The Rupee’s Zigzag ?

On Tuesday 21 May 08, the Bank of Mauritius (BOM) intervened on the domestic foreign exchange market selling Rs 10 millions of US dollars at Rs 27.75, a move to restrain the rise of the rupee that touched new heights at the beginning of this month on the back of investors betting on continued capital inflows and some speculation that there will be little intervention to check rupee gains. (For the priority of priorities was to allow the rupee to appreciate brusquely to dent inflation.) Before that, on 2 May, the BOM reduced the key Repo Rate by 50 basis points to 8 per cent per annum.

As I had argued in my previous article, the BOM, confident of having tackled the inflationary expectations and that the first-round effects have not lead/may not have led to broader price and wage pressures, was in position now to look for a more neutral interest rate -- the “short term rate that would keep GDP growing at its trend pace and inflation on a stable path”.  The Central Bank, however, recognised that, even though headline inflation was totally under control “… the adverse effects of external developments on the export manufacturing sector have become noticeable and concerns were raised that Mauritius, as a highly-open small economy, might not be as resilient as larger emerging economies in withstanding such external shocks. The view was also expressed, however, that in a fast changing world, it was imperative that the export industry adapts to global demand conditions, increases resiliency by tailoring its exports to customer needs, and enhances flexibility to be able to hold on its own in the global marketplace.”

The high-pitched campaign of our textile exporters has not fallen on deaf ears despite a strong feeling from the strong rupee advocates that the exporters lobby was overplaying it. But exporters were getting quite jittery and were feeling the heat of the strengthening rupee. They had been urging the Central Bank to intervene and halt the rupee's rise in the wake of enormous losses that the Mauritius Export Association, (MEXA) claims have amounted to some Rs 4 billions.  Indeed some important players in the Export Oriented Enterprises (EOE) sector were already undergoing restructuring -- a nice euphemism for closures.

The Palmar Group felt that the closure of its Sweat Sun factory was a necessity if the company were to recover from its current loss-making position and generate profitable growth for the long term to ensure that its Coromandel and Mon Loisir branches are kept running. Some 800 employees were laid off and many of these employees have children still going to school and others have contracted huge debts making the situation more difficult to deal with. The average age of the workers in the textile sector is around 45 to 50 years. Workers have been told that they will be rapidly redeployed between industries and occupation -- in other words employment will shift from declining sectors to growing ones such that any disturbances to the labour market will be short-lived. The promise of a job fair for those who have lost their jobs is not much of a comfort given the difficulties for recycling at this age.

MEXA, however feels that the sector is already in the midst of high turbulence . With the marked appreciation of the rupee, our EOE sector has started losing markets to competition from countries like China, Pakistan, Turkey, Sri Lanka and Bangladesh whose currencies either depreciated or went up much slower than the rupee. And it was also threatening de “casser l’essor d’une florissante industrie touristique”.  Moreover the tempo of growth of the exports sector is being severely affected by such adverse factors as low productivity and infrastructure bottlenecks. Blockages in infrastructure development have caught the political ship unprepared.

The main constraint to maintaining the growth momentum in the next years will be the availability of high quality human resources, electricity, water, sewerage/waste disposal facilities in addition to bottlenecks at the port and airport and road congestion. In the tourism sector for e.g. planning should have started yesterday in hotel accommodation, utilities, roads, airport, telecommunications, marketing, etc., for the tomorrow of 2 million tourists. And in the EOE sector, there is the need for programmes like the earlier Technology Diffusion Scheme or Textile Emergency Support Team (TEST) which had helped to ssess competitiveness and support restructuring of a consequent number of export-oriented textile and apparel sector firms.

The Mauritius Employers Federation has also complained that in practice businesses continue to face numerous administrative hurdles in carrying out their day-to-day activities. This imposes a heavy cost on doing business and has serious implications for productivity and competitiveness of enterprises. The SME sector is also having problems to survive, thrive and move into exports. It continues to be constrained by lack of finance and financial instruments, high rate of interest and high rentals, the short reimbursement period, and a lack commercial and industrial space. The Small and Medium Enterprises that have recently taken advantage of the new opportunities in the regional markets are particularly extremely vulnerable to this exchange rate volatility because of their low resource base and the lack of support from financial institutions.

The appreciating rupee is taking its toll is on another of our industrial gem, the Tee Sun of the Mon Loisir Group which is also going through the inevitable process of “restructuring”. Laid-off workers will either be redeployed in the Mon Loisir group of industries or will be hired by other businesses. It is to be noted that the Mon Loisir  Group  is one of the most important conglomerates of the country. Its eight units located here and in Mozambique produce monthly some 500,000 t-shirts, polo shirts, sweat-shirts and jogging pants which are exported to Europe, the United States and South Africa.  Europe takes the major share with around 60% of the exports. It has some one thousand employees and a turnover of about 11 million Euros, i.e. some Rs 452 millions.

This is one of the “fleurons” of our textile industry – a vertically integrated enterprise that relies on timely delivery and flexibility to satisfy small as well as big volume orders and has the capacity to adapt quickly to changes in demand and fashion and to exploit niche markets by providing its own collection of up-market quality products of international standards. Our national flagship cannot be said to have grown fat cushioned by the protective walls of competitive depreciation; if such competitive and up-market companies are feeling the full onslaught of the strong rupee on top of the treacherous international conditions, is it not the case that the rupee has been allowed to appreciate excessively?  Yes it has.

The table below shows the currencies of most of the economies have appreciated against the dollar; the Mauritian rupee seems to be following the stride, though at a somewhat exaggerated pace. As against the EURO, most of the currencies have been depreciating; the Mauritian rupee, the only currency moving against the trend, appreciated markedly by 4.1%. Surprising indeed!!! Many of these economies have missed their inflation targets and they had begun to raise interest rates to tackle inflation. This has caused their currencies to strengthen further against the dollar causing difficulties for exporters. Meanwhile the global economic environment is turning out to be more negative than expected and there are some downside risks to the countries’ external demand. So they are caught up between the need to rein in inflation and maintaining the growth momentum.

 

 

Main textile exporters	Exchange rate changes (%) Rs to Euro Jan 08 to Apr 08	Exchange rate changes (%) Rs to $ Jan 08 to Apr 08	Inflation 2007
Botswana Pula	-14	7.7	3.5
Chinese Yuan	-3.9	4.2	3.3
Indian Rupee	-8.4	-1.3	7.6
Indonesian Rupiah	-3.8	1.9	6.5
Malaysian Ringgit	-3.5	4.4	1.5
Pakistani Rupee	-14	-3.1	7.7
Sri Lanka Rupee	-7	0.9	12.1
Thai Baht	-12	-5.6	2.0
South African Rand	-21	-16.1	6.1
Vietnamese Dong	-6.2	1.3	7.5
Tunisian Dinar	-16	4.3	4.6
Turkey Lira	-17	8	10.9
Mauritian Rupee	4.1	12.0	8.8
Appreciation = +ve

 

What explains this yo-yo type movement in the exchange rate? Why this rising forbearance for currency appreciation in all these emerging markets? In ‘A Battle of Ills’, HSBC researchers Stephen King and Stuart Green  point out that part of the problem originates from financial meltdown in the US. The aggressive lowering of the interest rate by the Federal Reserve is having a pervasive effect on emerging markets’ inflation by providing an unusually exaggerated monetary stimulus to these economies. How?

As the economy witnesses huge capital inflows, the upward pressure on the local currency is likely to mount. The central bank may allow the currency to appreciate or choose to curb the currency strength in order to underpin exports and thus economic growth. If it opts for the latter, it essentially means that it has to absorb the additional supply of dollars resulting from foreign inflows which otherwise will result in appreciation of the currency. The central bank therefore moves to buy these dollars, in turn increasing the level of the foreign exchange reserves. But these reserves present a challenge to monetary management.

The central bank’s purchase of dollars inevitably results in an increase in money supply as it buys dollar in exchange for the local currency. To mop up this excess liquidity (which has a fiscal cost), the central bank sells government securities and this increases the domestic interest rate and widens the interest differential, encouraging further inflows of hot money through various channels and thereby frustrate monetary tightening even further. Thus “the more the Federal Reserve lowers interest rates, the more difficult it becomes for emerging market policy makers to impose any form of lasting restraint on inflation”.

 

If the central bank, on the other hand, allows the local currency to appreciate, it is likely to slow down exports growth and deteriorate the current account deficit even further. Moreover, the weak performance of the EOE, especially the textile sector, may be more susceptible to the excessive appreciation of rupee as compared to the other economies.

What, then, are the available alternatives?

(1) Induce a one-off appreciation of the currency to the extent of a 10% or higher to bring inflation down without bothering too much about the loss of external competitiveness. Stephen King and Stuart Green warn us that this may “actually work to exacerbate the existing inflationary problem by attracting hot money in search of an easy and rapid return” expecting further appreciation. But what if a higher level of appreciation is needed to really have an impact on inflation!! Will the authorities be prepared to go all the way, especially in the present situation of a global slowdown, for an extensive currency appreciation without any foolproof guarantee that inflation will be tamed? Brazil’s currency appreciation by more than 100% failed to bring inflation to heel.

 

(2) A second alternative is to simply opt to sit tight and hope for the best given that the current situation is driven by forces on which domestic monetary policy has had limited impact. Or temper the rising currency with tighter capital controls, prioritise the investment projects and choose a policy mix that focuses on inflation without too much emphasis on interest rates.

(3) A third alternative is a one-off large appreciation of the rupee accompanied after a lag by a reduction in the interest rate. The brusque rupee appreciation would dent inflation and reduce pressure from capital flows. The rate cut would help bolster the economy to face more turbulent times. This combination of policies — a stronger rupee, lower rates, lower inflation — would restore the balance of a consistent monetary policy framework.

 

This seems to have been the route taken by our BOM with somewhat limited results either on inflation control or in running a more independent monetary policy. Japan is another country, known for being hawkish on inflation, that has shifted its policy stance from increasing interest rates to cutting them in the face of a stronger yen and falling exports to the United States and slowing in exports growth to Asia and Europe. Indeed we should not expect to escape completely unscathed from the housing-related slowdown in the US economy.