Low-rate limits

At last the Bank of Mauritius gets concerned about low interest rate, unproductive investment and savings.

On 10 November, the monetary policy committee (MPC) unanimously voted to keep the Key Repo Rate (KRR) unchanged. The minutes record that “some members viewed that monetary policy seemed to have reached its limits and any further cut in the interest rate would most likely fuel unproductive investment.” Note that it is not said all members.

But we can safely assume that Governor Basant Roi subscribes to this view as he has stated convincingly, at the Bank’s annual dinner, that “the recipe for growth does not rest on a single monetary policy tool, but on a comprehensive set of bold reforms and other associated policy initiatives.” Also, in the Bank’s annual report 2015-16, he indicates that “the Bank is vigilant to upside risk to the inflation outlook.”

Thus a Sunday newspaper, which usually supports monetary easing, speculates that the MPC is likely to reverse its policy at its next meeting scheduled for 22 February 2017. It will not do so. The MPC cannot afford to raise interest rate only seven months after reducing it significantly by 40 basis points. This would deal a severe blow to its credibility. The rate cut of 20 July 2016, decided hastily just before the presentation of the 2016-17 national budget, was one too many. It will assuredly have in the medium term an adverse impact on what the MPC now considers “the key importance of financial stability in the context of the current level of non-performing loans and low domestic savings in the economy.”

Interest rate is deemed to be relatively low in the Mauritian context, for market players keep on bidding lower prices for government securities to obtain higher yields. Mauritius does not have an ultra-loose monetary policy (near-zero interest rate), but it is loose enough to warrant caution. As The Economist wrote in its edition of 24 September 2016, “the evidence is mounting that the distortions caused by the low-rate world are growing even as the gains are diminishing.”.

One would expect gains in investment from monetary loosening. But the Mauritian private sector has failed to take advantage of the easing of credit conditions to invest. Figures speak volumes about the dearth of domestic investment in a low-rate environment. The KRR has undergone five successive cuts since 5 December 2011, and it stands today at 4.0%. Despite a cumulative reduction of 150 basis points in the policy rate, investment has been declining in real terms year-on-year. According to the Quarterly National Accounts, gross fixed capital formation registered negative growth of 0.8% in 2012, 3.3% in 2013, 6.0% in 2014 and 5.4% in 2015. In 2016, it grew by 4.5% in the first quarter but contracted again by 0.2% in the second quarter.

Not only is there an insufficient amount of investment, but also a chunk of the realised investments is unproductive. Banks are saddled with bad debts as non-performing loans (NPL) rose by Rs 13 billion in the year ended 30 June 2016 to reach Rs 46.7 billion, representing 7.1% of total advances. Just like for the exchange rate, an interest rate level that is good for the exports sector is not necessarily good for the financial sector. Banking stability is now the focus of the Governor’s attention: “Challenges facing the banking sector pertain to the rising level of NPL, large exposures and significant credit concentration in the banking sector.” Yes, but although banks increased their coverage ratio, that is the specific provision to impaired credit, to 51.3% as at end-June 2016, the level of provisioning was still modest and below international peers.

Banks’ claims on private sector grew at double-digit annual rates in 2005, 2006, 2007, 2008, 2010 and 2012. Such rapid credit expansion has left behind a trail of sizeable bad loans, especially in the troubled construction sector which accounted for 30.5% of total outstanding bank credit at the end of June 2016. Credit growth began to weaken in 2013 when authorities adopted some macro-prudential measures and as corporates engaged in deleveraging. However, the damage is done to our production structure.

Excess money creation distorts the interest rate, causing it to mislead firms into producing too many long-lived capital goods, namely buildings and construction work. Sustained consumption of capital requires increasing voluntary savings, but the interest rate level is not consistent with time preference and resource availability. Misdirection of production is further caused by government policies that misalign prices and undermine the viability of business plans.

During the twenty-nine months of status quo in KRR (July 2013 to October 2015), enterprises were compelled to liquidate unproductive investments. But the ensuing central bank actions, igniting credit expansion, have been counterproductive. There is sound economic growth only when investment is financed by credit made available from previous savings, not in excess of savings.

The Bank of Mauritius must stop creating money out of nothing and also avoid a fall in the money supply. Neither objective will be attained with erratic changes in the monetary base (currency in circulation and deposits held by depository corporations at the Central Bank). The yearly growth rates of the monetary base, the magnitude over which the Bank has the most control, have ranged from 21.1% in April 2015 to minus 10.3% in April 2016 and to 9.2% in September 2016. Both objectives could be best achieved by a policy directed towards a zero increase in the monetary base.

While considering limits of monetary policy, the Central Bank must limit its own monetary power.