Analysis: Financial vulnerability

The amendment to the double taxation avoidance agreement with India will inevitably reduce the attractiveness of the financial centre of Mauritius. Global Business Companies (GBC) have greatly contributed to the large net financial inflows, to the accumulation of foreign exchange reserves and to the financing of the sizeable current account deficit of the island economy. The global business (offshore) sector has thus fostered economic development, but it is also a source of systemic risk for domestic financial stability. While Moody’s views “a systemic banking crisis as being unlikely”, a disruption to the offshore sector could increase the financial vulnerability of the local economy. Mauritius’ balance of payments has become highly dependent on offshore activities via two channels. First, significant investment income is generated on global capital that passes through Mauritius. In 2015, net investment income amounting to USD 894 million, and representing 8.8% of gross domestic product (GDP) at basic prices, more than offset the current account deficit (USD 566 million). Excluding GBC, the latter would have been 11.4% of GDP! Second, capital inflows and outflows in the offshore sector are relatively huge. Last year, net inflows (capital that stays in Mauritius) of USD 1,343 million helped turn the balance of payments into a surplus (USD 568 million). According to Moody’s, “approximately two thirds of total net financial inflows in Mauritius have historically been related to investment in India.” A decline in capital inflows, which are highly contingent on foreign inflows to India, would impinge on the balance of payments, entail loss of foreign reserves and lead to sharp rupee depreciation. This raises concerns in a context where macroeconomic fundamentals are weakening. Real GDP growth has tottered at an annual average of 3.5% in the period 2009 to 2016. Industrial production grew by a paltry 0.2% in 2015. Trade in goods and services has been in deficit since 2004. Net imports, which are expected to be 10% of GDP in 2016, could be higher on account of the negative impact of Brexit on our export revenues and tourism receipts. Inward foreign direct investment is plunging, which is reflected by lacklustre capital expenditure in the economy. As public sector debt climbed up to 65% of GDP in March 2016, the government has little fiscal space to revive economic growth. It follows that, in order to grow, the Mauritian economy relies on its offshore industry which is an important pillar of its financial sector, dominated by banks whose total assets are 330% of GDP. Distorting incentives have skewed away banks’ resources from domestic to international operations. Foreign-sourced businesses are taxed at 3% whereas domestic-sourced earnings are subject to 27% tax because of additional levies. Moreover, reserve requirement obligations on foreign currency deposits are less stringent. Consequently, banks’ exposure to foreign assets is quite high. At the end of December 2015, they constituted 55% of total assets, including foreign loans of 22%. In contrast, banks’ domestic private sector credits were only 24% of their total assets. On the liabilities side, foreign currency deposits from GBC and other non-residents made up respectively 39% and 16% of total bank deposits. The heavy reliance of Mauritian banks on GBC deposits and assets and on non-resident financing makes them vulnerable to the ebbs and flows of global capital. The lower allocation of banks’ resources to local sectors, resulting from significant cross border lending primarily in India and Africa, has acted as a brake on domestic credit expansion. Muted growth in banks’ claims on the Mauritian private sector has been accentuated by the BAI collapse, ranging from an annual rate of 1.4% in April 2015 to 4.4% in April 2016. Hence, economic activity is likely to remain sluggish. Loan banking has yielded to deposit banking, and here is the rub. If the former is a way of channelling savings into productive loans to earn interest, the latter consists in offering transaction services for a fee. The problem with Mauritian banks is that they are essentially funded by deposits (75% of total liabilities in December 2015) and have little recourse to market funding, i.e. borrowings (9% of total liabilities). They crucially hinge on GBC and other non-resident deposits, which comprise respectively 29% and 12% of banks’ liabilities. These are typically large volume deposits of short maturity which expose banks to refinancing risks. Intervention by the Bank of Mauritius in case of massive withdrawals caused by loss of confidence can only be limited, for the central bank has little capacity as a lender of last resort in foreign currencies. Thanks to big balance of payments surpluses since 2007, Mauritius has accumulated substantial foreign exchange reserves which reached a record high of USD 4.6 billion at the end of May 2016, representing 8.2 months of imports of goods and services. But should the global business sector experience a downturn, with a curtailment of new investment flows through Mauritius, the economy in general and international banks in particular would be seriously affected. As banks operate both onshore and offshore activities under a single banking licence, with linkages with non-bank financial services, we must avoid spillover effects from the global business segment that will render the domestic sector financially vulnerable.