With headline inflation clocking a whopping 10.70% in June, it is perhaps time to present an outlook on where we expect inflation to head over the coming year as well as over the longer term. Before answering these questions, we must look at the main factors behind the current rate of inflation.

One must go back to the first half of this decade in order to understand why inflation has risen and how this factor is likely to affect the country in the longer term. During this period, nominal Gross Domestic Product growth, a measure of aggregate growth in demand for money was on average lower than the growth in money supply.

A general curtailment in credit extended by banks to the private sector coupled with an unsustainable fiscal deficit situation led to excess liquidity in the economy. The link between monetary growth and inflation is clear in the case of Mauritius; in general, periods of high monetary growth tend to lead to higher inflation with a one to two year lag.

More recently, the policy of free bus rides to students and the elderly and the regulation of profit margins on selected food items in 2005 was evidenced in the moving average calculation of the Consumer Price Index (CPI) during the first half of 2006. In April 2006, the CPI base was also affected by the unexpected reduction in gasoline prices.

<B>Consumer Price Index more favorable</B>

The CPI base was essentially lower than what it should have been. Then came the 2006 budget exercise which removed subsidies on rice and flour and reviewed the prices of alcohol and tobacco products. These measures when coupled with the ?low? base have played a major role in pushing up the inflation rate to where it stands today.

Furthermore, continued weakness in economic fundamentals in the second half of 2006, coupled with a thin FOREX market rife with speculators led to a depreciation of the local currency. This has led to obvious price increases of imported goods. Furthermore, geopolitical developments in Nigeria, Iran, Venezuela and the lack of any major oil discoveries over the last two decades in the face of increasing global demand has pushed the price of oil upwards.

While the business of forecasting is fraught with obvious difficulties, one must separate the one time effects that have led to the current high rate of inflation and other factors that are likely to stay with us for the foreseeable future.

The CPI base is now more favorable and downward pressure is likely to increase by the fourth quarter of 2007 and into the first half of 2008. Hence, our forecast for inflation by next June stands at around the mid 6% level. The favorable base is of course temporary and longer-term forecasts diverge significantly as the Mauritian economy is likely to remain vulnerable to exogenous shocks.

<B>Cost of capital too high</B>

The prices of oil and various commodities should continue to rise in the near future and are likely to continue to lead to more volatile differences between headline and core inflation.

While excess liquidity in the economy remains a long-term concern, we are more optimistic about the medium term benefits of the current trend in money supply growth. It is important to note that small and medium enterprises will need lower interest rates and more willing lenders that come with lower inflation, and a more diversified and stable economy in order to finance their investment needs.

The cost of capital is too high in Mauritius and remains a major impediment to sustainable increases in private investment in a country that continues to face a wide investment savings gap. It is hence important for the Government to maintain fiscal discipline, (which would help in reducing the crowding out effect that still exists on private investment) and continue along the path of economic reform.

Contribution by <B>INVESTMENT PROFESSIONALS LTD</B> (feedback at [email protected])