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 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 and 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 as being 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 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 output 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 ; 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, increase its funding for
research needs and create the institutional environment that supports
technological change; it should also aim for more of targeted expenditures that will help to build a diversified productive capacity for the future. The structural reforms and the
development of specific growth
supporting measures will recreate the economic foundations for global
competitiveness and generate productivity improvements
to restore the economy’s competitiveness .
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.
