31 May 2006

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Business Today

Spike in interest rates could jeopardise economic growth

James Debono

Economic operators fear the Central Bank’s decision to raise interest rates by 0.25 per cent would increase costs, which would jeopardise short-term economic growth.
While appreciating the Central Bank’s concern on reversing the declining trend in foreign reserves and to stabilise the currency, Federation of Industry President Adrian Bajada yesterday warned that short term economic growth may be “jeopardised” by the Central Bank’s decision.
In recent days two former finance ministers; Lino Spiteri and John Dalli have also questioned the wisdom of the Central Bank’s decision.
Yet, according to economist Prof. Edward Scicluna, after opting for a fixed exchange rate with the Euro upon entry into ERMII last year, the only instrument left to protect the system from capital flight is that of raising interest rates. According to Scicluna the effects of the Central Bank’s decision on the economy cannot be seen independently of the whole package of policy decisions, including the exchange rate regime mechanism based on a fixed peg.
Last year Scicluna had described the decision to go for a fixed peg as the “worst” economic advice government could have had.
“The nature of that package demands that economic shocks on the system will have to be compensated for by price and wage adjustments. Failing that, any particular shock finally translates itself into a fall in reserves,” Scicluna said, when asked to comment on the Central Bank’s decision. He also noted that the collateral economic effects of this decision are bound to be negative, especially due to the state of the economy at this point in time.
“But are we left with any other choice?” Scicluna asked.
Whoever supported the fixed peg policy must now carry on along its planned course, Scicluna told Business Today.
“There are no surprises on this. If it can deliver its goods in one year’s time, well and good. I, for one think we took the wrong decision last year. But for this latest decision I am not surprised at all. It is part of the script."
On the other hand, the Federation of Industry said it understood the decision but feared its consequences.
FOI President Adrian Bajada acknowledged that interest rate hike is meant to reverse the declining trend in foreign reserves, while containing the surge in imports of consumer goods and thus soften inflationary pressures.
He also remarked that the increase in interest rates should safeguard the stability of Malta’s currency and the changeover bid to the Euro, which would, in turn, enhance the credibility of the country.
“Indirectly, this sustains future long term economic growth,” Bajada told Business Today. But he was wary of the short-term consequences of the central bank’s decision.
“Nonetheless, one cannot ignore the short term aspects. For example, access to finance such as bank loans is expected to become costlier both to enterprises and consumers.”
The FOI expressed its concern that the increase in interest rates will further aggravate the financial situation of a large number of enterprises, especially domestically-oriented SMEs that are already facing cash flow problems resulting from higher operational costs, and a relatively subdued demand.
“Therefore, the recent spike in interest rates could jeopardise short-term economic growth,” Bajada told Business Today.
MLP deputy leader Charles Mangion concurred that the decision was spurned by the downward trend in the Central Bank’s external reserves due to a progressive narrowing in recent months of the interest rate differential in favour of the Maltese lira, caused mainly by rising euro interest rates.
While saying that the measure could be effective in controlling the drain on reserves, he also expressed his concern that the decision is bound to have a negative impact on an economy which is still not performing well.
“The cost of money will become more expensive. This could further dampen the chances of an economic recovery,” Mangion said.
Writing in the Sunday Times, former finance minister John Dalli was more categorical in his analysis, expressing doubts on whether the Central Bank’s measure is an effective way of redressing capital flight.
Dalli argued that in order to redress capital flight, fundamental political decisions are needed rather than sheer tempering of monetary policy.
“If the Central Bank is worried about the outflow of money from Malta, it should not be looking at the interest rates but at the high hassle cost forced upon investors in Malta by Jurassic regulations and which is forcing them to send their money to places where they can make it work.”
He also expressed doubts on whether this measure will be effective in controlling inflation as this is not being pushed through rampant demand but through adjustments forced upon us by the international price of oil.
Dalli also augured that when the Public Accounts Committee in Parliament talks to the Central Bank governor about monetary policy, its members would ask pertinent questions.
But according to Charles Mangion, who also serves as chairman of the PAC, the committee cannot demand an explanation from the Central Bank governor.
“We are supposed to meet the central bank governor twice a year. I cannot call for a special meeting on this issue.”
Apart from John Dalli, former minister Lino Spiteri has also been an outspoken critic of the Central Bank’s decision.
Writing on the Times on Monday, the former Labour minister argued that a major cause for ongoing conversions into foreign currency, is fear that massive tax evasion will be uncovered after the Maltese lira ceases to be legal tender.
According to Spiteri the rise in interest rates will not stop that outflow, or the funds going into immovable property in Eastern Europe.
Spiteri said that sustainable economic growth depends on strong performance by existing exporters of goods and services and new, export-oriented domestic and foreign real investment.
By raising financing costs, the Central Bank’s decision contradicts this objective, particularly at a time when the interest differential in favour of the Malta lira should be declining, rather than maintained, Spiteri argued.


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