Current Account Deficit: All is not well

(Published in Business Magazine No. 1009, 18-24 Sep 2013)
It has been quite some time that we have been chanting that "all is well", persisting with our business-as-usual attitude and ignoring the fact that the external current account deficit (CAD)  remains our biggest worry today – and  one of our most pressing macroeconomic challenges.  It is better that we start doing something about the CAD  before  the crisis comes knocking at the door.

For the eighth year running, we have been registering large and persistent current account deficits  that have been well above the sustainable level. The Financial Stability Report (August 2013) of the Bank of Mauritius  posts a current account deficit  of  8.2 per cent of GDP for 2013 Q1. It was around 9.5% of GDP  in 2012. What is more disquieting is that the CAD  “remained financed by net financial flows, mainly portfolio investment and… non-residents’ direct investment in Mauritius, net of repatriation, amounted to Rs2.2 billion in 2013 Q1.” 

The 2013 IMF Article IV Mission  had warned us that growth in 2013 could be reduced  by  1.75 percentage points with reduced tourism, trade, and FDI inflows and that “large short-term capital flows linked to the Global Business Corporations (GBCs) could also prove to be more volatile than in the past.” The mission also noted that competitiveness appeared to have declined over the last decade and they considered it urgent to reduce the current account imbalance through structural reforms that would restore the economy’s competitiveness.

 

The irony with the current account situation is that it did not degenerate overnight; the problems were known and the solutions were clear. But timely, appropriate measures to adequately fix things to more sustainable balance-of-payments dynamics were absent. Instead, there was a penchant for short-term fixes and band-aids, treating symptoms rather than the disease. Policy makers assumed that growth was on autopilot and failed to address serious structural problems. They seemingly deliberately chose to make the economy more vulnerable by increasing its dependence on short-term, risk-driven volatile and unproductive capital inflows while ignoring the worsening current account deficit.

Table I: The Current Account Deficit

 

% of GDP	2006	2007	2008	2009	2010	2011		2012	2013 E
CAD	-9.1	-5.4	-10.1	-7.4	-8.2	-11.0		-9.5	-9.6
Source: Statistics Mauritius Net primary income and Net transfer are exclusive of transaction of GBC1

 Declining competitiveness

Inaction on structural reforms in the real economy remains a key missing ingredient. Rather than reliance on the quick fix of opening up the taps of capital inflows in the real estate sector (FDI in the real estate sector, as a proportion of total FDI, has increased from 23.5% in 2006 to 60.8% in 2012), it was crucial to institute structural measures to bring the current account deficit to sustainable levels by fostering competitiveness through structural reforms, and by investing in physical and human capital, which is critical for longer-term growth prospects.

Declining competitiveness has been our main concern going forward. Available indicators suggest that Mauritius has become less competitive. Between 2006 and 2012, the exports of goods and services-to-GDP ratio fell from 60% in 2006 to 54%  estimated for  this year. The export of goods, exclusive of ship’s stores and bunkers, is still more than 1% below its 2006 peak. Mauritius has not made much progress in either the diversification of its export basket or in the destination of Mauritian exports. A study carried out by the IMF in 2011 revealed the low level of sophistication of our exports that has not changed much since 2004-05, signalling a slow-down in innovation and expansion into new industries. “The stagnation since 2004-05 points to important constraints faced by the traded goods sector.”

Table II: Export concentration

% of exports of goods	2006	2012
Articles of apparel and clothing accessories	36	36
Fish and fish preparations	10	19
Sugar	16.2	12.0

 

 

In the tourism sector, projects like shopping fiestas and carnival copycats do not seem to be generating lucrative spillovers. We continue to lag behind our regional competitors, especially Maldives and Seychelles. Between 2010-2012, Seychelles realized an average growth rate of 9% (with a peak of 11.4% in 2011), and Maldives did 13% (with a peak of 20% in 2010) while we could  barely notch up a 3% annual average rate.  International tourist arrivals surged by 5% during the first half of this year compared to the same period last year, according to data released by the United Nations World Tourism Organization (UNWTO). In Africa, the 4% growth of recent years was sustained during the first half  of 2013 thanks to the continued recovery of North Africa (+4%) and the positive results of Sub-Saharan destinations (+4%). We are indeed rapidly falling behind. While Maldives and Seychelles logged in growth rates of  14.6%, 17.2 % respectively in  tourist arrivals during the first semester of this year, we have managed to realize a mere 1% .

The Achilles’ heel of Mauritian export performance in recent years has been weak productivity growth. Compensation of employees for the whole economy  increased at an annual average rate  of 7% over the period  2007-12, while labour productivity increased by only 2.9 percent, resulting in sustained increases in unit labour cost at an average annual rate of 4%. On the other hand, capital productivity decreased in the same period.  Indeed, the rising labour costs might have reduced the return to capital and eroded competitiveness of the economy. Multifactor productivity for the economy (which shows the rate of change in productive efficiency -- that is qualitative factors such as better management and improved quality of inputs through training and technology)  grew by a mere 0.1% over the 2007-2012 period which compares unfavourably with growth rates  of 6.1% in earlier periods.

 

Table III. Manufacturing Unit Labour Cost of selected countries, 2011

Country	USA	France	Germany	Italy	UK	Mauritius	Taiwan	Korea
National currency	0.6	0.3	-2.2	2.5	-2.3	6.5	1.8	-6.1
US $	0.6	5.3	2.8	7.7	1.4	14.4	9.2	-2.0

 

Comparing the changes in Unit Labor Cost (ULC) in the manufacturing sector with other countries, we notice that most of them were experiencing a relatively lower increase in ULC, the steepest growth being for Mauritius (6.5%). The ULC in dollar terms increased by around 14.4%, one of the highest, explained by the high appreciation of the rupee relative to the US Dollar. We certainly have lots of catching up to do in the productivity race.

From Trilemma to Dilemma

Trying to make the BOM a scapegoat for the growth debacle is one thing, but expecting the BOM to be supportive in its exchange rate and monetary policies  in situations of strong capital inflows shows a lack of understanding of the impossible trinity or trilemma. This refers to the trade-offs among the following three goals: a fixed exchange rate, an independent monetary policy and free capital inflows (absence of capital controls).  An economy can choose at most two of these three. This explains the trilemma before the BOM Governor when he was to announce the monetary policy in a situation of excess liquidity as a result of sizeable foreign inflows.

The Governor was proposing to raise interest rates and go against the market expectation of reducing interest rates and encouraging growth which of late had slowed down dramatically. The trilemma implies that an economy can enjoy capital inflows and an independent monetary policy so long at it gives up worrying about the appreciating exchange rate. It is impossible to have all three goals at a time.

The global financial cycle has however transformed the “trilemma” into a ‘dilemma’ or “an irreconcilable duo” making it still more difficult for our monetary policy to support growth.  Our monetary policy is now more dependent than ever on the financing conditions in the main world centres of global finance. Helen Rey of the London Business School has been arguing recently that  whenever capital is freely mobile, the global financial cycle constrains national monetary policies regardless of the exchange rate regime. “Independent monetary policies are possible if and only if the capital account is managed directly or indirectly.”

Policy response

The right policies to deal with the ‘dilemma’ should aim at curbing excessive leverage and credit growth. A combination of macro prudential policies guided by aggressive stress testing and tougher leverage ratios are needed. Some capital controls may also be useful. In the immediate, a combination of sterilised currency intervention and capital account management may be unavoidable to prevent further rupee appreciation if strong capital inflows persist. If they do not, it becomes more  imperative that basic economic sensibilities start guiding efforts to restore the shine to our structural economic story. The CAD is not sustainable if Mauritius  stays on a path of low investment, poor productivity and weak growth.