## Abstract

We assess the competitiveness of Mauritius in recent years using two approaches. First, we estimate the difference between the equilibrium and the actual real exchange rate using four methods: the macroeconomic balance approach, the single-equation fundamentals approach, the capital-enhanced approach, and the external sustainability approach. The methods consistently suggest that at the end of 2007 the exchange rate was aligned with its equilibrium value. Second, we undertake a comparative analysis of structural competitiveness indicators and find that Mauritius often fares better on business climate than other small island economies and high-growth Asian economies. Nevertheless, there are areas for improvement.

## I. Introduction

The Indian Ocean island nation of Mauritius, an open but relatively undiversified economy, has recently faced large negative terms of trade shocks, for three main reasons: the phasing out of the Multi-Fiber Agreement starting at the end of 2004, the European Union reduction of its sugar price guarantees starting in 2006, and recent higher world commodity prices, especially for food and petroleum products. As export growth dwindled and the economy began adjusting to the new environment, the current account (CA) deficit worsened to an average of 4 percent of GDP for 2004–07. Real GDP growth has been low by historical standards, averaging 3.6 percent between 2001 and 2007 compared to 4 percent in the 1990s and 5 percent in the 1980s. These facts raise questions about the competitiveness of the Mauritian economy and what might be done to ensure external stability and reduce vulnerabilities.

This paper examines the competitiveness of Mauritius from 1980 through 2007, paying particular attention to recent years. Assessing the equilibrium real exchange rate (ERER) through the prism of whether the real exchange rate is aligned with its equilibrium value is important because persistent misalignment can hinder growth, lead to currency crises, or more generally disturb macroeconomic equilibrium. ^{3} We employ a mix of panel and time series techniques to estimate the ERER using the macroeconomic balance approach (FEER– MB), the (country-specific) single-equation fundamental equilibrium exchange rate approach (FEER–SE), and the capital-enhanced equilibrium exchange rate approach (CHEER). We then supplement the analysis by applying the external sustainability (ES) approach. Nonprice indicators of structural competitiveness are also analyzed, especially the business climate, trade costs, and the information, technology, and communications (ITC) sector.

There are several elements of novelty in our study. First, we construct a large database (comprising 140 countries) to estimate the reduced-form relationship between the CA balance and its determinants in the FEER-MB approach. Second, we assess the robustness of our conclusions from this approach by computing alternative CA norms that reflect different sub-samples of countries and estimation methods. Third, in addition to the three methods put forward by the IMF’s Consultative Group on Exchange Rate Issues (CGER), we apply the CHEER approach to better understand the recent evolution of the Mauritian rupee relative to its equilibrium value. Our analysis is made possible by the availability of reliable data at different frequencies for Mauritius.

We find that the real exchange rate at the end of 2007 was aligned with its equilibrium value as determined by economic fundamentals. Furthermore, little adjustment may be necessary over the medium term. The conclusion is broadly consistent across methods. We also find that Mauritius fares better than comparator countries (high-growth Asian economies, middle-income countries, and other small island economies) in terms of structural competitiveness. The analysis suggests that the country’s competitiveness could be further improved by stimulating competition in goods markets, making labor markets more flexible, enhancing skills, and further reducing the cost of doing business.

In what follows, Section II describes the evolution of exchange rate regimes in Mauritius since its colonial past. Section III outlines the results of the four quantitative methods employed to estimate the ERER. Section IV surveys the country’s competitiveness using nonprice structural competitiveness indicators. Section V draws conclusions.

## II. The Evolution of the Exchange Rate in Mauritius ^{4}

Mauritius has over time adopted a variety of exchange rate regimes. As part of the British Empire, though at first it did not have its own currency, the government established a currency-board-like system in 1848, the first of its kind in the world. Until 1870 Mauritius switched between the pound sterling (gold) and the Indian rupee (silver). Between 1878 and 1934 Mauritius was in a common monetary union with India with the Indian rupee as the legal tender. This reflected trade links with India and the inflow of Indian labor. Throughout the 19^{th} and early 20^{th} century, the currencies of British colonies were almost all linked to the pound sterling through currency boards; when the United Kingdom abandoned the gold standard in September 1931, most colonies did likewise. In 1934 Mauritius, like several other British colonies, introduced its own currency—but still under a currency board pegged to the pound sterling. This regime lasted until November 1967 (Figure 1).

In preparation for independence, in November 1967 Mauritius moved the rupee from a currency board to a peg to the pound sterling, but there was a dual foreign exchange market that separated capital account transactions from CA transactions. Capital transfers were subject to a stamp duty initially set at 15 percent. With gold convertibility ending when the dollar standard was abandoned in 1971, trade diversifying away from Britain, and the weakness of the pound sterling, Mauritius left the sterling area in June 1972 and established a central exchange rate with special drawing rights (SDRs). It maintained a second exchange rate for the stamp duty for capital transfers. In January 1976 Mauritius officially pegged the rupee to the SDR, with a 2 percent band, but in practice the exchange rate for official purposes was a crawling band around the US dollar. Following a period of overvaluation, the rupee was devalued in 1979 and 1981. The stamp duty on transfer of capital was raised in July 1981 from 36 percent to 45 percent.

In June 1982 the Mauritian rupee was officially delinked from the SDR and pegged to a trade-weighted basket of the currencies of its major trading partners, but the composition of the basket was not disclosed. The change was part of a broad liberalization launched under an IMF program. The exchange rate remained pegged de facto to the US dollar, with a 5 percent band. The limit on the sale of foreign exchange for travel was administered as a capital control. Until the early 1990s Mauritius maintained a multiple currency practice in the form of a 15 percent tax on some capital remittances.

Exchange rate restrictions were lifted in 1992, and transactions involving foreign currencies were fully liberalized in July 1994. Beginning in 1992 the de facto crawling band around the US dollar was narrowed to 2 percent. The capital transfer tax was abolished. Since the mid-1990s Mauritius has maintained a managed float, and the Bank of Mauritius intervenes solely to smooth exchange rate fluctuations rather than alter the trend.

Post-Bretton Woods the nominal exchange rate (NER) continuously depreciated against the US dollar (Figure 2) because inflation was higher in Mauritius than in its trading partners. Monetary policy accommodated the higher inflation differentials by letting the NER depreciate to achieve a stationary REER.

**Nominal and Real Effective Exchange Rates, 1980−2007**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: INS (monthly data).**Nominal and Real Effective Exchange Rates, 1980−2007**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: INS (monthly data).**Nominal and Real Effective Exchange Rates, 1980−2007**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: INS (monthly data).An examination of various price-based REER indices relative to major trading partners indicates that the competitiveness of Mauritius has improved markedly since 2002 (Figure 3). ^{5} The indices (CPI, GDP deflator, manufacturing unit labor cost, and export prices) move closely together over time. After staying relatively flat throughout the 1990s they suggest considerable depreciation since 2002. This path is a natural consequence of negative terms of trade shocks, which required a depreciation to restore the economy to sustained growth (Funke, Granziera, and Imam, 2008).

**Price-based Real Effective Exchange Rate Indices, 1980−2006**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: INS and authors’ calculations (annual data).**Price-based Real Effective Exchange Rate Indices, 1980−2006**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: INS and authors’ calculations (annual data).**Price-based Real Effective Exchange Rate Indices, 1980−2006**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: INS and authors’ calculations (annual data).## III. Empirical Analysis of the Equilibrium Exchange Rate

Assessing the distance of the actual exchange rate from its equilibrium value is key to identifying potentially unsustainable external imbalances. While there is no consensus on what constitutes the best empirical approach to estimating the ERER, it is useful to employ as many models as possible so as to increase the likelihood of obtaining an accurate judgement. To arrive at robust conclusions, we employ four quantitative approaches to identifying the ERER and analyzing a country’s competitiveness:

the macroeconomic balance approach (FEER-MB), which assesses deviation from equilibrium by observing by how much the CA is projected to deviate from the sustainable norm implied by the fundamental determinants of saving and investment;

the single-equation fundamental equilibrium exchange rate approach (FEER-SE), which assesses the equilibrium exchange rate based on a country’s macroeconomic fundamentals;

the capital-enhanced equilibrium exchange rate approach (CHEER), which adds the uncovered interest parity (UIP) condition to analyzing deviations from equilibrium; and

the external sustainability (ES) approach, which observes the difference between the underlying CA balance and the net foreign asset (NFA)-stabilizing CA balance.

The four methods have several advantages. The FEER-MB and FEER-SE approaches— focusing on flow equilibrium concepts—employ economic fundamentals in reduced-form equations to arrive at the ERER. Estimated coefficients are thus easily interpretable from the policy lens. The FEER-MB approach also has the attractive feature that the exchange rate required across countries can be made internally consistent on a multilateral basis through a normalization. ^{6} The ES method can be a useful cross-check of the findings of the FEER-MB approach, as it derives the sustainable CA from a stable NFA position (hence is based on a stock equilibrium concept). Unlike the other methods, the CHEER approach takes the view that non-zero interest rate differentials can explain the persistence in real exchange rates, bringing capital account factors into to the analysis. ^{7}

Several conceptual limitations are shared by these methods. Notably, both the FEER-MB and ES approaches hinge on the *estimation* of a sustainable CA (or CA norm). In the literature, this is often derived based on the historical relationship between the CA balance (or NFA position) and a set of economic fundamentals. A key assumption is that the econometric estimates reflect the *equilibrium* relationship between the dependent variable and the economic fundamentals. While this assumption may be challenged, we take the view expressed by Chinn and Prasad (2003, p. 48) that this type of analysis “does provide an indication of the levels of current accounts that may be considered ‘normal’ for a country, based on a number of its macroeconomic attributes, including stage of development, demographic profile, and government budget balance, etc.”

Another concern is that the calculated FEERs (in the FEER-MB method) are often sensitive to the assumed value for the sustainable CA balance. Different judgements about what constitutes a sustainable CA will lead to different FEER estimates. Furthermore, trade elasticities, which are the basis for calculating real exchange rate adjustments that align the underlying and sustainable CA balances, are often sensitive to the specification of trade equations. ^{8} In addition, uncertainties related to data quality (especially in developing economies) and estimation methods abound. For example, the country-specific FEER is often estimated on short time spans, making the results sensitive to the information set. It can also produce conservative estimates of misalignment since the actual and equilibrium (predicted) real exchange rate have, by nature of the estimation method (Least Squares), the same average over the period analyzed. Finally, misalignment may fail to be detected when important macroeconomic factors are not accounted for in country-specific equations due to the rapid loss of degrees of freedom in a short sample. For such reasons, assessing the robustness of the results is key.

Notwithstanding these considerations, our results are reassuring since the various methods employed to analyze the ERER for Mauritius lead to similar conclusions.

### A. Macroeconomic Balance Approach (FEER-MB)

In the FEER-MB approach we estimate an ERER implied by a medium-term equilibrium CA. This, in turn, is determined by external and domestic macroeconomic fundamentals (Edwards, 1989; Wren-Lewis, 1992; Williamson, 1994; Isard and Faruqee, 1998; Faruqee, Isard, and Mason, 1999; Driver and Westaway, 2005). The CA position is deemed to be ‘in equilibrium’ or sustainable if current policies can maintain external and internal balance with no need for a major policy shift (Milesi-Ferretti and Razin, 1996).

The analysis consists of three steps.

We estimate a model of the determinants of the CA balance using panel data for 140 countries between 1980 and 2005.

^{9}The approach has the strength that a large cross-section of countries at different points on their development trajectory provides a wealth of information about the equilibrium relationship between the CA balance and its fundamentals. This also raises the precision of our estimates.- We project the CA norm for Mauritius over the medium term (2008−13) using coefficient estimates from the model and the IMF forecast for economic fundamentals (IMF, 2008, Table 1). The following specification is estimated:$\begin{array}{c}{\left(\frac{\mathit{\text{CA}}}{\mathit{\text{GDP}}}\right)}_{\mathit{\text{it}}}={\alpha}_{i}+{\eta}_{t}+{\beta}_{1}{\left(\frac{\mathit{\text{FISC}}}{\mathit{\text{GDP}}}\right)}_{\mathit{\text{it}}}+{\beta}_{2}{\left(\frac{\mathit{\text{NFA}}}{\mathit{\text{GDP}}}\right)}_{\mathit{\text{it}}}+{\beta}_{3}{\mathit{\text{RELGDP}}}_{\mathit{\text{it}}}+{\beta}_{4}{\mathit{\text{GROWTH}}}_{\mathit{\text{it}}}+{\beta}_{5}{\mathit{\text{POP}}}_{\mathit{\text{it}}}+{\epsilon}_{\mathit{\text{it}}}\\ (1)\end{array}$
where the time-varying fundamentals—a mix of factors affecting external and internal balance—are the overall fiscal balance (expressed as a ratio to GDP); the NFA position (relative to GDP); relative per capita GDP (expressed as the deviation from US income); per capita GDP growth; and population growth (a demographic control capturing fiscal pressures). Cross-sectional heterogeneity is addressed by including indicator variables for major fuel exporters, financial and offshore centers, Eurozone members (identifying years since membership), and countries affected by the East Asian crisis (identifying post-crisis years). Country-specific fixed effects (

*α*_{i}) are included to account for unobserved heterogeneity. Year-specific shocks common to all cross-sectional units are captured by a set of time dummies (*η*_{t}). We determine the exchange rate adjustment that would be needed to close the gap, if any, between the CA norm and the underlying CA (measured using WEO projections for the medium-term and stripped of temporary factors such as purchases of aircraft) based on estimated trade elasticities.

^{10}

To project the CA norm, coefficient estimates based on three panel estimators are considered: pooled OLS, random effects, and fixed effects (Appendix Table 2). ^{11} The results are reassuring: the coefficients do not vary much across estimation methods. Notably, a Hausman test yields no evidence of systematic differences between the random and fixed effects estimates. Notwithstanding several differences in terms of the underlying data, empirical specification, and estimation methods, our estimated coefficients are also similar to those obtained by Lee et al. (2008) in a sample of 54 economies for 1973−2004.

Coefficient estimates from the panel analysis accord with economic theory and intuition in terms of signs and magnitude. An increase in the overall fiscal balance-to-GDP ratio predicts a CA balance higher by ⅓ of a percentage point of GDP; and a higher NFA/GDP position is also associated with a higher CA balance, though the size of the coefficient is lower. While higher per capita income improves the CA balance, higher per capita growth causes it to deteriorate. The demographic variable shows that an increase in the population growth rate by 1 percentage point is associated with a CA balance that is lower by ½ a percentage point of GDP. Finally, countries that export fuel, have been affected by the East Asian crisis, or are global financial centers have substantially higher CA surpluses for the period; the reverse is true of offshore financial centers, such as Mauritius, whose CA balances are 5–6 percentage points lower than in onshore centers.

To illustrate the workings of the FEER-MB approach, we report the coefficients estimated by the fixed effects estimator that are then employed to derive one CA norm (Appendix Table 2, column 3).

where *t* = 1980,…, 2005 in the model, and *t* = 2006/07,…, 2012/13 for the projection, ^{12} and the reported intercept is the fixed effect estimated for Mauritius. Note that the coefficients on time-invariant explanatory variables are absent from Equation 2 as they cannot be estimated with this method.

Figure 4 shows the fitted CA balance (using coefficients from Equation 2) for Mauritius relative to the actual balance. It appears that the REER has been close to its equilibrium value for much of the period and that the country’s exchange rate policy has been appropriate given the observed economic fundamentals. Over the period analyzed, the average fitted CA balance derived from observables only (dotted line) is slightly below the average realized CA balance (solid line). To account for the effect of time-invariant unobservables, we adjust the fitted CA balance by adding the estimated fixed effect for Mauritius (dashed line). At the end of the time period considered (FY 2004/5), the fitted (equilibrium) CA balance is 0.14 percent (of GDP), compared to the actual CA balance of −1.8 percent (of GDP), suggesting a slight REER overvaluation.

**FEER-MB Approach: Actual and Fitted CA balance**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The actual CA/GDP is expressed as a three-year moving average.Source: Authors’ estimates.**FEER-MB Approach: Actual and Fitted CA balance**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The actual CA/GDP is expressed as a three-year moving average.Source: Authors’ estimates.**FEER-MB Approach: Actual and Fitted CA balance**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The actual CA/GDP is expressed as a three-year moving average.Source: Authors’ estimates.The CA norm over the medium term (2007/8−12/13) is computed using coefficients from our estimated models at an average CA deficit of 4.7 percent of GDP using the fixed effects model (Equation 2) and 4.2 percent using the random effects model. Since the underlying CA (based on medium-term WEO projections) averages a deficit of 4.4 percent, the difference between the two balances (no more than ½ a percentage point) can be considered negligible. Therefore, the FEER-MB approach suggests that the REER is close to its equilibrium value because the CA norm is close to the underlying CA.

To check the robustness of this result, we also calculate CA norms using alternative coefficients that describe the equilibrium relationship between the CA balance and economic fundamentals. One set of coefficients arises from a fixed effects model estimated on the sub-sample of middle-income countries (shown in the last column of Appendix Table 2). Another comes from the pooled OLS model of Lee et al. (2008, Table 1). Finally, we consider the average of our various CA norm estimates. ^{13} Figure 5 summarizes the results by plotting all our estimates of the CA norm derived using different estimators and samples of countries, and demonstrates that they are close to the country’s underlying CA (within 1 percentage point). To conclude, this method predicts that little or no additional real exchange rate adjustment—over and above the real appreciation incorporated in the underlying CA on the basis of established policies (see footnote 10)—should be necessary over the next five years. ^{14}

**FEER-MB Approach: CA Norms vs. Underlying CA**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The underlying CA is expressed as a three-year moving average and is stripped of temporary factors such as purchases of aircraft and ships. It is predicated on an exchange rate appreciation of 2 percent per year. The CGER-based CA norm is derived using coefficient estimates from the pooled OLS estimation (Lee et al, 2008). The average CA norm estimate represents the average across all five CA norms.Source: Authors’ estimates.**FEER-MB Approach: CA Norms vs. Underlying CA**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The underlying CA is expressed as a three-year moving average and is stripped of temporary factors such as purchases of aircraft and ships. It is predicated on an exchange rate appreciation of 2 percent per year. The CGER-based CA norm is derived using coefficient estimates from the pooled OLS estimation (Lee et al, 2008). The average CA norm estimate represents the average across all five CA norms.Source: Authors’ estimates.**FEER-MB Approach: CA Norms vs. Underlying CA**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The underlying CA is expressed as a three-year moving average and is stripped of temporary factors such as purchases of aircraft and ships. It is predicated on an exchange rate appreciation of 2 percent per year. The CGER-based CA norm is derived using coefficient estimates from the pooled OLS estimation (Lee et al, 2008). The average CA norm estimate represents the average across all five CA norms.Source: Authors’ estimates.### B. Single-Equation Fundamental Equilibrium Exchange Rate Approach (FEER-SE)

Here we analyze the ERER by estimating a country-specific, reduced-form structural relationship between the real exchange rate and a vector of economic fundamentals. The approach is typically applied to the REER and is similar to estimating a behavioral equation in which expected future movements in the real exchange rate are determined by fundamentals and short-run behavior by the risk premium and the interest rate differential (also known as the BEER). However, the focus of this section is on medium-term determination of the ERER rate rather than short-term. ^{15}

We undertake a country-specific analysis for Mauritius because reliable data for a sufficiently long time-span (1960–2007) is available. For purposes of estimation, we use the autoregressive distributed lag (ARDL) approach to cointegration developed by Pesaran and Shin (1999) and Pesaran, Shin, and Smith (2001). ^{16}

The starting point is a general model comprising the following variables: terms of trade (the ratio of export price index to import price index), government consumption (relative to GDP), openness (the ratio of total trade to GDP), relative productivity (proxied by the GDP per capita relative to the average of main trading partners), NFA position, and a capital controls dummy for post-1994 liberalization. Using a general-to-specific methodology, we eliminate those variables that do not appear to have a cointegrating relationship with the REER. We also find that the NFA/GDP ratio, the capital account liberalization dummy, and relative productivity do not yield statistically significant or meaningful results in the long-run model.

We identify long-run cointegrating relationships between the REER and three variables: terms of trade, openness, and government consumption. ^{17} We report only one parsimonious specification (which preserves degrees of freedom), as follows:

First, as expected, the terms of trade of goods have a positive coefficient, since a positive shock improves the trade balance and the resulting higher domestic demand pushes up the prices of nontradables, so the real exchange rate appreciates. Second, an increase in openness, which can be seen as a proxy for the easing of trade restrictions, is associated with lower domestic prices, hence a real depreciation. Third, a rise in government consumption (about 15 percent of GDP) is associated with real depreciation. This suggests that government spending composition in Mauritius may favor the tradable sector, imposing downward pressure on the trade balance, and requiring a real depreciation to maintain the external balance.

The FEER-SE analysis suggests that the Mauritian rupee has been close to its equilibrium value since 2003 (Figure 6). It follows that exchange rate policy has been generally appropriate for the past several years.

**FEER-SE Approach: Actual vs. Equilibrium REER**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The estimation is undertaken for the period 1960−2007.Source: Authors’ estimates.**FEER-SE Approach: Actual vs. Equilibrium REER**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The estimation is undertaken for the period 1960−2007.Source: Authors’ estimates.**FEER-SE Approach: Actual vs. Equilibrium REER**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Note: The estimation is undertaken for the period 1960−2007.Source: Authors’ estimates.### C. Capital-Enhanced Equilibrium Exchange Rate Approach (CHEER)

To better assess the recent evolution of the Mauritian rupee and to employ higher frequency data in our assessment of the ERER, we also consider the CHEER approach (Johansen and Juselius, 1990; Juselius, 1995; MacDonald and Marsh, 1997, 1999; Juselius and MacDonald, 2004). Detailed expositions of the method can be found in MacDonald (2000, 2007). Heerah-Pampusa and Hurree-Gobin (2006) applied it to the Mauritian rupee and found a small degree of overvaluation between 2003 and 2005. Our sample consists of monthly data from July 1995 through December 2007.

In brief, the CHEER approach is based on the idea that the exchange rate may deviate from its purchasing power parity (PPP)-determined value due to non-zero interest rate differentials. These are allowed to have a medium-term as opposed to a transitory effect on the exchange rate. The slow adjustment of the CA to relative prices means that the CA must be financed by the capital account (through the balance of payments condition). Thus, persistence observed in the real exchange rate should be reflected in persistence in the nominal interest rate differential.

The method thus combines the PPP with another parity condition: the uncovered interest parity (UIP). The CHEER approach, unlike the previous ones, captures capital flows as a factor affecting the ERER, but ignores real determinants such as relative output and NFA. Therefore, the extent of over- or undervaluation is defined as the variation in the real exchange rate that is unexplained by the interest rate differential. This approach is particularly useful here because Mauritius has opened up its capital account in recent years and is attracting significant capital flows.

First, note that the UIP condition equalizes nominal rates of return on domestic and foreign currency assets. Therefore, the expected change in the nominal exchange rate is determined by the interest rate differential and any risk premium (e.g., for country risk) as follows:

where *s*_{t} is the (log) nominal exchange rate (MUR/US$); (*i*_{t} − *i*_{t}^{*}) is the interest rate differential for T-bills; σ_{t} is the risk premium; and *E*_{t} is the expectations operator. Assuming σ_{t} = 0 (justified because the interest rate differential on sovereign debt already incorporates the country risk premium), it follows that if domestic interest rates are above foreign rates, the domestic currency is expected to depreciate to equalize rates of return. Imposing σ_{t} = 0 and subtracting the expected inflation differential from both sides of the equation, we have

where *e*_{t} is the real exchange rate and (*r*_{t} − *r*_{t}^{*}) is the real interest rate differential. (For a visual interpretation of the two parities relative to the US, see Appendix Figure 1.)

We estimate a vector autoregressive model (VAR) of the nominal exchange rate, the inflation differential, and the interest rate differential. The vector of monthly variables is given by

where *p*_{t} and *p*_{t}^{*} are the consumer price indices (CPIs) of Mauritius and the US. The interest rates (*i*_{t} and *i*_{t}^{*}) are yields on the 90-day T-bill.

As a first step, all variables considered (nominal exchange rate, prices, and interest rates) are tested for unit roots (Appendix Table 4). All are integrated of order one in levels, but the results for prices are slightly ambiguous. We test for the existence of cointegrating relationships using the Johansen method and find strong evidence of one cointegrating vector (Appendix Table 5). Finally, we use the Hodrik-Prescott filter to obtain the equilibrium nominal exchange rate.

The CHEER approach reveals that deviations from the equilibrium MUR/US$ exchange rate explained by the interest rate differential have been relatively small since July 1995. (In general, the actual exchange rate has remained within the 95 confidence interval for the equilibrium exchange rate.) In December 2007 the MUR/US$ exchange rate was 29.04 and the equilibrium value was 31.7 with a corresponding 95 percent confidence interval given by [28.8, 32.8]. Since the actual value falls within the confidence interval, we conclude that the estimated deviation from equilibrium was not statistically significant. Our findings using the CHEER approach therefore confirm those from the previous methods, reinforcing the conclusion that exchange rate policy in Mauritius has been appropriate in recent years.

Note that the nominal exchange rate has recently been somewhat volatile around the estimated equilibrium, depreciating above the trend in mid-2006 because of a large real interest rate differential with the US dollar. The rupee started to appreciate again at the end of 2006 because monetary policy became more credible when an independent Monetary Policy Committee was appointed. The cuts in US interest rates since August 2007—the beginning of the rupee’s deviation from long-run equilibrium—were not followed by commensurate drastic reductions in Mauritian interest rates, so the interest rate differential was increasingly positive. This explains the continued appreciation of the rupee against the US dollar and its slight deviation from trend toward the end of 2007.

### D. External Sustainability Approach (ES)

The ES approach is a variant of the external-internal balance approach which compares the underlying CA balance with the NFA-stabilizing CA balance (Lee at al., 2008). ^{18} The aim is to identify what, if any, real exchange rate correction is needed to close the gap between the two CA paths. In most applications the ES approach is applied by choosing (somewhat arbitrarily) a desirable NFA position and making assumptions about the main determinants of the country’s external position—growth, inflation, and return on external assets and liabilities—to compute the CA balance consistent with it. Both the FEER-MB approach and the ES approach focus on a medium-term concept of equilibrium for the real exchange rate. However, in the former case the CA norm is derived based on a reduced-form equation (that identifies the main determinants of the CA balance) whereas in the latter, a benchmark NFA position is first specified.

Several approaches can be considered in choosing a benchmark NFA position. One option is to employ a backward-looking target such as the latest NFA position observed (for an application to industrialized and emerging economies, see Lee at al., 2008). A second approach is to assume that the medium-term CA projection represents a sustainable level (in which case, no real exchange rate adjustment is necessary), calculate the NFA position consistent with it, and determine whether it is plausible (given the country’s investment outlook and capacity to save). A third approach is to specify a reduced-form model of NFA positions in a large cross-section of countries, and obtain estimates of the equilibrium NFA to GDP ratios conditional on country characteristics (Calderon, Loayza, and Serven, 1999; Lane and Milesi-Ferretti, 2001). A fourth method assesses sustainability of the balance of payments components in determining the desired NFA position (applied for the WAEMU region by Weisfeld et al., 2008).

We apply the ES method using the first approach and considering two NFA/GDP benchmarks. The first is the end-June 2006 (observed) NFA position (of slightly above 85 percent of GDP). Assuming a medium-term GDP growth rate of 5 percent and an inflation rate of 5 percent, we obtain a CA norm that stabilizes the NFA position at that level of 7.9 percent. The second is the net external position estimate from Lane and Milesi-Ferretti (2006) of 21 percent (of GDP) at end-2004. Stabilizing the NFA stock at that level over the medium term would imply a CA surplus of 2 percent of GDP (against an underlying CA of −4.4 percent of GDP; see Section III.A). Both findings suggest that the real exchange rate is slightly overvalued (by 4 to 7.7 percent using the elasticities discussed in footnote 14) if Mauritius were to target a medium-term NFA stock in this range.

However, this analyis should be interpreted with caution for two reasons. First, neither of the two benchmarks carries much normative content. Furthermore, official net external position statistics in Mauritius are affected by the activity of Global Business Licenses (GBLs), which are offshore vehicles resident in the country that invest abroad to take advantage of double taxation avoidance treaties. Currently, these statistics fail to capture the liability side of GBL activity, reflecting only the foreign assets of the commercial banks sourced from the GBLs (IMF, 2008). This creates a positive bias in the NFA estimate for Mauritius; a correction would imply that lower (or negative) NFA/GDP ratios could be taken as benchmark in the ES approach, in which case the resulting CA norm would be lower than those considered here.

## IV. Structural Competitiveness Analysis

In addition to equilibrium exchange rate methods, a comparative analysis of nonprice indicators can be useful in analyzing a country’s relative competitiveness. Indicators like institutional quality (reflecting labor market flexibility, access to finance, or rule of law) can offer valuable insights on where bottlenecks lie and may help policymakers to formulate policy responses. Caution is required in interpreting this section’s results: though useful in identifying binding constraints on growth, structural indicators of competitiveness often conceal problems because economic agents often adapt to the environment by themselves addressing binding constraints directly. For example, power outages are known to be a problem in Mauritius, but surveys fail to show them as a problem because most firms have bought expensive power generators, thus bypassing the constraint (Clarke et al., 2006). While typical surveys, and indicators based on them, would thus suggest that power outages are not an impediment to normal business functioning, in reality an upgrade of the power system is desirable to bring down input costs.

In analyzing several composite competitiveness indicators we find that Mauritius is one of the best performers in sub-Saharan Africa and often outranks comparator economies. We look at the four most popular indicators: (i) the Global Competitiveness Index of the World Economic Forum; (ii) the World Governance Indicators of the World Bank; (iii) the Doing Business Report indicators of the World Bank; and (iv) the Corruption Perception Index of Transparency International.

Mauritius fares well on structural competitiveness. Figure 8 plots standardized scores for Mauritius and three comparator groups. The country ranks in the top third most competitive countries in the world according to the Global Competitiveness Index. It is ahead of comparator small-island economies for which data are available though it trails high-growth Asian economies (South Korea, Hong Kong, Singapore, Taiwan, Malaysia, Thailand, and Indonesia). The World Governance Indicators summarize survey opinions on several dimensions of institutional quality: voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and control of corruption. Again, Mauritius ranks high by international standards, outperforming high-growth economies as well as small island states. The Doing Business Report 2008 named Mauritius the best-performing country in sub-Saharan Africa and ranked it 27^{th} in the world. Compared to other nations, it fares particularly well on institutional variables related to commerce and entrepreneurship, such as starting a business and securing a license.

**CHEER Approach: Actual vs. Equilibrium NER**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: Authors’ estimates.**CHEER Approach: Actual vs. Equilibrium NER**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: Authors’ estimates.**CHEER Approach: Actual vs. Equilibrium NER**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: Authors’ estimates.**Composite Indicators of Structural Competitiveness**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: World Economic Forum, World Bank World Governance Indicators, World Bank Doing Business Indicators, and Transparency International.**Composite Indicators of Structural Competitiveness**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: World Economic Forum, World Bank World Governance Indicators, World Bank Doing Business Indicators, and Transparency International.**Composite Indicators of Structural Competitiveness**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: World Economic Forum, World Bank World Governance Indicators, World Bank Doing Business Indicators, and Transparency International.The analysis of structural competitiveness indicators helps identify areas where Mauritius can improve. According to the 2007/08 Global Competitiveness Report, the main problems are the relatively inefficient government bureaucracy, limited labor flexibility, and an underskilled workforce. The 2008 Doing Business Report flags a need for progress in registering property and the cost of closing businesses. ^{19} The same report highlights the relatively limited access to credit.

Considering its performance in trade and the ICT sector, Mauritius again fares well compared to both high-income countries and regional averages. We consider a subindex of the Global Competitiveness Index, the trading across borders measure, to determine how Mauritius stands in terms of exporter and importer costs of doing business. Djankov, Freund, and Pham (2006) have documented the trade cost of delays in shipments and highlighted the importance of reducing them as well as tariff barriers to stimulate exports. In number of documents required for a transaction, cost in US$ per container, and time to export, Mauritius is outperformed only by the OECD countries (Figure 9 and Appendix Table 6).

**Relative Performance on Trade Costs**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: World Economic Forum.**Relative Performance on Trade Costs**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: World Economic Forum.**Relative Performance on Trade Costs**

Citation: IMF Working Papers 2008, 212; 10.5089/9781451870701.001.A001

Source: World Economic Forum.In access, quality, affordability, and institutional efficiency and sustainability, ICT sector services fare relatively well (Appendix Table 7). Mauritius seems to be outperformed only by high-income countries (though by a large margin); it has clearly outpaced other income-based country groupings (including the upper-middle-income group). Still, progress is needed in the area of quality, notably in broadband access to the Internet and minimizing telephone faults.

## V. Conclusions

With the phasing out of the European Union sugar protocol, the elimination of the Multi-Fiber Agreement, and rising world commodity prices, Mauritius has to deal with a triple terms of trade shock. To identify external vulnerabilities, this study analyzed the country’s equilibrium exchange rate using four quantitative approaches—the macroeconomic balance, the single-equation, the capital-enhanced equilibrium exchange rate, and the external sustainability approach—and also analyzed the business climate, trade, and ICT costs in comparative terms.

Our analysis demonstrates that the Mauritian rupee appears to be close to its equilibrium value. The following findings support this conclusion:

The macroeconomic balance approach (FEER-MB) used parameters from a model estimated on panel data for 140 countries and the IMF forecast of economic fundamentals to project the Mauritius CA norm over the medium term. We found that the CA norm is close to the underlying CA stripped of temporary factors, suggesting that little or no exchange rate adjustment may be necessary. The results held up to a series of robustness checks, such as different estimators and samples of countries.

The single-equation fundamentals approach (FEER-SE) used time series methods to compute the equilibrium REER using variation in openness to trade, terms of trade shocks, and government consumption. It concluded that the REER and the equilibrium level have been aligned since 2003.

The capital-enhanced approach (CHEER) brought the uncovered interest parity condition into the analysis by investigating the relationship between monthly exchange rate variations and the interest rate differential with the US. Despite some volatility, the nominal exchange rate appeared close to equilibrium at the end of 2007.

The external sustainability approach (ES) observed that estimates of the country’s net external asset position in 2004 and 2006—interpreted illustratively as benchmarks— are consistent with a CA balance that indicates a slight real exchange rate overvaluation.

Given that the exchange rate regime is a managed float, the main policy recommendation that emerges from our analysis is that interventions in the foreign exchange market should continue to be aimed solely at reducing volatility rather than affecting the trend. This is likely to keep the real exchange rate close to its equilibrium level as determined by the economy’s fundamental macro-variables. Alternative target levels of the CA balance, and the NFA position, over the medium term may require small exchange rate corrections, but these can be minimal if accompanied by measures to address structural bottlenecks and bolster competitiveness.

Structural competitiveness indicators offer a glimpse into areas that require attention, such as labor market reforms, ICT, and certain dimensions of institutional quality. While the government’s reform program has gone far in restoring competitiveness, action may be needed to stimulate competition in goods markets, make labor markets more flexible, raise the average skill level, and further reduce the cost of doing business. As Mauritius embarks on its ambitious plan to become a business and financial services hub, such measures are essential for making the country more competitive.