Ask any market analyst and he/she will tell you that a low interest rate regime is good for stock markets. In an environment where the cost of capital is low, companies are more able to increase capital expenditure and grow (read growth in employment and consumption) and more individuals can borrow in order to finance their short and long term needs. Following the 9/11 terror attacks, the world has witnessed historically low rates as central banks have continuously slashed their benchmark rates in order to stimulate economic growth? and what economic growth we have seen !

Between 2002 and 2006, global growth expanded by a whopping 4.54% and global stock markets rallied as corporate profits skyrocketed. In Mauritius, however, lower rates proved to have mixed results as banks still curtailed lending (and rightly so) and more importantly since our economic woes emanated from the supply side and necessitated reform!

High inflation rates

Central banks, however, are able to lower interest rates by following a much less restrictive monetary policy (read monetary expansion in many cases). Economists will tell you that money is neutral in the long term, i.e. unless growth is generated from the supply side, monetary expansion will eventually lead to higher prices (read inflation). Historically periods of high monetary growth have contributed to higher inflation with a one to two year lag in the case of Mauritius.

The rest of the world too has seen inflation crop up over the past two years. Indeed, some economists have argued that the global liquidity glut created the now burst housing bubble in the US and has also contributed to higher stock prices.

Furthermore global expansion has created new consumers in countries like India and China while western consumers have continued to increase their consumption, thereby driving commodity prices upwards. In light of the US subprime crisis and a potential US recession (which could lead to a more pronounced global economic slowdown), the Federal Reserve cut its benchmark rate by 50bps and may trim the Fed rate by another 25bps before the year is over. This has been done at a time when upside risks to inflation remain strong.

European and Asian central banks find themselves stuck between a stone and a hard place. They cannot stop the process of monetary tightening because of the upside risks to inflation (food and energy segment in particular) but they also cannot allow the interest rate differential between their rates and US rates to widen further as this would cause their currencies to continue to appreciate vs. the dollar, which would most certainly hurt their export driven economies. The world is certainly heading towards interesting times. US Consumption, after all, accounts for 19.30% of global GDP itself.

Enhancing factors of production

The reliance on central banks to generate growth or to bail out banks that lent excessive amounts of money to high risk borrowers is not an optimal solution in the long term. Long term growth is generated from enhancing the factors of production rather than from the demand side.

While the art of politicking may sometimes sideline the need to maintain the cap on economic reforms, Mauritius on its part has no choice but to reform in order to enhance productivity growth. While we often hear about investment and savings, the fact that Mauritius has averaged near zero total factor productivity growth between 1995 and 2005, is largely ignored by analysts.

Monetary policy has its obvious limits and can only help soften the blow without really avoiding it. The US may well be able to avert a recession while housing prices still face downward pressures (large supply of homes and subdued demand at current prices) by lowering rates further as it heads towards presidential elections but higher food and energy prices are likely to continue to impact on the inflation rate in the longer term. In sum, do not rely too heavily on monetary policy, work towards enhancing the factors of production instead!

Contributed by

INVESTMENT PROFESSIONALS LTD (Feedback: [email protected])