Portugal, whose sovereign debt is now BB or junk status, Spain and now Italy are suffering flat or falling GDP growth and contagion as the bond markets push their sovereign bond yields up to or over 7% – an unsustainable level if fiscal deficits are to be put into balance. And France is now also seeing its bond yields rise. India is grappling with inflation close to 10%, its currency is falling prompting intervention by the Reserve Bank of India, and it has moved its interest rates up several times in a concerted effort to choke off this inflation – with the result that economic activity is now slowing down sharply. China is also facing an inflation problem, an economic slowdown, over extended bank lending and a little understood demographic time bomb as the one child per family policy of Mao Tse Tung starts to affect its economy by raising the average age. In 2025 the average age of a person in China will be 47 compared to 28 in India.
A macroeconomic weapon of mass destruction
It is the Euro zone however that is perhaps most troubling. Warren Buffet once said that he considered derivatives to be Weapons of Mass Destruction for their capacity to destroy wealth. The Euro in its current form is also proving to be both incendiary and explosive and can therefore be considered as a macroeconomic weapon of mass destruction. Why is this?
In essence apart from large fiscal deficits and too high debt to GDP levels, it is the loss of competitiveness of up to 30% vis-à-vis Germany in the Southern and Eastern European countries which, within the confines from their perspective of an overvalued and fixed exchange rate, is beginning to cause not just rising unemployment as businesses close but also growing social pressures and unrest. This is not what advocates of the Euro had in mind 10 years ago.
The world’s financial markets are watching and waiting to see whether Germany will relent and allow the European Central Bank (ECB) to guarantee the sovereign debts of governments with printed money, or whether the International Monetary Fund (IMF) will rescue Italy. If Germany accepts such debt monetization from the ECB in order to save the Euro, then Germany will seek fiscal union in return – with powers to raise taxes, to make large scale transfers between countries and to issue Euro zone bonds with joint liability. Central banks were not meant to hand out free money to governments which have spent themselves into insolvency.
Frankly, I don’t see it happening. Are all these countries going to sign up and live under a system based on Berlin telling them how much they can tax, borrow and spend? Already the Economic police from Brussels are camped out in every government ministry in Athens, supervising expenditure cuts and tax raising, preparing for privatizations, and they are also present in Portugal, Italy and Spain. It was not meant to be like this. If these countries stay as members of the Euro in its current format, they are looking at years of austerity and depression while they try to adjust their living standards downwards to cope with the loss of competitiveness and impossibly high level of sovereign indebtedness.
Even the Chinese, who declined to support the EFSF rescue fund, are saying to Europe that the people should work harder!
Let’s say that Germany will relent in spite of the trauma it went through with hyperinflation in the Weimar Republic before World War 2 – and it allows the ECB to take the monetization route, whilst laying down terms of fiscal behaviour to the Euro zone profligate countries. Such conditions would be non-negotiable so as to placate German voters. It would only be a matter of time before southern European leaders routinely start to blame the Germans for their domestic woes. The lessons of history are not at all encouraging in this regard.
So to avoid growing capital flight and banking problems, let alone social unrest from unemployment, there needs – in the absence of quantitative easing by the ECB on a large scale to calm the bond markets or an IMF rescue the size of which has never been seen before – to be a transition or orderly break-up of the Euro with currency realignment to adjust competitiveness so as to get unemployment down and people back to work through economic growth.
This can happen in basically two ways. Either Germany can leave the Euro (perhaps with Holland). Interestingly it only ever suspended the Deutschmark, having never cancelled it – so it could be introduced back again. This would leave the Euro to fall in value. Or else the southern European countries could leave and re-establish their own currencies. This, of course would present France with the dilemma of whether to re-introduce the Franc, or perhaps stay with Germany and Holland in a smaller sized Euro currency union.
What is clear is that in the absence of significant IMF assistance or monetization by the ECB, the firepower of the EFSF is simply too small to purchase Greek, Spanish, Portuguese, as well as Italian bonds. The numbers simply do not add up: Italy has Euro 1.9 trillion of sovereign debt – most of it maturing over the next 5 years and this is well beyond the capacity of the Euro 440 billion EFSF to accommodate, without significant debt restructuring.
The key thing missing from the plans to move towards tighter fiscal union (which will take many years and treaty changes to achieve) in Europe is that nothing is being done to address the issue of competitiveness which, together with large fiscal deficits and high debt to GDP levels for Greece, Portugal, Spain and Italy, is the root cause of the current crisis. Devaluation, either of restored national currencies or a Euro composed of the Southern/Eastern European countries, has the merit changing the terms of trade of the economies of the affected countries thereby enabling them to start to put their increasingly unemployed and restless working populations back to work.
Careful guardians of deposits
What are the lessons for Mauritius, which has, I would like to say, so far navigated its course well through the choppy waters? First, it is important to be very careful what you wish for – if you are an advocate of currency union – which is a stated goal of some of the regional groupings to which Mauritius belongs as member or observer, such as the Southern African Development Community or the East African Community. Lower trade tariffs and visa free travel are one thing, on the other hand currency union as we are witnessing in Europe, without a common central bank lender of last resort, has the potential of being devastating to a country.
Keeping our own currency in Mauritius is therefore vital from the perspective of retaining a very important adjustment mechanism if our relative costs move too far in either direction, up or down. Second, it is important to keep the country’s fiscal deficit to 3% or less, and debt to GDP at 60% or less, and inflation under control. All these parameters are vital for an open economy like Mauritius if confidence, and with that foreign direct investment, is to continue to flow in. This is vitally important given that the country runs a deficit on the balance of payments current account.
Third, having a coherent and long term plan for investing in infrastructure to raise the productive potential of the economy overall is also important. It is good to see the investment in roads taking place at long last – we are all aware of the implicit costs of traffic congestion. Growth in consumption of electricity and water, as living standards rise, needs to be catered for, and whilst there is clearly more to done in these areas, some progress is being made.
Let us now turn to the banking sector. The banks in Mauritius are not making over large profits when judged by international norms of interest spreads and return on capital. Banks here are not run by “banksters” nor are they out to rob people. The banks are careful guardians of deposits whilst at the same time contributing significantly and consistently over many years in a variety of ways to the development of the Mauritian economy: through providing employment, as payers of taxes, levies, and dividends, by earning forex, and as corporate social responsibility contributors. Financial services are, moreover, a growth sector of the economy.
The fact that the domestic banking scene is populated with several banks means there is healthy competition as well as an ability to respond to local needs. It is worth noting that the situation in Eastern Europe, where the 80% of loans come from foreign (Italian, Austrian, German and French) banking groups which are now pulling back their lending due to lack of capital and cross-border lending concerns, is not something that will happen here due to the strong aggregate position of local banks in the economy. This is, I might add, exactly as it should be in a small island economy.
The Governor of the Bank of Mauritius is always encouraging banks here to lend more, and to this I would like to say that credit growth is satisfactory.
So banks do not consider that access to finance is an issue in Mauritius – balance sheets, liquidity and profitability are all sufficiently strong to support additional lending, due in no small part to the careful regulation of the industry. Well thought through and well-presented projects generally obtain finance without difficulty.
On the aspect of profits, apart from the important contribution to the economy I have mentioned before, I would like to make the point again here that banks are inherently fragile creatures – balance sheets typically being geared between 6 and 8 times on a bank’s capital base. Depressed profits, as we have seen in the US and Europe, typically result in more risky strategies being adopted. We have seen in the US and Europe how the combination of depressed margins and directed lending has led to banks gearing up balance sheets and chasing risky business so as to attempt to keep profits up only to suffer huge write-offs subsequently, be it from mortgage backed securities or recently Greek, Spanish and Italian sovereign bonds.
Careful Risk Management as well as careful regulation are therefore critical aspects that have to be carried out well if banks are to avoid the potentially huge impact that loan losses can have, not just on one year’s profits, but on the entire capital base, not to mention depositors’ confidence, if imprudent lending occurs. Consistent application of risk-based pricing therefore plays a crucial role, not just for a bank’s overall return on its lending, but also as regards exercising the duty of care due to depositors.
Consistent support and commitment for SMEs There has been much said about the Small and Medium Enterprises Financing Scheme, and I would like to say that there is strong and unequivocal support for the Rs 3 billion of credit facilities to be extended over the next three years. We appreciate the importance of having a flourishing SME sector for the economy as a whole. It is, however, a form of Directed Lending and will thus dilute the application of risk-based pricing although the 35%.
Equity Fund guarantee will help mitigate the reduction in the cost of finance for SMEs. Consistent support and commitment for SMEs from banks in the domestic arena are demonstrated by dedicated lending teams at most banks and by an aggregate exposure to the sector of Rs 20 billion. It would, though, have been much better to have concluded the arrangements for the SME Scheme on the basis of trust and working cohesively together rather than having in the background the coercive threat of penalties if quantitative targets are not met.
The need to work cohesively together is something that is, I believe, very well understood in Mauritius. For a small country like Mauritius where there is a shortage of skills, hence the need for a strong emphasis on training and raising productivity, the job of managers is to coach and bring forward talented people who can work well with and inspire those around them, and where private sector and public sector cooperation is regarded as a normal feature of life.
I see this happening increasingly in Mauritius, and the future will be bright as long as a strong focus on these attributes can be sustained. So, notwithstanding the uncertain international scene, I remain optimistic for the future here, but it is vital in my view to manage, regulate and look after the banks carefully and, above all, certainly to keep the Mauritian Rupee!
By Antony R. Withers.
Chief Executive, Banking, Mauritius Commercial Bank.