We are living beyond our means

• The time of reckoning has come

by David Kelleher

The Governor of the Central Bank, Michael C. Bonello, last week spelt out what the real economic situation in Malta is like, what is so obvious, yet few will admit.
Replying to one question, the Governor did not mince his words: we have been living well beyond our means for far too long and the time of reckoning has come.
The Governor was speaking at a business breakfast organised jointly by Le Meridien Phoenicia Hotel and The Malta Business Weekly last Thursday.
The “juicy” parts came out not in Mr Bonello’s presentation but rather in his reply to statements made by the director general of the Association of General Retailers and Traders (GRTU).
Raising a number of points, Mr Vince Farrugia said that in his opinion, the economy is not being managed. There is a huge problem of cash flow, the banks are over liquid, the price of money is high – something is not working.
“We have a government interested more in fiscal policies than in managing the economy, we have a public sector which has been given a high rise in its packages. Monetary policy is too docile or doing worse to the economy,” Mr Farrugia said.
The Governor, however, argued:
• Management of the economy:
“We have to accept that the role of government today is not what it used to be. We are living in a liberal market oriented economic environment, which assumes that all factors have their responsibilities and roles,” Mr Bonello said.
The failures of managed economies is not just a question of theory but also of practice. Any attempts to manage the economy have failed, and in small economies like ours, it is likely to be even more so, he said, adding that one has to understand what one is saying and to identify the problem.
Monetary policy is one of a range of policies to manage the economy. You have many actors, all acting independently. The importance of the coherence of various policies cannot be underestimated. There are attempts to do so, such as the MCED. But at government level, Mr Bonello agreed that the practice of interministerial committees has not caught on.
• The banks are not liquid: The Central Bank has been consistently injecting money into the system because the banks are not as liquid as they should be.
• The cost of money is excessively high: The primary concern of monetary policy is price stability and the option of the Central Bank enjoying an autonomy of managing monetary policy with an eye to domestic economy is no longer viable.
“You have to keep an eye on interest abroad,” he explained. “If you do lower interest rates below the level of interest abroad, a lot of people in this room will rub their hands and advise their customers to avail themselves of the Lm30,000 limit and shift their money abroad, which is what they have been doing successfully over the past year without any due consideration being given to exchange rates and market risk.”
The cost of money is not high at all, he said. The Central Bank looks to what is happening in external reserves. If Maltese investors perceive interest rates abroad as being more attractive than they are here, they invest abroad. “If we lower interest rates too much, we are not likely to achieve the objective of stimulating the economy.”
The cost of money, Mr Bonello said, may appear high to people who are over-extended, who have borrowed much and who have not worked out proper business plans, and here the banks should have perhaps been more helpful.
“The complaint that there is not enough money going around has to be analysed and we must find out what are the real reasons,” he added.
The Maltese have probably over-invested, Mr Bonello explained. “For example in the retail sector – they have made heavy investment in nice shops, but, as an outsider, I cannot but be struck by the unsustainability of all this. You cannot have rows of shops selling jewellery in just one street. You have oversupply.”
Just because people are concerned they are not making enough money from their investment, the solution is not through pumping in more money into the economy.
“We are spending too much in Malta, we should be spending less and saving more. We are overextended. We have been living beyond our means for far too long and the time of reckoning has come,” Mr Bonello said.
Mr Bonello called for proper discussion and not to resort to quick fixes. There is not one single solution, he added, and the problem “calls for a concerted approach from all round the economy to put things right. We have to adjust to a new situation”.

Governor’s presentation
The parameters in monetary policy are set out in the Central Bank of Malta Act which states that the bank must promote the balance and the orderly development of the country through ensuring monetary stability. The bank’s primary concern has to be the monetary stability and preserving the value of the currency. This entails a commitment in favour of price stability and the exchange rate, the governor said.
Price stability, he said, is the Central Bank’s prime concern and it will be evident from the amendments to the law to be presented to Parliament very soon.
“Experience has shown that only with stable prices is it possible to grow and create wealth. The market economies of a number of countries have explored what kind of regime they should have: should it be fixed or floating exchange rates? Many small economies’ experience has shown more success in the pursuit of price stability through the fixed rate regime than otherwise. The fixed exchange rates creates an environment of stability and prosperity,” Mr Bonello said.
Malta’s exchange rate is pegged to a basket composed of the Euro, the Dollar and the Sterling. Last year the Maltese lira deviated at most by 8.5 per cent to the US$, and by four per cent against the Euro and the Sterling.
To maintain the exchange rate, the level of reserves is critical, Mr Bonello said.
“The Central Bank can only maintain the rate by buying or selling foreign exchange, which it can do only if it has access to foreign reserves. The external reserves reflect the balance of payments, so if you have a negative balance of payments, it can be financed by drawing on the capital account, to finance imports or else drawing on accumulated foreign reserves,” he said.
The balance of payments was a negative 12 per cent in 1996, narrowed to four per cent in 1999 but increased in 2000 to seven per cent.
“A deficit on the current account also means that your domestic spending and investment exceeds your inflows, basically, you are living beyond your means – something about which we have developed quite a knack for in this country, both on the national and on the personal levels. Thus in 2000 the inflows were insufficient and we had to draw on our external reserves,” Mr Bonello said.
The implications of all this, he said, are that in an environment of free flows of capital and the worldwide tendency for the capital account to be liberalised, domestic interest rates must move in line with interest rates abroad. The Central Bank thus loses its autonomy in the conduct of the monetary policy. This happens not just in the case of Malta but also in the case of bigger countries. Capital movements can be so large as to overwhelm far bigger central banks.
“When we accept the logic of fixed exchange rate regimes in Malta, because it suits us, the CBM is bound to align its policy lines to those of the countries which make up our basket. In this case, thus, domestic considerations must take a secondary role.
“Sometimes people lose sight of this: you can’t have it both ways. If you want to derive the full benefit of the fixed rate regime, you have to follow interest rates developments abroad and you cannot set your rates primarily on domestic considerations alone,” Mr Bonello said.
With regards to further interest cuts, Mr Bonello said cutting rates to levels below those abroad could give the country a short-term boost, stimulate demand, however such a move will lead to capital outflows and increased demand for imports.
“At the moment we have the right mix, tight fiscal policy and thus rates are lower than they would otherwise have to be,” Mr Bonello said.
Some people seem to think that monetary policy is the solution to everything, he said, however it only addresses one target: price stability through fixed exchange rate.
“When the exchange rate is pegged, the CBM cannot fix this policy in response to domestic developments. It has to respond to developments in the balance of payments and to the level of external reserves.
“Fiscal policy must be compatible with a sustainable balance of payments situation for the exchange rate to be sustained.
Thus monetary policy cannot solve problems that come from the underlying state of the economy as such: thus devaluation cannot address a fundamental lack of competitivity, which again seems a notion of many people in Malta, Mr Bonello said.
A devaluation, he added, may boost competitiveness and exports in the short-term in an economy which has spare capacity and has flexibility. In these cases, it might be useful and successful but otherwise, as experience has shown, devaluation raises import prices and price levels.
The gains from devaluation in an economy like Malta are only temporary and Malta’s experience post 1992 has been that in less than four years, the advantages which were gained from the 1992 devaluation had already evaporated.
“The bottom line is that monetary policy has a limited role to play and is only one of a panoply of tools that should be used to manage an economy successfully,” he said.
The Central Bank governor said that one had to look elsewhere for our economic solutions – the real world. Once the logic of a fixed exchange regime is accepted, one can hope to compete internationally.
“Because when inflation in Malta is higher than other competing countries, as it is at the moment, then we stand to lose export markets. Exports become difficult. The more competitive the Maltese economy becomes, the easier it is to maintain a fixed exchange rate,” he explained.
Mr Bonello said those involved in setting wages and prices, such as trade unions, had a crucial role to play in safeguarding competitiveness. The stronger the real economy is, the lower the perceived threat of devaluation and the less need of high interest rates.
“Domestic interest rates can be kept relatively low without endangering the currency. There will not be any loss of currency, as the economy is seen to be strong enough. Thus a virtuous circle is set in motion. This is our objective,” the Governor said.
And the solution?
Mr Bonello called for fundamental reforms to allocate and use resources more efficiently. Markets for goods and service and production must work better and at a lower cost.
He said there are several examples of rigidities and inefficiencies in the domestic economy. While the country is good at analysing them, not much progress has been made to tackle them.
“This will remain a brake on the economy. Nobody can promise any quick fix, these real problems have to be tackled. We are living in a real world where everybody else is tackling these issues and paying the short-term cost to get the long-term gain. Only those countries which do so can survive,” he said.
The Governor gave a number of examples.
Maltese energy users, he said, have not been exposed to the real cost of energy to consume less and behave more reasonably. Monopolies in the transport sectors still exist and impose higher costs. With regards to wage increases, the current system of wage indexation referring to past inflation automatically without considering whether we have earned these increases through increased efficiency, has to be reassessed.
There are still skill mismatches, Mr Bonello said, and the education system is still not producing the skills needed in an enlarged economy. The public sector was another issue.
Concluding his presentation, Mr Bonello said the structural deficit on the current account of the balance of payments is leading to a drain on the country’s reserves at the present moment, and the structural deficit on the capital account is not financed by sufficient inflows on the capital account.
“This reflects the fact that the productive side of the economy has remained fundamentally unable to generate enough exports to cover the country’s import requirements. In other words, not enough of the country’s resources are efficiently dedicated to exports, which is crucial to Malta’s survival, Mr Bonello said.
The economy, he added, remained excessively dependent on the government for employment, income, and human resources.
“The rigidities are still there. As long as they persist, and the current account deficit and the fiscal deficit, monetary policy has to be rather limited. The only effective remedies to this situation are those which attack the structural problems, the underlying inefficiencies and competitiveness.
“Increasing domestic demand, either to monetary or fiscal policies, as some suggest, or by exchange rate devaluations, as others suggest, cannot tackle the underlying issues. They will only have temporary effect and leave the economy in a worse state than it was before,” Mr Bonello said.