How to read the budget

Edward Scicluna says Gonzi’s budget could have easily steamed ahead with impressing Brussels with its discipline. Instead it took a political decision to assuage voters.

The only suitcase in the world to be just used once a year was opened before the President, its contents removed, ceremonially approved, and read out in parliament. Lawrence Gonzi’s third budget since taking on the finance ministry read like the back of an instant broth sachet – dehydrated goodness, just enough for some meagre servings, a hot bowl to quell the winter shivers.

There were new goodies for Gonzi’s electorate: tax savings for the middle class, more grants for their kids’ private school education, a stipend for private higher education students, cash for childcare costs, less tax for property heirs, exemption from NI payments retroactively for families hosting foreign students (conspicuously located in PN localities that shifted to Labour in recent council elections), cutting tax for travellers… in short, a budget aimed at quelling the murmurs of mutiny amongst his favourite voters, those who contributed to one of the highest tax yields ever of the decade. Millions of liri reaped in income tax and VAT helped slash the omnipresent deficit, which Gonzi claims is below 3 per cent of the gross domestic product – one of the ultimate targets for joining the single European currency.
It is true that the EU has removed much of the auspiciousness of the budget with all the boring rigours of fiscal discipline. Alfred Sant’s customary quip slagging off the budget is now officially the next most interesting item after the budget. This year, he said Gonzi’s “solid future” sounded like an advert for Viagra.
But as economist Edward Scicluna painfully unravels the budget for me, there’s a nagging, unpopular and technical item that throws a dark shadow over Gonzi’s latest fist-opener, and that’s Britain’s most hated currency – the Euro.
“The past two budgets have been in the main addressed to the EU’s own requirements, that of addressing the deficit. Full stop,” Scicluna says, referring to the many criteria a candidate for the euro like Malta has to fulfil before adopting the single currency. It means keeping deficits down to below 3 per cent of the GDP, and also keeping public debt down (Malta’s debt stands at 68% of the GDP). Malta wants to be a stable economy fit for the euro by 2008.
“In this very last budget pending the forthcoming final examination for entry into the euro zone, the government could have opted once again to ignore local gripes and instead devoted the entire budget speech impressing Brussels with our intentions of further expenditure reforms and so on. The government decided instead to leave that and focus on issues closer to home. One reckons it was a calculated political decision. In fact the language of the budget speech is completely locally oriented.”
To the ‘surprise’ of seeing Lm12m in tax savings announced (other than the Lm8m originally envisioned), Scicluna calls it a slippage. “There is very little which can be said to give real comfort to the rating agencies and the EU Commission. In their parlance they would admit to a programme of certain fiscal slippage. This relief is a reversal of belt-tightening aimed to the section of the population which has borne the increasing tax burden of the last few years. Whether the slippage is significant enough to lose us our place in the euro zone is another issue. Taxation mainly comes from middle-income families and they finally squeaked, so government opted to give them a breather… given the strict convergence programme, government appears to have lifted its foot slightly off the deflationary pedal.”
With the creation of new jobs and a growth of over 2%, Malta has made progress but is still the slowest growing country among the new member states. But how much should we be growing by? “Our output gap is estimated by the EU to be about 1.5% below the potential. That gap represents the resources we have at our disposal enough to produce up to a 4% increase in wealth each year. But because of lower demand from abroad, we are performing below our potential.”
But Gonzi says there are enormous amounts of foreign investment coming to Malta. “That’s encouraging for the future and we should not underestimate it. The same goes for the increasing investment in education. But we’re talking of the present, and the present is affected by domestic demand and foreign demand. Domestic demand is there, people are consuming despite earning less, consumption is maintained by saving less – that’s why domestic demand hasn’t suffered. Foreign demand is still wanting.”
And what’s the key to increased foreign demand?
“Competitiveness. The output gap means we have hotel beds and people to serve tourists, but the tourists are not there – wasted resources. The same for manufacturing. Our competitiveness index in the late 80s and early 90s was good. Over the last years we out-priced ourselves, living beyond our means, and what did we do? We locked our exchange rate to a relatively high fixed peg, giving us no means to adjust our exchange rate to remain competitive.”
The calls for competitiveness have put pressure on workers to accept wage-cuts or freezes. “Nobody wants it, but that would have been one of the routes. The other way would have been to go for a lower exchange rate when we went into the ERM, which we didn’t do. The fact is, if you’re living beyond your means, you have to lower your standard of living to become competitive again in order to boost exports. Changing the quality of your product and branding helps, but finally the crucial factor is price.”
Malta’s commitment to the EU, irrespectively of the euro, is to keep its deficits below 3% and be seen to cut out debt down to levels of even 40% and 30% over a long period of time. It told Brussels it would freeze its debt ratio by 2005, by spending less and get more revenue.
“Like any EU member state, we have to have our public finances in order and to render them sustainable. The world has suffered too much from governments which overspent even during economic booms, leaving them without savings to patch them over during bad times.
“Like some European governments, that’s what we did, starting with negligible debt in the mid-1980s, up to the present where we’ve exceeded the 70% mark. That means that every year we’ve pumped in more money through borrowing, irrespective of the economic performance. Pumping more money in the economy during bad times is pardonable, and even advisable. But stoking the economy when it’s booming – and I recall many periods when we did exactly that during growth rates of 6% – running up excessive deficits through borrowing, pushing growth to 10% and increasing inflation, resulted in using up any leverage we might need in the future.”
At present, Gonzi’s statistics – severely doubted by Alfred Sant – point out a deficit that is 2.8% of the GDP, and debt slowly moving down towards 60%. Being inside the European Rate Mechanism II, a two-year waiting room before joining the euro, Malta is also showing it is converging the economy to EU requirements – stable, growing, inflation under control.
Scicluna adds: “We must not have any significant imbalances. I emphasise that. Because it’s not just a question of cutting the deficit, the public debt, and having low inflation and stable interest rates. The Maastricht tests are much more sophisticated than that. Our economy gets stress-tested by the Euro examiners to see whether it could withstand certain financial shocks, just like a threadmill-stress test for the heart.”
So where have Malta’s previous budgets taken us so far? The answer lies in how its public finance deficit has been reduced. There’s three ways to do that. Cutting current expenditure, or perhaps capital expenditure, or raising revenue.
“We have taken the latter route to date. As we know taxes have been increasing over the years, dampening the economy, delivering less revenues, in turn requiring higher rates of taxation. Since last year the government decided not to introduce any new taxes, so the route it seems to have chosen for the near future is cutting down on capital expenditure.
“I think it would have been wise for government to reduce current expenditure. It’s more sustainable, because you reorganise the way you do things – just like so many privatised corporations did to increase productivity. Government could have done this in so many ministries, and by restructuring health and education financing and, pensions. Taming these three monsters would bring good results for the public finances. But they are difficult routes. You need expertise and consensus. We spent 10 years to arrive just where we are on pensions today.”
Ireland was one country to have opted for increased taxation in the mid-80s, depressing the economy by taking money away from the productive private sector to a non-productive public sector – and finally choosing a radical programme to cut down on its spending, which ultimately meant cutting down on the inefficient public sector activities.
For Scicluna, boasting of the current deficit rate may be a bit too early at this time. The European Commission will be looking at Malta’s statistics somewhat differently. It means that on revenue, Brussels won’t take into consideration the privatisation of companies for debt-ratio calculation.
They’d think: ‘if you had to remove these one-offs, what would the deficit look like?’ And there’s also tax amnesties, such as on repatriation of foreign monies, and the sale of government real estate for example which is not considered as revenue.
Additionally, there are accruals. Say for example, government pays Lm20 million to a contractor for road works. Accrual accounting demands that, even if payment was to be made the year after the road works are completed, that capital expenditure – the Lm20m – has to appear in the country’s books when commissioned, and not when paid.
“So if government says capital expenditure in 2007 will fall by Lm20m, is it because the resources the government’s using for the roads are Lm20m less, or is it because the cheques to pay for the roads were put in the drawer and sent to the contractor in the following year? Under the accruals basis whether the contractor gets the cheque or not is immaterial. Once these exceptional or one-off revenues would be removed, the deficit would be expected to be higher than stated in the budget,” Scicluna says.
As of now the EU is projecting that in 2007 Malta’s structural deficit – cyclically adjusted and net of one-offs – will not be below the 3% of GDP. “Obviously the government disagrees,” Scicluna smiles. “So we will have to see who is right. The examiner or the candidate.”
The second issue is debt ratio and the only way the debt to GDP ratio can come down, excluding privatisation of government assets, is not simply by getting the economy and therefore GDP to grow. That’s because each year, the debt grows due to the interest payments made to service the debt.
“It means we need average interest rates on the outstanding debt to equal the GDP growth for the debt ratio to be frozen, and stop growing. At the moment in 2006, Malta appears to have frozen the debt ratio. Most importantly however, we have to show that it’s coming down! And that can come down by getting a surplus on what is known as the primary balance: the structural deficit calculated before interest payments. Again this is cyclically adjusted.
“Now, in our convergence programme presented to Brussels, a 3.5% positive balance has been chosen as its target. This is significant, because it means that for the next 10 years, governments of whichever colour have to produce a surplus in the primary balance every year. It means that net of interest payments of future public spending has to be about 2% lower than revenues every year, for many years to come.
“More significantly it is not yet obvious that we have obtained this during 2006. So Malta will go before the Euro examination team with a promise that it will achieve its target during 2007. It’s promising a positive balance, showing it credible and convincing, but then it has no track record to show for it! What do you expect the examiners to do? Would they say ‘We will take the risk and let Malta enter the Euro zone’, or maybe ‘We aren’t sure. We’d rather that Malta waits another year and then we shall see?’”
The third issue are the stress tests, basically tests to the economy to see how debt would explode under various types of worst-case scenarios. In Malta’s case, had all the bad things like interest rate or exchange rate shocks, had to happen in combination to our economy, our stress test took the debt to GDP level to just over 100%, Scicluna says.
“All the other candidate countries’ debts, after being kicked by these stress tests, did not go beyond the 75% mark. Even Cyprus is better off than Malta, and so our risks in terms of these stress tests, are somewhat higher and work against us.”
And finally there’s long-term sustainability. “We’re an ageing population – coupled with our public finances and the pensions issue, that puts us at medium-risk. We’re lucky not be high-risk, like Italy, but we’re not in the low-risk category. Once again the overall risks related to Malta start adding up.”
So it seems you are not entirely sure of Malta’s chances at joining the euro in 2008?
“I’m afraid so... It looks more as one who is trying one’s luck at passing an exam… I’d say Malta is pushing its luck. My cold-blooded, objective assessment would be that the examiner would say that overall there are too many risks and uncertainties, suggesting to us to give it another year.”
What would the implications of postponing be?
“Well it depends on how we take it. It’s like failing an exam for just a couple of marks. Psychologically, some students respond by sending education to hell and go and get drunk, or else they eat humble pie, try harder and pass the exam the next time round. There could of course be some slackening in the process of trying harder, but that’s a political scenario now depending on whether there’s an election now or not. As for the effect on the outside world I would say that for most observers including the IMF and the rating agencies the result won’t be a surprised, they have already factored it in and the event won’t be seen as a disaster for Malta if it is seen to remain on the track.”
So has Malta been too ambitious on its target for the euro after all?
“With hindsight, for the population at large the answer is yes. For the experts including the EU and IMF themselves the programme was always termed ‘very ambitious’”.