Rundheersing Bheenick, the Governor of the Bank of Mauritius, recently warned against the dangers of excessive lending by banks (to individuals and corporations) during the 40th anniversary celebration of the country?s central bank. This is at a time when the country?s two largest banks have very favorable loans to deposits ratios (i.e. have the capacity to lend) and when there is excess liquidity in the economy.

Furthermore, optimism about the economy is on an upward trend with the commitment of the Government to pursue the necessary economic reforms. Mauritius also faces a wide investment savings gap wherein our savings rate is well below our investment rate (if this trend continues in the longer term, we may not be able to sustain our current growth path).

So then is Rundheersing Bheenick right when he is already ringing the alarm bells? In order to answer this question, one must go back to the 1980s when the economy underwent a long period of growth and optimism was again on an upward path. During these good economic times, in an environment of relatively high interest rates (similar to where we stand today) financial institutions relaxed their lending standards in order to book more profits.

Between 1985 and 1995, growth in credit extended to the private sector averaged around 24%. This trend did not end in the mid to late 1990s as the liquid asset ratio that banks had to maintain was reduced to zero. It should not surprise our readers that during that time, Mauritius underwent a real estate boom (speculation on land ballooned to unsustainable levels), consumption spending as a % of gross domestic product increased as Mauritians became used to the high life and corporations borrowed heavily to finance their projects.

<B>Banks learnt their lesson the hard way</B>

By the late 1990s however, the economic situation prevailing on the island started to deteriorate. Investors were increasingly pessimistic about the sustainability of the growth rate witnessed between 1985 and 1995. The Export Processing Zone sector, a former major contributor to overall growth started to face trouble.

If one looks at Central Statistic Office?s data, productivity growth in the 1990s had hovered below the growth in unit labor cost. With the coming of the end of trade preferences, the flaws in doing business here became more obvious. In any event, the incidence of default for heavily indebted borrowers began to increase significantly; this is when the term ?sale by levy? became prevalent.

Quite naturally banks tightened credit norms which made the life of highly indebted firms even more difficult. Hence, banks learnt their lesson the hard way and we began to learn how difficult it could be to get a loan from them.

During the first half of this decade, the Government continued to finance its budget with an ever-increasing amount of debt, mostly financed domestically. During tough economic times, it should not surprise anyone that financial institutions prefer lending to the Government rather than to the private sector.

One can argue that there was a certain degree of crowding out of private investment. In response to tighter credit, many firms borrowed from abroad. Of course, foreign borrowing is subject to currency risk and many firms have paid the price for this as they lacked the expertise in debt management and hedging strategies.

Today, firms face a very high prime lending rate and tighter credit norms which put obvious constraints on capital expenditure. However, rather than pointing the finger at banks or even the Government (which, in any event has finally decided to revive the debt management unit which should help the country achieve a more optimal domestic to foreign debt ratio in the coming years), we believe that firms must come up with better projects where the return on capital is higher than their cost of borrowings.

There are many listed and unlisted companies in this country where the return on capital employed hovers below their cost of debt (not to mention their weighted average cost of capital, which is even higher). In such a scenario, banks must indeed be careful in extending credit to such companies in the private sector.

Of course we cannot generalise; there are undoubtedly many good projects out there that deserve financing and banks that sit on top of a pile of liquidity need to do their part in fostering growth in private sector investment. So, the Governor?s comment appears to be a friendly ?early warning shot? across the bows of the great commercial banking ships as a reminder that, left unchecked, things can get out of hand (à la subprime mortgages in the US).

<B>Contributed by INVESTMENT PROFESSIONALS LTD</B> (Feedback : [email protected])