The Explosive Mixture of Public Deficit and Low Savings

Published on 8th January 2010

A holiday resort in Mauritius
Spending is the order of the day. As though to celebrate a big first for Mauritius, the 2010 national budget adopted just before the December festivities encourages people deliberately to spend. Ministers, trade unionists and employers all rejoice to the idea that consumption will boost economic growth in this electoral year!

What a Keynesian illusion! Consumption has never been the true growth engine. What really drives the economy is the creation and development of enterprises. They need savings to invest and they must be willing to invest. But firms still lack visibility at the moment.

It is private investment, not consumption that makes for the competitiveness of an economy. Now, as long as our economy falls short of being competitive, the only impact of a consumption boom will be to bring about a significant rise in imports, thus widening the trade deficit. In this case, there won’t be any positive effect on local production.

More credits, fewer savings

A trade deficit in itself has nothing catastrophic, especially if the Mauritian rupee appreciates against the US dollar. Today, however, the deficit is a sign that our economy is not creating enough jobs and wealth. It is to be hoped that Mauritian exporters will benefit from the recovery of the external markets.

Otherwise, given that Mauritians usually prefer buying imported goods, a spending spree will profit mainly foreign competitors. Such consumption is sustained by the downward trend in prices as inflation has fallen below 3% in 2009. Furthermore, inflation as perceived by households by far exceeds real inflation, for it is the prices of consumer goods that soar up the most. Ordinary people thus dissave in order to keep their level of consumption.

The purchasing power has improved thanks to moderate prices rather than due to salary increases. However, if households have been able to spend more than could have allowed the rise in their purchasing power, it is because they have got into debt and have considerably cut down their savings. By doing so, they dangerously run down their financial reserves. They live on credit and so does the state: these are not the characteristics of a sustainable economy.

On the one hand, households dip more and more into their savings while the national savings rate is constantly going down: it was 28.4% of gross domestic product (GDP) in 2001 and has slumped down to 13.6% in 2009. On the other hand, households run into debt because the cost of borrowing is still accessible to them as there is keen competition between banks. The equation is simple: more credits, fewer savings. But borrowers have to repay sooner or later.

Today’s deficits are tomorrow’s taxes

Public expenditure is budgeted to jump by 14% in 2010. Consequently, the budget deficit will increase. Admittedly, a deficit of 4.5% of GDP is considered reasonable in an economic crisis situation. Nevertheless, it remains high. No one can bypass the fundamental economic law that today’s deficits are tomorrow’s taxes: it is the future generation that will eventually bear the brunt of current deficit.

As public deficit rises, savings decrease: the two phenomena are inextricably linked, for the government has to resort to more public borrowing to finance a higher deficit, thus taking away the savings of households. It is the private sector that will suffer from government overspending, in as much as savings that finance public deficits are not channelled into productive investments.

The more the government borrows, the less is left for the financing of the private sector. This crowding-out effect plays up especially if savings go down while government borrows more. But the private sector keeps quiet as it takes advantage of the additional stimulus package offered by the government.

The combination of public deficits and of the contraction of savings is likely to drag the Mauritian economy into a vicious spiral. To avoid this, public expenditure should be curtailed in the future – the only way to reduce the deficit and thereby the debt of the public sector. The latter is nearing the critical threshold of 60% of GDP. In the meantime, the burden of debt (interest charges only) weighs more and more heavily in the budget, thus aggravating the deficit. And it has become the second largest expenditure item after social security but before education.

Money created out of nothing

One did not have the impression that the Finance Minister, Rama Sithanen, was unduly worried by the low savings rate in his budget speech. He emphasized that bank deposits have grown faster than GDP. But precisely this very strong monetary expansion has led to excess of liquidity in the economy, and it is a potential source of inflation.

Money creation originates from deposits rather than from loans: deposits make loans which in turn make deposits which then make loans, and so on. By cutting drastically the interest rate, the Bank of Mauritius has accelerated this process and favoured circulation credit, that is money created out of nothing. It is not sound money because it does not come from real savings that derive from production. So every deposit does not necessarily account for real savings.

The relation between savings and economic growth is bidirectional. In a middle income country like ours, it is rather savings that generate growth. And it is interest rate, not national income, that determines the level of savings in that it reflects the price of the relative scarcity of capital.

Salary compensation, higher imports, greater consumption and rising petroleum and food prices could weaken the rupee in the coming months. The Bank of Mauritius is likely to raise the benchmark interest rate in June, or sometime before the general elections.

By Eric Ng Ping Cheun

Director of PluriConseil Ltd


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