By Sameer Sharma
Economists are often criticised for being overly prescriptive when it comes to economic policy making. Economics is indeed more complicated than most economists think. Relationships between variables are non linear, and expectations and sentiment have their own difficulty to measure dynamics at play. In the case of a highly politicised Mauritian landscape, higher frequency data is also hard to come by. The politicisation of economic data creates its own complexities.
There is in fact a tendency in policymaking circles to show great disdain for those who attempt to look at the available data to explain complex problems. This is because many economists and policymakers also often wear political hats, which adds more confusion and bias to the mix. The right approach for an economist to take then is to clearly explain the logic of his arguments. The wrong identification of the problem can more often than not lead to the wrong antidote.
Below potential growth
The potential growth rate of an economy is the maximum sustainable level of output that an economy can sustain given its current resources. When the realised level of growth of the economy is above capacity, the result is invariably inflation as producers of goods and services adjust prices. This is known as a positive output gap (overheating), and typically the central bank responds to higher inflationary pressures by increasing interest rates while governments can also reduce liquidity in the system by raising taxes or by cutting spending.
When an economy generates growth that is below potential growth, the output gap is said to be negative. In this scenario, domestic inflationary pressures are low, the central bank typically responds by cutting interest rates while the government typically engages in demand side measures such as income tax cuts, negative income taxes, pension increases, minimum wage increases. Essentially, the idea is to stimulate demand by injecting more liquidity into the system.
While this sounds simple, potential output is actually not observable and is ever changing. Producers of goods and services can over time invest and increase or decrease production capacity.
Potential output is typically estimated by using statistical techniques or by estimating a production function for the economy. All measures are imperfect. A good rule of thumb to know how close an economy is to its current capacity is by looking at whether inflationary pressures are rising or falling. When an economy has a wide negative output gap, demand side measures make some sense especially when directed to the poor and the lower middle class because they tend to consume most of what they earn relative to the rich.
This is essentially what the Mauritian government has been doing, and given the current global and local economic slowdown, further talk of pension increases and the recent interest rate cuts by the Bank of Mauritius should be viewed in this light. The challenge in Mauritius of course is that the country imports a large share of what it consumes, and the rising import bill drags overall growth down, thereby partly countering gains made by boosting consumption.
In the chart, I use an average of two statistical approaches known as HP and Kalman filters to estimate potential output growth over more than two decades and spanning at least four different political regimes after adjusting for seasonality in calculating potential growth, and compare this to actual GDP growth. The output gap itself is estimated by taking de-seasonal year-on-year quarterly GDP growth from potential output. Data in the chart is shown as annual for ease of reading. Admittedly, the lack of forward looking business survey data can lead to modest measurement error, but the results are similar to those of the likes of the International Monetary Fund: they also find that the difference between actual growth and potential growth in Mauritius is very low, and more worryingly that potential growth has been slowly but surely declining during the period from close to 5% during the early 2000s to around 4% today.
The reason why our ability to grow has been steadily declining is more structural or “supply side” driven. The decline has a lot to do with weaker growth in capital formation (productive investments made in the economy and the lack of the emergence of new sectors for quite some time), weakening labour force demographics, skills mismatches and our abysmal record when it comes to productivity growth. While all four political configurations which have governed Mauritius since the early 2000s have spoken about structural reforms, none has been able to arrest the decline in our potential growth rate so far.
There was a brief albeit modest increase in potential output following the 2006 reforms and given the debt fuelled investments of large corporates, but actual growth surpassed potential and the economy overheated. This was unsurprisingly a period of high inflation, including core inflation, and readers will recall the many tussles back then between the finance ministry and the central bank on who was right on interest rates. Post the 2008 global financial crisis, the heavily indebted corporates focused more on debt restructuring than on making new investments given that their balance sheets weakened, labour input growth continued to decline, and productivity remained low. In general, while an improvement in the output gap was noted over the past five years, the economy has tended to operate below capacity, and overall potential output has continued to decline slowly but surely. This is a secular and apolitical trend.
There has been no large scale response from the private sector to increase investment to augment capacity.
This is likely because structural reforms are a tough pill to swallow and only deliver results over time when politicians need results now, especially when income inequality has become a hot topic. With the population greying and important structural reforms hitting the brick wall of politics and the political system which defines it, the trend will be hard to reverse. Demand side measures can only take actual growth closer to potential, but if the potential is declining, policymakers are essentially chasing a decreasing target. If the gap is low, there is also little gains which can come out of further demand side economics. Given the fact that we import so much of what we consume, there has been no large scale response from the private sector to increase investment to augment capacity like in the United States or India in order to meet rising demand. They simply click on the import order button and a Chinese exporter benefits!
The cost in terms of additional public debt on future generations has also increased with little in terms of growth pickup to show for all these demand side measures as well intentioned and pro-poor as they might be. Sure, the Mauritian government has invested in the Metro express, improved business facilitation, brought about better rules when it comes to intellectual property rights and increased other infrastructure spending, but the private sector has remained timid if one includes or excludes real estate related activities. In any event, such measures will take time and are unlikely to completely offset the large structural challenges which continue to torment the Mauritian economy. In any event, the economy has not seen any reversal in growing above 4.0% for almost a decade now.
In response to rising debt levels, government policymakers have argued that the bulk of Mauritian debt is local and still sustainable. This is partly true. The state is not like a household. Mauritius has a monopoly on the Mauritian rupee and will simply never default on rupee debt. Inflation, which is typically the bigger concern with unsustainable local currency debt, has remained too low. But if debt funded demand-side policies lead to a continued rise in imports and a further deterioration in the terms of trade (financed by foreign villa sales, income from the offshore sector and tourism receipts all facing slowdown, stagnation or moderate declines), then such policies could, if sustained, lead to unintended but significant downside risks to the Mauritian economy and to the value of the rupee. Capital flows are invariably volatile and cyclical, and the global economy is currently slowing. Mauritius depends too heavily on foreign savings mainly flowing to the real estate.
So what are some of these structural reforms and supply side measures that both the government and the public do not like to hear much, about and how do we fund it all? Any demand side measures aimed at closing the small output gap, such as further sustainable pension increases, should first be financed by taxation on those who are more well off. Taxation should take the form of higher property taxes on the rich. Secondly, many developed “villages” such as Tamarin or Grand Baie can and should be converted into towns, making their populations beyond a certain income threshold eligible to pay municipal taxes.
With more than 12 months of import coverage worth of international reserves, it is high time for Mauritius not to let the result of these capital flows go by while it lasts, but to seed the creation of a professionally managed and apolitical sovereign wealth fund which would aim to generate higher returns and pay dividends to the state and the central bank in order to help complement tax revenues and avoid over taxation to fund demand side measures. The dividend and asset allocation framework would be similar to that of an endowment. It would be an indirect way of using the fruits of capital flows for the common good.
A clear rules-based approach
Rather than engaging in central bank special reserve fund transfers which are akin to printing money, the government should issue a special perpetual bond (“perp”) to the central bank at a rate that is higher than the cost of conducting monetary policy but lower than market rates for long term bonds, thereby improving the balance sheet of the central bank and optimising the cost of debt of the government all the same. This will not be accounted as debt as governments and central banks belong to the same country, and perps are accounted for as equity anyway. It should also be noted that 80% of all realised profits made by the central bank would go back to the government anyway.
Regarding monetary policy and beyond perp or long term bond issuances between the government and central bank to fund supply side measures, in an uncertain global landscape where traditional monetary policy tools have reached their limits, both the Bank of Mauritius and the ministry of finance should engage in coordination in the following manner. Firstly, both the central bank and the fiscal side should formalise the adoption of a flexible inflation target with a band and be made accountable for this, instead of the traditional approach of just making the central bank accountable for a medium term inflation target.
Secondly, the central bank should formally set up a special line of credit to the government in a clear rules-based framework (focusing on supply side and limited demand side measures) as long as actual inflation remains below the target (taking the band into account). Given fiscal constraints, the line of credit at preferential rates, which would not be accounted for as debt in the traditional sense (the assets of one and the liabilities of the other could cancel out at the country level), would provide full coordination in a rules-based fashion to stimulate the economy whenever the output gap is negative. As inflation approaches the target (which is flexible within the band), the central bank would gradually reduce the quantum of the available credit line. The central bank would maintain its independence, and this would resolve some of the criticism made towards Modern Monetary Theory by purists who speak about helicopter money.
We must focus on providing the right kind of capital to viable firms which can scale up, especially exporters.
Part of the proceeds spread over five years can be used to fund massive job guaranty schemes and youth re-skilling programmes. Additional funds from this special perp issuance along with continued traditional government debt issuance can be used to seed the creation of a new venture capital, private equity type, private flexible credit and start up ecosystem in Mauritius all managed within an apolitical setup to truly respond to a key challenge faced by start-ups, medium-sized and large enterprises alike, the lack of adequate equity, flexible financing, mentorship and access to markets. The Competition Commission must be strengthened and made to fend off oligopolistic tendencies of some private players while government contracts (and those of public companies) need to be awarded to smaller private players in a transparent and fair manner.
We must focus on providing the right kind of capital to viable firms which can scale up, especially exporters. Like in all more developed emerging and developed economies, local pension funds such as the National Pension Fund (NPF) too need to consider local private equity and infrastructure as an asset class. The way NPF assets are managed needs to be modernised, especially when it comes to an asset allocation framework which corresponds to the current CPI plus 3% to 4% return targets. Mauritius can unlock billions for infrastructure spending, the ocean economy and beyond out of its private and pension funds if policymakers get behind the development of capital markets and of new asset classes.
Given obvious limits on the taxation front and the need to fulfil electoral promises, Mauritian policymakers must now think out of the box and focus on ways in which new thinking on monetary policy and fiscal policy can work together. Supply side measures are key for Mauritius. More money needs to be spent in improving the quality of the local public universities, and the quantum of funds to research and development must be massively increased. Mauritius must be more open to immigration and target young entrepreneurs looking to set up shop and have a concrete strategy to grow the population over the longer term.
Last but not least, Mauritius must reform the way public companies and institutions are managed, with a much greater dose of meritocracy than is currently the case. A lot of this can only happen with a reform of the current political system which holds the nation back. Should this be done, then the sky is certainly the limit for a small country like Mauritius.