The Ineffectiveness of Monetary Policy

Published on 3rd March 2009

A financial crisis has led to a severe recession in developed economies. Can the reverse be true for Mauritius? The country has escaped the financial meltdown due to the fact that banking practices are essentially deposit funding. However, an economic downturn might have serious repercussions on the banking sector.

On the stock exchange, Mauritius Commercial Bank and State Bank of Mauritius have suffered a massive setback, being at their lowest price since December 2006. A contraction in textile and tourism activities will inevitably eat up banks’ profitability although their exposures to these sectors vary. A general economic slowdown will reverberate through the banking industry as the latter is deeply integrated into the real economy with credit to the private sector representing 84% of gross domestic product.

The Mauritian government has come with an additional stimulus package aimed at staving off recession. The Bank of Mauritius (BoM) has cut the Key Repo Rate by a total of 250 basis points during the year 2008. These measures draw on the teachings of Keynes and Friedman that if bankers are reluctant to lend, it is the duty of the government and the central bank to keep the flow of lending so as to maintain the overall spending in the economy.

Good credit leads to productive consumption

While it is true that credit is the key to economic growth, it is doubtful that spending is what drives an economy. One must make a distinction between good and bad credit, as well as between productive and non-productive consumption. Good credit comes from the pool of real savings, and it allows someone to consume in order to produce (productive consumption). Bad credit is money unbacked by production but created through artificially low interest rates, leading to an exchange of nothing for something (non-productive consumption).

For instance, the government could employ individuals, or subsidise private firms, to dig holes in the ground. The money that it pays them will boost consumption. Since government does not generate wealth, it secures the money through taxation, by printing money or by borrowing. Not only is there a diversion of wealth, but the holes do not contribute to people’s well-being.

Some industrialists, dissatisfied with the government’s package, advocate further stimulus measures but do not bother about how these are to be funded. They just want to save their personal business. They are too narrow-minded to realize that more public spending and loose credit only foster non-productive consumption and weakens the process of wealth formation.

Credit to the private sector dipped by 2.4% in November 2008, but expanded again by 2.8% in December. Credit growth rate for last year was 26%. Even if banks are being cautious about lending, credit continues to flow smoothly. However, the increasing excess cash holdings noted during January suggests that lending is likely to decelerate in the coming months.

Excess liquidity is structural

In his Letter to Stakeholders published on 3 February 2009, the Governor of the BoM, Rundheersing Bheenick, admitted that there was “structural excess liquidity in the system”. Since the end of October 2008, banks have been holding much more than the minimum requirement. While the cash reserve ratio has been set at 4.5%, the average cash ratio stood at 5.48% for the maintenance period ended 1 January 2009, 5.95% for 15 January and 6.06% for 29 January. For the first time since May 2007, the BoM conducted a Reverse Repurchase Transaction on 13 February, absorbing Rs 800 million, half the amount received.

This excess liquidity should normally go to treasuries, but their prices are steadily rising: the overall weighted yield on Treasury Bills (Bank Rate) has shed 247 basis points since the last rate cut on 8 December. The secondary bond market is a total failure as no trading of bills has occurred on the stock exchange since May 2008. There is no proper interest rate transmission mechanism: the overnight Interbank Rate moves inside and outside its set limits, and it goes closer to and further away from the Bank Rate on a weekly basis. Interest rate expectations cannot be formed in a rational way but on lobby considerations.

The build-up of excess reserves in Mauritian banks can be construed as evidence of a Keynesian “liquidity trap”. According to Keynes, when the rate of interest falls to a certain level where “almost everyone prefers holding cash to holding debt which yields so low a rate of interest”, central banks can “lose effective control over the interest rate”.

The liquidity trap represents a process whereby people raise their cash holdings in direct proportion to an increase in money supply, thus neutralizing the latter’s effects. In 2008, deposits grew at an annual rate slightly higher than broad money.

In case the Mauritian economy stumbles into a liquidity trap, monetary policy will no more be effective. Government’s response to the global crisis cannot therefore rely on what the Finance Minister, Rama Sithanen, calls a “softer monetary policy”. Anyway, the decline in headline inflation (to 9.3% for the twelve months ended January 2009) is too slow to warrant a further monetary easing at the next meeting of the Monetary Policy Committee on 26 March. True, year-on-year inflation for January 2009, measured as the percentage change in the consumer price index compared with January 2008, dropped to 5.2%.

In a statement at the conclusion of a staff visit to Mauritius released on 20 February 2009, the International Monetary Fund opined that inflation measured on a year-on-year basis “is a more appropriate measure than the frequently used backward-looking average in guiding monetary policy decisions”. The problem is that year-on-year inflation needs to be adjusted for seasonality, and besides the population has learnt to base their inflation expectations on headline inflation.

Responsible lending fosters economic growth

The BoM would be wise to leave the Repo Rate unchanged, but it should not overlook the problems caused by low interest rates. In addition, the sharp depreciation of the rupee is fuelling cost-push inflation. And the expansionary budgetary policy has steered the course of future demand-pull inflation.

A politically expedient government has to show that it is doing something, though the impact of fiscal policy may be limited. For a supposedly independent central bank, it can take the liberty of doing nothing. Such a policy would root out non-productive activities as interest rates would reflect the real cost of funds to banks and the risk taken by borrowers. That is the foundation of responsible lending.

Also, an absence of monetary policy would compel all stakeholders to fix structural problems. Thus, the government would have to curtail public spending and taxes, and to liberalize the economy further, especially the labour market, to allow a rapid allocation of productive factors, particularly labour, to profitable sectors. Economic agents would need to improve their finances by cutting costs and paying off loans. There is not much Mauritius can do beyond a flexible labour market, an austere public sector and a lean private sector.

By Eric Ng Ping Cheun

Director, PluriConseil Ltd

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