By Sushil Khushiram
Money financing by the BOM conflicts with the principle of central bank independence, and with the Bank’s goal of price and financial stability
The Finance Bill 2019 proposed an amendment to the Bank of Mauritius (BOM) Act for the central bank to provide free money financing to Government. Is this amendment compatible with the notion of independence inherent in the legal provisions of the BOM Act, and will it not undermine the central bank’s credibility for the proper conduct of monetary policy?
Central Bank Independence
Central banks across the world are entrusted with a primary mandate of controlling inflation, on the basis that economic growth is best served by monetary stability, i.e., a low and stable rate of inflation. Because of the inherent dangers of fiscal expansionary policies in fuelling inflationary pressures, it is necessary to have a separation between the responsibilities for fiscal and monetary policies. Central banks are thus empowered to conduct monetary policy as independent institutions, mainly meaning independent of Government.
Even in the aftermath of the 2008 global financial crisis, the institutional arrangement for central bank independence has remained unchanged. Monetary policy displayed an aggressive stance, through quantitative easing policies, in shouldering the financial crisis in advanced countries, whereas fiscal policy was subdued and even austerity-driven.
A key feature of independence is the restriction on central bank financing to Government. In an overwhelming majority of countries, legal provisions curtail central banks from extending credit to Government, ranging from total prohibition to the granting of advances only on a temporary basis. In practice, most countries limit credit, overdrafts and advances to around 10-20% of Government revenue. Free money financing of Government by the central bank, other than distributable profits, is widely shunned.
BOM Act Provisions
The BOM Act sets out the conditions governing BOM financing to Government. A section entitled “Limitations on activities of Bank” clearly states that “The Bank shall not … guarantee loans or advances for the Government …, nor grant loans or advances to the Government…, except as provided in sections 6(1), … and 58”. These two named sections provide for strict limits on BOM holdings of Government securities and BOM advances to Government.
Government securities owned by BOM reflect BOM financing of Government. The value of Government securities owned or held as collateral by BOM, barring some minor exclusion, is subject to a ceiling of 20% of Government total revenue. The BOM can also make advances, i.e., provide short-term finance, to Government. The amount of these advances together some other holdings of Government securities is subject to a ceiling of 10% of Government revenue.
Free financial transfers from the BOM to Government are only allowed as a distribution of BOM net profits, after constituting reserves for monetary policy and other purposes. BOM can thus transfer up to 85% of its annual net profits to Government, its only shareholder, but with important caveats. BOM General reserves should be maintained at the level of paid up capital, and a transfer is not permissible when (i) the BOM’s net worth is impaired, or if (ii) “the Bank would not be in a financial position to conduct its activities properly”.
As regards the BOM Special Reserve Fund (SRF), it may be used with Board approval for (i) increasing the BOM’s paid capital, and for (ii) monetary policy purposes in exceptional circumstances.
The proposed amendment to the BOM Act authorizes the use of the SRF, in exceptional circumstances and with Board approval, “for repayment of central government external debt obligations, provided that this is not likely to adversely affect the efficient discharge by the Bank of its functions under this Act.” This additional use of the SRF is also placed in third order of priority after any use for increasing paid up capital or for monetary purposes.
The use of the SRF in exceptional circumstances, with a lower prioritization and with Board approval, is an improvement over the initial proposal to “allow use of the SRF for fiscal policy purposes as well”, as stated in the Annex to the Budget Speech. But, it still remains contrary to the spirit of independence inscribed in the legal provisions of the BOM Act, especially the stipulated constraints on central bank financing of Government.
The BOM’s independence is necessary to attain its primary objective “to maintain price stability and promote orderly and balanced economic development”, and to “conduct monetary policy and manage the exchange rate”. BOM financing of Government, by an expanding overall demand in the economy, is likely to exert upward pressure on inflation and aggravate the external current account deficit.
The statutory ceilings on BOM financing of Government are thus intended to safeguard the BOM’s independence in carrying out its functions. Notably, the limits on Government securities and advances are related to Government revenue and not expenditure, so as not to encourage more Government spending. Let alone the extension of financing, even BOM guarantees of loans and advances to Government are frowned upon.
The required annual transfer of BOM profits to Government is conditional upon meeting capital needs, protecting its financial net worth, and ensuring the financial means for a proper conduct of its activities.
The SRF is not meant to transfer any amount except for supporting the Bank internal reserves or for monetary policy needs. If the SRF balance proves insufficient to cover any net unrealized losses in BOM assets and liabilities in any year, this deficiency must be met by Government. The BOM then extends finance to Govt for this purpose through the issue of Government securities. Even in these special circumstances, BOM does not provide any free funds to Government to shore up any SRF deficiencies. Only credit is extendable, and interest bearing at that.
The proposed utilization of the SRF for repaying Government external debt is tantamount to giving Government money freely to meet its expenditures and finance its deficit. This is directly at odds with the existing provisions of the BOM Act to curtail central bank financing of the central bank. Moreover, since the SRF is to be used for repaying external Government debt only with BOM Board review and approval, it was improper to budget a pre-determined amount of Rs18 bn.
Money Financing Impact
The official reason for SRF financing to Government is to meet the public sector debt ceiling of 60% of GDP by June 2021. External debt repayment would normally be financed by greater domestic borrowing, which would leave the public debt level unchanged. With SRF financing, there is no need to raise domestic borrowing for external debt repayment, and public debt can therefore be reduced.
Without SRF financing, Government would be compelled to reduce the fiscal deficit to bring down public debt below the statutory ceiling. The availability of BOM free money financing thus enables Government to run a higher fiscal deficit than would otherwise be the case.
The stimulatory impact of a higher budget deficit financed by BOM money will, in the short term, cause a further deterioration of the external current account deficit. It is also accepted that a money financed budget deficit has a higher expansionary effect than a debt financed budget deficit. The external deficit on goods and services is estimated to reach14% of GDP in 2019, with a current account deficit of 7% of GDP. The IMF considers that the Mauritian rupee is consequently overvalued by 17%, in terms of the real effective exchange rate.
A continued worsening of the external imbalance will inevitably result in a significant depreciation of the rupee in the longer term, leading to considerably higher inflation. On the other hand, a smaller budget deficit without BOM money financing will help to moderate the external deficit, and abate rupee depreciation and inflation risks.
Huge net capital inflows, mainly related to global business activities, contribute to generate balance of payments surpluses, but are not immune to volatility and adverse shocks. Moreover, the sustainability of these capital flows is increasingly uncertain in view of mounting pressures for stricter global tax and transparency standards.
The BOM is Government-owned, but is endowed with an independent status to pursue price and financial stability. Unchecked BOM money financing is highly questionable in view of the unfavourable macro-economic consequences. The budgeted amount of BOM financing of Rs18 bn far outruns the annual BOM profit transfers to Government, averaging less than Rs1 bn, and even exceeds a whole year’s budget deficit.
Basis for Board Approval
The exceptional circumstances that the BOM Board can invoke to approve SRF financing to Government are left totally unspecified, and no limits are prescribed for such exceptional financing. The proposed BOM Amendment could be misused and potentially open the floodgates to excessive money financing to Government.
A one-off money financing of moderate size by the BOM and for appropriate use by Government could be considered acceptable, but the dangers of excessive financing are significant. Even if the proposed discretionary powers are exercised wisely by the current BOM Board, there are still risks of unrefined accommodation to Government in the future. It will not escape the Board’s attention that the SRF has been mostly replenished through valuation gains, engineered by BOM interventions in the first half of 2019 to depreciate the rupee.
External debt prepayment does not represent any immediate urgency. The share of foreign currency denominated debt in total public debt is only about 15 per cent, which is considered low by the IMF. The statutory Government debt deadline of June 2021 can well be extended with a minimal loss of fiscal credibility, if accompanied by a convincing plan for fiscal adjustment. The timing of SRF financing ahead of general elections to boost Government expenditures, but avoiding budget discipline, also raises a thorny issue.
Most importantly, any BOM money financing should not be approved by the Board without a prior review of the economic capital framework of the central bank. The adequacy of risk provisioning and of the capital and reserves of the BOM should be determined on the basis on a full and detailed assessment to fits balance sheet risks, in the light of best practices adopted by central banks worldwide.
In the absence of this knowledge, the BOM Board will be unable to resist pressure to become a rubber stamp for Government money financing. On the other hand, an economic capital review could also enable the BOM to devise are vised profits distribution policy to Government to explicitly take account of surplus reserves for distribution, in addition to a proportion of current profits.
The proposed amendment to the BOM Act will authorize the BOM to print money by distributing its capital reserves to Government, for the purpose of debt reduction. Sizeable money creation for Government to finance a higher budget deficit will eventually hurt growth prospects, through adverse effects on the external balance, the exchange rate and inflation.
Money financing by the BOM conflicts with the principle of central bank independence, and with the Bank’s goal of price and financial stability. It should only be approved on clear and well-founded grounds, and within strict limits. A capital adequacy and risk provisioning assessment of the BOM is essential for determining its capital needs, and the extent to which surplus reserves are distributable to Government.
* Published in print edition on 19 July 2019