The Adjustment of Maltese Firms to the Post-crisis Economic Environment: Evidence from a Firm-level Survey

In contrast to the experience of southern and peripheral economies in the euro area, Malta has weathered the financial crisis relatively well and its labour market remained resilient in the face of shocks. Using information from a firm-level survey conducted in 2014, this paper focuses on the nature of the shocks hitting the economy after the crisis and the reaction of Maltese firms to these shocks. Concerning the latter, a distinction is made between the firms’ decisions to adjust their workforce and on the wages given to new hires compared to incumbents. The empirical analysis is conducted with a multivariate probit framework that controls for both firm and workforce specific characteristics as well as the nature of the shocks faced by the firms. The results highlight the high degree of heterogeneity in demand conditions across sectors although concerns about skill shortages were broad-based


Introduction
As the smallest member of the euro area, with one of the most open economies in the world and located in a region, the Mediterranean, characterised by political upheaval and economic distress, Malta has weathered the financial crisis relatively well.
Economic activity in Malta recovered strongly after the Great Recession of 2009 and the economy was hardly affected by the European sovereign debt crisis of 2012.Since 2010, Malta registered one of the highest growth rates among the euro area countries and, as at 2015Q4, real GDP stood 25% higher compared to the pre-crisis peak.This compares favourably with the euro area, where the pre-crisis peak was only reached at the end of 2015 following the double dip recessions of 2009 and 2012.The positive performance of the Maltese economy is due to a number of factors, such as the diversification towards new sectors, which increased the resilience and flexibility of the economy, as well as the absence of major shocks to the financial system (Note 1).Estimates by the European Commission suggest that, by 2014, the growth rate in Malta's potential GDP had already surpassed the pre-crisis growth peak.
The labour market has kept the pace with the rapid evolution of the economy since EU membership in 2004 and proved resilient to the crisis.Employment growth averaged 3.2% between 2010 and 2015, more than four times the average growth rate registered between 1995 and 2008.Job creation in the services sector continued unabated even during the crisis.The unemployment rate and NAIRU were hardly affected by the crisis and maintained their downward trend, reaching historical lows in 2015.The labour supply increased sharply, driven by reforms targeted to increase the participation rate of females as well as an influx of foreign workers.The share of the latter increased from less than 2% of the workforce at the time of EU membership in 2004 to 10.8% a decade later (Grech, 2015b).These factors have eased labour shortages in selected sectors and kept wage pressures contained (Note 2).In addition, the pension reforms of 2006 and 2015 should eventually encourage older workers to remain active for a longer period of time over the coming years.This positive performance masks wide differences across sectors.Since EU membership, Malta experienced the largest increase among EU countries in the share of services, with sectors such as finance and professional services, ICT, online gaming and education accounting for almost half the growth in value added and employment.On the contrary, the share of manufacturing has almost halved since the late 1990s although even within this sector, there has been a shift away from labour intensive industries like textiles towards higher-value added ones, such as the pharmaceutical industry.The shift towards export-oriented services led to an improvement in external competitiveness, with the current account, which has been in deficit since the 1990s, turning to a surplus position since 2012.
Against the background of these structural changes in the economy, the Central Bank of Malta carried out a firm-level survey in 2014 as part of the Wage Dynamics Network (WDN) project (Note 3).The survey focused on changes in the post-crisis economic environment, the impact of reforms, as well as pricing and wage setting practices.The survey followed a similar one, conducted in 2010, that focused on the relevance of various cost-cutting strategies during the crisis (Central Bank of Malta, 2010).These surveys provide rich evidence, directly from firms, with a detailed breakdown by sector and size classes that is typically not available from existing statistics.This paper focuses on two key questions.First, what was the nature of the shocks hitting the Maltese economy after the crisis?Second, how did Maltese firms react to these changes?Concerning the latter, a distinction is made between the firms' decisions to adjust their workforce and on the wages given to new hires compared to incumbents.The empirical analysis is conducted within a multivariate probit framework that controls for both firm and workforce specific characteristics as well as the nature of the shocks faced by the firms using detailed information from the WDN survey.
The main findings are the following.Firms in the services sector experienced a favourable economic environment after the crisis.On the contrary, those in manufacturing were hit not only by adverse demand conditions but also by heightened uncertainty and hence, needed to adjust their workforce.The two most common adjustment strategies in manufacturing were freezing of new hires and a reduction in working hours.In terms of institutions, the survey confirms the trend decline in trade union membership.Around three out of four firms were concerned about skill shortages, with this finding being broadly stable across sectors and size classes.Such shortages are key obstacles to firms' hiring plans and, together with difficulties in staff retention, could push up the wages given to new hires.This result support policies aimed at upgrading the skill-set of the workforce through both further investment in education and the strengthening of active labour market policies.
The rest of the paper is organised as follows.Section 2 describes the design of the survey.Section 3 focuses on the nature and size of the shocks hitting the Maltese economy after the crisis.Section 4 describes the methods of adjustment used by firms, while Section 5 looks into the hiring and wage-setting process, focusing in particular on the wages of new hires.Section 6 concludes.

Data and Survey Design
A total of 271 companies were selected from the Business Register of the National Statistical Office to participate in the survey.The firms were carefully selected to ensure a stratified sectoral representation in three employment brackets: 10-49, 50-199 and those with more than 200 employees.Firms with less than ten employees, public enterprises and those operating in the agriculture and fisheries sectors were excluded.Firms falling within the top decile of each sector by employment were included since these capture the main developments in the labour market.The fieldwork lasted from May till July 2014 and was carried out using face-to-face interviews.A detailed description of the design of the survey and its sector characteristics is available in Micallef and Caruana (2015).
Throughout the rest of the paper, the results are aggregated in five different sectors: manufacturing, construction, wholesale and retail trade (henceforth, trade), the financial sector and the rest of the services sector (henceforth, other market services).The latter category is very heterogeneous and includes both traditional industries, such as tourism, as well some of the new industries like computing, professional services and remote gaming.It also includes sectors such as health and education.
Table 1 describes the sectoral coverage and the response rate.178 companies agreed to participate in the survey, implying an overall response rate of 66%.These firms employ around one-third of the target population, with coverage being strongest in the financial sector and manufacturing (Note 4).Weights were assigned to each company to gross up the survey micro-data to the population aggregates.Unless stated otherwise, the results are grossed up using weights based on firm population.the adjustment of firms.For instance, medium and large firms are less likely to adjust their workforce compared to those with less than 50 employees (the reference category).Sectoral heterogeneity is more limited.Manufacturing firms are more likely to adjust their workforce compared to other market services (the reference category) but there are no statistically significant differences between the other sectors.
Companies operating in a competitive environment are more likely to adjust their workforce.However, the effects are only statistically significant for those exposed to foreign competition but not for those facing only domestic competition.
The adjustment process is also affected by institutional factors and the composition of the workforce.The presence of collective pay agreements increases the likelihood of adjustment, a result that could be influenced by the predominance of trade union membership in the manufacturing sector.Companies with a higher share of low skilled workers are more likely to adjust their workforce whereas, on the contrary, those faced with skill shortages are less likely to adjust, in line with the hoarding hypothesis discussed above.Problems associated with skill shortages have been frequently mentioned by the local business community especially in light of the labour market tightness after the crisis.This is in line with the results of the 2010 survey, in which firms' preferred strategy when faced with shocks is to reduce non-labour costs (Central Bank of Malta, 2010).
Aspects associated with production technology and the firms' cost structure, such as the share of labour in production and the share of bonuses in the total wage bill, were not found to have a statistically significant effect on the adjustment process.
The second column in Table 2 also accounts the nature of the shocks hitting the firms.Out of the five shocks considered, only adverse demand and uncertainty shocks have a statistically significant effect on the adjustment process.
All the statistically significant covariates in Model 1 remain robust when controlling for the nature of the shocks in Model 2 with the exception of manufacturing.This implies that instead of sectoral differences in the adjustment process, companies in manufacturing were more adversely affected by negative demand conditions and an increase in uncertainty compared to other sectors, which, in turn, required an adjustment in their labour force.Demand and uncertainty shocks could have been triggered by the European sovereign debt crisis and the associated recession in the euro area, as well as volatility in commodity prices and the exchange rate, to which the manufacturing sector is more exposed compared to other sectors.The dependent variable is a 0-1 dummy that takes the value of 1 if the firm needed to signficantly reduce its labour input or alter its composition during 2010-2013. (1) (2)

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Theoretical Considerations
According to the vast literature on this subject, firms can offer new employees either a predetermined wage (also known as posted wage) or else bargain with prospective employees over their wages (Hall and Kreuger, 2008).Due to economies of scale in the bargaining process, Gertler and Trigari (2009) argue that that the posted wage is likely to be the contract wage.Hall and Kreuger (2008) posits that sectoral and institutional features, such as the extent of collective bargaining, which is usually predominant in public corporations and manufacturing sector, are important determinants of the predetermined wage.Bewley (1999Bewley ( , 2007) ) report that employers are aware that deviations from an established internal pay structure could adversely affect workers' morale.Using information from the second wave of the WDN survey, Galuscak et al (2010) report fairness considerations and the negative impact on morale as the main reasons preventing firms from deviating from the contract wage.On the other hand, labour regulations and collective agreements play a significant role in preventing firms from offering a lower wage to new hires.In Central Bank of Malta ( 2010), around 60% of firms reported that even in a situation of labour abundance, they are reluctant to lower entry wages due to reputation effects and the impact on wage effort.
Entry wages could also be determined by the characteristics of the job.In this regard, Bewley (1999Bewley ( , 2007) ) makes a distinction between primary and secondary jobs.The former are usually full-time and permanent while the latter are often short-term and part-time.Primary job employers are more concerned with salary considerations on morale, staff retention and the quality of new hires compared to secondary job employers whose primary interest is to find a steady supply of workers to hire, knowing that the hiring process is a recurrent event.The latter jobs more likely to be concentrated in particular sectors, such as the tourism industry and the retail sector.

Empirical Analysis Using a Multivariate Probit Framework
The above theoretical considerations on the entry wages of new hires are tested empirically using a multivariate probit framework.Two different specifications are used, one that models the probability that firms pay a lower entry wage and another one focusing on the determinants leading to a higher wage to new hires.Firms were asked the following question: How did the labour cost of a newly hired worker compare with that of similar (in terms of experience and task assignment) workers at your firm?For this question, firms had to choose one of the following five options: 'much lower', 'lower', 'similar', 'higher' and 'much higher'.
In the first model, denoted Pr(High)=1 in Table 3, the dependent variable is a binary dummy that takes the value of 1 if the wages for new hires are reported by firms to be 'higher' or 'much higher' compared to incumbents during the reference period.In the second one, denoted Pr(Low=1), the dependent variable takes a value of 1 if wages for new hires are reported to be 'lower' or 'much lower'.
The choice of covariates used in the empirical model depends on the theoretical considerations outlined in section 5.2.Following Galuscak et al (2010), the covariates are broadly defined in four categories, representing firm characteristics (e.g.size and sector), the product market in which the firm operates (e.g.competitive pressures and exposure to foreign markets), elements of the pay structure (e.g. the presence of collective bargaining and the share of bonuses) and the characteristics of the workforce.In addition, another category is included to account for the impact of regulation (e.g.hiring costs, risks that labour laws are changed and high payroll taxes).The exact definition of these variables is found in the Appendix.
Regression results show that firms in the services sector are more likely to offer higher wages to new employees compared to manufacturing firms (the reference group).Differences due to size classes did not turn out to be statistically significant.
The model predicts that higher wages for new hires are more likely to be awarded in firms facing skill shortages and high workforce turnover.The latter is a binary variable that takes the value of 1 if the firm reported strong worker flows due to exits.Finally, companies with a more flexible wage structure (i.e. a higher share of bonuses in the wage bill) are also more likely to offer higher wages to attract talent.
The other covariates in the model, that is, those related to tenure and skills of the workforce, the market environment and the presence of collective bargaining, do not play a statistically significant role.
A number of interesting conclusions also emerge from the second specification, which looks at lower wages for new hires.Firms in the other market services sector are less likely to offer a lower wages to new hires, confirming the previous findings.
Perhaps surprisingly, the results show that firms with collective bargaining are more likely to offer lower wages, which is different from that reported by Galuscak et al (2010).However, collective bargaining is likely to capture developments in the manufacturing industry given the relatively high concentration of union membership in this sectors compared to the rest of the economy.In fact, manufacturing was the only sector in which the percentage of firms that reported to give lower wages to new hires has increased during 2010-2013 compared to pre-2010 (see Figure 5).More generally, this finding corroborates the evidence of on-going restructuring in this sector to enhance its competitiveness.
For instance, 13% of manufacturing firms reported that it is much less difficult to adjust hours.Also, around one in four firms in manufacturing felt that it has become less difficult to move employees to other locations or across different positions, pointing to increased flexibility in this sector to adjust its workforce following on-going restructuring efforts to regain competitiveness.
Finally, regulation can also play an important role in the initial wage decision.For instance, those firms that considered risks that labour laws can be changed to be 'relevant' or 'very relevant' obstacles in hiring new employees on a permanent contract are more likely to offer low wages to new hires compared to incumbents.This shows that uncertainty concerning the future direction of labour laws could have adverse effects on the initial wage offered to some workers.The dependent variable in Pr(High=1) is a 0-1 dummy that takes the value of 1 if wages for new hires between 2010-2013 are 'higher' or 'much higher' compared to incumbents.
The dependent variable in Pr(Low=1) is a 0-1 dummy that takes the value of 1 if wages for new hires between 2010-2013 are 'lower' or 'much lower' compared to incumbents.
Payment of a higher wage Payment of a lower wage Pr(High=1) Pr(Low=1)

Conclusion
In contrast to the experience of southern and peripheral economies in the euro area, Malta has weathered the financial crisis relatively well.Since EU membership, the country has evolved very rapidly and diversified its economic base towards new industries, mostly in services, which increased the resilience of the economy and its ability to withstand industry-specific disturbances.
This paper documented the nature and size of the shocks hitting the economy and the methods of adjustment used by Maltese firms after the crisis based on a firm-level survey.Such surveys provide valuable information on the characteristics of Maltese firms, facilitate the identification of labour market trends and provide an alternative source of information to complement official statistics on selected topics.
According to the survey, more than half the firms in the services sectors benefitted from favourable demand conditions between 2010 and 2013.The situation was different in construction and manufacturing.Those manufacturing firms that were the most strongly affected by adverse demand conditions consider this situation as permanent rather than transitory.
Freezing of new hires and a reduction in working hours were the two most preferred methods of manufacturing firms to adjust their workforce.There are indications, however, of ongoing restructuring in this sector, such as the adoption of more flexible work practices, in order to regain its competitiveness.
A recurrent theme that emerged from this study is difficulties faced by firms due to skill shortages.Around three out of four firms consider skill shortages as a relevant obstacle to hire new workers, a concern that is frequently expressed by domestic employers.With few exceptions, this problem is felt within almost all sectors of the economy, although it is somewhat more pronounced in services.Regression analysis indicates that higher wages for new hires are more likely to be awarded in firms facing shortages of skills as well as high workforce turnover.This result support policies to upgrade the skill-set of the workforce through both further investment in education and the strengthening of active labour market policies.Examples of the latter include incentives, both to employers and employees, to pursue lifelong learning programmes and promote the development of job-specific skills.Finally, linkages between academia and the business community should be strengthened to ensure that the diversification towards new industries does not lead to shortages in specific segments of the labour market.

Notes
Note 1. See Grech (2015a) and Central Bank of Malta ( 2016) for a description of the changing structure of the Maltese economy.
Note 2. See Micallef (2015) for a description of the main reforms implemented to attract females in the labour market and their impact on potential output growth.
Note 3. The survey was carried out as part of a research network comprising 25 central banks from EU countries and co-ordinated by the European Central Bank (ECB).The WDN project started in 2006 with the objective of understanding the wage-setting practices in EU countries.A second ad hoc survey was conducted in 2009.Preparations for the third wave of the survey started in 2013, with the participating countries conducting their surveys in 2014.See Druant et al (2009), Babecky et al (2009), Bertola et al (2010) and Dhyne and Druant (2010) for some of the main findings of the WDN project.
Note 4. The effective sample for construction is relatively low, consisting of just 9 firms, and hence, results for this sector should be treated with caution.
Note 5.As at 2015Q2, slightly more than 40% of the core banking sector's non-performing loans was concentrated in construction and real estate.
Note 6. See Bonnici (2013) for a discussion on the relatively high interest rate on loans to businesses in Malta.
Note 7. Unfortunately, the small number of observations limits the possibility of estimating separate probit models for alternative labour adjustment strategies.

Table 1 .
Sample response rate and employment coverage Source: National Statistics Office and author's calculations.