1

Effects of fiscal policy on the conduct and transmission mechanism of monetary policy in

Mauritius

Abstract

In view of analyzing the effects of fiscal policy on the conduct and transmission mechanism of

monetary policy in Mauritius, this paper reviews key features of the operational framework for

fiscal and monetary policies and interaction between the two main policy authorities, providing a

brief description of the evolution over the years. The trend in monetary policy as well as fiscal

policy and their impact on various macroeconomic variables are analyzed to identify the

effectiveness and constraints of the current macroeconomic framework.

By Dooneshsingh Audit1

1 The views expressed in this paper are those of the author and do not necessarily reflect those of the Bank of Mauritius. I am grateful to colleagues participating at the validation workshop organized by the COMESA Monetary Institute, in particular, Mr. Chileshe Mumbi Patrick and Dr. Mustafa Mohamed Abdalla, for their valuable comments and suggestions on the draft version of this paper. General disclaimer applies.

2

Contents

Introduction

Section I: Theoretical and Empirical Literature

Section II: Evolution and features of Monetary Policy

Section III: Evolution and features of Fiscal Policy

Section IV: Analysing the interaction between Monetary Policy and Fiscal Policy

Section V: Comparing current monetary policy framework with best practice

Section VI: Monetary policy framework and Inflation expectations

Section VII: Has monetary policy accommodated fiscal policy?

Section VIII: Putting all the pieces together and Policy Recommendations

3

Introduction

The macroeconomic policy practice in Mauritius has undergone several transformation during

the course of its development. The evidence until now suggests that those changes have worked

well for the country with each stage of development being somewhat well-prepared by conscious

decision-making in terms of policy design and implementation.

While the design and practice of monetary and fiscal policies have undergone several

conversions over the course of the economic development of Mauritius, the country has

maintained an overall policy mix that is credible and delivered a number of positive outcomes.

The evolution of the structure of coordination between monetary and fiscal policies has adapted

to the different needs of the stages of development. The current structure of coordination

between monetary and fiscal policies rests upon a well-developed banking and financial sector

that has allowed the price discovery process for the government debt securities to work relatively

efficiently. This essential feature allows monetary policy to operate independently focusing on

the objective of maintaining price stability and promoting orderly and balance economic

development.

Section I: Theoretical and Empirical Literature

The very existence of fiscal and monetary policies of a country is to generate welfare gains for

its citizens. Welfare gains could be in terms of full employment, low inflation, contained income

inequalities and sustainable development. Most of the decisions related to achieving these

objectives rest with the fiscal authorities while monetary authorities provide service to these

objectives by ensuring that some of the conditions for fulfillment for these objectives are put in

place. This assertion can be traced back to the origins of monetary policy. However, the limits

of fiscal action are set by the resources available to the country, more precisely, the inter-

temporal budget of the country. When government revenues fall short of government

expenditure for its efforts towards desirable objectives, the government borrows in one time

period for repayment in later time periods. This process is sustainable as long as the government

commands credibility over the ability to repay its debts, which in turn depends on the level of

existing debt, proposed size of fiscal deficit, debt servicing conditions, size of the economy and

the rate at which it is growing.

The government can thus borrow as long as there is a demand for its bonds or other forms of

securities. If investors perceive the fiscal path of the government as unsustainable, they would

rate government bonds as too risky and would thus either limit their exposure to such assets or

lend at higher interest rates. Government borrowing thus is constrained by the real stock of

government bonds investors are willing to hold and the interest rate on those bonds. The

monetary authorities can influence these two constraints by adjusting the money base or

influencing short-term interest rates. An increase in money supply, ceteris paribus, would cause

4

inflation to rise and the real stock of government bond held by investors to fall and thus induce

them to demand more government bonds.

Alternatively, an increase in money supply or through the adjustment of the key policy interest

rate of the economy, interest rates could be depressed to relax the constraint on fiscal authorities.

An increase in money supply could simultaneously have implications for the exchange rate, in

terms of depreciation of the domestic currency that could lead to pick-up in inflation and again a

fall in the real stock of government bonds held by investors. A depreciated currency also allow

the government to reduce its financing cost with past debt having lower real value and increase

its nominal revenue through ‘seignorage’, the inflation tax. Seignorage has its origins in ancient

times when it represented a fee that the royal mint collected from the public to convert their

holdings of bullion into coins. Other governments resorted to debasement, wherein government

would call in the coins, melt them down and mix them with cheaper metals. The practice of

debasement was widespread in the later years of the Roman empire and the French monarchs in

the fifteenth century, unable to collect more normal taxes, used debasement as a form of inflation

tax to finance the ‘Hundred Years War with the English’. Intrinsically, the modern time

‘seignorage’ is no different from those practices, with government debt contracted at a value of

money more than the value of money that it is being repaid through inflation, although the net

effect is partly mitigated through payment of interest.

With seignorage providing support to fiscal policy, the policy debate moved to whether fiscal

policy and monetary policy were independent or some form of influence was being exerted by

the fiscal authority on monetary policy or some coordination prevailed between monetary and

fiscal authorities with both having predetermined objective. This literature revolves around the

issue of ‘rules versus discretion’ and ‘independence of the central bank’. Another strand of this

literature builds on the seminal paper by Sargent and Wallace (1981) that argues that even if

fiscal policy and monetary policy are set independently, the monetary authority will have to

adjust to restore equilibrium after some lags. Sargent and Wallace (1981) introduce the concept

of “monetary dominant” regime, where the monetary authorities independently set monetary

policy and “fiscal dominant” regime, where the fiscal authority independently sets the budget

with implications for inter-temporal budget constraints on monetary policy. They show that even

under monetary dominance, tighter monetary policy in one time period leads to loose monetary

policy in later period due to the need to pay interest on bonds issued and the continuous growth

of the economy. With tighter monetary policy and continuously expanding economy, fiscal

levers might become exhausted, constrained by either higher interest cost or ability to issue

additional government bonds. Ultimately, the monetary authority has to respond by making

monetary policy loose.

Sargent and Wallace (1981) rational has been deepened and been confirmed by other models and

growing mix of empirical and theoretical papers. Canzoneri, Cumby and Diba (1997) and others

show that when the inter-temporal budget constraint is set, the price level remains the only

variable that can adjust to restore equilibrium. Along these lines, papers in the literature attempt

5

to provide answers to whether the price level is determined by the needs of fiscal solvency – this

group of literature has been referred as ‘the fiscal theory of the price level’. The first-generation

models of balance of payments crises show how the inconsistency between fiscal policy

fundamentals and the exchange rate peg leads to abandonment of the peg (Krugman, 1979). The

impact of fiscal fundamentals on the exchange rate has been shown in the literature, not only

through theoretical models, but also in documentation of various crises. Even with managed

floating regime, if an important part of the government debt is in foreign currency, fiscal

mismanagement has ultimately led to crises. Directly or indirectly, fiscal policy has important

implications for monetary policy.

Fiscal solvency have various implications for the overall credibility of the policy framework in

place in a country and weighs significantly on the prices in the economy, including interest rate,

sovereign spreads and the exchange rate. Higher deficits are generally associated with higher

medium term and long-term interest rates. Unsustainable fiscal path, if not resolved lead to

crises. Government debt to GDP that exceeds a certain threshold causes the country’s sovereign

ratings to worsen and thus lead to wider spreads and higher interest rates. This in turn leads to

depreciation of its currency and ultimately to higher inflation.

The advent of inflation-targeting, emergence of ‘Taylor’s rule’ and more work on the benefits of

independent central bank have brought new light on the coordination framework between

monetary policy and fiscal policy. Investigating how fiscal policy affects monetary policy

through estimates of their respective reaction functions over time, the literature essentially tries

to verify whether fiscal policy directly influence monetary policy. Within an inflation-targeting

regime, such direct effect can be safely ruled out, but the indirect effects are nonetheless present.

For instance, Blanchard (2004) show that an increase in interest rate could lead to a deprecation

of the domestic currency rather than its appreciation if the fiscal path becomes unsustainable and

the risk of default increases following higher borrowing cost. Monetary policy cannot remain

indifferent to such possibilities. While abuse in terms of influence on monetary authority should

be avoided to protect the credibility of monetary policy and the overall policy regime,

coordination between monetary policy and fiscal policy is a precondition to ensure objectives of

both fiscal and monetary regimes are met.

Therefore, a key objective of this paper is to verify whether monetary policy has been influenced

by fiscal policy to accommodate the latter through the channels elaborated above. The paper will

investigate whether decisions on the policy rate or the exchange rate were motivated by fiscal

considerations. It will also try to evaluate whether the monetary authority has sacrificed its

inflation objectives in favour of generating additional fiscal space. In this quest, the standards of

independent monetary policy will be compared to the current practice to indicate whether the

prerequisites of independent monetary policy have been in place or not.

6

Section II: Evolution and features of Monetary Policy

Prior to 1991, monetary policy was conducted primarily by establishing an annual ceiling for the

expansion of credit by banks and by imposing reserve requirements. The Bank also issued

interest rate guidelines to banks. Lower lending rates were set for priority sectors. The Minister

of Finance announced the Bank Rate and yield on Treasury Bills was set in relation to the Bank

Rate. Over time such a system of direct controls brought in rigidities to the banking growth

prospects and ultimately constrained economic prospects of the country.

Mauritius embarked on a gradual process of financial liberalisation in the late 1980s. Exchange

controls were removed in gradual steps until the suspension of the Exchange Control Act in July

1994 and a more flexible exchange regime replaced the previous basket-peg regime.

Concomitantly, the Bank of Mauritius switched from direct control to indirect monetary

management. In fiscal year 1996-97, the Bank started announcing an inflation objective in its

annual report.

To establish open market operations for monetary policy purposes and to improve liquidity

management, the Bank of Mauritius in December 1999 introduced a Lombard facility and a

framework for repurchase and reverse repurchase transactions. The Lombard facility was a

standing facility to provide overnight collaterised advances to banks at preannounced interest

rate. It was used by the Bank as a signalling mechanism for its monetary stance. Transactions

under the Lombard facility halted around mid-2003 as the interbank rate fell below the Lombard

rate. The regime that prevailed, however, was far from being an inflation targeting regime as the

targets changed every year and there was no clear link between the changes in policy rates and

the inflation outcomes. On 18 December 2006, the Bank introduced a new framework for the

conduct of monetary policy with the Key Repo Rate (KRR) acting as the policy rate to signal its

monetary stance.

The promulgation of the Bank of Mauritius Act 2004 in June 2005 allowed for institutional

independence for the conduct of monetary policy with provisions included in the Act for the

setting-up of a Monetary Policy Committee (MPC) and on 23 April 2007, the MPC was

launched. In view of providing further independence to the MPC, the Bank of Mauritius Act

2004 was amended in August 2007 to empower the MPC to formulate and take final decision on

the monetary policy instead of having to submit its findings and recommendations to the Board

of Directors of the Bank, which took the final monetary policy decision. As the experience of the

MPC grew, its composition and proceedings have been fine-tuned to improve its performance

and the Bank of Mauritius Act 2004 was accordingly amended.

Table 1 provides in brief the inflation outcomes registered in Mauritius.

7

Table 1: A historical perspective on headline inflation

Note: December and June figures used for computing the Means and Standard Deviations.

The analytical Table 1 on headline inflation is to provide an overall view of the experience of

economic agents with inflation in Mauritius and have comparable historical figures.

The period 1990-2009 limits the time frame so as to include only the liberalised phase of

the economy.

The period 1994-2009 is included in the table to note the difference in average inflation

since exchange control was abolished in 1994.

The period 1999-2009 marks a remarkable attempt on embarking on inflation-targeting

approach in the conduct of monetary policy.

Another break is introduced in 2007, the year of the introduction of the MPC.

Due to exceptional events in 2007 and 2008 with significant hikes in commodity prices and

outbreak of global financial crisis, the period 2009-2013 is considered to have a better sense of

the ‘normalised’ inflation rate. Post the global financial crisis, monetary policy globally has

been significantly accommodative with the focus on reviving growth and as a result of the later

years of mild inflation and vulnerable growth revival. This backdrop has allowed Mauritius to

pursue accommodative monetary policy and adjust the structure of interest rate downward. The

MPC occasionally used its change in monetary stance to build its credibility as an inflation-

8

fighter. The focus of the MPC on its mandate has allowed inflation expectations to be anchored.

Chart 1 shows the evolution of the KRR and inflation (Headline and Year-on-year) in Mauritius.

Chart 1: The KRR and Inflation (Headline and Year-on-year)

Section III: Evolution and features of Fiscal Policy

Fiscal policy in Mauritius has been guided by the needs of the country at the different stages of

its development. In the late 1970’s, like many underdeveloped countries in the world at that

time, Mauritius was a monocrop economy, largely dependent on sugar production and exports.

Government revenue was thus constrained by the size of the economy and averaged around 22%

of GDP. Government expenditure, however, as a percentage of GDP was around 30% of GDP.

The almost 8% gap between government revenue and government expenditure made the country

vulnerable to the price of a single exports on the world market – Sugar. Overall fiscal deficit

averaged 11% of GDP and a major fall in the price of sugar led to an economic crisis.

Mauritius sought and obtained support from IMF stand-by facility in 1982-83 to the tune of

Rs728.6 million, representing 6% of GDP to undertake several reforms and embarked into a

phase of market liberalisation and diversification of the economy. As part of the reform

package, the Mauritian rupee was devalued twice, sales tax was introduced and subsidies were

reduced. The reforms paid off handsomely with the economy growing at over 5.5% annually

and government expenditure brought down to around 25% of GDP, resulting into significant

9

improvement of the fiscal path. The fiscal deficit decreased from a peak of 13.7% of GDP in

1980/81 to a trough of 1.1% of GDP in 1987/88. Within that time frame, the government also

repaid a sizable share of its foreign debts, in particular that owed to the IMF. Budgetary central

government external debt declined from 33.6% of GDP in 1984/85 to 16.2% of GDP in 1989/90

while budgetary central government internal debt decreased from 45.6% of GDP to 38.8% of

GDP over the same period.

Chart 2: Government Revenue and Expenditure as a % of GDP

Chart 3: Fiscal Deficit as a % of GDP and Inflation

10

The improvement of the fiscal path and reforms undertaken led to a more diversified economy

and restored macroeconomic balance in the economy. Inflation that had shot to a peak of 26.5%

in 1980/81, following the devaluation of the domestic currency, fell to a low of 0.7% in 1986/87.

From an average fiscal deficit of 6.3% in the 1980’s, the 1990’s recorded an average fiscal

deficit of almost half of that size at 3.3%.

Chart 4: Budgetary Central Government Debt as % of GDP

Over the course of the evolution of the fiscal path, the authorities undertook continuous

improvement of the tax regime by enhancing tax collection and administration and rationalizing

various levers of the tax. Introduction of new tax policies and rationalization of government

expenditure have generally been perceived as adverse to the public, even those that were meant

to actually reduce the number of tax payers and the per unit cost of government expenditure of

the economy. Strong leadership at the helm of governments and proper implementation of

various tax reforms have succeeded in demonstrating the positive impact on the economy of

several reforms carried out. These include the introduction of Sales tax in 1982, Pay As You

Earned (PAYE) in early 1990’s, Value-Added-Tax in 1998 and the ‘single-rate’ tax system in

2006-07. Along with these reforms, the income and corporate taxes were significantly reduced

from rates as high as 30-40% in the 1980’s and 1990’s to the current single rate of 15%, in line

with the focus of encouraging work, production and efforts. The rationalization of the tax

regime allowed the direct tax rates to be reduced, while those of indirect taxes to be contained.

Simultaneously, inefficient price controls and subsidies were eliminated.

Post-1990’s Mauritius was endowed with a more diversified economy and developed financial

system with more liquid and sound banks and the emergence of several type of other financial

intermediaries. These led to the development of deeper money markets and allowed the country

11

to rely less on foreign borrowing and seek its financing needs internally. The 2006-07 reforms

appear to have caused another important break in fiscal management in Mauritius – interest

payments on government debt fell from 17.8% of total government expenditure to 11.0% of total

government expenditure as shown in Chart 5, thus allowing government expenditure on other

items to increase.

Chart 5: Share of Interest Payments and Current Expenditure in Total Government Expenditure

Chart 6: Share of foreign grants in Total Government Revenue

12

Another key development in fiscal policy has been the promulgation of the Public Debt

Management Act 2008 that limits the ratio of public debt to GDP to 60% and has a provision that

requires that this ratio be reduced to 50% by 31 December 2018 and remains so for subsequent

years. It also provides for any rise in the percentage at the end of a fiscal year not to exceed 2%

by reference to the percentage in respect of the previous fiscal year. These provisions strengthen

fiscal discipline in the country and ensure that the country remains on a prudent fiscal path.

During the course of its economic development, Mauritius has benefitted from foreign grants in

support of reforms that have been undertaken. In the 1980’s, they helped the economy cope with

the market reforms under way in liberalising the economy and in 2000’s, supported the economy

to manage sugar sector reforms and the transition phase following the end of the Multi-Fibre

Agreement and ACP-EU Sugar Protocol. Foreign grants have supported the government budget,

but have been temporary features of the budget, in important size. As shown in Chart 6, foreign

grants as a share of total revenue peaked at 5.7% in 1985/86 before falling to around 1% and

then rising to 4.4% in 2008/09.

Section IV: Analysing the type of coordination between monetary policy and fiscal policy

In order to evaluate the type of coordination between monetary policy and fiscal policy, we apply

models that have been documented in the literature review to the Mauritian economy. Annual,

quarterly and monthly data have been used to verify different possibilities and make appropriate

conclusion over the nature of coordination between monetary policy and fiscal policy.

Annual analysis

Using Annual data between 1977 and 2014, the relationships among fiscal deficit, inflation,

exchange rate have been investigated. The variables used for the annual analysis are fiscal

balance as a percentage of GDP, interest rate, inflation and log of the exchange rate of the dollar

vis-à-vis the Mauritian rupee. The interest rate used is the estimate of an implied interest rate

based on interest payments and government debt.

A deterioration of the fiscal path is expected to lead to higher interest rates to compensate for

higher risks and higher inflation. Depreciation of the domestic currency, i.e. an increase in

Rs/USD, as has been shown in the literature, could support fiscal balance through the impact of

‘seignorage’ and raising revenue through higher import duties collected and added taxes on

profits of export enterprises. While the negative correlation with inflation and positive

correlation with LOG(Rs/USD) is confirmed for the years 1977 to 2014, interest rate and fiscal

balance have been weakly positively correlated with a coefficient of 0.18. Ordinary least squares

(OLS) regressions were estimated with inflation as the dependent variable in Equation 1(a) and

with fiscal balance as the dependent variable in Equation 2. All variables in the regressions have

been tested for unit root and observed not to have unit root.

13

INFLATION= 5.16 – 0.730 FISCAL+ 1.093 INTEREST – 2.924 LOG(RS/USD)

(t-statistics) (0.51) (-2.24) (1.50) (-1.32) Equation 1(a)

R2 = 0.39 D.W. = 1.53

Given that the constant term in Equation 1(a) is not statistically significant, it is dropped to

estimate Equation 1(b). However, the inferences drawn remain the same except that interest rate

become statistically significant and the fit improves mildly.

INFLATION= - 0.849 FISCAL+1.345 INTEREST – 1.975 LOG(RS/USD)

(t-statistics) (-3.84) (2.55) (-1.687) Equation 1(b)

R2 = 0.38 D.W. = 1.54

Correlation Matrix I

FISCAL = -18.90 – 0.176 INFLATION +0.720 INTEREST – 3.527 LOG(RS/USD)

(t-statistics) (-4.91) (-2.24) (2.06) (3.76) Equation 2

R2 = 0.55 D.W. = 0.63

The expected inverse relationship between fiscal balance and inflation is verified in both

Equation 1 and 2 at 5% level of significance. However, the inverse relationship between interest

rate and inflation, and the impact of depreciation of the domestic currency on inflation have not

FISCAL

BALANCE

IMPLIED

INTERESTINFLATION MURUSD LMURUSD

FISCAL

BALANCE1.00 0.18 -0.54 0.55 0.66

IMPLIED

INTEREST0.18 1.00 0.15 -0.17 -0.04

INFLATION-0.54 0.15 1.00 -0.49 -0.53

MURUSD0.55 -0.17 -0.49 1.00 0.98

LMURUSD0.66 -0.04 -0.53 0.98 1.00

14

been confirmed. Even the sign of their respective coefficients are opposite to what would have

been expected. The reason for the non-significance and abnormal sign of the coefficient could

be due to the fact that the interest rate and exchange rate used in the regressions are annual

averages such that the short-term dynamism registered by them during the year could have been

offset. Another reason could be the restrictive sample size of only 38 observations.

Reaction function of the central bank since the setting-up of the MPC

Using quarterly data between 2008Q3 and 2015Q1, the reaction function of the central bank has

been estimated with the Key Repo Rate (KRR) as the dependent variable, and inflation,

log(GDP) and primary balance as a percentage of GDP (PB) as independent variables. Equation

3 shows that both inflation and LGDP depict the expected relationships reflecting KRR

adjustments were guided by inflation and growth concerns. Higher inflation caused the KRR to

go up while lower GDP growth led to cuts in the KRR. Primary balance as a percentage of GDP

is not found to be significant in the regression, indicating monetary policy might not have

accommodated fiscal needs. The regression nonetheless has some shortcoming with LGDP

having a unit root and the sample size being 27 variables only. But, the tentative conclusions

from the regression can be substantiated by the minutes of the Monetary Policy Committee

(MPC) meetings and the fact that for some period the yield on treasury bills were disconnected

with the KRR as a result of lingering excess liquidity.

KRR = 30.68 + 0.206 INFLATION - 2.370 LGDP + 0.055 PB

(t-stat) (2.50) (3.95) (-2.16) (1.82) Equation 3

R2 = 0.60 D.W. = 1.21

In Equation 4, a model closer to Taylor’s rule is estimated with the dependent variable KRR and

independent variables inflation gap, output gap and primary balance as a percentage of GDP.

Only inflation gap is found to be statistically significant in the estimated reaction function of the

Central Bank. All variables in Equation 4 regressions have been tested for unit root and

observed not to have unit root.

KRR = 5.36 + 0.191 INFLATION GAP + 0.480 OUTPUT GAP + 0.066 PB

(t-stat) (39.06) (3.00) (0.26) (1.69) Equation 4

R2 = 0.36 D.W. = 0.47

15

These results suggest that for under the current structure in place, monetary authority has been

functioning independently and not tried to accommodate fiscal policy. The coordination

between monetary and fiscal authorities is more to do with macroeconomic objectives than the

financing needs of the government. This arrangement provides confidence to financial markets

and investors in general, and dismisses any risk of crowding out.

Analysing short-term dynamics impacting on inflation outcome

Monthly data for the period June 2006 to January 2015 have been collected to assess the impact

of external factors, in particular, international commodity prices and monetary variables, namely,

growth in broad money liabilities and the exchange rate on inflation. Compared to the annual

and quarterly estimations, this model has the advantage of a larger sample size of 104

observations and it is expected to make up for the limitations of the other two models in

capturing short-term dynamics that influence inflation. All variables in Equation 5 regressions

have been tested for unit root and only YTM3 has been observed to have unit root.

FAO = Monthly FAO food price index

BML = 12-month moving average of monthly growth rates of Broad Money Liabilities

RS_USD = Monthly Average Exchange rate of the US dollar vis-à-vis the Mauritian rupee

YTM3 = Monthly weighted average yield on 91-day Treasury Bills

INFLATION = -15.38 + 3.68 BML + 0.29 RS_USD + 0.72 YTM3 + 0.03 FAO

(t-statistics) (-3.87) (12.64) (3.14) (16.67) (5.24) Equation 5

R2 = 0.91 D.W. = 0.45

In Equation 5, all the independent variables are statistically significant indicating that they could

impact on inflation. However, the positive coefficient that is again observed for interest rate,

here with a coefficient of +0.72 for YTM3, is intriguing. The correlation coefficient between

INFLATION and YTM3 is also positive at 0.85. One explanation could be that both the

aggregate demand channel through which lower borrowing costs cause prices to rise and the

exchange rate channel through which lower returns on domestic bonds cause the exchange rate to

depreciate as a result of capital outflows have not been working during the period under study.

Instead, it could be that lower borrowing cost could in effect be reducing cost of production and

doing business such that businesses were able to keep prices contained or even lower prices to

16

adapt to the lackluster conditions prevailing globally post the global financial crisis. These

tentative conclusions could explain part of the reason why persistently low borrowing cost did

not lead to higher prices. The coefficients obtained in Equation 5 could however be biased and

inconsistent due to the presence of serial correlation as depicted by the low Durbin-Watson

statistics. Moreover, persistence of low inflation could have anchored inflation expectations at a

lower range that had, in turn, built into a virtuous cycle of low inflation and low borrowing cost.

For Mauritius, this could in effect be very much the case and the work of Blanchard (2004)

provides theoretical underpinnings for such a possibility. But these outcomes are dependent on

several factors at work simultaneously and need not hold permanently.

Correlation Matrix II

Mauritius is a small open economy that imports most of its food and energy needs and act as

price taker in all markets. The impact of international commodity prices weighs considerably on

inflation as depicted by the high statistical significance of FAO, despite a negative correlation

coefficient between FAO and INFLATION at -0.36 for the period under study. But without

money growth and exchange rate effect, the impact on inflation could be restricted. Indeed,

BML and RS_USD cause inflation to rise and if they both were to evolve in opposite direction to

FAO, inflation would overwhelmingly be contained.

The presence of serial correlation in Equation 5 was expected given the fact that the data used

are monthly time series. Some of the relationships observed could be the result of a combination

of factors rather than indicating causality and might not therefore hold in the long run. Pairwise

graphs of each factor as well as pairwise Granger causality tests have been undertaken to

evaluate the relationships between the independent variables in Equation 5 and inflation.

INFLATION FAO YTM3 LUSD RS_USD BML

INFLATION 1.00 -0.36 0.85 -0.03 -0.01 0.77

FAO -0.36 1.00 -0.62 -0.73 -0.74 -0.17

YTM3 0.85 -0.62 1.00 0.15 0.17 0.49

LUSD -0.03 -0.73 0.15 1.00 1.00 -0.15

RS_USD -0.01 -0.74 0.17 1.00 1.00 -0.14

BML 0.77 -0.17 0.49 -0.15 -0.14 1.00

17

Chart 7: Credit to private sector growth, BML and Inflation

Pairwise Granger Causality Tests: BML and Inflation

Sample: 2006M06 2015M01

Lags: 3 Null Hypothesis: Obs F-Statistic Prob. BML does not Granger Cause HEADLINE_INFLATION 101 2.73367 0.0480

HEADLINE_INFLATION does not Granger Cause BML 3.66557 0.0151

Sample: 2006M06 2015M01

Lags: 6 Null Hypothesis: Obs F-Statistic Prob. BML does not Granger Cause HEADLINE_INFLATION 98 1.40991 0.2203

HEADLINE_INFLATION does not Granger Cause BML 2.08121 0.0638

Chart 7 suggests that broad money liabilities growth (BML) could influence inflation

significantly as depicted by the similar trends in BML and Inflation. Credit to private sector

growth, a component of BML, is also illustrated in Chart 7 in view of its importance in driving

economic activities in the country. Granger causality tests indicate that BML could cause

inflation in the short run, but in the relatively longer run, the influence would decrease.

0

2

4

6

8

10

12

-0.5

0

0.5

1

1.5

2Ju

n-06

Nov-0

6

Apr-0

7

Sep-

07

Feb-

08

Jul-0

8

Dec-0

8

May

-09

Oct-0

9

Mar

-10

Aug-1

0

Jan-

11

Jun-

11

Nov-1

1

Apr-1

2

Sep-

12

Feb-

13

Jul-1

3

Dec-1

3

May

-14

Oct-1

4

Credit to Private sector growth BML INFLATION

18

Chart 8: Exchange rate (Rs/USD) and Inflation

Pairwise Granger Causality Tests: Rs/USD and Inflation

Sample: 2006M06 2015M01

Lags: 3 Null Hypothesis: Obs F-Statistic Prob. RS_USD does not Granger Cause HEADLINE_INFLATION 101 1.50303 0.2188

HEADLINE_INFLATION does not Granger Cause RS_USD 0.07326 0.9742

Sample: 2006M06 2015M01

Lags: 6 Null Hypothesis: Obs F-Statistic Prob. RS_USD does not Granger Cause HEADLINE_INFLATION 98 3.28609 0.0059

HEADLINE_INFLATION does not Granger Cause RS_USD 0.87151 0.5194

Chart 8 illustrates an ambiguous relationship between the exchange rate (Rs/USD) and inflation

with no clear association of their respective trends. However, Granger causality tests indicate

that Rs/USD could cause inflation with six months lag, but not in three months.

0

2

4

6

8

10

12

25

26

27

28

29

30

31

32

33

34

35Ju

n-06

Nov-

06

Apr-0

7

Sep-

07

Feb-

08

Jul-0

8

Dec-0

8

May

-09

Oct-0

9

Mar

-10

Aug-

10

Jan-

11

Jun-

11

Nov-

11

Apr-1

2

Sep-

12

Feb-

13

Jul-1

3

Dec-1

3

May

-14

Oct-1

4

Rs/USD INFLATION

19

Chart 9: Weighted interest rate on 91-day Treasury bills (YTM3) and Inflation

Pairwise Granger Causality Tests: Interest rate and Inflation

Sample: 2006M06 2015M01

Lags: 3 Null Hypothesis: Obs F-Statistic Prob. YTM3 does not Granger Cause HEADLINE_INFLATION 101 1.87938 0.1384

HEADLINE_INFLATION does not Granger Cause YTM3 2.45371 0.0680

Sample: 2006M06 2015M01

Lags: 6 Null Hypothesis: Obs F-Statistic Prob. YTM3 does not Granger Cause HEADLINE_INFLATION 98 1.74483 0.1205

HEADLINE_INFLATION does not Granger Cause YTM3 1.61626 0.1525

Chart 9 illustrates a close relationship between the interest rate (YTM3) and inflation, but the

positive correlation is intriguing and could be the result of a combination of factors during the

time under study than depicting a regular relationship. It will be investigated further. At 5%

level of significance, Granger causality tests indicate that YTM3 might not cause inflation.

0

2

4

6

8

10

12

14Ju

n-06

Nov

-06

Apr

-07

Sep-

07

Feb-

08

Jul-0

8

Dec

-08

May

-09

Oct

-09

Mar

-10

Aug

-10

Jan-

11

Jun-

11

Nov

-11

Apr

-12

Sep-

12

Feb-

13

Jul-1

3

Dec

-13

May

-14

Oct

-14

INFLATION YTM3

20

Chart 10: FAO food price index and Inflation

Pairwise Granger Causality Tests: FAO food price index and Inflation

Sample: 2006M06 2015M01

Lags: 3 Null Hypothesis: Obs F-Statistic Prob. FAO does not Granger Cause HEADLINE_INFLATION 101 0.94550 0.4220

HEADLINE_INFLATION does not Granger Cause FAO 0.63577 0.5938

Sample: 2006M06 2015M01

Lags: 6 Null Hypothesis: Obs F-Statistic Prob. FAO does not Granger Cause HEADLINE_INFLATION 98 2.50672 0.0278

HEADLINE_INFLATION does not Granger Cause FAO 1.23716 0.2956

Chart 10 shows a close relationship in the trends of FAO food price index and inflation. Granger

causality tests indicate that FAO food price index could cause inflation in the relatively longer

run, but not in three months.

0

2

4

6

8

10

12

100

120

140

160

180

200

220

240

260Ju

n-06

Nov-

06

Apr-0

7

Sep-

07

Feb-

08

Jul-0

8

Dec-

08

May

-09

Oct-0

9

Mar

-10

Aug-

10

Jan-

11

Jun-

11

Nov-

11

Apr-1

2

Sep-

12

Feb-

13

Jul-1

3

Dec-

13

May

-14

Oct-1

4

FAO INFLATION

21

Chart 11: ICE Brent and Inflation

Pairwise Granger Causality Tests: Oil prices (ICE Brent) and Inflation

Sample: 2006M06 2015M01

Lags: 3 Null Hypothesis: Obs F-Statistic Prob. ICE_BRENT does not Granger Cause HEADLINE_INFLATION 101 2.75509 0.0468

HEADLINE_INFLATION does not Granger Cause ICE_BRENT 0.29808 0.8267

Chart 11 shows a close relationship in the trends of ICE Brent and inflation. Granger causality

test indicates clearly that ICE Brent could cause inflation.

The next step is to carry out a Vector Error Correction Model (VECM) for the monthly variables

to discern more precisely the short term and long term dynamics among the variables that impact

on inflation outcomes. The benefits of estimating a VECM is that it addresses the issue of serial

correlation, captures the information contained in lagged variables and produces more robust

regression coefficient estimates.

0

2

4

6

8

10

12

0

20

40

60

80

100

120

140

160Ju

n-06

Nov

-06

Apr-

07

Sep-

07

Feb-

08

Jul-0

8

Dec

-08

May

-09

Oct

-09

Mar

-10

Aug-

10

Jan-

11

Jun-

11

Nov

-11

Apr-

12

Sep-

12

Feb-

13

Jul-1

3

Dec

-13

May

-14

Oct

-14

ICE Brent INFLATION

22

Vector Error Correction Estimates Sample (adjusted): 2006M10 2015M01

Included observations: 100 after adjustments

Standard errors in ( ) & t-statistics in [ ] Cointegrating Eq: CointEq1 HEADLINE_INFLATION(-1) 1.000000

BML(-1) -1.117495

(0.62350)

[-1.79229]

RS_USD(-1) 0.308043

(0.08439)

[ 3.65045]

YTM3(-1) -0.801826

(0.07322)

[-10.9515]

Error Correction: D(HEADLINE_I

NFLATION) D(BML) D(RS_USD) D(YTM3) CointEq1 -0.073519 -0.003772 -0.016151 0.123834

(0.01500) (0.01318) (0.06112) (0.05909)

[-4.89985] [-0.28628] [-0.26425] [ 2.09586]

D(HEADLINE_INFLATION(

-1)) 0.646562 -0.108960 0.278880 0.610428

(0.09935) (0.08725) (0.40470) (0.39121)

[ 6.50812] [-1.24887] [ 0.68910] [ 1.56034]

D(HEADLINE_INFLATION(

-2)) 0.169381 0.078357 -0.206227 0.313398

(0.12301) (0.10803) (0.50110) (0.48440)

[ 1.37696] [ 0.72534] [-0.41155] [ 0.64698]

D(HEADLINE_INFLATION(

-3)) -0.049066 0.107009 0.028019 -0.680013

(0.09237) (0.08112) (0.37627) (0.36373)

[-0.53121] [ 1.31920] [ 0.07446] [-1.86957]

D(BML(-1)) 0.063912 -0.028232 -0.057952 -0.142994

(0.12621) (0.11084) (0.51414) (0.49701)

[ 0.50638] [-0.25471] [-0.11272] [-0.28771]

D(BML(-2)) 0.382830 0.018195 -0.478641 -0.093234

(0.11628) (0.10212) (0.47367) (0.45788)

[ 3.29240] [ 0.17818] [-1.01050] [-0.20362]

D(BML(-3)) 0.341404 -0.050754 -0.594636 -0.445318

(0.11858) (0.10414) (0.48304) (0.46695)

[ 2.87914] [-0.48738] [-1.23102] [-0.95368]

D(RS_USD(-1)) -0.022545 0.025846 0.581366 0.031636

(0.02596) (0.02280) (0.10577) (0.10224)

[-0.86832] [ 1.13352] [ 5.49659] [ 0.30941]

23

D(RS_USD(-2)) 0.037743 -0.045587 -0.302235 -0.181816

(0.02837) (0.02492) (0.11558) (0.11173)

[ 1.33024] [-1.82956] [-2.61493] [-1.62730]

D(RS_USD(-3)) -0.015446 -0.011921 0.327066 -0.046679

(0.02629) (0.02309) (0.10711) (0.10354)

[-0.58746] [-0.51626] [ 3.05360] [-0.45083]

D(YTM3(-1)) -0.034468 -0.034409 0.262322 0.505068

(0.02579) (0.02265) (0.10504) (0.10154)

[-1.33668] [-1.51945] [ 2.49726] [ 4.97392]

D(YTM3(-2)) 0.013737 -0.032626 0.036553 -0.142734

(0.02855) (0.02507) (0.11629) (0.11242)

[ 0.48121] [-1.30136] [ 0.31432] [-1.26969]

D(YTM3(-3)) 0.029278 0.020382 -0.161873 0.123994

(0.02737) (0.02403) (0.11148) (0.10776)

[ 1.06986] [ 0.84809] [-1.45206] [ 1.15062]

LFAO 0.142294 0.006955 0.034466 -0.249629

(0.02946) (0.02588) (0.12003) (0.11603)

[ 4.82939] [ 0.26878] [ 0.28715] [-2.15150] R-squared 0.892063 0.181819 0.395445 0.328175

Adj. R-squared 0.875747 0.058140 0.304059 0.226620

Sum sq. resids 1.152767 0.889063 19.12944 17.87571

S.E. equation 0.115777 0.101676 0.471631 0.455913

F-statistic 54.67393 1.470089 4.327191 3.231508

Log likelihood 81.25639 94.24403 -59.19677 -55.80749

Akaike AIC -1.345128 -1.604881 1.463935 1.396150

Schwarz SC -0.980404 -1.240157 1.828659 1.760874

Mean dependent -0.040000 -0.001152 0.000894 -0.063600

S.D. dependent 0.328449 0.104767 0.565348 0.518425 Determinant resid covariance (dof adj.) 5.48E-06

Determinant resid covariance 3.00E-06

Log likelihood 68.32669

Akaike information criterion -0.166534

Schwarz criterion 1.396568

The VECM shows that broad money growth (BML) influences inflation with two and three

months lag, but become insignificant over time and counterproductive at 10% level of

significance. In contrast, exchange rate (Rs_USD) and interest rate (YTM3) become significant

in the long run. Ceteris paribus, one unit of increase in Rs_USD (depreciation) causes inflation

to rise by 0.31 unit while one unit increase in YTM3 causes inflation to fall by 0.80 unit in the

long run. Further, FAO food price index has been observed to add to inflation. This would also

be true for oil prices too, which is not included in the VECM due to the high correlation between

ICE Brent and FAO that could cause multicollinearity problem. The results suggest that interest

rate is the appropriate monetary instrument to control inflation, while exchange rate

developments should be consistently monitored to achieve desirable inflation outcomes.

24

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

HE

AD

LIN

E_I

NF

LAT

ION

to

HE

AD

LIN

E_I

NF

LAT

ION

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

HE

AD

LIN

E_I

NF

LAT

ION

to

BM

L

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

HE

AD

LIN

E_I

NF

LAT

ION

to

RS

_US

D

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

HE

AD

LIN

E_I

NF

LAT

ION

to

YT

M3

-.0

8

-.0

4

.00

.04

.08

.12

510

1520

2530

Res

pons

e of

BM

L to

HE

AD

LIN

E_I

NF

LAT

ION

-.0

8

-.0

4

.00

.04

.08

.12

510

1520

2530

Res

pons

e of

BM

L to

BM

L

-.0

8

-.0

4

.00

.04

.08

.12

510

1520

2530

Res

pons

e of

BM

L to

RS

_US

D

-.0

8

-.0

4

.00

.04

.08

.12

510

1520

2530

Res

pons

e of

BM

L to

YT

M3

-0.4

0.0

0.4

0.8

1.2

510

1520

2530

Res

pons

e of

RS

_US

D t

o H

EA

DLI

NE

_IN

FLA

TIO

N

-0.4

0.0

0.4

0.8

1.2

510

1520

2530

Res

pons

e of

RS

_US

D t

o B

ML

-0.4

0.0

0.4

0.8

1.2

510

1520

2530

Res

pons

e of

RS

_US

D t

o R

S_U

SD

-0.4

0.0

0.4

0.8

1.2

510

1520

2530

Res

pons

e of

RS

_US

D t

o Y

TM

3

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

YT

M3

to H

EA

DLI

NE

_IN

FLA

TIO

N

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

YT

M3

to B

ML

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

YT

M3

to R

S_U

SD

-.8

-.4.0.4.8

510

1520

2530

Res

pons

e of

YT

M3

to Y

TM

3

Res

pons

e to

Cho

lesk

y O

ne S

.D.

Inno

vati

ons

25

-20

-10010

510

1520

2530

Accu

mul

ated

Res

pons

e of

HEA

DLI

NE_

INFL

ATIO

N to

HEA

DLI

NE_

INFL

ATIO

N

-20

-10010

510

1520

2530

Accu

mul

ated

Res

pons

e of

HEA

DLI

NE_

INFL

ATIO

N to

BM

L

-20

-10010

510

1520

2530

Accu

mul

ated

Res

pons

e of

HEA

DLI

NE_

INFL

ATIO

N to

RS_

USD

-20

-10010

510

1520

2530

Accu

mul

ated

Res

pons

e of

HEA

DLI

NE_

INFL

ATIO

N to

YTM

3

-2-101234

510

1520

2530

Accu

mul

ated

Res

pons

e of

BM

L to

HEA

DLI

NE_

INFL

ATIO

N

-2-101234

510

1520

2530

Accu

mul

ated

Res

pons

e of

BM

L to

BM

L

-2-101234

510

1520

2530

Accu

mul

ated

Res

pons

e of

BM

L to

RS_

USD

-2-101234

510

1520

2530

Accu

mul

ated

Res

pons

e of

BM

L to

YTM

3

-100102030

510

1520

2530

Accu

mul

ated

Res

pons

e of

RS_

USD

to H

EAD

LIN

E_IN

FLAT

ION

-100102030

510

1520

2530

Accu

mul

ated

Res

pons

e of

RS_

USD

to B

ML

-100102030

510

1520

2530

Accu

mul

ated

Res

pons

e of

RS_

USD

to R

S_U

SD

-100102030

510

1520

2530

Accu

mul

ated

Res

pons

e of

RS_

USD

to Y

TM3

-20

-1001020

510

1520

2530

Accu

mul

ated

Res

pons

e of

YTM

3 to

HEA

DLI

NE_

INFL

ATIO

N

-20

-1001020

510

1520

2530

Accu

mul

ated

Res

pons

e of

YTM

3 to

BM

L

-20

-1001020

510

1520

2530

Accu

mul

ated

Res

pons

e of

YTM

3 to

RS_

USD

-20

-1001020

510

1520

2530

Accu

mul

ated

Res

pons

e of

YTM

3 to

YTM

3

Acc

umul

ated

Res

pons

e to

Cho

lesk

y O

ne S

.D.

Inno

vatio

ns

26

Flowchart 1: Factors impacting on Transmission Mechanism of Monetary Policy

The transmission mechanism depicted in Flowchart 1 is helpful to recapitulate the findings from

the empirical analysis. The regression analysis indicates that in the short run, the central bank

can contain inflation by anchoring inflation expectations through its policy decisions, but that

changes in policy rate become effective over time. It has further been shown that exogenous

changes in fiscal policy, global economy and commodity prices influence price developments

and thus impairs the functioning of the transmission mechanism. The regression results also

confirm the considerable impact of exchange rate developments on inflation. It has also been

shown that in the long run, interest rate is an appropriate monetary instrument for controlling

inflation while control in money supply is effective only in the very short run. Persistence in

tightening of money supply growth could over time become counterproductive – This is in line

with Sargent and Wallace (1981) postulate.

27

Section V: Comparing current monetary policy framework with best practice

Current arrangements in place for monetary policy are in line with international best practice as

shown by Table 2. Nonetheless some further improvement need to be brought, on which the

Bank is currently working on.

Table 2: Comparing Current arrangements with Best Practices

Best Rationale Current

Practices Comments Arrangements

Institutional Building Blocks

Price stability enshrined in law as primary objective of the CB.

Prevent developmental objectives from undermining the price stability objective.

Section 5(2) of the Bank of Mauritius Act 2004 stipulates that the primary objective of the Bank is to maintain price stability and promote orderly and balanced economic development.

Independence and Objectivity of the Monetary Policy Committee

Independence, transparency and accountability are pillars of Central Bank governance that ensures that decisions are motivated by the objectives and mandate of the Bank.

Section 54 of the Bank of Mauritius Act 2004 provides for mandate of the MPC to formulate and determine the monetary policy to be conducted by the Bank in order to implement Section 5(2).

MPC members consist of the Governor, two Deputy Governors, five external members appointed by the Government. In case of a tie in voting, the Chairman of the MPC, the Governor, has the determining vote.

MPC members have to adhere to a Code of Conduct and the Chairman of the MPC reports to the Bank of Mauritius Board on compliance to the Code by MPC members once a year.

Macro-financial Building Blocks

Clear separation between monetary and fiscal policy.

Curtail fiscal dominance to contain uncertainties in monetary policy conduct.

The Bank may grant advances to the Government to cover negative net cash flows at a rate to be agreed with the Government. The total amount of such advances outstanding is subject to a quantitative limit and repayment obligations as per Section 58 of the Bank of Mauritius Act 2004.

The Bank's department responsible for the liquidity management is also responsible for the organization of government securities auctions. Decisions on the amount to put on tender and bids to accept are jointly made by the Bank and the Treasury. The yield that prevails reflects market rate.

Ability to articulate the role of the exchange rate in the monetary strategy.

Clear objectives and strategy for official intervention consistent with the monetary regime.

Exchange rate interventions in the market are limited to remove excess volatility and correct for any departure from fundamentals. The IMF classifies Mauritius exchange rate regime as "floating".

28

Stable, sound and deep financial sector.

Central Bank manages liquidity at aggregate level (allocation among banks via interbank market).

The Mauritian banking system is well-capitalised and resilient against a range of shocks according to stress tests carried out by the Bank. Banks’ profitability and comfortable capitalisation provide valuable cushions against a range of shocks to their credit portfolios.

Technical and Organizational Building Blocks

Effective liquidity forecasting framework.

The Central Bank ensures stable liquidity conditions in the money markets.

The Bank of Mauritius issue Bank of Mauritius Bills/Notes and make use of other instruments like the Cash Reserve Ratio to manage liquidity. However, in recent years, chronic excess liquidity has lingered.

A set of monetary policy instruments aligned with the level of money market development.

Effective monetary operations allow the Central Bank to steer effectively money market rates in the short term.

The Bank has used a broad range of monetary instruments to alleviate the build-up of excess liquidity, but have had limited success in bringing money market rates in line with the Key repo Rate (KRR). The persistence of excess liquidity has thus resulted into some disconnect between the monetary policy stance decided by the MPC and the actual monetary policy stance as reflected in money market conditions. The Bank is currently looking into various alternatives to remedy this problem.

Adequate financial markets infrastructure (FMIs)

Support the functioning of financial markets and monetary operations

The Bank has developed a robust financial market infrastructure to support the functioning of financial markets and monetary operations.

Adequate statistical data.

Provide the Bank with the necessary data to support its analytical work, and macro-modeling.

Statistics Mauritius and the Bank have developed a comprehensive set of statistical data to support analytical work and macro-modeling.

Tools to communicate effectively monetary policy.

Help anchor inflation expectations through a transparent communication policy strategy.

Much has been done to enhance communication of monetary policy in Mauritius: a MPC Statement is released after each MPC meeting to explain the gist of the decision on the monetary policy stance; The Governor holds a press conference to provide more information on the MPC decision and answer question of the press; the minutes of the MPC meeting are published with a two-week lag, disclosing the voting of each member of the committee; an inflation report detailing analytical work on inflation is published twice a year; The Governor highlights key points of monetary policy during the financial year in the Annual Report of the Bank.

Proven Central Bank analytical capacities to support an understanding of the transmission channels.

Ability to assess the role of money, interest rates, and the exchange rate.

With the support of the IMF, the Bank has over the years upgraded its macro-modelling capacity.

29

Clear decision-making process and Central Bank organisation suited to support policy implementation.

Ensure that monetary policy decisions are made according to a formal structure to ensure the effectiveness of the MPC decision.

MPC Briefing papers are provided to MPC members along with presentations of key issues. The law also provide for other stakeholders, including the Ministry of Finance and Economic Development to make representation to the MPC to provide important information that may support the MPC decision making process.

Section VI: Monetary policy framework and Inflation Expectations

Notwithstanding several significant shocks to the global economy during the period 2007 to

2014, prudent fiscal policy and timely monetary policy seem to have well supported the

economy. An important achievement of the current monetary policy framework in place has

been the anchoring of inflation expectations, reduction in the variability of inflation and lower

inflation rates. Prior to the establishment and work of the MPC, inflation expectation in the

economy varied across different economic stakeholders.

Chart 12: Inflation expectations and Actual inflation

With greater transparency, increased communication of monetary policy, commitment to fiscal

discipline, and persistence of low global inflation post the global financial crisis, inflation

expectations have been anchored at a lower range. Given the small open economy case of

Mauritius, with Mauritius being a net food and energy importer – two items having much

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Sep-

10

Dec-

10

Feb-

11

May-

11

Aug-

11

Nov-

11

Feb-

12

May-

12

Aug-

12

Nov-

12

Feb-

13

May-

13

Aug-

13

Nov-

13

Feb-

14

May-

14

Aug-

14

Nov-

14

Feb-

15

May-

15

Aug-

15

Per

cen

t

Survey Months

Expected Inflation

one year ahead

Actual Inflation during

the survey month

30

weightage in the Consumer Price Index basket – global prices have considerable impact on the

final outcomes of inflation as shown by the regression results in earlier sections. The most

effective means by which monetary authorities are able to control domestic inflation in the short

run are by anchoring inflation expectations and containing excessive growth of money supply.

In the longer run, interest rate changes become more effective.

Section VII: Has monetary policy accommodated fiscal Policy?

To evaluate whether monetary policy has accommodated fiscal policy over the period under

review, the first point considered is the extent to which domestic debt had been held by the

Central Bank. The share of domestic budgetary debt held by the Central Bank peaked at 62.4%

in 1981/82 at the onset of the macroeconomic crisis that Mauritius faced. The plot was pretty

evident from what preceded the crisis: rising fiscal deficit with limited revenue collection for the

treasury, growing government expenditure and eroding confidence in the policy framework in

place. The increasing share of domestic budgetary debt held by the Central Bank implied that

money supply must have increased and should have been inconsistent with the peg in place at

that time. The only way out of the crisis that followed was to devalue the Mauritian rupee and,

as mentioned earlier that was what was done. It all appears that in that era the central bank might

have been under a regime of fiscal dominance.

Chart 13: Domestic Budgetary Debt held by the Central Bank

31

Following the double devaluation of the domestic currency in the early 1980’s, fiscal

consolidation and government debt held by the central bank was sharply reduced. In the late

1980’s and very early 1990’s, the share of domestic budgetary debt held by the Central Bank was

almost nil with domestic private banks and pension funds holding over 80% of domestic

budgetary debt. The occasional increases in central bank holding of government bonds were

more the result of open market operations than for the purpose of financing the deficit since the

market grew confident in the ability to pay of the Government. Moreover, with the promulgation

of the Bank of Mauritius Act 2004, advances to Government have been subject to a quantitative

limit of 10% of government revenue.

Even if central bank financing is excluded, fiscal dominance could still be practiced if the

exchange rate or policy rate were pushed in a direction to satisfy the needs of the fiscal stance.

Although the regression results are inconclusive on the effect of exchange rate on fiscal balance,

the positive correlation coefficient of 0.66 between exchange rate (LMURUSD) and fiscal

balance suggests that depreciation of the rupee have supported fiscal consolidation. Exchange

control has been suspended in Mauritius since July 1994 and exchange rate interventions have

been limited to remove excess volatility from the market and to keep it in line with

macroeconomic fundamentals. Since the exchange rate is determined by the market, the

likelihood of controlling the exchange rate for fiscal needs is limited. Nonetheless, in the small

open economy of Mauritius, the Central Bank has significant influence on the exchange rate

through its interventions and could have acted to meet fiscal needs at times. But, disentangling

exchange rate interventions for macroeconomic balance from fiscal reasons are complex given

the limited available tools and information set.

The next point we investigate is whether the policy rate, more particularly the KRR had been

reduced to cut down borrowing cost or in line with the mandate of the MPC. In this case, the

regression results demonstrate quite clearly that the main concerns for adjustment in the KRR

related to the inflation and growth outlook. Furthermore Chart 14 confirms the fact that when

the inflation outlook was on the upside, the monetary stance was tightened by hikes in the KRR

while when the inflation outlook was on the downside, the KRR was cut to support growth.

The low inflation outcomes, anchored inflation expectation, loose monetary policy globally and

heightened risk aversion prevailing worldwide amid vulnerable growth outlook have resulted in

domestic money markets being very liquid. The bid-cover ratios have been high in recent years

with Treasury Bills yields plummeting and reaching record lows as shown in Chart 15. Open

market operations to reduce excess liquidity has had limited impact given the chronic nature of

excess liquidity and its size, under current economic conditions and risk averse environment

globally. It can thus be safely concluded that monetary policy has not tried to unconditionally

help fiscal policy.

32

Chart 14: KRR, Headline Inflation and Money market rates

Chart 15: Bid-cover and Money market rates

33

It is however true that in Mauritius, monetary and fiscal policies are coordinated, but they are for

maintaining macroeconomic and financial equilibrium. The country has through various reforms

improved fiscal management and has consistently tried to stay on a prudent fiscal path even in

the midst of the global financial crisis whose spillover effects were partly contained by a

stimulus package and timely loose monetary policies. Fortunately for Mauritius, the fiscal

reforms were initiated and implemented prior to the onset of the global financial crisis.

Section VIII: Putting all the pieces together and Policy Recommendations

All estimation results indicate that fiscal policy in Mauritius has significant impact on inflation

and other macroeconomic variables. Without proper fiscal management, governments lack fiscal

space to counter the adverse effects of economic shocks and tend to move from one bad

equilibrium to another. Unsustainable fiscal path ultimately leads to economic crises. Mauritius

has been able to weather the global financial crisis relatively well, principally due to its fiscal

reforms in 2006-07. Fiscal outcomes have important implications for sovereign ratings and risk

premium and in turn for borrowing cost and inflation in an economy. The Government is a

major player in small open economy Mauritius such that economic activities get a boost through

multiplier effects of government expenditure and induced business optimism by Government

actions. Fiscal discipline has been enshrined in the law of the country with the Public Debt

Management Act 2008. Fiscal discipline is reinforced with Central Bank independence. The

promulgation of Bank of Mauritius Act 2004 set the stage for the move towards central bank

independence and the study demonstrates that the institutional changes brought about have

succeeded in building credibility of the overall policy framework and considerable payoffs have

been obtained in terms of anchored inflation expectations, low inflation rate and inflation

volatility. It is noteworthy, however, that independence of the Central Bank would not have

been effective without a well-functioning coordination between fiscal and monetary authorities.

In the absence of fiscal discipline, for instance, the outcome could have been much different.

Fiscal policy has been prudent. In spite of the stimulus package offered after the adverse shock

of the global financial crisis started impacting on the performance of the Mauritian economy,

fiscal deficit has remained on a prudent path, thus, supporting the conduct of monetary policy.

Major fiscal reforms were undertaken in 2006-07 that have led to improved revenue collection.

Additionally, low interest rates on public debt have contained government expenditure growth to

a large extent. The excess liquidity that has prevailed in recent years suggest that crowding out

has been absent. In effect, there is evidence of government spending being supportive of private

investment through multiplier effects on aggregate demand and business optimism.

In recent years, external debt financing has increased noticeably as a result of the low borrowing

cost conditions that prevailed. However, the increased budget central government external debt

could have been an important source of excess liquidity in the economy. To paraphrase Sargent

34

and Wallace (1981), the monetary authorities might be subject to some “unpleasant monetarist

arithmetic”. The fiscal authorities in their quest to ensure fiscal discipline, have to remain in line

with the target of keeping government debt as a percentage of GDP around 50% by 2018 and

cannot have huge fiscal deficits. So the need for public debt financing is limited to repayment of

existing debts and potentially an annual deficit of 3% of GDP. GDP growth has been less than

4% annually, demand for private sector credit has been slowing down and private investments

even contracting. The end result is that new government debt issues are unable to absorb the

excess liquidity in the market. The issue of monetary authority debt securities can only provide

short term temporary solutions, and might in effect add to the excess liquidity after some lags

with initial excess liquidity absorbed returning into the market along with the added interest

payments. In face of such a situation, increasing share of foreign borrowing can only complicate

the matter with less supply of government bonds to the market and added liquidity from external

sources. Additional government debt could have been used to generate new growth in the

economy, which could have in turn partly absorbed new supplies of liquidity. But, issue of Bank

of Mauritius bills only tend to defer the problem of excess liquidity to a later date if growth does

not pick-up adequately in the intervening time. In face of low GDP growth, the chronic excess

liquidity is unlikely to be resolved. The first recommendation is about the issue of Bank of

Mauritius bills, which is proposed to be kept for short-term management of excess liquidity since

it cannot address the problems of chronic excess liquidity. The second recommendation is to

consider an exchange of part of the foreign debt for domestic debt to resolve partially the

problem of chronic excess liquidity. This would also shield the economy from exchange rate

risks.

The third policy recommendation is about controlling inflation through changes in interest rates.

It has been shown that in the long run, interest rate is an appropriate monetary instrument for

controlling inflation while control in money supply is effective only in the very short run.

Persistence in tightening of money supply growth could over time be counterproductive, in line

with Sargent and Wallace (1981) postulate. Further, it was observed that exogenous shocks like

food and oil price shocks weigh on price developments and therefore have important

implications for the transmission mechanism of monetary policy. The regression results also

confirm the considerable impact of exchange rate developments on inflation. It is recommended

that all these considerations be included in the decision-making process to enhance the

effectiveness of monetary policy.

In sum, fiscal discipline and independence of the Central Bank that have been put in place in

Mauritius have worked well for the country. But, the limits that the size of the economy imposes

on fiscal and monetary practice must be upheld to further improve the coordination between the

two.

35

References

Alberto Alesina and Lawrence H. Summers, “Central Bank independence and macroeconomic

performance: some comparative evidence”, Journal of Money, Credit and Banking, Volume 25,

May 1993

Bank of Mauritius Act 2004

Bank of Mauritius Annual Report2 (2006 to 2014)

Bank of Mauritius Inflation Report 2012 and Financial Stability Report 2012

Bank of Mauritius Monthly Bulletins (Various issues)

Bank of Mauritius Occasional Paper Series 2006 Number 1

Barry Anderson and Joseph J. Minarik, “Design choices for fiscal policy rules”, July 2004

Dooneshsingh Audit, “A target range of inflation for Mauritius”, Bank of Mauritius internal

paper October 2009 (unpublished)

Eda Zoli, “How does fiscal policy affect monetary policy in emerging countries?”, BIS working

paper No. 174, April 2005

Hryo Kuncoro and K. Dianta A. Sebayang, “The Dynamic Intercation between monetary and

fiscal policies in Indonesia”, Romanian Journal of Fiscal Policy, Volume 4 January-June 2013

Hounaida Daly and Mounir Smida, “Fiscal Theory of Price level”, November 2014

Laurens Bernard and De la Piedra Enrique, “Coordination of the Monetary & fiscal policies”,

March 1998, IMF Working paper WP/98/25

Mark Carney, Bank of England Governor, speech on “Inflation in a globalized world”, August

2015

Mathew B. Canzoneri, RFobert E. Cumby and Behzad T. Diba, “Is price level determined by the

needs of fiscal solvency?”, NBER working paper 6471, March 1998

Maxwell J. Fry and R. Basant Roi, “Monetary policy-making in Mauritius”, April 1995

Michael D. Bordo, “The history of monetary policy”, February 2007

36

MPC statements and Minutes of the MPC, April 2007 to July 2015

Moody’s Investor Service announcements, 21 December 2005, 1 June 2006, 26 June 2012 and

29 May 2015

Neetyanand Kowlessur, “Liquidity Management: Issues and Proposals”, Bank of Mauritius

internal paper 26 May 2003 (unpublished)

Olivier Blanchard, “Fiscal dominance and inflation targeting: lessons from Brazil”, March 2004

Statistics Mauritius website www.statisticsmauritius.gov : Public Finance historical data set

Thomas J. Sargent and Neil Wallace, “Some unpleasant monetarist arithmetic”, Federal Reserve

Bank of Minneapolis, Fall 1981