Grappling with a tight foreign exchange liquidity

Par Sameer Sharma

Mauritius, a vibrant island nation, finds itself grappling with a tight foreign exchange liquidity situation which has placed immense pressure on its currency, the Mauritian rupee. This economic predicament is largely attributed to the lack of confidence by forex earners in the rupee, stemming from an all too expansionary fiscal policy stance coupled with an ineffective monetary policy implemented by an undercapitalized central bank.

Artificial exchange rate

Officially the foreign exchange appears to have been stabilized but the exchange rate itself today is more artificial than real. Market pricing is being constrained by a quota-like system and moral suasion. Try to get the volumes you need a few days after interventions, and the challenge remains very real. The price of anything needs to be market driven and needs to bebacked by high volumes. The exchange rate may look good for political consumption, but the reality of the current level of the exchange rate is more complex.

In January 2022, local banks held an aggregate excess foreign exchange amount exceeding 80 billion rupees, well above their minimum liquidity requirements. However, this amount has been steadily declining, with latest figures indicating a mere 5.5 billion rupees – representing less than a week’s worth of foreign exchange turnover.

Despite the Bank of Mauritius’ effort to bolster the situation by selling over USD 350 million in foreign currency in 2023, largely financed by an increase in central bank foreign exchange borrowings from USD 1.2 billion to more than USD 1.6 billion, the impact has been partly nullified by continued fiscal expansion and negative real interest rates. These central bank borrowings, backed by collateral in the form of securities held in the hold-to-maturity book of the central bank balance sheet, have proven to be costly due to the high US interest rates and the credit spread applied to a country with Mauritius’s credit rating. The Bank of Mauritius cannot sustain this kind of borrowing.

The Bank of Mauritius’ balance sheet currently presents a bleak picture, plagued by significant asset liability issues and insufficient equity to cover the risks on the balance sheet. The assets of the Mauritius Investment Corporation, which form part of the central bank’s balance sheet, have been inflated, while loss-making foreign exchange reserves securities have been transferred to the hold-to-maturity book of the international reserve portfolio to prevent the bank’s equity from going negative. This move, however, creates significant liquidity issues and makes the foreign reserves portfolio even less dynamic, which is the last thing to do when managing such portfolios.

The Mauritius Investment Corporation should be shut down to prevent excess liquidity in the system.

The International Monetary Fund’s Assessing Reserve Adequacy (ARA) metric, which accounts for the central bank foreign borrowings, public foreign debt (excluding that of the central bank), import bills and the size of global business deposits in the system, now places Mauritius closer to the lower bound of what would be considered adequate in terms of international reserves adequacy.

Mauritius, being heavily reliant on imports for consumption, may witness an exacerbation of its current account deficit situation once again after a moderate recovery in 2023. This, combined with the increase in the minimum wage, is putting renewed pressure on the rupee, which has once again entered overvalued territory during the later part of the year.

This is all happening in the backdrop of local investors finding more attractive higher return investment opportunities outside rather than within Mauritius. Investment portfolios are being rebalanced with foreign allocations taking a more prominent role than before. These are structural issues that are not been addressed by macroeconomic policy makers so far.

Mauritius’ real interest rates have remained negative despite inflation expectations being well above the central bank’s target. This is attributed to the public and private debt situation and the ability to service this debt should interest rates be normalized. Mauritius’s economic model, fuelled by debt and consumption, and driven by populist politics, is inherently unsustainable and puts structural pressure on the rupee.

The government’s expansionary fiscal policy is showing signs of overheating the economy. Unless Mauritius undertakes meaningful structural reforms, controls fiscal spending, and enhances local factors of production, forex earners will continue to hold onto their forex while longer-term investors will continue to allocate more funds abroad as part of their asset allocation mix. The Bank of Mauritius’ current strategy of constraining demand via a quota-like system is proving ineffective because getting good transaction volume at the official rate is very difficult.

Switching from selling to buying foreign exchange

So, how can confidence be restored in the short term? The most viable steps include normalizing interest rates, recapitalizing the central bank, providing targeted relief to the poor and middle class through tax refunds, raising tax revenues, and controlling government spending. Additionally, all unused funds transferred to the government by the Bank of Mauritius should be returned, and the Mauritius Investment Corporation should be shut down to prevent excess liquidity in the system. Lastly, the government should ensure that all real estate transactions are settled in local currency.

Mauritius needs to attract more foreign direct investment which goes beyond real estate villa sales. The country needs to have a better regulated and more competitive landscape versus the current hand shake agreement of the 80s and 90s of allowing oligopolies and monopolies to flourish in exchange for job stability and political party financing. The Competition Commission of Mauritius needs to be completely revamped. The government should stay out of the business of picking winners and losses. Public contracts need to be awarded in a fair and transparent matter and in general a new alternative funding ecosystem needs to be developed domestically.

The government should ensure that all real estate transactions are settled in local currency.

The stock market and the openness to more active minority shareholders who demand more in terms of performance needs to be encouraged. Mauritius also needs to become much more open to high skill immigration and then build a better value for money healthcare and education system to keep those immigrants from leaving. We need a new product. We need to enhance our attractiveness beyond taxes.

We need a more competitive and dynamic free market ecosystem which we do not have today, so that we can attract more foreign exchange inflows. We also need more developed capital markets. We need to put the right people who actually understand how capital markets work at the right places. For example, we need to develop our forex market further rather than use 1980s quota systems which make the forex market regress back to that time period. There is a lot to do to bring more capital inflows. It is hard work and these reforms will take time and will face resistance from some within the private sector who enjoy rent seeking.

There is no denying that the rupee outlook is currently more uncertain when it should not be. Borders are open, and sound fiscal and monetary policy can gradually restore confidence without any need for 1980s foreign exchange controls. The nation’s dependence on foreign rent seeking, coupled with the unpredictable nature of geopolitical crises, makes it crucial for Mauritius to build fiscal and monetary buffers. As the island nation heads into 2024, it must strategically plan for a resilient economic future while leaving no stone unturned to restore the strength and stability of the Mauritian rupee as measured by volume backed market rates. We seem to be counting a lot on Indian rent for Agalega or Chagos compensation, but rent seeking is not synonymous to sound macroeconomic policy making.

At the time of writing, the Bank of Mauritius has switched from selling foreign exchange to buying whatever little excess foreign exchange liquidity remained in the market albeit via forwards. Essentially the Bank of Mauritius has gone long dollar on a forward basis. Whether it be the positive carry of going long dollar and short rupee, or whether it be liquidity constraints forcing it to leverage forwards versus spot, or a bit of both, this is quite the reversal from the Bank of Mauritius.  Worse the latter did not use any communiqué to explain the logic of it suddenly turning from short dollar spot to long dollar forward. The Bank of Mauritius may believe that it can leverage moral suasion, constrain domestic foreign exchange demand via rationing and via limited debt financed foreign exchange interventions to control the foreign exchange, but Mauritius does not have the level of international reserves to play that game without fixing structural ills.

Policy makers should exercise great caution in the era of perma crises. Buffers and productivity matter. The rupee is but a reflection of our true self after all. The sooner we learn this, the better.