FOCUS: The Arrogance of a Mis-Aligned Exchange Rate

The Eurozone is overwhelmed with crises. The housing market collapse in the US morphed into a financial crisis, sovereign debt crisis, balance of payments crisis, economic crisis, euro crisis and finally into a political crisis. The debt-gorged Eurozone economies have run out of policy space. Austerity measures have been much like the prescription of a starvation diet for patients in a family suffering from malnutrition. As was expected by the pro-growth supporters, austerity measures are back-firing. Several Eurozone economies are in either recession or are about to kiss it. Europe is stuck with a generational destruction of society’s balance sheet. The scary part of the string of crises is the failure of the political class to construct and reach a coherent consensus to resolutely pull the Eurozone out of its economic and financial morass. Unrestrained political bickering and dithering have made the crises more complex and the solutions more demanding.
The threats to growth and financial stability are so serious that the Bundesbank, the central bank which is known to have made low and stable inflation an almost basic human right for the Germans, signaled in the days past its intention to trade off its anti-inflation stance for growth. The second largest economy, China, and other emerging economies are slowing down. Japan is in a sluggish mode already. The largest economic bloc, Eurozone, is in recession with a projected contraction of 0.3 percent for 2012. The UK is in a double-dip recession. The US, the largest economy of all, is likely to be handicapped to soldier on alone effectively.  
Against this unpromising global setting, the growth outlook for Mauritius is hazier unless there is a decisive policy reversal. Our GDP growth in recent years has been telling us that the economic wheels are spinning at reduced rates. It’s the kind of a growth inertia – an internal momentum picked up from past performance – that is not telling us if we are getting anywhere. The economy is clearly not firing well in all its cylinders, which amply reflects the inadequacy of our recent policy responses to the economic crises. The offshore sector is the only foreign currency-earning sector that has maintained its growth tempo. But it’s now under attack due, possibly, to the Government having been dialing wrong numbers in the fast changing geopolitical landscapes and seascapes.
There is no single set of macro-economic data presentable in a short form that encapsulates the vulnerability of the Mauritian economy in such a telling way as the one below. There is a difference between living by making things and living on borrowed money and volatile capital inflows. Any economist who dismisses the current account deficits of 10 per cent of GDP in today’s context as a light concern must be a highly dangerous explosive in policy making. Space limitation prevents me from dwelling on technical points. Suffice it to say, exports and tourism receipts have flattened out for six years whilst imports have gone up. For an export-oriented economy it’s not a nicety that anyone of us should accept with adulation.

The cumulative deficits, adjusted for offshore transactions, over the 6-year period amount to Rs140.0 billion. Add to this amount the increase in the foreign exchange reserves of the BoM of Rs 40.0 billion over the same period. Total capital inflows thus amount to Rs180.0 billion. These deficits and the foreign exchange reserves build-ups have been financed by way of external borrowings by the public sector and private sector, external grants and SDR allocations by the IMF, FDI and portfolio investment, including a flush of speculative capital. Bearing in mind that all the balance of payments data are netted figures, the size of speculative capital inflows must be big and disturbing.
When the increase in domestic credit to Government and private sector of around Rs135 billion (after allowing for external borrowings by the private sector) over the 6-year period is added to the capital inflows of Rs180 billion the total amount of funds injected into the Mauritian economy amounts to Rs315 billion, equivalent to the GDP of one year. Despite such a massive injection of capital into the economy growth has been surprisingly very low year-in and year-out. Has capital become so inefficient in Mauritius? Or, are we having a flush of speculative capital (which, by definition, is flight capital and counterproductive) making a quiet kill somewhere in the economy? Have speculators been conducting carry trade? Those are the quietest and happiest guys in town as would have been divorce lawyers looking through their telescopes at wealthy people in flagrante delicto.
“The view I have derived from the last three decades of experience is that it is almost an iron rule that, whenever countries run really large and sustained current account deficits (more than 5 per cent of GDP), they end up in financial crisis.” Reinhart and Rogoff provide authoritative support for this view in their recent masterpiece, This time is Different (Princeton University Press). This is what happened to Latin American countries in the debt crisis in 1982 and to the Asian countries in 1997. It also happened in the current financial crisis, the epicenter of which was those countries that ran large current account deficits in the region of 5 per cent. Greece ran a current account deficit of 11.2 per cent in 2009. Portugal’s deficit was around 10 per cent.
Our current account deficits had widened to 10.7 per cent of GDP in 1979-80 and 15.5 per cent of GDP in 1980-81 with dire consequences that have gone into oblivion. We are running current account deficits of not less than 10 per cent today. They are like a spectacular car wreck. There’s everything disturbing to the mind to see. Yet spin-doctors and economic cheerleaders often run the nothing-to-see-here storylines. Deficits of 10 per cent would have been temporarily tolerable if, and only if, they were due to imports of such items of intermediate and capital goods that went as inputs for production of goods and services meant for exports. But this is not the movie we are watching. Policies are biased in favour of consumption as opposed to productive private sector investment. By the way, aren’t the sales of foreign exchange by the BoM to the STC outside the market framework an implicit exchange rate subsidy in an economy already wired and mired with a plethora of subsidies?
The current account deficits of Rs33.5 billion for 2011 plus the reported outstanding private sector external borrowings of Rs30.0 billion (i.e. Rs63.5 billion)  is equivalent to as much as 78 per cent of the foreign exchange reserves position of the BoM. Will the BoM have the muscle to defend the rupee should pressures due to capital outflows build up? If it doesn’t, a hard landing of the rupee would become inevitable. Or will the BoM keep intervening on the forex market until it runs out of foreign currency reserves, in which case external bankruptcy would become a reality? We are in the terrain of elevated risks. The Americans and the Europeans had refused to believe in their impending misfortunes until they smacked in the face almost overnight.
There is an old joke among economists about a cop who comes upon a drunk crawling around a street light. “What are you doing man?” he asks. “Looking for my keys,” the drunk answers.
“Where did you lose them?”
“Over there.”
“Well, why are you looking for them here?”
“Because the lighting is better here.”
Like the drunk following the light, policy makers appear to be seeking enlightenment elsewhere leaving the long term economic interests of society, like so many car-keys, forgotten and left behind. It requires some luck and pluck to make a U-turn.
Terrain of Elevated Risk
What’s to be feared is a reversal of capital flows as gently hinted by the World Bank. It did happen in 1997 and in 2006 when interest income was made taxable. The risk of external bankruptcy or a very hard landing of the rupee is a clear and present danger. Ours is not a garden-variety kind of current account deficits. They are serious structural deficits needing fundamental policy changes. With the kind of trends shown in the table, the destination is certain; the time for reckoning is variable.
Party-pooper and Apostate
We are creating little wealth; we are consuming it all. We are not only consuming current wealth. We are also consuming wealth that does not exist. We are consuming tomorrow’s wealth. It’s not the way to get rich; it certainly is the way to get poor. An orgiastic out-of-control party is on. The well-offs are feeling great and fine. None of them seems to believe in a reversal of fortunes. Nobody seems to be asking the right questions. Those who dare ask the right questions or say anything, even obliquely, that sounds like an irritant party-pooper is dismissed as an apostate.