Will this budget get us out of the rot? you may ask. The liquidity and the ideas are grand but implementation and avoiding the downsides of MMT will be the biggest challenges
By Sameer Sharma
Fiscal policy is not an accounting exercise and a nation which holds a monopoly over its currency is not like a normal household needing to worry about inherent limits to spending to the same extent as the latter. In what the Finance Minister calls the “new normal”, the balance sheets of the central bank (BoM) and that of the Government have been effectively consolidated into the balance sheet of the Republic of Mauritius. The quasi-financing of fiscal spending by the BoM is closely aligned to what is known as modern monetary theory (MMT) and takes a small import-dependent island economy into interesting waters indeed.
“For Mauritius to even sustain 4% plus rates of growth over time, it must more than double its productivity growth rate. The low hanging fruit there lies in a reform of the way parastatals are managed but politics prevent this. So we need to push up labour input growth by improving our labour pool in terms of quality and size, we need to reduce the barriers to entry in many sectors where some large players take it all, diversify and stimulate higher return investments…”
From the Rs 60 Bn grant to the setting up of the Mauritius Investment Company to the BoM’s planned issuance of Sukuks and green bonds, it is now functioning within the prism of MMT and in full coordination with fiscal policy. To be fair, the western world is closer to MMT today than MMT theorists could have ever hoped for. With public sector net debt estimated at 78% of GDP and despite a projected decline in the cost of debt of Government to 3.8%, debt metrics when coupled with unfunded liabilities such as civil service pensions and the Basic Retirement Pension mean that we will remain in MMT mode for a while to come. The issue has never been the level of debt but whether the returns we make on this borrowed money is higher than the cost of debt. This has rarely been the case when we look at investment returns on public assets.
Modern monetary theory essentially says that a country which holds a high degree of sovereignty over its currency can have the central bank finance fiscal spending, as long as inflation remains below a clearly defined target in order to achieve full employment, or in other words until the economy grows at capacity. As long as one- to two-year ahead expected inflation remains below a certain “lakshman rekha” it is argued and when the economy is operating well below capacity – as it is currently doing –, the state which includes both the Government and central bank can inject massive amounts of liquidity into the system in order to stimulate aggregate demand until the economy converges to its potential.
Liquidity injections when the output gap is negative is not as inflationary. Typically it is recommended that this injection of liquidity be geared towards stimulating local factors of production rather than imports, because of the potential currency impact and obviously because the idea is that investing in things that create more output potential is “not inflationary” in theory. When inflation is above target because the economy is overheating, then the state is supposed to remove liquidity from the system by raising taxes and by the central bank raising interest rates for example.
The challenge with MMT as applied to a small open economy of course revolves around:
– first, Mauritius’s central bank not having a clearly defined and quantifiable medium term flexible inflation target;
– second, the challenge of maintaining central bank independence and the resulting credibility in achieving the inflation target;
– third, the risk that liquidity injections stimulate imports and lead to heightened currency volatility;
– fourth, that the Government can indeed implement projects on time – which boosts local factors of production and overall growth potential;
– fifth, that when expected inflation is high and the economy is overheating, both the central bank and the Government can have the will and credibility to remove the liquidity which was so much easier to inject.
Last, we assume that economists are able to accurately measure the growth potential and the gap between actual and potential growth (which is itself unobservable) and that the market prices medium term inflation risk properly. In the MMT world, the Government must hold as much debt as possible domestically in the currency in which it can print. More than 83% of debt will be denominated in Rupees, maturities are being pushed up and on the foreign debt side, more low yielding EUR denominated debt which more closely matches the currency composition of Mauritian exports will be taken vs USD debt.
Think of potential output as being a function of labour input growth, capital input growth and productivity growth of the economy. Mauritius’ growth has been structurally weakening for more than two decades slowly but surely, as unfavourable demographics and a large pool of semi-skilled labour hinder labour input growth. This variable contributes no more than 1.2% to the potential pre-Covid 3.8% overall growth potential of the economy. On the capital side, the rentier economy and associated private sector’s focus on land conversions and foreign villa sales which bring “FDI” has little impulse on capital growth. There is little productive capital expendable, many companies have high debt to free cash flow metrics and some even borrow to pay dividends which are off-shored.
At the heart of low capital growth is low CAPEX, and at the heart of low CAPEX is the fact that many projects in Mauritius generate return on capital employed below the weighted average cost of capital. We barely get 1.4% out of this variable. On the productivity side, Mauritius can only manage at best 1% annual contribution. The lack of innovation in the economy is obvious to everyone. For Mauritius to even sustain 4% plus rates of growth over time, it must more than double its productivity growth rate. The low hanging fruit there lies in a reform of the way parastatals are managed but politics prevent this. So we need to push up labour input growth by improving our labour pool in terms of quality and size, we need to reduce the barriers to entry in many sectors where some large players take it all, diversify and stimulate higher return investments. We also need to enhance productivity everywhere including in the publicly owned companies.
Once we understand the above, it is possible to neutrally assess the budget as an indicator of fiscal and overall macroeconomic policy. An openness to foreign migration is a positive step by the Government but the stagnation of the education budget and the lack of reform in general for higher quality remains a major constraint especially in mathematics and quantitative fields. On the capital front, the MIC’s ability to prevent massive de-leveraging and stimulate investments over time requires having the right people at the right places because implementation will be key. The implementation argument goes for the creation of the much-eeded venture cap ecosystem, so as to diversify away from needing to be born rich with lots of collateral to make it in business.
There is still a strong focus on the construction sector and in things the rentier economy likes to push for. However, there is at least a plan to put money behind other new sectors of the economy such as pharma and building the data architecture which is a positive as long as the Government comes out with a complete digitalization policy. Both the FSC and BoM talk a lot about Supervision Tech and pushing RegTech into the offshore sector for better AML monitoring for example – but who will implement it effectively?
The move towards stimulating local agri-production is consistent with MMT and is a step in the right direction. On the productivity side, it will all be about human capital coming from abroad’s ability to innovate which won’t happen quickly but is a necessary move. There was no announced reform of the highly inefficient parastatal bodies.
Will this budget get us out of the rot? you may ask. The liquidity and the ideas are grand but implementation and avoiding the downsides of MMT especially on the inflation and currency fronts will be the biggest challenges. Dodo Land is now firmly in MMT land, a first for a small island economy.
* Published in print edition on 5 June 2020
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