DBRS Morningstar Confirms Republic of Malta at A (high), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Malta’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS Morningstar confirmed the Republic of Malta’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that the risks to the ratings remain balanced despite the disruption brought about by the Coronavirus Disease (COVID-19). Malta’s GDP contracted by 9.9% y-o-y in Q3 2020, more than previously anticipated, and the reintroduction of restrictions across Europe has intensified the headwinds to growth in the near-term. The government’s fiscal response to mitigate the effects of the pandemic, combined with the sharp contraction in activity, will result in a sharp deterioration in public finances this year. However, Malta entered the current crisis after a prolonged period of strong economic and fiscal performance, which provided the government valuable fiscal headroom to soften the pandemic setback.

The evolution of the pandemic remains the main uncertainty clouding the economic and fiscal outlook. A successful vaccination campaign in Europe could lead to a relaxation of restrictions and a partial revival in international tourism later this year. DBRS Morningstar expects Malta to gradually return to a healthier fiscal position as the support measures are phased out and the economy recovers, helping to stabilise the public debt ratio. The success of the Maltese authorities in strengthening the country’s governance framework will remain central to avoid reputational risks that could spill over to the broader economy.

Malta’s A (high) rating is supported by its euro zone membership, moderate level of public debt, solid external position, and households’ strong financial position. On the other hand, Malta’s small and open economy remains exposed to external demand or confidence shocks. In this sense, the tourism sector, an important source of income, employment, and investment in Malta, presents a vulnerability as long as the adverse effects of the pandemic continue. Similarly, Malta’s attractiveness to foreign investment could suffer if measures to address the financial integrity risks and institutional governance weaknesses noted by international bodies are deemed insufficient. Despite Malta’s sound public finances, medium- to long-term challenges could come from its contingent liabilities, changes in international taxation affecting Malta’s attractive tax system to foreign companies, or increasing age-related spending.

RATING DRIVERS
Although unlikely in the current environment, the ratings could be upgraded if two of the following occur: (1) a sustained material reduction in the public debt ratio driven by sound fiscal management and economic performance; (2) effective implementation of reforms to enhance Malta’s governance framework, including the financial and judicial sector; or (3) further evidence of increased economic and fiscal resiliency to external shocks. The ratings could be downgraded if one or a combination of the following occur: (1) a sustained deviation from a prudent fiscal approach materially deteriorating the fiscal and public debt outlooks; (2) if the pandemic shock to the economy results in substantial deterioration in Malta’s growth performance; or (3) a substantial weakening of investors’ confidence due to insufficient progress on improving its governance framework.

RATING RATIONALE

The Maltese Economy Will Be Severely Hit by The Pandemic Shock After Prolonged Expansion

The pandemic shock has abruptly halted a period of remarkable economic performance in Malta, characterised by strong output growth (averaging 6.4% a year during 2013-2019) and shrinking the GDP per capita gap with the EU. While Malta has been diversifying its economy over time (see: “Growth and Diversification in Malta’s Economy” https://www.dbrsmorningstar.com/research/349640), the tourism sector remains a key source of income to the Maltese economy, contributing 12.8% to Malta’s GDP and 14.9% of total employment in 2018, according to the OECD.

The containment measures, which included temporary travel bans and temporary closure of nonessential services, dealt a severe hit to the Maltese economy. Even as the economy rebounded from the heavy losses in the second quarter of 2020, GDP dropped by 9.9% y-o-y in the third quarter, more than the 4.3% y-o-y for the euro area. As expected, the restrictive measures had an uneven impact on the economy, impacting more heavily the tourism-related sectors that are more vulnerable to the curbs. While trade, transport, food and accommodation experienced a massive decline (-33.9% y-o-y), sectors such as information and communications (+9.9% y-o-y), arts and entertainment (+7.0% y-o-y), and financial and insurance activities (+3.9% y-o-y) have managed to grow over this period. Industry also registered positive growth of 1.5% y-o-y, after a significant contraction in the second quarter. On the other hand, the labour market has withstood the shock relatively well, with the unemployment rate broadly in line with pre-pandemic levels at 3.9% in October 2020. The wage supplement scheme has played a key role in protecting employment, raising uncertainty over potential job losses when the scheme is eventually phased out.

The Central Bank of Malta’s latest projections point to a 7.5% GDP contraction in 2020, followed by a partial recovery of 5.9% in 2021. Subsequently, GDP is expected to grow by over 4.0% in both 2022 and 2023 conditional on a successful vaccine rollout. The rebound will be principally driven by domestic demand as international tourism is expected to remain below pre-crisis levels for some years. The evolution of the pandemic and its impact on the tourism sector, which is predominantly reliant on foreign tourist arrivals, remain the main economic uncertainties. Over the medium- to long-term, Malta’s attractiveness as a financial and business location could face challenges from: (1) slow progress in enhancing its governance framework, (2) changes in international corporate taxation, or (3) changes to the EU regulatory framework. On the other hand, funds from the Next Generation EU and EU Budget are expected to boost activity and investment over the medium-term.

The Pandemic Shock Derailed Malta’s Strong Fiscal Performance

Before the pandemic, Malta’s fiscal performance had improved significantly over the past two decades. Furthermore, Malta recorded annual average fiscal surpluses of 1.7% of GDP between 2016 and 2019. Key factors underpinning this trend have been its strong economic performance, improved spending efficiency, lower interest payments, and the proceeds from the Individual Investor Programme (IIP) since its introduction in 2014.

Both the government and the European Commission project the budget balance to reach a deficit of 9.4% of GDP in 2020 following on from a surplus of 0.5% of GDP in 2019. The Draft Budgetary Plan estimates the immediate fiscal impact of the measures to mitigate the impact from the pandemic at 5.8% of GDP in 2020. The main measures include the wage supplement scheme to protect employment, direct subsidies to firms in the most affected sectors, a voucher scheme to support domestic demand, higher healthcare spending, and a temporary reduction of the property transaction tax. In addition to this, the government introduced tax deferrals (1.5% of GDP) and a state guarantee scheme (2.8% of GDP) to alleviate firms’ liquidity constrains. The government projects the fiscal deficit to shrink to 5.9% of GDP in 2021 related to an expected economic rebound and the phasing out of temporary support. In addition to an increase in capital expenditures, Budget 2021 includes an extension of the wage supplement until March, a new voucher rollout, and other social-oriented measures amounting to 2.2% of GDP, according to the European Commission.

In line with the fiscal prudence exhibited by Malta in the past, DBRS Morningstar expects the government to gradually return to a healthier fiscal position over time as the pandemic fades and the economic expansion becomes self-sustained. The main risks are related to the pandemic at the moment. Over the medium- to long-term, important drivers of revenue growth such as Malta’s impressive economic expansion, its citizenship by investment scheme, and corporate taxation could face challenges. This accounts for DBRS Morningstar’s negative qualitative assessment of the “Fiscal Management and Policy” building block. In relation to the potential loss of future revenues from the citizenship by investment programme, DBRS Morningstar takes comfort from the authorities’ prudent management of the revenue windfalls from the scheme.

The Public Debt Ratio Is Expected To Deteriorate Substantially But Remains Comparatively Moderate

Prior to the outbreak of the pandemic, Malta’s public debt-to-GDP ratio stood at 42.6% following a period of steep reductions in the ratio. This has provided the government with valuable room to respond to the coronavirus shock, without materially jeopardising debt sustainability. The government projects the debt ratio to rise to 55.0% in 2020 in light of the sharp increase in financing needs and nominal GDP losses, and to continue to edge up to 58.6% of GDP in 2021, as the fiscal deficits are expected only to revert gradually. The most recent Central Bank of Malta forecast foresees a steady increase in the debt ratio to 60.5% of GDP by 2023.

DBRS Morningstar continues to expect the debt ratio to resume its downward trajectory over time. Potential risks to this debt path could stem from a sharp deterioration in Malta’s growth outlook or the materialisation of contingent liabilities. In an adverse scenario, the government might decide to financially support its large and concentrated financial system or its state-owned enterprises outside of the general government. The government could recapitalise Air Malta, heavily impacted by the collapse in air travel worldwide, in coming months. Over the long term, further measures might be needed to contain the costs of age-related spending on the healthcare and pension systems. Measures already implemented include lengthening the working age and contribution periods, and strengthening the pension system.

Financial System Remains Sound But the Pandemic Shock and Reputational Risk are Concerns

Malta’s role as a small financial hub has resulted in the development of a large banking system relative to its domestic economy. Core domestic banks, with assets of around 197% of GDP in Q2 2020, mostly follow a traditional business model based on retail deposits for funding. Core banks’ main exposure is to the real estate market, which has remained relatively resilient in the face of the pandemic thus far on the back of a robust labour market and government support measures. The international banks and domestic non-core banks have limited or no linkages to the domestic economy.

The economic fallout from the pandemic has impacted core banks’ profitability during the first half of the year, mainly driven by a significant drop in non-interest income and increased provisions. The impact on asset quality has so far been moderate, with core banks’ non-performing loans (NPLs) as a share of total loans, at 3.5% in Q2 2020. Nevertheless, NPLs are expected to increase once the loan moratoria granted by banks come to an end as some households and firms could have difficulties in repaying their debts. As of end-October 2020, 11.7% of total outstanding loans (including new loans extended by the Malta Development Bank since the onset of the pandemic) were subject to the moratoria, which in the case of food and accommodation activities rises to 51.6%. However, Maltese core banks’ capital ratio (CET1 ratio at 20.0%) and liquidity (LCR ratios 329.7%) buffers remain sound on average and are expected to withstand losses without breaching their regulatory requirements in an adverse scenario, as reflected by recent stress tests conducted by the Central Bank of Malta.

The Moneyval/Financial Action Task Force (FATF) assessment of Malta's framework and effectiveness in combating money laundering and terrorist financing, expected later this year, remains a concern. The Maltese authorities implemented a series of ambitious reforms on this front and strengthened the human and financial resources of the financial services authorities which resulted in a significant pick-up in terms of inspections and enforcement actions taken last year. Nevertheless, if these international bodies deem these efforts insufficient to address identified deficiencies, this could deteriorate the reputation and confidence of the banking system and further strain Maltese banks’ correspondent banking relationships. DBRS Morningstar makes a negative qualitative assessment of the “Monetary Policy and Financial Stability” building block to reflect the potential impact of this on banks’ intermediation and economic activity.

Malta’s External Position Remains Strong Despite the Adverse Impact of the Pandemic on the Tourism Sector

The current account surplus averaged 3.9% of GDP during 2014-2019 as the travel, financial, professional, and gaming service net export position more than offset the large deficit in goods trade. Malta’s exports have fallen sharply in 2020 due to lower external demand, supply side disruptions, and the massive decline in foreign tourist arrivals due to the travel restrictions. The number of inbound tourists dropped by 73.9% during January-October 2020 compared with the same period 2019. Similarly, lower demand will compress imports in 2020. Looking ahead, both exports and imports are expected to improve gradually, with a partial recovery in foreign tourist arrivals most likely weighing on the travel balance in coming years. The latest projections from the Central Bank of Malta point to a smaller current account surplus of 1.6% of GDP in 2020 and 2021 before increasing to 2.1% of GDP in 2023. From a stock perspective, Malta’s net international investment position (NIIP) stood at +61.1% of GDP in Q3 2020. While gross external indebtedness is very high at 699.4% of GDP in Q3 2020, it poses limited risks to the domestic economy as it is mainly reflective of stable flows of inter-company lending and Malta’s role as an international financial centre.

Stable Policy Environment But Further Steps to Strengthen Governance Are Needed

Malta benefits from a strong national and overarching European policy framework, which has underpinned Malta’s economic and public finance improvement since joining the European Union. The World Bank’s governance indicators for Malta are in general broadly in line with those of the EU average; however, they have exhibited a widespread deterioration during 2018-2019, especially marked in the cases of ‘Control of Corruption’ and ‘Regulatory Quality’. Malta’s governance and institutional set-up has been under increased scrutiny in recent years following the assassination of the investigative journalist Daphne Caruana Galizia in October 2017.

The new administration led by Prime Minister Robert Abela has provided a new impetus to efforts to strengthen the rule of law. The Venice Commission has commended the passage of six new laws by the Parliament to strengthen the separation of powers and checks and balances (e.g., judicial reform and appointment procedures) but underscored the fact that more needs to be done to achieve an adequate system of checks and balances. The presence of these shortcomings has led to a negative qualitative assessment of the “Political Environment” building block.

ESG CONSIDERATIONS
Human Rights and Human Capital (S) and Institutional Strength, Governance & Transparency (G) were among the key ESG drivers behind this rating action. Malta’s per capita GDP is relatively low at USD 30,637 in 2019 compared with its euro system peers. The World Bank’s governance indicators for Malta have exhibited a significant deterioration during 2018-2019, especially in ‘Control of Corruption’ and ‘Regulatory Quality’. These considerations have been taken into account in the “Economic Structure and Performance”, “Monetary Policy and Financial Stability” and “Political Environment” building blocks.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/372099.

EURO AREA RISK CATEGORY: LOW

Notes:
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020).

The sources of information used for this rating include Malta Ministry for Finance (Draft Budgetary Plan 2021, October 2020), Central Bank of Malta (Economic Projections 2020-2023, December 2020; Interim Financial Stability Report 2020, November 2020; Economic Update 12/2020, December 2020), Malta National Statistical Office (NSO), Malta Financial Services Authority, Moneyval, Venice Commission (Opinion on Ten Acts and Bills Implementing Legislative Proposals, October 2020), European Commission (Analysis of the Draft Budgetary Plan of Malta, November 2020; 2020 Rule of Law Report Country Chapter on the rule of law situation in Malta, September 2020), Organisation for Economic Co-operation and Development (OECD Tourism Trends and Policies 2020, March 2020), European Central Bank (ECB), Eurostat, International Monetary Fund, World Bank, United Nations Development Programme, Bank of International Settlements, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/372098.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings
Initial Rating Date: April 3, 2015
Last Rating Date: July 24, 2020

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