Having the Cake and

2^nd June 2006

The Malta Independent - Friday Wisdom

…eating it, is what best typifies the attitude of critics to the quarter point increase in interest rates announced by the Central Bank whilst at the same time singing glory to the project for accession into the Euro at the earliest possible date.

One cannot enjoy consistently spending more then one earns and at the same time expects to find money in the bank. One cannot enjoy the spirit of Rome, the eternal city, and expects that all Romans should speak back in English. One just does not go with the other.

So those who support accession into the Euro in January 2008 cannot pretend that the Central Bank in its execution of monetary policy in the pre-accession phase has any choice but to shadow the monetary policy adopted by the European Central Bank (ECB)

When we joined the ERM II in May 2005 the official interest rate of the ECB was 2% whereas Malta’s official interest rate (technically referred to as the central intervention rate) was 3.25% giving a differential in Malta’s favour of 1.25%.

This differential has to narrow down gradually until accession date to permit seamless fusion. Following two quarter point rises in interest rates the ECB rate is now 2.5% and by all accounts it will be raised at least to 2.75% next week at the forthcoming ECB council meeting. Some are even hypothesising the possibility of a half point increase to bring the ECB rate to 3%.

Consequently the increase in Malta interest rate from 3.25% to 3.5% means that the margin has narrowed since ERM accession from 1.25% to at least 0.75%. possibly 0.50%. Given that we are still 19 months away from the projected accession date it is quite logical for the Central Bank to slow down the speed of narrowing the margin differential by raising local interest rates. Indeed we have raised interest rates by one-quarter point for the three or four quarter points raised by the ECB.

One could bring all sorts of arguments against raising domestic interest rates due to internal factors; arguments that on their own are valid and relevant. But if we are to be realistic and believe in the overriding need to join in the single currency in January 2008 we cannot escape that even in this preparatory phase, our monetary policy cannot be attuned to domestic economic issues. Once we join the Euro, monetary policy will be fully transferred to the ECB who will implement their policy on a Euro-land perspective and not on the issues of any single member country especially if it happens to be the smallest one.

In this regard at least the Opposition is consistent in arguing that we should postpone entry to the Euro until we achieve a real growth rate of 4%.

Realistically this is only hypothetically possible within reasonable time frames if our international competitiveness is given a boost from the exchange rate policy, meaning some sort of devaluation which falls in line with proposals for economic regeneration proposed some time back by the Leader of the Opposition.

Such a policy would however prejudice our achieving the all important criterion of keeping our inflation within 1.5% of the average of the best three countries of the EU which explains why it would be unrealistic to think of any such devaluation now and still expect to make to Euro accession come January 2008.

Where such policy falls on its face however is in the instability that such a prospect would create. This would on its own force the Central Bank to raise interest rate far more aggressively in order to stem the outflow of capital and this would work again the smooth fusion into the Euro causing the differential between the respective rates to widen rather than narrow down gradually.

There is plenty to be critical of the Central Bank but not in its implementation of monetary policy during the ERM II phase. One could question whether the Central Bank is sensitive enough to the chronic deficit in our Balance of Payments which increased from 9.6% of the GDP in 2004 to 13.1% in 2005. No country can live with this sort of deficits for an extended time and the pressure on the erosion of reserves seems to be coming more from this source rather than from capital transfers which remain comfortably in black.

One could question whether a Central Bank, which has been relieved of its regulation and exchange control duties, still needs to employ 306 full time and 16 part-time staff. What sense does it make to employ six additional clerks in 2005? Is it possible that the Central Bank, that preaches with moral authority the need for economic restructuring to increase efficiency, which is essential to underpin monetary and economic stability and growth, could not re-structuring itself to lead by example rather than simply keep adding on to its headcount no matter have much responsibility is taken off its plate?

The Central Bank as well cannot have the cake and eat it.