The New Financial 'Traffic' signs

It is said that the global financial crisis will be hitting mainly Mauritius’ textile and tourism industries which account for 15 per cent of its gross domestic product (GDP). A slowdown of the Mauritian economy, which is a likely eventuality in 2009, will be caused by real factors in the form of falling export orders and tourist arrivals.

The Finance Minister, Rama Sithanen, seems to be prepared to spend his way out of these exogenous shocks. A fiscal response, if well targetted and geared towards productivity growth, can help avert a recession. On the other hand, a misguided monetary stimulus through a lowering of the key Repo rate would give an endogenous shock to the economy: the latter may falter precisely on monetary factors.

At present, the crisis is doing collateral damage to two of our sectors: the stock market and the property market. Both are asset markets sharing the common belief that they will keep rising no matter what happens to the real economy. This is an illusion but it has led Mauritians to become reckless in their speculations. Now the stock bubble bursts and the real estate boom starts to unravel.

Since the day Lehman Brothers declared bankruptcy, the share index of the Port Louis Stock Exchange has lost 330 points, or 20 per cent, but has crashed 770 points, or 37 per cent, since its peak of 2,101 points achieved on 18 February 2008. Although the values of the blue chips remain within their fundamental worth, stockholders prefer to convert assets into cash.

For their part, many property owners are still convinced that real estate is the one sure bet in economic life. But they have pushed property prices so high, in some cases up to three times their original value, that they can only fall back drastically as the supply of new buyers runs out.

The substantial rise in the prices of real estate assets and capital goods has been fuelled by negative real interest rates on the back of an inflation rate higher than term deposits rates and even treasury yields. The Mauritian economy has been buoyed up by an investment boom in the most capitalistic sectors, namely the construction industry. In its September last issue of National Accounts, the Central Statistics Office writes that the 11.3 per cent real growth in private investment estimated this year “would be mostly attributable to high investment in commercial and office buildings, hotels and IRS projects”.

The real risk to the Mauritian economy is that these excesses will unwind as building and real estate developers realize that their investment projects are overly ambitious. The latter have been financed by credit expansion when economic agents have been unwilling to sacrifice their consumption and raise their voluntary saving. Entrepreneurs act as if households had increased their saving when they have actually not done so.

Voluntary saving has not only failed to keep pace with economic growth, but it has also fallen to a negative rate in real terms. In 2008, gross national saving (GNS) rose by only 3.3 per cent against a nominal GDP growth of 12.2 per cent and at a lower rate than the 6.3 per cent inflation rate shown by the GDP deflator. More worrying is the fact that saving lags well behind investment for the fourth consecutive year.

The crux of the economic problem of Mauritius lies in its resource gap as a consequence of higher investment relative to saving. The resource gap, as measured by the difference between GNS and gross domestic fixed capital formation, stood at 4 per cent of GDP in 2005, exploded to 7.2 per cent of GDP in 2006, narrowed to 3.8 per cent of GDP in 2007 but widens again to 5.8 per cent of GDP this year. Society’s investment cannot possibly exceed its voluntary saving for long periods.

The final amount of saving and investment must always be identical ex post. No society can durably force economic development by inflating investment through credit expansion unbacked by a parallel increase in voluntary saving. Any level of investment that exceeds that of saving results in wrong investments of the country’s saved resources and finally in an economic crisis.

Misallocation of resources has been encouraged by uncontrolled growth in the money supply as loans have been granted at below the natural rate of interest that balances voluntary saving and demand for capital. From 1991 to 2006, the money supply M2 in the form of bank notes and deposits grew at an average rate of 13 per cent per year, thus increasing six times. Between March 2000 and January 2004, the savings interest rate was continuously cut from 9 to 4 per cent.

The shock of monetary growth has distorted the productive structure and made it artificially capital intensive. The Austrian business cycle theory, first propounded by Ludwig von Mises and Friedrich Hayek, teaches us that recession is triggered by a shortage of saving, i.e. saving insufficient to complete capital intensive investments launched by error. Borrowers who have invested in long term capital projects will be called upon to improve their balance sheet.

In public pronouncements, Mr Sithanen regards recession as reflecting a fall in demand for products or labour, which can be corrected by ramping up spending. According to this view, common to Keynesians and monetarists alike, injecting more money in the economy would help avoid a recession. But such a policy could delay necessary liquidation of unwise investments. Instead, the government should reprioritise spending in favour of viable firms that can restructure and have the potential for securing a return on capital employed above its weighted average cost of capital.

Mauritian banks need to be extremely cautious about credit quality. They may suffer large losses on property lending as credit to construction has posted a 34 per cent annual growth in August. The Bank of Mauritius (BoM) may respond to the surge in property prices by using regulation, not monetary policy, with a tightening of mortgage lending standards.

When the BoM raised the cash reserve ratio (CRR) from 4 to 6 per cent last August, banks were supposed not to move up their prime lending rate, but they did not keep their word. Whereas they are not remunerated on their cash balances at the central bank, they are borrowing funds from it via repurchase transactions at 9.50 per cent. A reversal in CRR would be a magnanimous gesture in return for a reduction in lending rates.

By Eric Ng Ping Cheun
Director, PluriConseil Ltd