Getting Serious About the EURO

The Malta Independent 

 
On page 47 of the Central Bank of Malta Annual Report for 2003 chart 4.5 (reproduced herewith) is titled REAL AND NOMINAL EXCHANGE RATE – INDICES FOR THE MALTESE LIRA. This adopts 1995 as the 100 index base and shows that as at the end of 2003 the real rate of exchange of the Maltese lira had overvalued itself by nearly 10% over its 1995 base.

To quote the Central Bank of Malta verbatim as to what this actually means

“A rise in the Real Effective Exchange Rate (REER), ceteris paribus, suggests a loss of price competitiveness and vice-versa. Given the nature of the Maltese lira exchange rate basket, movements in the Nominal Effective Exchange Rate(NEER) are rather contained. It is therefore movements in relative prices that exert the major impact on the REER. The NEER rose by 0.5% during 2003. At the same time, the REER gained 1.1%, as a decline over the first three quarters was offset by a rise towards the end of the year, when year-on-year inflation in Malta picked up and exceeded inflation abroad.”

A 10% overvaluation is a major misalignment by all counts. In a highly competitive world it makes our export product and tourism uncompetitive. This is showing in our dismal economic growth performance, stagnant exports, declining tourist counts, and structural current account deficit in the balance of payments. It is not yet showing in our reserves position but this is more due to savers’ inertia and an interest rate policy allowing a premium over relative overseas market rates. I contend it has little to do with an appropriate rate of exchange value for the Maltese lira.

I am not arguing that a realignment of our rate of exchange to the 1995 base is an automatic solution to our problems. I am on record several times that such adjustment on its own will have very short-lived benefits as it feeds further rounds of inflation necessitating further exchange rate adjustments. But as a part of a total re-structuring package there is ample case to be made that a re-alignment in the exchange rate could deliver the desired results better and quicker.

I just cannot fathom therefore how the Governor in his report declares that

“The Maastricht inflation and long-term interest criteria have been met on a sustainable basis, and there are no indications of major misalignment in the value of the Maltese lira.”

Arguing the virtues of maintaining a stable rate of exchange policy is understandable, but negating one’s own research presented in the same report and describing a 10% real over-valuation as giving no indication of major misalignment is negating bare-faced facts.

But the wrong assumptions in the Governor’s report go even further. He categorically assumes that the fact that we have so far managed to pass the Maastricht criteria test for inflation and long term interest means we can put our mind at rest about continuing to adhere to such criteria even whilst addressing the fiscal deficit and public debt in trying to bring them within the EMU benchmarks.

If only it were that simple. The economy is under stress from lack of flexibility, lack of efficiency, insufficient productive investment and a general waste of resources. This is the fire under a kettle with boiling water where the vapour is coming out of a spout in the form of excessive annual fiscal deficit and horrendous rapid accumulation of national debt.

We need to remove the fire from underneath the kettle by performing real economic re-structuring along the lines of the 10 objectives I had explained in this column in my contributions during the first quarter of this year, and as further explained in a recent address I made at a Seminar of the Institute of Financial Services ( full text and presentation can be downloaded from my web-site). Otherwise as soon as we try to block the vapour outlet from the spout of fiscal deficit the pressure will start showing elsewhere. The pressure will come out from the next point of least resistance in the form of higher inflation, higher interest rates, loss of reserves and eventually a forced rate of exchange re-alignment.

Joining the Euro is a national effort which cannot be guided by the Central Bank alone or even by the government alone. Joining the Euro without conducting a priori real economic restructuring will eventually put all the stress of economic adjustment on the real economy, on growth, on employment and on general macro-economic stability. While other countries would score points as they use the Euro to attract investment having undergone proper economic re-structuring prior to joining, we might have to do the re-structuring through the Euro discipline after joining when the only variable left at our disposal would be economic contraction of the type suffered by communist economies when they were suddenly opened to market forces.

The Central Bank is right in demanding urgent re-structuring. It is wrong in applauding the government for promising to adjust the deficit by 2006 without explaining how. Applauses should be reserved for deliveries not for promises. It is also wrong in negating the existing misalignment in the value of the Maltese Lira.