The decision of the 32nd Monetary Policy Committee (MPC) to keep the Key Repo Rate (KRR) unchanged at 4.65 per cent per annum was a wise decision.
Much of the wrangle between the Ministry of Finance and the Bank of Mauritius, for the moment at least, is misplaced. Instead of throwing stones at each other’s glasshouses, they need to work together to mop up the excess liquidity in the banking system and strengthen the financial sector.
Indeed the main issue at present is not whether the MPC should be the raising or lowering of the Repo Rate. It is not the low interest rates as such but the excess liquidity in the financial system which is the main cause of the instability in the sector and the distortions in the economy. The low interest rates are the result of the excess liquidity in the system. But the prolonged periods of low interest rates, the lack of competition in the banking sector and the absence of an efficient bond market do aggravate the problem of excess liquidity and the proper functioning of the financial market.
Before we take up our point about the soundness of the decision of the MPC of maintaining the Repo rate at 4.65%, let’s identify the sources of this excess liquidity. The main factors accounting for the excess liquidity are the robust FDI inflows, higher foreign borrowings of government relative to its domestic rupee borrowings to finance the budget deficit, intervention on the forex market to realign the rupee given the overvaluation of the rupee, a lower private sector credit to GDP ratio especially credit to the productive sectors. So we have a situation of a buildup in foreign reserves as reflected in the Balance of Payments surplus and in the increase in the Net Foreign Assets of the BOM and other depository corporations together with a slackening in the growth of credit to the private sector including the productive sectors.
The current situation of excess liquidity in the money market is indeed a matter of concern as it creates the potential for market distortions and inefficient allocation of resources and increases the risks to financial stability. There is clear evidence that the excess liquidity in the system has resulted in the disconnect between the KRR and money market interest rates; it has diverted resources to more lucrative speculative activities and weakened the monetary policy transmission mechanism.
When there is involuntary excess liquidity in the economy, the transmission mechanism of monetary policy, which usually runs from a tightening or loosening of liquidity conditions to changes in interest rates or asset demands and then to economic activity, is altered and possibly interrupted completely. If the holdings of excess liquidity are involuntary, then attempts by banks to boost credit demand by lowering the cost of borrowing is largely ineffective. An expansionary monetary policy in that case would simply inflate the level of unwanted excess reserves in commercial banks and not lead to an expansion of lending.
Similarly, contractionary monetary policy will simply cause banks to reduce their unwanted reserves, and will only affect monetary policy if it reduces reserves to a level below that demanded by banks for precautionary purposes. That’s why we see the decision of MPC to be wise for attempts by the monetary authorities to stimulate aggregate demand will prove largely ineffective. Similarly, it would be futile to expect an increase in KRR to impact on Prime Lending Rates, savings and demand conditions. Hence, there is no point in arguing about the likely direction of the changes in the KRR when the urgency of the moment is the mopping of the excess liquidity, the development of an efficient corporate bond market and the creation of a Sovereign Fund to invest abroad. These measures will reduce the spread between the market interest rates and KRR and the margins between the lending and deposit rates and thus improve financial intermediation.
But these improvements in the banking system will be not be enough on their own to influence demand conditions and stabilize the economy. It will have to be accompanied by a commitment to structural reforms in the economy. Despite the optimist growth forecasts by the Ministry of Finance and some fiscal initiatives at bridging the output gap, we continue to be caught, like many other economies, in a prolonged period of underinvestment with GDP falling further and further below our potential — a period of secular stagnation where sluggish growth, output and employment levels well below trend coincide with low real interest rates. Thus there is a case for more of public investment and for structural reforms to boost the low rates of growth in potential GDP towards its long-term trend level. It is very much a supply side issue and the BOM cannot be expected to be of much help in closing the gap especially in conditions of low interest rates and emergence of substantial bubbles.
We should restore the economy to a situation of reasonable growth together with reasonable interest rates. And to achieve a reasonable growth rate in a financially sustainable way, we will have to, first of all, reinforce the supply side fundamentals, namely redesign the education and vocational training policies, forge closer relationships between companies, academia, vocational and technical institutions; focus on innovation to spur private investment. Mauritius future innovation-led growth must rely more on technical efficiency within an efficient national environment to reinforce innovation within the business sector and encourage firms to compete on the basis of unique products or services.
Government can play a key role in supporting growth by investing in science and technology, by increasing its funding for research needs and creating the institutional environment that supports technological change. It should also design more of targeted expenditures that will help to build diversified productive capacity for the future; develop specific growth supporting measures that recreate the economic foundations for global competitiveness and develop valuable sectors that are truly competitive in the global market place and those structural reforms that would generate productivity improvements to restore the economy’s competitiveness and reduce the current account imbalance.
For these measures to be financially sustainable, we need well-targeted public spending along with a mix of savings, efficiencies, reforms, asset realisation and revenue-raising measures.
“Secular stagnation is not an inevitability. With the right policy choices, we can have both reasonable growth and financial stability,” recommends Charles W. Eliot, professor at Harvard and former US Treasury secretary.
* Published in print edition on 14 February 2014