BANK OF MAURITIUS ANNUAL DINNER

WITH THE PRIVATE SECTOR

Address by Mr. R. Basant Roi, Governor of the Bank of Mauritius

(1 December 2000)

Ladies and Gentlemen

Good Evening

Welcome to the Bank of Mauritius Annual Dinner.

In the past four years or so, unprecedented attention has been given to central banking in Mauritius. Observers have made a variety of comments about the monetary policy stance of the Bank. It is commonplace that a fully functioning central bank in a democracy is never short of criticisms. This is a common feature the world over. Central bankers do lend their ears to criticisms from analysts and players in financial markets. However, having the benefit of privileged information, central bankers do make informed judgement of a given situation on the basis of which appropriate policies are formulated and implemented.

The essence of central banking inheres in what is often referred to as the trilogy of central banking responsibilities: the maintenance of price stability through the conduct of monetary policy, the maintenance of a sound and stable banking and financial system through supervisory and prudential policies and the maintenance of efficiency, integrity and safety of the payments system. Each of these three elements interacts with the other to form a package deal for good central banking. And the unified objective of this trilogy of central banking is overall economic and financial stability. When any one or more of the elements of this trilogy go haywire, economic performance suffers a setback. In the last two years the Bank of Mauritius has been and is still striving to get right these three elements of the trilogy. We have made good progress in this direction. The process is painful to most of us though. But we do stand to gain in the years ahead. Americans have a beautiful way of saying it – ‘No pain, no gain’.

Let me first briefly dwell on one of the three elements of the trilogy, that is, on the achievement of price stability through the conduct of monetary policy. This theme seems to have remained contentious despite widespread agreement among policy makers in the developed world. It has been a topical issue in Mauritius also. What should be the goal or goals of monetary policy?

Until the first two decades after the Second World War, monetary policy occupied a backseat in macro-economic management. Fiscal policy, the other of the two arms of macro-economic policy, had gained prominence largely due to the Great Depression of the 1930s. The Keynesian philosophy that fiscal action provides stimulus to aggregate demand was then fashionable. Those were also the years when you had exchange control the world over that prevented free movements of capital. Governments could print banknotes and spend without causing much strain on their foreign exchange reserves positions. The 1970s witnessed the breakdown of the Bretton Woods system and the emergence of a combination of high inflation and low growth. You will recall this phenomenon of the 1970s having been variously referred to as ‘stagnation’ and ‘stagflation’. The Keynesians failed to explain this phenomenon.

Monetary policy then moved to the front seat of economic policy making across the world in order to fight inflation. The policy goal of central banks has since been a preferred topic for heated debates. The relative importance of growth and price stability as the objective of monetary policy has been widely argued by central bankers and academics. Over the years, a consensus has been reached among developed countries that the dominant objective of monetary policy should be price stability.

Developing countries followed suit. All of us who have studied economics must be knowing that in the past development economics focused on savings, investment and technology as the spring-board for growth. The financial sector as a contributor to growth received less attention. It used to be argued that inflation was endemic in the process of economic growth; it was the result of structural imbalances rather than a monetary phenomenon. Evidence suggests that the process of economic growth in which monetary expansion was overlooked also led to inflationary pressures thereby dampening economic growth prospects. Inflation is now increasingly recognized as a monetary phenomenon; it hinders sound, solid and sustainable growth. Prof.essor Wallis has put it well: inflation is a monetary phenomenon just like shooting is a ballistic phenomenon. The need to use monetary policy for achieving an acceptable level of inflation on a sustained basis has assumed importance in developing countries also.

However, we cannot afford to overlook the trade-off between growth and price stability. There is indeed a trade-off between the two. Price stability as the objective of monetary policy is justified by several factors. To name a few, let me say that volatility in prices gives rise to uncertainty in decision making, rising prices affect savings adversely and they make speculative investments more attractive. There is also a social dimension of high inflation rates: the poorer sections of society suffer the most as they generally have no hedges against inflation. The most important question then arises as to what should be a tolerable rate of inflation for Mauritius. In my own view, a medium-term inflation rate of 3 to 5 per cent is acceptable.

At this time last year, I was underlining the rationale for the Bank's monetary policy stance, which to many observers and operators was then perceived as being too tight. With hindsight, economic agents should today be happy to be reaping the benefits of the anti-inflationary policy pursued by the Bank through a significant reduction in the inflation rate. In fact, inflation rate has gone down from 7.2 per cent in November 1999 to 4.3 per cent in November 2000, that is, a reduction of nearly 3 percentage points despite the recent increase in the domestic price of petroleum products. The deceleration in the rate of monetary expansion, greater stability in the exchange value of the rupee as well as subdued inflation in our major trading partner countries have contributed to the reduction in the rate of inflation. However, we cannot claim that the fight against inflation is over. It is never a one-off fight. The moment one declares victory in that fight is likely to be the very moment that the seed of the next round of inflation is sown. There are upside risks to inflation stemming from the global economic recovery and rising oil prices. Mauritius has only recently embarked on the process of internally adjusting its economy to the increases in world oil prices. The rein on monetary expansion will continue to be held appropriately. We are quite confident that the inflation performance in the current fiscal year is likely to be better than in the preceding year.

You will recall that with a view to giving a further edge to its indirect monetary management, the Bank introduced in December 1999 repurchase operations and a standing overnight facility, namely the Lombard Facility, for commercial banks. The rate applicable on the Lombard Facility, the Lombard Rate, also acts as a transmission mechanism for the monetary policy stance of the Bank to market operators. In recent months, as a preemptive measure, the Bank of Mauritius has increased its Lombard Rate on two occasions - from 11.5 per cent to 12.0 per cent on 29 September 2000 and further to 12.5 per cent on 9 November 2000. These increases, in as much as they get reflected in the yields obtainable on rupee denominated assets, also enhance the attractiveness of rupee investments relative to foreign investments.

There is a custom in the UK of Xmas plum pudding. Before it is cooked, a coin is dropped in the mixture. Anyone finding it in his helping is believed to be someone of good fortune. We have not been the lucky ones. We have bitten a soft euro in our pudding. It does not seem that the days are far off when we will have a bite on a hard euro. In the past several days, the euro has staged a come-back. Hopefully, on this occasion, its recovery will be sustained. The weakening of the euro since its introduction in January 1999 has been a great disappointment to all of us. All the forecasts, even the most pessimistic ones, have found their place in the graveyard. The euro has been considerably weaker than justified by medium-term fundamentals. The weak euro has been a matter of concern to us all and, in particular, to the export-oriented sectors. The euro could have gone down to Rs20. The Bank did prevent this from happening.

The weakness of the euro certainly complicates the task of monetary policy. On the one hand, the bulk of our imports are invoiced in US dollars and the bulk of our exports are invoiced in euro on the other. A substantial depreciation of the rupee would have jeopardized the goal of price stability but would have helped keep afloat even the ailing firms. Depreciation or not, a few of our firms – the inefficient ones – are destined to fail unless a major reversal takes place somehow. Against this background, the Bank opted for the middle course, but with a vision for the future. The severity of the current problem is not fundamentally rooted in the monetary sphere. We are aware that even the best of macro-economic policies are necessary, but not sufficient conditions, for success. Sufficiency is achieved when macro-economic policies are effectively blended with appropriate micro or structural policies, more so in strategic industries. What we find today is a process of restructuring and innovation that are under way in some of our firms. Failing the re-engineering that is going on, even a policy of systematic depreciation of the rupee would not guarantee the survival of the firms in the medium-term, for we are living not in the 1980s but in the new millennium with competition becoming stiffer than before. We cannot afford to succumb to the temptations of expediency for we run the risk of paying a price. In the highly competitive and highly integrated world, that price could turn out to be high indeed. Seen in this light, I must say, we have steered the economy fairly well. Without that vision, confidence about the future is elusive.

Continued vigilance is nevertheless necessary to ensure that our competitiveness is not eroded. The more we integrate with international financial markets, the more we have to allow markets work their way through. The exchange rate policy will continue to reflect the macroeconomic fundamentals of the country. Intervention by the central bank in the foreign exchange market will not aim to offset underlying market pressures but be limited to smoothing out seasonal and unwarranted short-term fluctuations in the exchange rate of the rupee.

Looking back, I must say that the Bank of Mauritius has responded in a flexible manner to the adverse impact of the weakness of the euro. However, I should like to mention that the response to the measures announced by the Bank has to be driven by the operators themselves. In March last the Bank introduced a rediscount facility at preferential rate of interest. More recently, with a view to strengthening the manufacturing base and enabling EPZ companies to modernize their equipment so as to benefit more fully from the opportunities offered in the wake of the Africa Growth and Opportunity Act, the Bank has announced that it would provide a Special Line of Credit up to an amount of Rs 500 million to the EPZ through commercial banks. Effective 27 November 2000, the Bank of Mauritius has also started conducting short-term back-to-back foreign currency swaps with commercial banks in euro, Pound sterling and US dollar, in respect of swaps transacted by banks with EPZ companies and tourist establishments. Let me hasten to add that, in the first four days of its introduction, the value of swap transactions amounted to Rs208 million. The success of these schemes will again depend on the response of EPZ and tourist operators and not on the central bank. May I seize this opportunity to extend a note of appreciation to the Chief Executives of banks, their Heads of treasury as well as to the other members of the Financial Markets Committee for their co-operation.

Let me now turn to the foreign exchange situation that has prevailed recently. The state of the foreign exchange market is currently influenced by leads and lags stemming from exchange rate expectations. These have the effect of bringing forward import payments and delaying export receipts, thereby putting pressure on the foreign exchange market. The prevailing state of mind about exchange rate expectations has recently also been fuelled by certain articles in the local press. Efforts have, however, been publicly made by the authorities to tone down those exchange rate expectations and to exhort parties operating in the foreign exchange market not to act in such a manner as to destabilize the market. With a view to easing the supply conditions of foreign exchange on the market, the Bank of Mauritius sold foreign exchange amounting to US$146.2 million to banks during the period January to November 2000. The scale of intervention this year has been almost threefold of that conducted in 1999. The Mauritius Sugar Syndicate is also adding to the supply of foreign exchange on the market through the regular sales of foreign exchange arising from sugar export receipts. There are good indications of improvement in the liquidity conditions on the foreign exchange market. It is expected that normal conditions on this market will prevail in the light of the steps taken on both the fiscal side and the monetary sector.

May I say that the fiscal adjustment being made should help reduce Government borrowing from the Bank of Mauritius. Central bank financing rising to around 5 per cent of GDP is clearly not sustainable. Fortunately, this ratio has been drastically reduced recently. Continuous fiscal adjustment and a reduction in Government indebtedness should eventually allow an easing of the monetary policy stance of the Bank.

Sustaining a policy stance geared to low inflation requires a sound and competitive banking system. As I have underlined in the past, it is important that the central bank’s policies to further promote the soundness of our financial system through prudential regulations be perceived as efforts directed towards strengthening the micro-economic aspects of monetary management. Prudent regulation and strong and effective bank supervision are the cornerstones of a healthy financial system. Before this year is out, we will issue the Bank’s first Annual Report on Banking Supervision in Mauritius.

With a view to modernizing the domestic financial system infrastructure and improving the working of the payments system, the Bank, with the assistance of the World Bank, is actively pursuing its efforts to implement by mid-December 2000 a Real Time Gross Settlement System (RTGS), known as The Mauritius Automated Clearing and Settlement System (MACSS). This will become an important milestone for better integrating financial sector operations and ushering into new and more efficient avenues in the provision of financial services to the public.

Finally, let me touch upon the reforms in the labour market – an aspect of our system of wage determination that I have brought to the forefront from time to time in the past. I am extremely happy to note that there is increasingly a clear recognition of the need to overcome the current institutional rigidities and promote productivity-based earnings. May I digress here to say that the economic and financial paradigms have changed dramatically in the past ten years. We have to look back and have a better vision for the future. President Reagan, the Republican, quite rightly said in the 1980s, ‘You cannot strengthen the weak by weakening the strong. You cannot help the wage earner by pulling down the wage payer. You cannot help the poor by destroying the rich. You cannot help men permanently by doing for them what they could and should do for themselves’. The best known single sentence in political economy is in my view Adam Smith’s: ‘It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest’. Adam Smith was not only the author of the Wealth of Nations but also the author of the Theory of Moral Sentiments. In the early 1960s, a consensus view – indeed a philosophical one - was expressed by President Kennedy, the Democrat, in his inaugural address, ‘ If a free society cannot help the many who are poor, it cannot save the few who are rich’.

Let me leave you with these thoughts in welfare economics and political economy.

Ladies and Gentlemen, may I, on behalf of the Board of Directors and the Staff of the Bank of Mauritius and on my own behalf, wish you and your family a Merry Xmas and a prosperous New Year 2001.

Thank You.