By Sameer Sharma
At the beginning of the year, the Bank of Mauritius was very dismissive of inflation despite clear signs that inflation risks even prior to the Russian invasion of Ukraine were rising. The Bank of Mauritius’ views on inflation revolved around it being driven by external and largely transitory factors. To be fair, it was not the only central bank to have been dovish. The influence of politicians on central banks, given rising wealth inequality, growing popular discontent and the rise of populism, has increased globally.
The central bank in Mauritius of course operates in the extreme when it comes to state control of monetary policy and was also very bullish on GDP growth playing to the tune of Government talking points. Given the high level of public and private sector debt to GDP at more than 180 per cent, the policy of government was to stimulate construction and to allow inflation and rupee depreciation to reduce the real value of public and corporate debt. The finance minister would often, for example, say that as long as the weighted interest rate on the debt remained below nominal GDP growth, things would work out in the end. This strategy turned sour as commodity prices soared.
The central bank had eased macroprudential measures well before the pandemic hit the world and announced all types of incentives to get people to take up housing loans. An environment of persistent excess liquidity, which predated the pandemic induced crisis, also led to significant mispricing of credit risk. The Bank of Mauritius tried to convince financial stability report readers that debt service costs to GDP was a good and unbiased measure of a consumer’s ability to pay, and that all was well. Debt service costs of non-corporates to GDP may be below 18 per cent, but compensation to employees only stands at around 40 per cent of GDP.
The household credit to GDP gap, which is a measure of excess credit growth relative to trend, kept on rising since 2020. The cost of an average house when compared to the median household income in Mauritius is very high.
On the corporate side, the Mauritius Investment Corporation has created more moral hazard with debt obsessed conglomerates which control a large share of the economy rather than using the crisis to push them to open up their capital and align their interests to that of the national interest.
At the core, Mauritius has a debt driven consumption obsessed economic model which is fundamentally self-defeating over time. The country imports the bulk of what it consumes and a debt fuelled spending binge only serves to widen the current account deficit which will itself hit 14 per cent of GDP in 2022. This over time puts downward pressure on the rupee, increases the costs of imported goods, which are already rising globally, and pushes consumers to borrow even more money. In order to plug the wide deficit, the government typically relies heavily on foreign luxury villa sales which not only have a strong import component itself but put upward pressure on land prices. Higher land prices and construction costs in turn require more debt. One does not need to be a genius to realize that this kind of business model is unsustainable when interest rates rise.
Significant and initially painful structural reforms required
Globally, inflation pressures may be on the decline but significant uncertainties remain. For example, the reopening of the Chinese economy, when coupled with a relatively more dovish stance by the People’s Bank of China, may reinvigorate East Asian commodity demand during the Spring period of 2023. As at the time of writing, more than 300,000 Russian troops are awaiting orders from Moscow to begin a potentially much more brutal campaign against Ukraine. Russia expected a quick win in Ukraine and sent no more than 40 per cent of what it has amassed now into Ukraine in the first half of 2022 at great cost. Given the size of the occupied lands, there were not enough Russian troops to effectively hold onto the ground they had captured. Western weaponry also complicated matters. By late summer 2022, Moscow realized that it would need to go all in rather than conduct a more limited special operation.
As the ground in Ukraine continues to freeze, upside risks to commodity prices cannot be pushed aside given geopolitical uncertainties associated with this conflict. Over the longer term, the phenomenon of reshoring and the balkanization of global supply chains point to less efficiency and higher costs which means higher inflation than what was witnessed during the pre-pandemic period. Inflation will hence remain high enough for longer, albeit not as high as in 2022.
When it comes to Mauritius, the all too often ignored core inflation rate, which currently stands at 7.2 per cent, remains high and points to a once upon a time exogenous inflation shock infecting the entire economy. With wage increases and electricity prices going up in early 2023, core inflation will remain well above the central bank’s comfort zone. We are currently witnessing a moderate wage price spiral which needs to be contained.
Central banks hike rates to anchor inflation expectations to their targets.
Overall year on year inflation will come down in 2023 but remain well above 3 per cent, a level that is synonymous to price stability and long run trade competitiveness especially when we look at the real effective exchange rate. The Bank of Mauritius, which is late to the game, will need to continue to increase interest rates to cool inflation and stabilize the currency as it cannot sustain the moderate form of exchange rate control it has implemented for long unless we are no longer planning on remaining an international financial centre. Central banks cannot make exogenous inflation shocks which are supply side driven, but that was never why they hike rates in the first place. Central banks hike rates to anchor inflation expectations to their targets.
The challenge with the Bank of Mauritius is that beyond being late in tightening, it lacks the credibility given its previous inflation forecast errors and given the strength of its balance sheet or more precisely the lack thereof. The move to a flexible inflation target regime is a positive one but the asymmetric nature of the inflation band (minus 1 and plus 2 per cent where 3 per cent is the target) showcases the bias towards entertaining fiscal side concerns. The secondary bond market, which is a key element in the transmission mechanism of monetary policy along with the foreign exchange market, is not well developed either. The depth of the capital markets matters too. The pipelines matter.
In sum then, a central bank that lacks meaningful credibility when coupled with an underdeveloped capital market ecosystem means that it must make the extra effort to achieve its target. The size and asymmetry of the inflation band itself is a measure of its credibility and the strength of the influence of the fiscal side on monetary policy matters. At the same time the debt fuelled consumption model needs lower rates to sustain itself. As the need for higher rates for longer collide with that debt fuelled consumption model, the economy will be forced to deleverage and hence slow by much more than what the government expects. The probability of a shallow global recession is equal to the probability of a much more pronounced one. The latter scenario could be a significant risk to the Mauritian economy given our lack of fiscal and monetary buffers.
Mauritius must switch models to one that is based on productivity, production and exports of goods and services. This is a complex path and very little work has been done in getting us there because the consumption path with the debt drug was just easier politically and suited the conglomerates well. Such technical adjustments are complex, time consuming and require us to live within our means and work harder with less. It requires significant and initially painful structural reforms. All good things come to an end. This will be a much more challenging decade for Mauritius. The grasshopper will now need to dance after having sung for far too long.