By Sameer Sharma
Conventional monetary policy is about the central bank having a policy rate which sets an interest rate floor for the interest rate structure of the economy. All other interest rates are derived from this floor with the addition, of course, of various risk premias such as term premia, inflation risk premia, default risk premia (for credit risky bonds), or liquidity premia. In more mature markets, central banks through their key policy rate can thus impact both output and prices over a certain horizon.
There are however some key requirements for this tool to work well. Firstly, you need a clearly articulated and communicated inflation target. You cannot have vague objectives or implicitly multiple objectives. Most central banks have moved towards some form of a flexible inflation targeting over the years. Without a clearly communicated target that anchors inflationary expectations, how can any central banker know about at what rate the key policy rate should be set? If one reads through the views of economists in the Mauritian press, there are those who always view the interest rate as being too low, but the reality is that, without a clear target, it becomes more of a random guess or a view driven by multiple objectives than anything else as there is no reference point.
Secondly, beyond looking at forecast inflation relative to the target, the size of the output gap is an important element used in determining the level of the key policy rate. Central banks aim to stimulate demand when the output gap is negative (which typically also should correspond to lower demand side inflationary pressures providing them the leeway) and become more hawkish when the output gap is positive.
Thirdly, in order for interest rates to have an influence on output and prices, you need to have a well functioning secondary bond market. In the case of Mauritius, the very high number of outstanding and small issues of government bonds leads to a fragmented market. Without a clearly articulated monetary policy framework that is quantifiable then, no central bank can conduct a fully effective monetary policy.
The debates about high interest rates or low interest rates become more of a moot point. You cannot protect the value of the currency, keep inflation at a certain level, protect savers, stimulate demand all at the same time. That is why central banks typically focus on a narrow set of objectives such as price stability as clearly defined by a quantifiable target, be it flexible or fixed. While I do not wish to get into the details of the Mauritian monetary policy making, it is clear today that for various reasons, include some of those mentioned above, conventional monetary policy in Mauritius has its limits in terms of how it helps to close the output gap.
I would therefore argue that with the world economy facing increasing downside risks with the outbreak of the Coronavirus and with GDP growth at basic prices likely to hover at around the 3% range this year (3.3% to 3.5% at market prices) despite all the consumption growth driven fiscal measures taken over the past few years and in December (pension fund increases), and given limited availability of counter-cyclical fiscal buffers, it is high time for policy makers to consider the implementation of unconventional monetary policy measures especially when inflationary expectations remain weak and real interest rates remain close to zero.
Credit line or special bond issuance
How can Mauritius better face the risk of a worse than expected global economic slowdown? With downside risks to the global economic growth recovery increasing and with the output gap in Mauritius expected to widen further, the Bank of Mauritius should do two things.
Firstly, as long as the output gap remains negative or is on a deteriorating trend and as long as inflationary expectations remain well anchored at or below 3%, it should provide a credit line facility to the government set at the one month Bank of Mauritius bill rate. The quantum of the credit line should be large enough to allow the fiscal side to engage in counter-cyclical fiscal policy with the view to closing the output gap over the medium term. As the output gap closes, the central bank should adopt a clear and transparent rules based approach to gradually pull back the credit facility. Central bank lending to the fiscal side does not increase the level of government debt because both belong to the same country, and assets and liabilities cancel each other out. The credit line will also serve to temporarily expand the balance sheet of the central bank and by default its capital as well.
A win-win can be found between the fiscal and monetary policy side in the context of a deteriorating output gap and muted inflationary expectations.
Secondly, the government should issue a 10 to 15 billion rupees long term special bond (non tradable) at preferential rates (sterilisation cost + 50 basis points) to the central bank in order for it to fund supply side measures which are key to the long term economic growth rate of the economy. The central bank would create money (a liability) and have an asset (the special bond), but it would have net proceeds. It would also reduce foreign exchange risk on its balance sheet as it would have more assets in rupees.
The raised liquidity would be kept at the central bank and disbursed over time so as to minimise the impact on liquidity in the market. This will expand the balance sheet and capital base of the central bank (as the latter’s margins would improve) resolving all the exaggerated “bruhaha” about the Bank of Mauritius going out of business. More importantly, in the case of a worse than expected global economic slowdown, these funds will provide ample room for the government to spend on supply side measures (not demand side) and better withstand the shock. There would be no increase in the country’s debt, and even if that means more interest payments to the Bank of Mauritius, 85% of profits of the central bank would go back to the government anyway.
It should be noted here, from the second point, that many central banks including the Reserve Bank of India recently have been conducting more open market operations by selling short term paper to the market while buying long term government bonds. In the case of Mauritius, as the secondary bond market is not well developed, such operations would have limits, which is why a special bond issuance is being proposed here. It is indeed rare that a win-win can be found between the fiscal and monetary policy side in the context of a deteriorating output gap and muted inflationary expectations both globally and locally. Policy makers should seize on these ideas especially if the V-shaped recovery we are being promised (post Coronavirus) does not look to materialise.