By Sameer Sharma
As calls continue to mount on the Bank of Mauritius to do something about inflation, the consequences of its past actions on its balance sheet will prevent it from being an effective actor in the inflation fight. In effect it is already well behind the curve, and beyond its balance sheet woes which are largely misunderstood and ignored in the mainstream media, it lacks a quantifiable inflation framework and the associated credibility that comes with it in order to meaningfully tame inflation.
Firstly, on the global front geopolitical tensions in Eastern Europe are likely to worsen the near to medium term inflation outlook but not derail the end of year thesis that inflation will begin to cool off albeit slowly. This is because growth has also been slowing and is now close to its long-term potential based on high frequency nowcasts. This slowdown from elevated levels of growth which was synonymous to a positive output gap indicates that after a year of record consumption and investment, demand destruction could already be underway due to rising costs/higher prices eating away at corporate margins and consumers’ spending power. We see this in company investor call outlooks and in developed and some emerging market equity sector price divergences.
Despite the Ukraine noise which will delay an inflation cool-off, macro normalisation is underway too, with both economic activity and inflation expected to cool off over the course of the year globally. The market is already pricing in some 125 basis points of rate hikes by the US Federal Reserve over the next twelve months along with quantitative tightening which is aggressive compared to the 2016 to 2018 hiking cycle and to the latest January Fed dot plots. One can also note that the 2 year and 5 year versus the 30 year yields are flattening. In plain speak, the market has been quite aggressive in pricing slower medium to longer term growth and much higher short term rates, in other words, the market is increasingly concerned about a policy mistake which, along with geopolitical tensions, is causing quite the sell-off in rate sensitive risk assets, especially growth stocks and cryptos.
An economy heavily reliant on easy money
Getting back to Mauritius, the economic recovery while encouraging remains moderate, uneven and fragile. The economy is still too heavily reliant on easy money when it comes to the deleveraging process in both the public and private sectors. The largest non-financial groups within the private sector have been able to put good pressure on policy makers when it comes to their bailout terms and pricing, some large banks have been able to get a golden opportunity to reduce credit exposure to some quite mediocre pre-Covid private sector credit/balance sheets as they focus more on their international businesses at the expense of the Mauritius Investment Corporation and the Bank of Mauritius whose balance sheet has seen quite the risk transfer with poor potential returns to show for it. Despite the fact that the convertible bonds which were issued had no intrinsic option value and should hence have been treated as plain vanilla low coupon mispriced debt, some large indebted conglomerates have been able to still treat these as quasi equity and claim that they have been able to lower debt metrics. This is quite the feat which would not be possible outside of paradise.
The economic recovery while encouraging remains moderate, uneven and fragile.
Some other conglomerates have even also focused on paper asset revaluations to push up both asset and equity values to then claim low debt to equity levels. While some in policy making may think that the collateral recourse they may get on these MIC floating charges in case of default is comforting, they have likely not learnt much about how assets get valued on paper in Mauritius, about the liquidity of the market and about how steep losses can be in such a market when given default.
More than 26 billion rupees of excess liquidity is also distorting credit risk pricing to the benefit of large corporates, but it is also incentivising the continuation of bad past behaviours which led to debt centric capital structures with little return on capital and free cash flow generation to show for it.
The local investor base is not very sophisticated and quite forgiving in Mauritius, but when one starts to look at debt compared to the free cash flow metrics, free cash flow yield, return on capital versus the weighted cost of capital, the reality is that unless business models and mentalities change, on paper makeups won’t be enough to meaningfully improve longer term economic fundamentals all the same.
The public side too has been busy engaging in debt accounting magic tricks, but the lack of productivity enhancing reforms in the economy and the lack of vision also mean that beyond some base effect gains, the medium term economic outlook remains moderate to weak at best, especially when one considers that we are very much still in the first half of the deleveraging process.
Without structural reforms, the same old mentalities from the dominant patrimonial private sector, without better targeted wasteful spending cuts and a move towards more targeted spending across the board, fiscal policy and the private sector will depend heavily and lobby heavily against any modernization of the monetary policy framework and tighter policy in general. Recent private sector lobbyst interviews in the media are not so innocent and are part of the back room pressure to keep monetary policy as easy as possible.
Any increase in interest rates will also impact the mark to market values of these deeply out of the money and wrongly structured convertibles with zero value conversion options which will impact the balance sheet of the central bank itself. That is why central banks do not put such things on their balance sheets.
Hiking the cash reserve ratio
Regarding the balance sheet of the Bank of Mauritius, with some Rs 15 billion left in economic capital as at January 2022 which is merely Rs 5 billion above the sanctioned minimum, the central bank is significantly under-capitalized for the risks it has on its balance sheet, let alone to conduct credible monetary policy. If it plans to fight inflation via the exchange rate channel, then it cannot depreciate the rupee to build up economic capital artificially. If it sells more than USD 120 million of foreign exchange to banks, then this will reduce its asset value by more than Rs 5 billion which will reduce economic capital below Rs 10 billion, and if the rupee appreciates against the trade weighted basket of the rupee, then there will be no capital left.
The central bank is significantly under-capitalized for the risks it has on its balance sheet.
The Bank of Mauritius cannot go bankrupt but it will need to print money to finance its liabilities, which is not exactly how one fights inflation. There is more than Rs 26 billion of excess rupee liquidity in the system, and the Bank of Mauritius does not have the economic capital to even sterilize half of this amount. Transmission mechanisms from interest rates to prices and output only work if you have a well developed, less fragmented secondary bond market with short term treasury rates and interbank rates closely aligned to the Repo rate.
Already the Repo corridor at 125 basis points is just too wide for the Bank of Mauritius to appear to be credible in hiking rates, and mostly these rates tend to remain at the lower band of the corridor. The only tool left for the Bank of Mauritius to be able to influence market rates and lending rates more strongly than word of mouth operations is by hiking cash reserve ratio (CRR) requirements. The problem is that CRR increases are crude and potentially distortive and are an untargeted attempt at influencing market and lending rates which may also have downside consequences.
There is a reason why the IMF has called for the government to take on more debt and recapitalize the central bank, which will increase public debt. The probability of this happening is near zero in the current context. The government may try to borrow more from foreign countries and try to get more grants which will on paper show an increase in foreign exchange reserves which, post some asset liability management magic, may temporarily contain economic capital depletion. But net of the associated liabilities it creates, these are not sustainable solutions and nor are they going to be very effective beyond fooling the media.
So, what can the Bank of Mauritius do? It will be forced to rely heavily on the global growth slowdown and the associated decline of global inflation. The central bank will not be able to implement any new monetary policy framework without more economic capital. It will need to simply try to match part of the 125 basis points cumulative expected Fed funds rate increases over the next 12 months via CRR increases which will need to accompany the Repo rate increases, else these will be symbolic gestures divorced from where market rates remain. In plain speak, the Bank of Mauritius will simply be able to limit the increase in interest rate differentials versus the US rate, which hopefully will partially contain further depreciation of the rupee. It will then need to bank on the expected cool-off in global inflation to then claim that it has been able to manage it well.