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The exit of the United Kingdom from the European Union – Its short-to-medium term impact on the Maltese economy 1 Noel Rapa Policy Note March 2017 1 Noel Rapa is a Senior Research Economist in the Research Office of the Central Bank of Malta. The author would like to thank Dr. Aaron George Grech for valuable comments and discussions. The views expressed in this paper are those of the author and do not necessarily reflect those of the Central Bank of Malta. Any errors are the author’s own. Corresponding author’s email address: [email protected] 1 Abstract This note studies the impact that the UK’s exit from the EU might have on the Maltese economy in the short-to-medium run using the Central Bank’s macro-econometric model. The study, which starts by reviewing economic relations between the two countries, takes into consideration both direct effects emanating from lower demand from the UK, as well as indirect effects due to the negative economic impact to the EU of this development. Any study of this kind is surrounded by a high degree of uncertainty as the terms of the UK’s exit are still unknown. In balance, the economic consequences for Malta are likely to be negative, with a peak effect on GDP ranging between 0.24% to around 0.54%, with the external sector featuring as the main contributor. However given Malta’s GDP is projected to grow by 12% over this period, the impact, even in the worst-case scenario, is relatively limited. JEL Classification: F47, F15, E02. Keywords: Impact of trade agreements, Economic integration, Malta. 2 Table of Contents Abstract................................................................................................................................. 2 Executive Summary .............................................................................................................. 4 How has Malta’s economic relationship with the UK evolved over recent decades? ............. 6 What are the likely effects of the UK’s exit from the EU on the UK and EU economies? ....... 8 How could this affect the Maltese economy? ........................................................................ 9 References ......................................................................................................................... 13 3 Executive Summary Malta and the UK have strong historic ties, and since 2004, these have included membership of the EU. Thus, the UK’s decision to exit from the EU has macroeconomic implications for Malta. This policy note seeks to discuss the latter by answering three questions: How has Malta’s economic relationship with the UK evolved over recent decades? Malta’s relative dependence on the UK market has fallen greatly over time, with the share of export of goods to the UK dropping from 40% in the early 1970s to about 3% in recent years. The fall in the relative share of UK tourists, though less strong, is also considerable, from nearly 80% in the early 1980s to less than 30% currently. While Maltese exports of goods to the UK amounted to nearly 10% of GDP in the mid-1970s, in 2016 they stood at just 1.4%. Expenditure by UK tourists now amounts to 4.9% of GDP, down from 9.4% in 2001. Eurostat data suggest that services exports to the UK are equivalent to some 13% of GDP, though a considerable amount are financial services flows, which tend to have nearly equivalent entries as imports of services. In fact, Malta’s net exports of services to the UK amount to 6% of GDP. The Maltese financial sector’s exposure to the UK is broadly in line with the two countries’ trade relationship. Malta’s reliance on UK workers has risen over time. About 1.8% of all persons currently in employment in Malta are British citizens, a proportion higher than the proportion of all foreign workers at the time of Malta’s accession to the EU. Besides this growth, there has also been a strong rise in the number of UK citizens who retire in Malta, from 1,930 in the 2005 Census to 3,537 in the 2011 Census. What are the likely effects of the UK’s exit from the EU on the UK and EU economies? At this stage, there is a high degree of uncertainty surrounding the terms at which the UK is likely to exit the EU. Despite this uncertainty, formal assessments conducted by researchers and international institutions point at significant downward economic risks to the UK economy. Indeed, the downside risks of reduced access to international trade are judged to outweigh possible increases in the UK’s long-run productivity due to eventual deregulation processes. 4 The EU is an important partner for the UK attracting around half of the UK exports. The EU also exports significant amount of goods and services to the UK implying that some EU countries are likely to lose economically due to the departure of the UK from the EU. Moreover, given its size, the UK’s exit from the EU is projected to have global effects, even though these are anticipated to be more contained when compared to the contractions in economic growth expected in the EU and UK. The quantification of these effects depends on the outcome of the negotiation process between the UK and the EU. The three most likely scenarios considered in literature are: an EEA membership allowing the UK to retain access to the single market; a series of bilateral agreements similar to the Swiss-model; the default WTO rules that would come into place should the talks between the two parties yield no results. How could this affect the Maltese economy? To quantify these effects, this study conducts an analysis using STREAM, the Central Bank of Malta’s macro-econometric model (Grech and Rapa, 2016) exploring two scenarios which stand at opposite ends of the spectrum of agreements likely to be struck by the UK and the EU: a best-case scenario assuming that the UK will remain a member of the EEA and a worst-case scenario that assumes unsuccessful negotiations between the two parties. The peak effects on Maltese GDP are projected to lie between -0.24% and -0.54% with the main contributor at least in the first two years being the external sector. Given the uncertainty surrounding the terms of the UK’s exit from the EU, these results should be treated with caution. The results presented focus solely on the impact of a drop in foreign demand and a change in foreign exchange rates. The analysis undertaken, for instance, does not take into consideration the possible benefits for the Maltese economy should UK companies relocate to Malta to retain access to the EU market. Finally, over the next three years, the Maltese economy is projected to grow by close to 12%, implying that even under the worst case scenario, the UK’s exit from the EU would have a negligible impact on Malta’s pace of economic expansion. 5 How has Malta’s economic relationship with the UK evolved over recent decades? Given Malta was part of the British Empire until 1964 there are strong economic ties with the UK. At the time of Independence, the strength of these ties was such that economic experts had argued that mass emigration was the “only feasible solution in the long run” for the Maltese economy.2 However, post-independence the Maltese economy evolved relatively quickly and diversified greatly. As a result the relative dependence on the UK market declined substantially over time. The share of Malta’s export of goods to the UK has fallen from 40% in the early 1970s to about 3% in recent years,3 whereas the share of UK tourists has fallen from nearly 80% in the early 1980s to less than 30% currently. Besides the decline in the UK’s relative share of goods exports and tourist arrivals, one also needs to note the fall in the relative size of these two activities in Malta’s GDP. While Maltese exports of goods to the UK amounted to nearly 10% of GDP in the mid-1970s, in 2016 they stood at just 1.4% of GDP. Expenditure by UK tourists was estimated at €485.1 million for 2016, up from close to €400 million in 2001, but in terms of share of GDP, this expenditure now amounts to 4.9% of GDP, down from 9.4% in 2001. 2 See Grech (2015) for more details. 3 Malta imports more goods from the UK than it exports. In 2016, imports of goods from the UK amounted to €343.3 million, or 5.3% of goods imports. 6 Eurostat data suggest that services exports to the UK amounted to €1.2 billion in 2015, equivalent to some 13% of GDP. However a considerable amount of these exports are financial services flows, which tend to have nearly equivalent entries as imports of services. In fact, Malta’s net exports of services to the UK amounted to €559 million, or 6% of GDP – the bulk of which represent the expenditure of UK tourists in Malta. This share is unchanged from its 2011 level. In 2016, Malta’s core domestic banks had an exposure to the UK equivalent to 7.4% of their total assets. About two-thirds of this exposure was constituted by loans to UK residents, while the rest was UK securities, prevalently relating to the UK sovereign. On the liabilities side, the exposure is much smaller, at 1.3%, mostly short-term deposits of UK residents. The domestic insurance sector’s asset exposure to the UK in 2016 stood at 5.2% of total assets, while domestic investment funds hold 4.1% of their total assets in UK securities. This suggests that financial ties with the UK are broadly in line with the trade relationship between the two countries.

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