MURLI DHAR

Are we really caught up in the euro zone economic trap?

— Murli Dhar

Special Line of credit in Foreign Currency

The Bank of Mauritius (BoM) took two important decisions on 9th June and 11th June respectively. The first one relates to a special line of credit in foreign currency being put at the disposal of economic operators conducting business with the euro zone. The view is taken that operators may find themselves in a situation of “mismatch” in view of the downturn facing the euro zone currently. It is being said that even though it has recently steadied around $ 1.25, the euro may fall further were the euro zone crisis to intensify in days to come. On this reading of the situation, it is being stated that the exchange rate of the currency in which Mauritian exporters of goods and services receive their earnings (euro, dollar) against the rupee (in which their local debts are denominated) may become “misaligned”. In other words, if the rupee were not falling in tandem with the euro, exporters would find themselves in difficulty. On the assumption that the rupee would appreciate against those export currencies, exporters would then obtain far fewer rupees per unit of foreign currency earned. A state of affairs of the sort would impair exporters’ ability to redeem their rupee debt. In the event, the story goes on to say that banks from which they have borrowed in rupees for their working capital needs would, in turn, face potential bad debts from such customers.

However, all this is based on the assumption that there would be a sharp fall eventually in the number of rupees obtained by exporters per foreign currency unit of export earning as the international crisis went apace.

The special line of credit in foreign currency is intended to help ward off such negative consequences. In the event the exporters take the view that the euro would slide further down in time to come, uncompensated by a parallel fall of the rupee, they may borrow euros or dollars from the BoM’s foreign currency line of credit through their banks with a view to pre-empting possible shortfalls in their rupee earnings from foreign currencies. The foreign currency obtained from the BoM could then be exchanged for rupees at the going rate to hedge themselves against the risk of getting far fewer rupees at the time their export earnings will materialize. Their actual export earnings are usually realized in not more than three months from the time of export.

Normally, bank customers hedge themselves against exchange rate movements by engaging in forward currency transactions with their own banks. The fact that the BoM has to step in could mean that their banks are unwilling or unable to provide the cover against this possible risk. This means that it is the BoM that should stock up sufficient additional foreign currency reserves to meet any contingent demand for hedging by the exporters, on top of what may be needed to make good shortfalls in overall export earnings due to the international economic crisis.

Bringing in additional foreign currency reserves comes at a cost. It is not the end of the matter when foreign currency is added on to boost our foreign exchange reserves. The additional foreign exchange will tend to cause the rupee to appreciate unless the appreciation is explicitly checked. As the foreign currency so injected gets translated into rupees in the next stage, such as when exporters take it up from the BoM facility to cover their risks, an equivalent amount of rupees will be injected into the domestic market. The effect will be to distort local market conditions such as by pushing up inflation.

If you do not want the large amount of rupees to be injected into the system, in parallel with the foreign currency inflows undertaken to boost up the reserves, to cause an appreciation of the rupee or other economic distortions, then those additional rupees should not be allowed to swell up currency in circulation. This is done by issuing debt instruments on the market to mop up the rupee liquidity. It costs much more in the prevailing global economic condition to service this rupee debt with whatever can be earned in reverse by investing the additional foreign currency raised for the purpose.

As a result, the debt servicing for the rupee amounts mopped up will exceed by far whatever earnings the additional foreign exchange could bring in. Someone has to bear this cost. It has been decided that it is the government (i.e., taxpayers) that will pick up the substantial extra rupee debt servicing cost to be incurred in the process as the BoM would not have enough resources of its own to foot this bill.

The situation that has led to the adoption of this measure by the BoM is many-faceted. One, the euro zone and other economies including emerging economies, have been inadequate to inject the dose of confidence that was needed to cause investment and growth to pick up. It is not quite clear when this will happen and whether it will be sooner rather than later. We are navigating in the dark.

Two, the scale of the recourse exporters will have to the BoM facility is unknown. Were the rupee’s exchange rate to appreciate immeasurably against the exporters’ currencies, they will resort the more to the BoM facility to hedge themselves. Surely, we will be rational enough to get the rupee to some sustainable stable condition without having to knock off our exporters altogether? If so, there will be a limit to the use of the facility by exporters and we will end up accumulating more reserves only as a precautionary measure against assumed prospects of the global economic condition worsening.

Third, it shows we have not done enough to insulate our exports from its structural lack of diversification all these years. Even if action towards market diversification started being taken now to ward off this fundamental imbalance, it would come at a time when we are facing quite tough international market conditions wholesale. With a bit of foresight in policy making and implementation, we could have chosen a more auspicious timing to do all this without having to shift the entire burden onto the central bank at this moment, isn’t it?

Monetary policy alone cannot make the underlying structural imbalances disappear as it is made out to appear. There was work to be done in other quarters to attract more productive foreign investment to raise our capacity to produce goods and services for which there is demand. Productivity also had to be raised. There was a need to re-look our entire platform of production as the world was shifting towards information age production. Look at South Korea for more clues on what needed to be done to cause this shift.

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Managing the Repo Rate

The second of the BoM’s actions this week concerns its Monetary Policy Committee’s decision to keep the key Repo rate unchanged at 4.9%. The MPC has argued its case for keeping the rate at this level in view of a perceived worsening of the euro crisis at this stage compared with what the situation was a quarter earlier when the decision was taken instead to slash it by 50 basis points. The other leg on which it has justified the status quo is the view that prices are not seen picking up at this stage on international markets. This means in simple language that the case for raising the rate is now less than what an international inflationary situation with oil prices threatening to go up further in the wake of the Iranian crisis was pointing out in March this year.

Clearly, the tension that has emerged in the past few weeks in the euro zone with Germany at one pole and the rest of Europe at the other pole, is a cause for concern; at the last meeting of the MPC a quarter ago, there were hopes that some solution would be found out for the euro crisis. The euro was also not slipping against other currencies at the pace we’ve seen it do so in the more recent weeks. There may be a case now for relaxing the interest rate but there was none at the last MPC meeting but the MPC acted more hurriedly by doing so at its March meeting.

One has to bear in mind that Repo rate decisions are not taken out of a given context. In the circumstances which prevailed in March last, the case, if at all, for reducing the rate by as much as 50 basis points did not arise. However, the Minister of Finance has stated this week that the latest June 11th decision of the MPC to keep the Repo rate unchanged amounted to a vindication of the Ministry’s support in March 2012 for bringing it down. Apples and oranges, isn’t it?

In general, one would expect the Ministry not to try to impose its view of things when there is an independent body, the MPC, set up by law to come to its own conclusion in the matter of interest rates. Even if the MPC allowed itself to be influenced by the Ministry’s biddings – and that would be unwholesome — the fact should still be that the MPC should own the decision. This would be good for the sound and healthy functioning of institutions, free of unnecessary tensions among the policy makers at different levels.

One should keep an open mind in these issues. It may well be that the huge salvaging being undertaken by the European Central Bank by way of injection of liquidity and other similar decisions to be undertaken at the policy-making level, such as giving credit directly to the businesses that are being starved of it and renewing a sense of security that is being eroded by over-cautious banks piling up huge amounts of liquidity, could alter the euro area’s profile for the better in less than a year’s time. Should not then the MPC change its stance once things start taking a turn for the better in our principal export market, in the light of these new initiatives by policy makers over there? Or, should it be expected to still abide by the desire of certain lobbyists on the local market who would settle for nothing less than successive reductions in the interest rate structure each time until the bottom is finally reached?

Mauritius will make progress only when it can go for newer substance by way of more and better productive investments rather than by trying to save itself ad hoc in a crisis-management style on each occasion pleading for minimalist decisions and going by the shortest of short cuts. Great countries do it differently by moving away from the light touch solutions that are advocated over here from time to time.

Murli Dhar

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