by 5.5% on average between 2015 and 
2017 (according to the Eurostat house price index), accompanied by rising 
mortgage lending. Banks' exposure to resident real estate activities, 
mortgages, and construction is about 60% of the total stock of credit to 
residents, up from 50% at the end of 2012. While recent house price inflation 
is not yet an issue, concerns could build over affordability in some areas.

Other risks emanate from the small and very open nature of Malta's economy, 
exposing it to various potential external shocks. Brexit and rising 
protectionist trends could have important implications for Malta's trade, 
services, and financial channels (see "Who Has The Most To Lose From Brexit? 
Introducing The Brexit Sensitivity Index," published June 9, 2016).

Challenges also arise from evolving global tax regulation. Malta's tax regime, 
an important factor for investors in certain sectors, is challenged by a 
variety of adopted and proposed measures at European and global levels. Any 
future regulatory pressures on the e-gaming sector could potentially have 
negative implications for Malta's economy given the increase in this 
industry's contribution to growth in recent years.

Weaknesses in the transparency and accountability of Malta's institutions also 
persist, in our view. In 2018, the United States Justice Department accused 
the owner of a small Malta-based international bank, Pilatus Bank, of having 
previously set up a scheme to evade U.S. economic sanctions against Iran. We 
believe this event was among the main factors leading to the country coming 
under increased scrutiny by the European Commission and European Banking 
Authority (EBA). The EBA recently concluded a formal investigation against the 
Maltese Financial Intelligence Analysis Unit (FIAU). The EBA said that the 
FIAU imposed neither effective, proportionate, and dissuasive sanctions nor 
any other supervisory measures to correct the defects the FIAU had identified 
to ensure Pilatus Bank's compliance with EU anti-money-laundering (AML) rules. 
The EBA has also pointed to some inefficiency in the Malta Financial Services 
Authority's (MFSA) supervisory practices and effective responsiveness, 
specifically in due diligence regarding AML systems and controls during the 
license authorization process.

While potential weaknesses in Malta-based international banks, such as Pilatus 
Bank, may not necessarily pose direct risks to the stability of the 
domestically-focused financial sector, they could have implications for the 
jurisdiction's reputation (see "Banking Industry Country Risk Assessment: Malta
," published Nov. 23, 2018). We understand that the Maltese authorities are 
willing to strengthen supervisory standards and are cooperating with the EBA 
toward this goal. In our opinion, the transparency and accountability of 
institutions bear directly on sovereign creditworthiness.

Flexibility and Performance Profile: Net general government debt to GDP will 
continue to decline in the coming years 
  • We project small fiscal surpluses in the coming years, allowing net general government debt to decline below 30% by 2022.
  • Large errors and omissions, stock-flow discrepancies, and large flows that do not affect the domestic economy complicate the analysis of Malta's external finances.
  • Bank lending rates to corporates are among the highest in the eurozone.
We project general government surpluses slightly below 1% of GDP in 2019-2022. 
Cyclical tax revenues and proceeds from the IIP should continue to support the 
government's fiscal position, but less so than previously. IIP proceeds are 
estimated to have reached about 4.5% of GDP cumulatively in 2014-2017. Fiscal 
surplus, excluding IIP revenues, reached 1.3% of GDP in 2017 (the overall 
surplus was 3.5%). An important risk (in either direction) to our projections 
remains the size of future inflows related to the citizenship program given 
its nature and increasing scrutiny from European institutions. On the other 
hand, we expect relatively large government spending on the back of social, 
pension, and infrastructure pressures. A key fiscal priority for the 
government is to address infrastructure shortfalls via capital expenditure. 
The National Development Social Fund (NDSF), created with 70% of the proceeds 
of the citizenship program, has been earmarked for investment spending. We 
note that the NDSF, currently maintained as a government deposit at the 
central bank, has invested in Bank of Valletta and Lombard Bank. 

As a result of recurrent fiscal surpluses, we expect net general government 
debt to GDP will further decrease to less than 30% by 2022, from about 60% in 
2014. Nominal GDP growth of more than 6% over 2019-2022 will also aid this 
decline. We note that the bulk of government debt is held domestically. Most 
the government's contingent liabilities come from public-sector corporations, 
many of which the government continues to support through guarantees. Overall 
fiscal management has improved in our view, but guarantees still constitute 
about 9% of GDP.

We project the current account surplus will narrow over the coming years. 
Export growth will moderate as the services sectors start to mature. The 
current account has been in surplus since 2013, though its magnitude has been 
revised several times. We note negative errors and omissions in balance of 
payments data over the past few years, potentially indicating an overstatement 
of current account surpluses or under-reporting of capital and financial 
account flows. The corporate tax regime is one of the factors attracting 
companies to create subsidiaries in Malta and book some of their activities 
through it. Such activity substantially increases stocks of both external 
assets and liabilities in Malta's international investment position, and gross 
inflows and outflows on the financial account of the balance of payments. 
Those flows are mostly pass-through and do not fund the domestic economy. 
However, any reduction of their volumes could reduce service exports--and 
therefore total current account receipts (CARs)--by noticeable amounts. In our 
assessment, we consider various metrics of external liquidity and indebtedness 
relative to CARs. Malta's external data are subject to frequent revisions, 
which constrains our analysis. Large changes in CARs would affect the key 
ratios we consider in our external assessment.

Malta's banking sector is split into three well-identified subsectors: core 
domestic banks, noncore domestic banks, and international banks. The 
international banks account for roughly 0.45x the total banking sector (total 
banking sector is about 4x GDP). They operate a variety of business models, 
including on-lending their parents' funds abroad and attracting non-resident 
deposits to fund parents. The sector, though it has been shrinking for several 
years, has a considerable effect on external accounts but it generates limited 
employment in Malta and does not have close links with the domestic economy. 
Potential weaknesses in Malta-based internationally-oriented financial 
institutions (like Pilatus Bank) could have implications for the 
jurisdiction's reputation, in our opinion, although they may not necessarily 
pose direct risks to the financial stability of the domestically-focused 
financial sector. 

Smaller domestic banks do engage in some international activities, such as 
participating in syndicated loans, but the two biggest domestic banks are 
overwhelmingly focused on activities in Malta. The cyber-attack in February 
2019 on Bank of Valetta, Malta's largest bank, has also raised questions about 
the potential risks related to the Maltese financial system's reputation (see "
It Is Too Early To Assess The Impact Of The Recent Cyber Attack On Malta-Based 
Bank of Valletta," Feb. 20, 2019). The domestic banks are highly liquid and, 
on average, nearly 30% of their balance sheet comprises liquid assets. The 
loan-to-deposit ratio is less than 0.6x, largely a result of households' high 
savings channeled into deposits, with other investment options being more 
limited.

Bank lending has been driven in recent years by growth in the mortgage book. 
Credit to corporates turned positive during 2018. Lending rates to the 
nonfinancial private sector are elevated and the second highest in the 
eurozone after Greece. Corporations are increasingly reliant on other sources 
of financing, such as intragroup loans, nonbank financial corporations, and 
even debt issuance. The concentration of the banks' loan book in construction, 
real estate, and mortgages poses a risk to the system's stability, in our 
opinion. We also view the concentration of loans (about 75% of total resident 
system loans) with just two banks as a risk to the system. These factors 
weaken the transmission of ECB monetary policy to Malta.

Membership of the eurozone anchors Malta's monetary policy and provides its 
banks with access to funding at low nominal interest rates. Nevertheless, we 
consider that membership in a monetary union increases the onus on member 
governments to support competitiveness through fluid labor, product, and 
services markets, and to build up fiscal buffers against future shocks.

Malta's inflation patterns diverge from eurozone averages, but somewhat less 
so than before because energy markets have integrated. Nonetheless, the ECB is 
less likely to consider the economies of smaller members when setting monetary 
policy, and this remains a constraint on Malta's monetary flexibility. 
Moreover, the integration of Malta's financial system into the eurozone 
appears to be insufficient to achieve efficient placement of surplus domestic 
savings, even though this issue is partly caused by the traditional home bias 
of domestic savers.