Neither the fault nor the remedy for the current failing economic condition in the country lies with monetary policy alone
The Monetary Policy Committee (MPC) of the Bank of Mauritius (BoM) took the decision to bring down the Key Repo Rate (KRR) of the BoM by one quarter of one per cent at its meeting of 17th June. Five of the members of the MPC voted, as the Ministry of Finance had wished it, for a lowering of the rate, albeit by a lower quantum, whereas the three in-house members of the committee wanted to see a small increase in the rate instead, but were outvoted.
Movements in the KRR serve as a signal for other interest rates in the country to follow suit, notably deposit and lending rates of financial institutions operating in the country. The decision of the MPC means that henceforth savers will be remunerated on their savings at an even lower rate than the bottom this rate had touched when successive reductions of the KRR had been engineered in the past. On the other hand, it means that businesses having borrowed from financial institutions would pay less interest on the amount of their existing and future borrowings. As a result, the biggest commercial banks of the country will walk away with massive gains by way of net interest earnings (the interest amount earned net of what they will lose by reducing borrowing rates to borrowers and what they gain by paying a much lesser amount interest to depositors due to reduced rates on savings deposits) given that the amount of savers’ deposits are by far superior to the amount of banks’ loans.
Decision makers refrained from fresh thinking
This decision of our MPC amounts therefore to a typical capitalist monetary trade-off reflex, applicable mostly to western countries where businesses and even households are usually borrowed up to the neck. Interest rate reduction acts as an incentive for businesses in those places to borrow even more money at cheaper rates in order to get more production out and for households to go on borrowing as a means of sustaining demand – and growth — in the economy. In such places, the interest rate is employed as a tool to overcome slackness of economic growth by pushing up internal supply and demand.
Conversely, when the interest rate has been depressed to ludicrously low levels, as it happened from 2001 in the US, to stimulate business and household demand, the economy heats up eventually and this comes up in the form of inflation. This phenomenon did not show up fully because cheap imports (from China, Bangladesh, Vietnam, etc.) served to cool off the real unmanifested pressure of domestic inflation. Nevertheless, the regime of low interest rates got mirrored in a spate of domestic asset price rises, such as house price bubbles and speculative commodity price inflation supported by the consequent huge flows of liquidity in the economy following the adoption of the easy money policy, i.e., lower interest rates. When this kind of situation happens, central banks push up the interest rate in the next round to prevent the economy going off the rails altogether. Even this could not be done by the concerned western economies which, by 2007, came crashing down. The result: a catastrophic breakdown of the economic system which is persisting to this day.
When imported models of western economic management are applied with the same rigour as what obtains in those places, they fail to reckon with the realities of our economic environment. Thus, while it is true that there is currently an “output gap” (a lower level of production of goods and services than the potential amount of such production due to resources remaining unemployed) in our economy, this is because external markets to which we sell our goods and services are unable to pick up materially larger quantities of our exports. This situation is exogenous, not related whatsoever to the level of the domestic interest rate supposed to be impeding our economic growth.
There is nothing we can do, even if we reduced the prices of our exports, assuming our input cost structures permit any such reduction without throwing the social equation out of balance, to improve prevailing conditions of demand in our external markets. Interest cost is not a major component either in the cost structure of our own exported goods and services. Suppliers’ credit, if granted by our exporters to foreign importers, barely exceeds 6 months and should normally wash out periodically. This means there should be no significant build-up of borrowing by our enterprises on this count unless exports boomed up unexpectedly. So, lowering local interest rates cannot do the trick of competitively fetching us external demand to close the “output gap”.
Nothing is achieved by way of macroeconomic engineering
This means that there is no “economic reality” in the decision to cut interest rates in the prevailing circumstances in a bid to pick up more domestic growth. So, what exactly is the MPC’s decision to cut interest rates in the economy meant to achieve? Practically nothing, in macroeconomic terms. The decision ultimately means that those who have been lobbying for and, now getting, the interest rates reduced are chasing other objectives. They want to pay less and less on over-borrowings they have undertaken to back up dubious borrowing decisions unrelated to productive investments and actual trading. Their bankers will also feel happy that the burden of adjustment for poor lending decisions is effectively passed on to savers (by cutting down the rate at which the latter are remunerated) to avert potential bad debts landing on their books. Classic conspiracy against those not skilful enough to defend themselves with vigour!
Let us assume that several enterprises have historically incurred large amounts of debt when banks were opening up the floodgates of lending under pressure of excess liquidity at a time new productive investment projects were failing to materialize. The current reduction in the KRR will go to give such heavy borrowers relief on debts incurred for all and sundry, including for activities geared to “rent-seeking” through property development at ever inflating prices when the going was good under the influence of external capital inflows.
Will it increase real production? Not so, unless new opportunities are created to make better use of our slack production potential, such as by opening up new lines of production going to newer markets unaffected by the international economic depression, the like of which we’ve been seeing in our traditional markets. This is not happening in our midst for a long number of years now and it does not fall in the portfolio of our monetary policy makers. Other policy planners have failed us badly on this count whereas monetary policy is being asked to pick up the consequences.
Targeting a threshold interest rate
It is true that, in an environment like that of Mauritius, increase in the level of the interest rate can ward off inflationary pressures. This requires the KRR to stand at a sufficiently high level for it serve to keep off inflationary tendencies while simultaneously containing enough space to accommodate incentivizing investment as necessary from time to time. There is some point therefore to argue that one cannot bring down the KRR to a such a low level that it may eventually leave little scope for using it as a lever to incentivize the right sort of investment when and if that sort of opportunity knocks at our door. Surely, bringing it down to 4.65%, as it was done at the last MPC meeting, is nothing magical that will serve to open up Sesame doors for our entrepreneurs!
Environments like Mauritius have to keep interest rates at a sufficiently high reference level which hurts neither depositors nor investors. At such a level, some amount of upward or downward “fixing up” of the interest rate becoming necessary in view of the longer term perspective will still keep up confidence in the economy. It may well be that moving the rate from even that high level may at times result in negative interest rate being paid to savers when inflation goes up but the rate should be in a good enough comfort zone not to sap the confidence of both savers and investors. Unlike the West, we in Mauritius are still embedded in a savings rather than a spending à outrance culture as it obtains in the West. It looks like this comfort level reference rate cannot be less than 5% in the present context, taking local and external market conditions into account.
If the objective of the MPC was to put investors into confidence, it could have more realistically taken to reducing the KRR if the latter had been set at such a higher threshold reference point (5% or more) than where it was at the latest MPC meeting. There was a case therefore for the rate going up first, to give the MPC the necessary future leeway to send the correct signals from time to time to prop up economic activity when the latter gives signs of slackening. In other words, there is the need to establish a downward sticking point below which the KRR should not be allowed to slip for the MPC not to embark continuously on a one-way downward street all the time.
To be in tune with the local environment
In this regard, policy makers have to keep in mind that we neither have the resilient extensive manufacturing base of developed countries which have been experimenting with playing on the interest rate instrument to compensate for slack fiscal initiatives to set off growth. Nor do we have the unlimited capacity to lean extensively on foreign savings to tide over conjunctural economic distress when the going gets rough. We need therefore to nurture our domestic savings effort to support investment for which policy initiatives have to come from the fiscal side rather than putting all the pressure on monetary policy alone.
It should be clear from the above that the current policy decision has been misguided. As it should be evident by now, past decisions to bring down the KRR successively have miserably failed to eke out the element of dynamic new growth, to which the continuously falling rate of economic growth bears ample testimony. New space had to be opened up for overall production to continue apace when certain activities were seen to be reaching their limits. This was not done and has not been done. Neither the fault nor the remedy for the current failing economic condition in the country lies with monetary policy alone.
* Published in print edition on 5 July 2013