Stabilizing the Mauritian rupee the right way

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Mauritians who live and work abroad, especially those who work in global markets, investment banking and risk always promote Mauritius in a positive way to the outside world no matter which Government locally is in power. Historically, Mauritian policy makers have also been careful about what they say when the foreign media has been listening in. Sometimes, saying nothing is better than speaking and gaining negative publicity for it. During a recent press conference which was picked up on Bloomberg, the Governor of the Bank of Mauritius (BoM) who represents a country that claims to be an International Financial Center that seeks to move up the value chain criticized “unpatriotic speculators” especially those operating in the hospitality and manufacturing industries for holding onto foreign currency and pushing the rupee/USD to record lows. The argument is that the economy is doing well, foreign currency inflows are rising to pre pandemic levels and that banks along with those the BoM and Government ironically bailed out just a couple of years ago (in badly structured and unfavorable deals) are now engaged in a speculative attack on the currency. The objective of this article is to focus on the drivers of Mauritian rupee weakness and what both the fiscal and monetary sides need to do in order to walk the walk.

Before one dwells too much on local dynamics, it is important for the Governor to understand that the world economy is slowing as central banks remove the drug of liquidity which had distorted risk taking behaviors and created all sorts of bubbles out of the system by tightening monetary policy. With financial conditions globally tightening, weak emerging market and frontier market currencies and credit spreads are facing downside and upside pressures respectively. Given the pace of tightening after a decade of ultra-loose monetary policies, the risk of accidents and unintended consequences remains elevated and risk aversion will remain strong. In such an environment, investors including many in Mauritius are rotating to short duration USD assets and into other safer haven currencies. 

Just one month ago, the market was pricing the terminal value of the Fed Funds Rate at 5.5% to 5.75% with a 0.25% cut only coming by early 2024. Today, the market is pricing the terminal rate at 5.25% with a 0.75% drop from peak by early 2024. Rate volatility is high and while some in Mauritius have been praying for a Fed pivot, if a pivot occurs because of a more pronounced global recession or stagflationary shock, then this will not necessarily spell good news for the rupee either. The BoM needs to thread carefully and not use up its limited FX ammunition too soon.

One key element which is amiss right now is a proper analysis of whether the local currency is still overvalued vs its long term fundamental value. The real effective exchange rate of the rupee is a trade weighted value of the currency adjusted for price differentials between Mauritius and partner countries. The long term fundamental value of the REER can be estimated as a function of various factors such as terms of trade, short term real interest rate differentials and productivity differentials between Mauritius and its partner countries. We will dwell on the short term factors later but for now, it is important to focus on the current REER vs its long term fundamental value. 

There are similar vector error correction model approaches which can be used on the nominal effective exchange rate as well. Results were not so different using the NEER. Applying such an analytical framework on the level of misalignment of the Mauritian REER as showcased in the REER chart tells a tale of an overvalued currency given relative fundamentals which now appears to be converging towards its fundamental value. Model limitations aside, there is likely no crazy conspiracy theory going on here as the current level of the REER was quite overvalued given the realities of the Mauritian economy. A central bank with a flexible inflation target should focus on its inflation mandate and only intervene in the FX market with the limited resources it has to do so when the currency is statistically significantly maligned. One cannot waste ammunition and fight against the current.

Beyond the value of the rupee vs long term fundamentals which has also been highlighted by the IMF in the recent past, there are of course other shorter term factors at play which would explain the speed of convergence and short term movements. Local high networth individuals, especially those whose companies earn in foreign currency have adjusted their strategic asset allocations wherein they now wish to own relatively more foreign assets in terms of investments vs local assets given the lack of viable investment opportunities locally especially when one take local currency risk into account. 

For example, someone who used to have a 60% MUR and 40% foreign currency allocation across asset classes has shifted this allocation to 50:50 and some have even gone further. Their optimal long term investment strategy which should not be confused with speculation (and nor is speculation a bad thing in a capitalist society) has been to go long local property and land assets which have been appreciating given foreign villa buying and central bank money printing until recently and go long foreign asset classes such as global equities, various structured notes and short duration bonds. In recent months, local HWNIs have tactically shifted their foreign investments towards short duration US dollar Government treasury bills and high quality corporate bonds which yield between 4.5% and 5% in USD. The spread between US dollar short duration treasuries and MUR treasuries is simply not wide enough compared to historical levels in order to justify holding onto more rupee exposure than they already have. There has also been a general loss of confidence in order to justify holding onto too many rupee assets than they already have.

The luxury component of the hospitality sector have been seeing significant foreign currency flows especially in EUR and have started to sell in the market. However, it is important to note that a lot of transactions between tour operators and such hotels occur outside of Mauritius. Should local interest rates continue to increase, there will be more selling pressure in order to meet local MUR liabilities. When it comes to the growth in foreign HNWIs coming to Mauritius especially from South Africa and Europe who tend to have more than USD 1 Million in liquid assets, they tend to use Mauritius as a pass through. Oddly enough policy makers seem to be content with allowing local property promoters to continue to execute property sales in EUR or to a lesser extent in USD. Promoters in turn prefer to only convert to pay local taxes and cover local liabilities and no more. 

Beyond meeting their domestic consumption needs when they come to Mauritius, most of their money is rerouted abroad towards foreign investments. More broadly, the largest banks in Mauritius which hold large amounts of USD Global Business deposits operate in parallel to the real economy with most of the money passing through and hence not impacting local supply and demand dynamics too much. There are essentially two foreign exchange pools in Mauritius with the larger pool having a low impact on the local currency.

When it comes to the loss of confidence accentuating short term moves vs long term fundamentals which was mentioned earlier, a lot of this has to do with the central bank balance sheet itself. The BoM has a liquidity problem and faces higher foreign currency borrowing costs. Net of the MUR equivalent 54 Billion in foreign currency borrowings, international reserves of the country stood at MUR 251 Billion by February 2023. However, if you strip out gold deposits which one hopes will not be swapped for dollars like Venezuela one day, IMF Special Drawing Rights, local commercial bank FX deposits held at BoM and IMF reserve positions, these international reserves would drop to MUR 161 Billion. For those who think this is plenty of ammunition, it is actually more complicated. 

Within the international reserves, the BoM had a USD 3.3 Billion (MUR 139.6Bn) sub portfolio which is accounted for at fair value through profit and loss in February 2022. This sub portfolio stood at a much lower USD 2.6 Billion (MUR 120 Billion) as at February 2022 as longer duration bonds and risk assets in general sold off. Interestingly, the Finance Minister spoke about not wanting to realize losses from long term investments to the press in January. The majority of the drop is driven by significant unrealized losses which point to the lack of active asset management and poor risk management practices at the level of the BoM which would have looked even worse had the local currency not depreciated by so much. It would be a terrible time to be selling loss making investments in current market conditions unless the BoM became desperate. This does however create short term to medium term liquidity challenges beyond the already complicated asset liability migraine the central bank faces. Hence adjusting for this, net ammunition only stood at MUR 41 Billion in February 2023 which would explain the small USD 20 Million interventions done so far and a greater reliance on word of mouth operations with attacks on “speculators” likely to continue.

The BoM can of course negotiate more borrowings with the likes of the Bank for International Settlements and other fellow central banks in the Middle East and Asia but borrowings do not come cheap these days and even fellow central banks will ask for high quality collateral in return. Long term repos with global investment banks given our credit rating would be set at SOFR + 100bps to 200bps which is quite expensive. The global economy and markets are rocky and the BoM should be conservative with the use of its liquid ammunition. The level of economic capital of the BoM was above 13% of total assets prior to November 2019. Global market volatility was lower back then and local MIC investment related risks did not exist yet. Today, despite a significant depreciation of the currency, the level of economic capital only stands at 3.9% and would quickly flip back to negative should the rupee ever appreciate again. The level of economic capital when coupled with fiscal dominance hurts its credibility in the market. More worryingly the BoM has a significant asset liability problem with inadequate income on assets (let alone the big unrealized losses) to cover expenses. A central bank which has a flexible inflation targeting framework should never get into a position where it needs to print money to fund domestic liabilities.

So, what can we do then beyond praying for this Chagos lease money to save the day? First, the Government should immediately return the MUR 40 Billion of central bank printed and transferred money to the central bank and recapitalize it without relying on depreciation. Printing money and sending it to Government to spend and transfer on is no war chest. This is how you make inflation worse and push the currency lower. The BoM needs to stick to its inflation mandate and continue to tighten monetary policy given the high level of core inflation, the closure of the output gap and un-anchored inflation expectations. This is where its role should end and where the Government’s should begin. We have drugged this economy for so long with negative real interest rates and debt to fuel consumption which has perversely also fuelled our trade deficit that significant tightening of monetary policy beyond 5.5% (currently at 4.5%) would cause elevated financial stability risks and accidents to crop up in Mauritius as well.

The Government can do a lot to help bring inflation down and help to improve the long term equilibrium value of the currency by cutting taxes on petroleum, engaging in meaningful cost cuts, selling non core assets to raise revenues, raising taxes on dividends on local companies, imposing tax surcharges on companies which have yet to return the MIC and Wage Assistance Scheme money and on imposing novel taxes such as land value taxation on large land owners bar those who are growing crops on agriculture land. Net fiscal consolidation which would include pension reform is good for inflation and the currency over time. The Government needs to promote free and fair competition and better regulate local oligopolies and encourage more non real estate foreign investments in this country. We need more competition to get more efficiencies and better prices. We need more immigrants who will live and spend more of their incomes in Mauritius, we need to encourage more Mauritians to come back by changing this rotten system. We need to effectively tackle the drug mafia which is also impacting the FX demand and supply and is less talked about and finally, it would be good to only sell villas to foreigners in rupees rather than in foreign currency. This can be done the hard way with large promoters and land owners or via incentives.

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