Swapping Deficits

7^th July 2006

The Malta Independent on Sunday

Are we in the process of swapping a deficit in government’s fiscal position for a structural deficit in the balance of payment of the whole country?

Let’s establish the statistical facts. Between 2003 and 2006 the fiscal deficit has been coming down from the near double figures it was since 1996 to an expected outturn of under 3% of the GDP in the current fiscal year, nicely slipping below the Maastricht criteria for eventual Euro entry.

However during the same period the deficit in the current account of the country’s balance of payments has deteriorated from 4.53% of the GDP in 2003 to 7.58% in 2004 to 11.02% in 2005 and 14.95% in the first quarter of 2006.

Normally the fiscal deficit moves quite in tune with the balance of payments deficits. Structural fiscal deficits generally contribute to the development of structural balance of payments deficits. Fiscal deficits by their own nature increase purchasing power in the hands of the private sector as the government spends more than it takes in through taxes. This enables consumers to increase consumption which in open economies easily leaks externally through increased import consumption thus leading to development of balance of payment deficits.

Why is it then that in Malta we are seeing an inverse relationship of rapidly deteriorating balance of payments position in the context of steadily improving budget position of the public sector? Should not the improving budgetary position actually reduce consumption spending thus contributing to an improving balance of payments position?

I can think of two reasons why we seem to be going against the conventional trend. The first one relates to the way the budget deficit gets financed. Given that public sector budgetary deficits are financed internally through local borrowing without any resort to external borrowing means that the extra spending power caused by the deficits in the first place is generally neutralised by the borrowing function. Consequently when budget deficit start reducing it does not really impinge on consumption patterns as the need to borrow less internally would leave a compensatory amount of spending power in the hands of the consumers.

Another evident reason for this inverse relationship is that the improvement in government’s fiscal position is happening in the background of a substantial deterioration in Malta’s terms of trade with its trading partners particularly due to the increased cost of energy, the demand for which seems to be pretty inelastic i.e. not quite sensitive to price movements given that energy consumption is quite often a necessity without much discretion regarding its use.

Consequently we are having to pay much more for importing the same volume of energy and there is no compensating increase in the prices we charge for our exports of goods and services.

You can hear the painful moans of factories and hotels because they cannot pass on to their clients energy price hikes, causing deterioration in profitability unless they can extract better productivity from their work-force and their investments. Indeed making such investments will place further strain on the current account position of the balance of payments as imports of capital goods is a direct charge as normal merchandise imports whereas the productivity gains from such investments can only accrue over an extended future period.

So coming down to brass tacks is the burgeoning imbalances in the country’s external payments position worrisome? Is it sustainable and could it lead to unpleasantries as often experienced by countries that endure extended periods of such balance of payments deficits?

The answer to these questions depends on many factors that cannot be clearly foreseen. A few years of balance of payments deficits can be tolerated if they are followed by period of compensatory surpluses. The balance of payments current account deficits could be carried without developing into a crisis for quite an extended period provided they get compensated by surpluses on the capital account. The capital account is the funds flows regarding investment rather than trade payments and surpluses on the capital account means that deficit of the current account can be carried without loss of official external reserves which are indispensable in a comfortable measure to deliver a stable rate of exchange policy.

If the surplus on the capital account reflects long term investments into the country than the situation gets much more comfortable than if it reflects short term hot money seeking some temporary advantage. The latter could easily reverse at the slightest hint of macro-economic instability and could by themselves make a small macro-economic problems balloon into a full blown crisis as happened in 1997 to Asian economies, as happened to Iceland earlier this year and as is happening in developing European economies of Turkey and Hungary right at this very moment.

Whilst not alarming, three years of sharply deteriorating balance of payments position can only be neglected at our own peril. A problem does not just go away by pretending it does not exist. The monetary authorities ought to inform us whether they are concerned and what measures they counsel to return to a healthy balance of payments position in the shortest time possible.

The monetary authorities should also express an opinion whether they see any link between the surpluses on the capital account and asset price inflation in real estate and equity values experienced during these last three years. If there is, as I indeed maintain, then the monetary authorities have to explain whether control of assets prices to avoid asset price bubbles, which could cause financial instability when they unavoidably burst, is within the scope of their price stability mandate or whether they see such mandate limited to consumption prices.