Who is licking the wounds and who is licking the chops ? This is not an innocent question that was set to me by an economist at an international institution today, February 12, 2014. In the past few days I received several requests from friends and young professionals in Mauritius to elucidate and re-state the problem of excess liquidity that appears to have emerged as the cause for the cross-firings between the Bank of Mauritius and the Ministry of Finance. It seems confusion has been confounded. I am away from Mauritius for quite a while and I am not that familiar with the happenings in the country. I have, however, attempted to state the problem in a FAQs manner to make it more understandable than if presented otherwise. My apology if a lack of familiarity with the current state of things cause further confusion to readers.
What is Liquidity ?
Let’s say you have one Rs100 banknote. It’s cash and is characteristically the most liquid asset anyone can hold on to in his life. It’s called the most liquid asset because it is readily converted into other forms of assets, goods and services at any point in time. You hand it over to a peanut seller at a corner stand in town for the purchase of Rs5.00 worth of peanuts. The seller tells you that he has no change and gives back the Rs100 banknote to you. You end up with no peanuts which you were willing to pay for at that point in time. It goes to say that your Rs100 banknote was not liquid at that point in time because it could not be exchanged for the goods you were willing to buy. Even your cash was not liquid at that point in time !!!! This is the basic concept of liquidity in the economics and finance. When a monetary policy maker talks about liquidity this question of even cash not being liquid at times has to be well borne in mind.
What is the meaning of excess liquidity in the economy ?
Mind you I said ‘liquidity in the economy’ and not ‘liquidity with banks’.
When the growth rates of money supply exceed the growth rates of the economy it is said that there is a surplus of money circulating in the economy. That excess is called excess liquidity in the economy. In other words, the surplus is in the hands of the public and as such it is a potential inflationary force in the economy. If the surplus keeps growing over a protracted period of time (also technically referred to as a monetary overhang) it becomes a cause for policy concerns. The BoM would then have to mop up the surplus by issuing either the BoM bills or treasury bills or both in order to stem this source of inflationary pressures. If holders of the liquidity do not find the yields on the bills attractive they don’t buy them and the BoM would be unable to mop the surplus. In that case, the BoM MPC would have to decide for an increase in the repo rate as a result of which the yields on the bills go up. Depending on how attractive the yields will be, the BoM would succeed in mopping up the excess liquidity. The potential source of inflationary pressures would be eliminated and the growth of money supply would thus be brought in line with the growth rate of the economy. (Note that this is a very simple illustration. Sometimes even when there is no surplus the MPC might decide to raise the repo rate in order to curb credit expansion and prevent an overheating of the economy. I’m not going to dwell in intricacies here.) Simple as it appears, this is a highly technical exercise that requires intense econometric skills and years of experience in monetary, financial and economic analysis of the Mauritian economy. Every economy has its own specificities, its weaknesses, its strength and its capacity to counteract headwinds. Few economists at the BoM, as far as I know, have that kind of expertise.
What is ‘excess liquidity with banks’ ?
Liquidity with banks means cash in hand plus BoM/Treasury bills and other government securities held by banks. By excess liquidity the BoM usually refers to the amount of such liquidity being held by banks that is over and above the ratio prescribed to them. In other words, the amount of such liquidity as a percentage of total deposit liabilities is currently far in excess of the prescribed ratio. If the excess of Rs16.0 billion (Is it only cash ? Or Government securities also ?) peddled by the BoM is the amount of liquidity over and above the prescribed ratio, it might have been understated. The BoM raised the cash ratio a couple of times in recent years. In fact, on the basis of the original ratio the excess could be far higher. One can go on raising the ratio until the excess is mathematically eliminated. However, in the balance sheets of banks the actual excess accumulated in recent years might be much higher than what the current ratio tends to suggest.
There are “potential” problems associated with this kind of excess liquidity. “If” the banks start making use of the excess liquidity to extend credit it could give rise to inflationary pressures in the economy. Money supply could rise over and above the growth rate of the economy. The BoM would then need to mop us the excess as described above. But we know banks are not going to throw money out of the window to borrowers in the country. After all, because of the risk-ridden conditions and persistent low growth, demand for credit is depressed. Banks are thus stuck with the excess of liquidity because, just like the Rs100 banknote that ceased to be liquid in the example above, the excess cash and the other supposedly liquid assets held by them cannot be usefully and profitably deployed. In so far as the excess liquidity cannot be usefully and profitably deployed they also cannot be an immediate threat to inflation. The potential purchasing power that constitutes the excess liquidity with banks is blocked in the balance sheets of banks. Why worry about inflationary pressures then ?
Yes, there is one reason why the Governor of the BoM should be worried about this question of excess liquidity : when banks will no longer be willing to carry on with excess liquidity in their balance sheets the only other recourse left to them will be to lower deposit rates and that reduction could be consequential. We know what this would mean to the BoM, politically and otherwise. The risk is that monetary policy, in particular interest rate policy, could eventually turn out to be an absolutely useless tool. The Governor of the BoM would be reduced to a puppet-master with about 20 dolls or so but no strings.
Will an Increase in the Repo Rate help alleviate the problem of excess liquidity ?
If you have understood and have had a full appreciation of what I said above you should happily conclude that an increase in interest rate cannot be the right policy response to the problem. It could rather exacerbate the excess liquidity situation. To further understand my point let’s first understand the sources of the excess liquidity. Discovering and understanding the sources is very important if the monetary policy maker has to attack the problem of excess liquidity.
My personal reading of the causes of excess liquidity goes as follows :
(i)     Government borrowed quite a large amount of money from abroad over the past several years. Government received quite a lot of grants from abroad. Government received hefty SDR allocations from the IMF (sort of an external grant) in 2009. The forex was sold to the BoM. All foreign currencies borrowed by the Government were sold for rupees to the BoM. The forex of BoM shot up ; currency in circulation, too, shot up ;
(ii)     The balance sheet of the BoM shows central bank credit to the tune of Rs1.5 billion has been granted to the private sector. If we assign a simple and conservative money multiplier of only 2, then BoM has consciously added Rs3.0 billion to the excess liquidity ;
(iii)     In the past several years there have been lots of private capital inflows in the form of portfolio investment and FDI and yet growth rates of the economy has been sluggish ;
(iv)     Are investors bringing in more capital than the costs of their projects ? If so, why ?
(v)     The possibility of some smart players taking advantage of interest arbitrage since interest rate on reserve currencies are lower than the rate of interest on rupee assets cannot be discarded. This could be a possible cause for the excess liquidity ;
(vi)     The ORR arrangement by the BoM/Ministry of Finance put in place for the BoM to buy foreign currencies in order to beef up its forex position. The rupee counterpart of the purchases must be huge. These figures are not released to the public, as far as I am aware ;
(vii)     Private sector borrowings of foreign currencies have added to the excess liquidity ;
(viii)     The BoM has an outstanding amount of investment of more than Rs6.0 billion in Government securities. It means the BoM has injected more than Rs12.0 billion (taking a money multiplier of 2) into the system. Why not sell the papers to holders of excess liquidity and thus mop it up if excess liquidity is causing so much national economic and financial insecurity. Sure, BoM will forgo interest income. So what ?
(ix)     The silent insiders busy ‘eating cakes’ must be aware of more sources of the excess liquidity.
The whole issue is essentially a central banking problem. Having been at the BoM for more than three decades, I never saw the MoF coming to the rescue of the BoM even in the worst of circumstances. Ministers of Finance and Financial Secretaries were smart enough to let the BoM sort out its own problems. Past Governors had to fend for themselves and come up with imaginative policy making to get the monetary sector out of troubles. But fortunately we now have this new mechanics called the MPC, put in the BoM Act by myself. Pushing persistently hard on the inflation button that is so appealing to the masses (who have no idea of how things really work in the real world of economics and finance) for 8 years cannot but be a wrong approach of central banking. It’s best for the BoM to adopt a realistic approach of resolving problems that fall on its side of the fence, without going out on a wild goose chase (inflation) in the wilderness. When I take the systematic 8-year of hawkish BoM attitude with regard to the interest rate policy stance at most of the MPC meetings people should wonder (I don’t.) how come inflation has gone down despite the much regretted and disliked low interest rate policy stance taken by the MPC !!!
It now appears that both the BoM and the MoF is trying to set each other as a duck in a shooting contest. The ugly quarterly spectacle that throws Mauritius into bad light and disrepute should stop ; it discredits Mauritius with a spiteful backward kind of status.
To cut a long story short : will a hike in the repo rate help alleviate the problem of excess liquidity ? I’m afraid not, in my opinion. There are other ways of resolving this problem. An increase in interest rate in Mauritius (which would make local rates more attractive than rates on foreign currencies) would invite foreigners to bring in more forex to Mauritius and therefore more rupee liquidity. It certainly would give more room for interest arbitrage. Even Mauritians holding foreign currencies would repatriate funds for a kill, if they have not done it already. (I’ll never forget the day when two brokers – one of whom was a Mauritian – at the London Stock Exchange had given me an estimate of capital flight from Mauritius by Mauritian nationals as a result of the imposition of tax on interest. The least said the better.) Moreover, even the growth forecast for 2014 is far from encouraging ; growth is still in its convalescent stage. A hike in interest rate would be a bad shot in the arm.
What could be done to prevent similar occurrences in the monetary area ?
I have always said that a fiscal policy mistake can be easily corrected but a monetary policy mistake, more so if continued for years, is not easily remediable ; it inflicts a series of distortions in the economy and in financial sector, too. The mistake can be remedied but at a high cost to the economy and society as a whole. Take, for instance, the present problem of excess liquidity. Readers will recall that Mauritius has a serious current account deficit problem. This problem has stopped making headline news. It’s like dirt tucked under the carpet. This problem ought to have been addressed by measures known to the BoM. The latter chose not to because the measures are not popular. One direct consequence of this gross policy negligence is that export sector, in a world of competitive depreciation that the IMF avoids referring to, kept underperforming and the deficit kept expanding. Economic growth took a twist ; the pace of growth declined and stayed at just above 3 per cent for some years. The deficit continued to widen and was financed by capital inflows that kept swelling rupee liquidity in the system. Worst, instead of tackling the problem of the current account deficit, the BoM/MoF assisted by the IMF technical team came up with the ORR arrangement. Under this arrangement the BoM buys foreign currencies on the market in exchange for rupees that it releases in the system. BoM is now exceedingly happy that its foreign exchange reserves have gone up and is at the same time exceedingly unhappy that it has released too much of rupees in circulation that needs to mopped up at a cost. It’s like the story of kid (allergic to sweets) who sucked and sucked his ‘bonbon’ to the finish and is now throwing tantrums about his ‘bonbon’ giving him an acute stomach pain. Who will pay for the cost of mopping up the excess liquidity ? BoM ? MoF ? Whoever pays, it will finally be paid out of people’s pockets.
The ORR intended to build the forex reserves of the BoM was a deliberate attempt to refrain from taking unpopular policy action ; papering the cracks on the wall was identified as the right thing to do. OMG !!! The original dear baby, current account deficit, is still with us. Low growth is like the ghost still haunting us. Worst, the country, like many other countries that have had a good time taking things easy, has become over-dependent on capital inflows and that is an extremely risky business. No country with a huge current account deficit can keep on relying on the savings of the external world. Already, serious concerns are being expressed about such countries. Anyone who is aware of which countries are under reference here must understand the riskiness of the situation. None of the problems has been resolved ; instead they brought in their cousin for dinner : excess liquidity ; it’s not at all a cool guest star in the banquet. A monetary policy mistake or exchange rate mis-alignment sustained over time is not any kind of mistake ; it’s an incubator for monetary troubles.