Foreign exchange intervention strategy won’t work

By Sameer Sharma

It has become very difficult to obtain foreign exchange in Mauritius these days, especially US dollars. Bid-ask spreads have increased given deteriorating liquidity conditions in the market while an artificially strong rupee which comes with notable supply-demand mismatches at the current official exchange rate has even led to the emergence of a still small but worrying parallel market. All this is occurring despite the opening of the borders and strong growth in tourist arrivals and consistent central bank interventions. Between September 2021 and September 2022, the Bank of Mauritius (BoM) has sold more than 665 million dollars in the foreign exchange market, but has so far failed to noticeably improve liquidity conditions in the market. The objective of this article then is to explain why the current policy will not work and is not sustainable, and it proposes alternative solutions which, if followed, can over time restore normal liquidity conditions in the foreign exchange market.

Global economic context and the rupee

While global inflation pressures are beginning to cool off as expected, given the noticeable collapse in global growth momentum, the beginning of de-globalisation, economic nationalism coupled with the balkanization of global supply chains, geopolitical tensions, the consequence of ultra-loose monetary policies during the pandemic and the technology war, will keep inflation high enough for longer. In the 1970s, central banks made a mistake by not tightening monetary policy enough in response to the stagflation shock of the 1970s. Back then, the argument was that inflation was a supply side problem and that central banks, which only have control over the demand side, would not be able to do much about it. Similar arguments are being made by private sector lobbyists in Mauritius in 2022.

This policy of not acting fast enough in the 1970s led to significant tightening of monetary policy in the early 1980s and to a much deeper recession. This is because central banks need to care about longer term inflation expectations especially when they begin to de-anchor. To get this credibility back, they had to double down on tightening under Paul Volker.

Today, mindful of the risk of a de-anchoring of inflation expectations, the likes of the Federal Reserve have been forced to tighten monetary policy more aggressively after falling behind the curve. The US economy may have slowed down, but strong employment numbers and buoyant consumer spending continue to point to a hawkish stance despite near 100% recession risk. At the same time, European growth momentum is collapsing faster than that of the United States, and this winter will be much harder. The combination of rising US interest rates and a less than rosy outlook elsewhere is leading to rising dollar demand.

Markets are forward looking. Even in periods of recession, investors tend to buy safe heaven currencies such as the Japanese Yen, the Swiss Franc and, given its liquidity, the US dollar. Hence, even if the Federal Reserve is closer to the end than to the beginning of its tightening cycle, this notion that the US dollar will then weaken is a tricky theory given the sombre economic outlook for the global economy in 2023.

Mauritian growth may have been boosted by strong tourist arrival numbers, but as the global economy continues to slow, so will Mauritian growth. Mauritius also lacks both adequate fiscal and monetary buffers in order to face the current crisis. A weak Bank of Mauritius balance sheet and ample excess liquidity in the rupee money market have kept short term market rates very low. The 3-month rupee treasury bill rate currently stands at 1.75%, the 7-day bill stands at close to 1% while the 7-day inter-bank rate stands at a mere 1.55%. The overnight inter-bank rate stands at 1.18%. Short term interest rates remain well below the repo rate, which is not how things should be.

The combination of excess liquidity and a weak central bank balance sheet are major factors to the current state of affairs. The Mauritian 10-year Government bond yield in the secondary bond market currently stands at 4.71% while the 5-year bond yield stands at 3.55%. All short term, medium term and longer term yields are well below current inflation and medium and long term inflation expectations which, as per the latest survey conducted by the BoM, stand at above 6% (5-year ahead).

At the same time, the US 3-month Treasury Bill rate stands at 3.95% while the US government 10-year bond yields 4%. US inflation expectations as measured by the five year/five year forward stands at a mere 2.35%. In a nutshell, holding US dollars and placing them to earn interest is significantly more attractive right now than holding onto Mauritian rupee savings instruments. This fact when coupled with a global economic slowdown, which will be worse than many expect, favours holding US dollar assets and being short weak emerging and frontier market economies with weak external trade imbalances. Mauritius is one such market. Interest rate differentials, the flight to quality and relative growth outlooks matter, and these are not trends the central bank can easily fight against.  

Impossible Trinity

In economics, the Impossible Trinity means that in an economy that does not have any capital control, exchange rate targeting will come at the expense of monetary policy independence. Mauritius being an international financial centre (IFC) that seeks to grow cannot close its doors to two-sided capital flows. The Bank of Mauritius has a price and financial stability mandate which is not quantified. This when coupled with a lack of independence from the fiscal side means that it is currently engaging in a curry strategy of policy rate tightening and exchange rate interventions.

Printing money to finance one’s domestic liabilities when the level of economic capital is negative is akin to expansionary monetary policy and will invariably impact inflation and the value of the currency.

In an attempt to increase the success rate of its small foreign exchange interventions in the market, a silent policy of foreign exchange rationing has been implemented. In a country that claims to be an IFC, pension fund managers, asset managers, wealth managers, family office managers are called speculators. The policy of rationing takes us closer to the world of capital controls or some type of managed float. The challenge for Mauritius of course is that it cannot have short term interest rates as the policy anchor and be targeting the exchange rate at the same time while maintaining open capital flows. Given that Mauritius cannot ration foreign exchange for long, it will either lose effectiveness when it comes to implementing monetary policy via the interest rate channel, or it will need to allow the currency to reflect fundamentals.

Bank of Mauritius intervention strategy and artificial value of rupee

Everyone in the market has already understood that the Bank of Mauritius cannot allow the Mauritian rupee to appreciate below 43.70 because its balance sheet would go negative. A central bank unlike a corporation can operate with negative equity and cannot default on domestic liabilities as it holds the monopoly on the printing press. But printing money to finance one’s domestic liabilities when the level of economic capital is negative is akin to expansionary monetary policy and will invariably impact inflation and the value of the currency.

Secondly, as will be showcased later in this article, the BoM has been engaged in a heavy dose of foreign exchange borrowing internationally, and a low level of economic capital will not please its international creditors. A central bank can certainly default on its foreign liabilities. For all these reasons and more, the market clearly understands that taking a long position in the US dollar versus the rupee or creating a synthetic short rupee long dollar position via a synthetic forward has little downside risk and decent upside returns especially when one takes favourable US interest rate differentials and the unfavourable global growth outlook into account.

The Bank of Mauritius is trying to manage the level of the exchange rate but this also has consequences in terms of reserve adequacy. Not only is it financing these sales with a stagnating level of international reserves with higher borrowings whose interest rate costs are rising, given rising US interest rates (and squeezing BoM net interest margins) but beyond international reserves depletion risk, as one gets further away from a free float exchange rate regime, the amount of international reserves one needs to have as a buffer needs to go up. The reserve adequacy metric known as the ARA metric will need to be adjusted to cater for a much less free floating exchange rate regime. This is not something that can be contemplated right now. The market knows this.

The Bank of Mauritius is selling between 10 million and 40 million US dollars every 2 weeks, the market knows the downside and realises that supply versus demand dynamics mean a rupee closer to 46 versus the US dollar than 44. So they buy and wait. The BoM is only causing the Mauritius foreign exchange chart to look like a yo-yo. There is very little liquidity at the rate at which it intervenes because supply does not meet demand over there. If the BoM wants to keep the exchange rate within a tight range of between 44 and 45, then it will need to be able to sustain larger foreign exchange sales for longer. Had the global economy not entered a crisis, this would have slowed the depreciation trend, but right now all we are doing is creating some artificial official rate at which most cannot buy at.  

Sustainability of current Bank of Mauritius strategy

To better understand the fact that the Bank of Mauritius cannot sustain what it is doing, we need to have a closer look at the recent evolution of its balance sheet. The rise of total assets of the central bank has mainly been driven by the rise in domestic assets, which essentially means monetary expansion. The central bank has been printing a lot of money and the Mauritian rupee has been depreciating. Other liabilities contain a lot of the on-balance sheet foreign borrowing the central bank has been conducting in recent months.

As can be seen in the Table, the level of economic capital which stood at 13.37% in November 2019 before the first 18-billion rupee transfer to the Government today stands at a mere 1.3%. It should be noted here that the right level of economic capital, for a central bank should be based on a quantitative assessment of tail risks associated with market risks, operational risks, strategic risks, the need to maintain monetary policy credibility, credit risks – which are much higher than a typical central bank given the Mauritius Investment Corporation (MIC) – and reputational risks. With the presence of the MIC and given the increased reliance on both foreign borrowings and on contingent liabilities as a share of total international reserves, the level of economic capital as a percentage of total assets should certainly be much higher than the 2019 level.

Table:  Bank of Mauritius balance sheet metrics have materially weakened

(Source: Bank of Mauritius Assets and Liabilities and author’s calculations)

Chart:  Foreign Exchange Reserves, Contingent Foreign Exchange Liabilities & Borrowings

(Source:  Bank of Mauritius Foreign Exchange Reserves Liquidity Template and author’s calculations)

It is also clear that any marginal appreciation of the rupee would take the level of economic capital to the negative territory, which is not what an emerging market central bank wants to have. The Other Liabilities/Economic Capital ratio should be increasingly viewed as a proxy for debt/equity from the perspective of a foreign creditor. Suffice to say that the central bank is severely under-capitalized and that the level of economic capital which is needed is significant.

We also note that the current level of economic capital as at September 2022 was well below 10 billion rupees which is a minimum requirement. This 10 billion figure should not be confused with the required level of economic capital which is risk based. The central bank needs to be recapitalized based on the latter concept rather than on the former. As Chart 1 demonstrates, the Bank of Mauritius’ level of international reserves depends heavily on contingent liabilities such as commercial bank money placed at the central bank for liquidity purposes and on borrowings. If we net these numbers off, the country’s remaining level of international reserves is not very high.

What can be done?

The first and necessary step is to recapitalize the Bank of Mauritius based on a proper quantitative assessment of all the risks that it has on the balance sheet including a proper valuation of MIC assets that do not defy the laws of quantitative finance. The cost of recapitalization of the central bank will run north of 50 billion rupees and more likely than not, above 60 billion rupees. Obviously, the state does not have that kind of money.

The road ahead for Mauritius is one of painful adjustments, but the longer we wait, the more it will hurt.

The way that one sadly recapitalizes the central bank though is by engaging in a combination of returning all unspent government special funds money back to the Bank of Mauritius, by government borrowings and by also allowing the currency to depreciate. All three options except for the return of unspent printed money will hurt taxpayers and the common man. There is no magic wand out there. Had MIC assets been well structured and properly valued, such assets could have been sold to a government funded and leveraged off balance sheet special purpose vehicle, but the MIC is now just too big. A gradual approach to offloading such assets will need to be considered.

Secondly, the return of special funds money which is printed money, the freezing of MIC investments, which are also driven by money printing, and significant fiscal reforms, which include significant wasteful spending cuts, a greater focus on targeted spending and tax raising opportunities, will help to improve both long term economic prospects and the currency outlook. Fiscal consolidation and currency stability will go hand in hand. Mauritius will also not be able to ignore unproductive state asset sales, public-private co-investment opportunities and productivity enhancing structural reforms. Mauritius will of course need to attract more non-villa related foreign direct investments by breaking down various barriers to entry on top of still encouraging the development of the silver economy and improving the product offering of the tourism sector.

Thirdly, in the short term, post recapitalization which itself can be spread over 2-3 years, the central bank can start to more credibly tighten monetary policy further and close the gap between the policy rate and short term interest rates. A lower interest rate differential will help to stabilise the currency. It is important for the Bank of Mauritius to anchor medium to long term inflation expectations to between 3% and 4.5% over an 18 to 24 month ahead timeline.

This means that the central bank will need to work with government in order to establish a flexible inflation target regime where the 7-day BoM Bill can become the new policy anchor. Foreign exchange interventions would only be feasible to smooth volatility as long as expected inflation remains within the inflation band over an 18 to 24 month period. There is no long term trade-off between growth and inflation. Stable prices are good for investments and growth. Rather than blaming speculators, we should improve the economy and have more attractive interest rates.

The current global growth slowdown will be worse than many think, and tightening will indeed need to be coupled with productivity enhancing reforms. The road ahead for Mauritius is one of painful adjustments, but the longer we wait, the more it will hurt. It is high time we wake up, put the right people at the right places and smell the coffee.