Second, the economy is already highly integrated with that of the EU. This is borne out by trade flows, as well as by a comparison of Malta’s economic structure in terms of the sectoral distribution of value added and employment with that of the Union. In addition, differences in productivity levels between Malta and the EU in the traded goods sector have been found to be small, which suggests that the Balassa-Samuelson effect is unlikely to be strong. Moreover, economic integration will deepen as barriers to the movement of goods, services and factors of production are removed as part of the accession process. These factors, which attest to a significant degree of real convergence, support an exchange rate regime based on a peg to the euro. Empirical evidence indeed shows that the exchange rate peg has been a valuable nominal anchor, restraining price and wage increases. In fact, inflation has averaged just 2.6% in the past five years, indicating a considerable measure of nominal convergence with our major trading partners, and with the euro area in particular. By reducing the costs associated with international trade and investment, the peg has also contributed to Malta’s orientation as an open economy. Price stability and openness have been key factors contributing to the country’s economic growth record, which averaged 3.3% in real terms during the same period. Between now and the adoption of the euro, therefore, Malta intends to maintain a fixed exchange rate regime based on a currency basket centred on the euro.
The Central Bank is aware that it will have to maintain the peg and manage a smooth transition to membership of the ERM and the single currency area in a rapidly changing economic environment. This will not be easy, but we should be able to rely on the well-established institutional and policy framework of the acquis and anchor our strategy to a clear end-point, the adoption of the euro. We, therefore, believe this to be a credible approach to euro area membership. In conducting monetary policy during this period, we recognize that international capital movements may present a growing challenge. For a long time, Malta’s exchange rate peg was backed by controls on inward and outward capital flows but these are now being gradually phased out. In theory, full capital account liberalisation may lead to large and volatile capital flows which, in turn, may put pressure on the peg. In practice, econometric evidence suggests that, because of its openness, the Maltese economy has already been exposed to significant capital flows. This, together with recent experience with a partially liberalised capital account, suggests that the impact of full liberalisation may turn out to be less than might have otherwise been the case. It is clear, nevertheless, that the Central Bank will have to adjust short-term interest rates – its key policy tool – to neutralise any pressures on the exchange rate. In other words, interest rates will not be able to respond to domestic economic developments, but will have to move in line with those abroad.