Mauritius: Staff Report for the 2004 Article IV Consultation

This 2004 Article IV Consultation highlights that real GDP growth of Mauritius is expected to rebound to about 4½ percent in 2003/04. This largely reflects the recovery of tourism and sugar production, and continued strong construction and transportation activity. The current account is projected to remain in surplus with the recovery of the tourism sector offsetting a widening in the trade deficit. The capital and financial account is projected to register a small deficit of 0.8 percent of GDP in 2003/04 compared with a surplus in 2002/03.


This 2004 Article IV Consultation highlights that real GDP growth of Mauritius is expected to rebound to about 4½ percent in 2003/04. This largely reflects the recovery of tourism and sugar production, and continued strong construction and transportation activity. The current account is projected to remain in surplus with the recovery of the tourism sector offsetting a widening in the trade deficit. The capital and financial account is projected to register a small deficit of 0.8 percent of GDP in 2003/04 compared with a surplus in 2002/03.

I. Introduction and Medium-Term Challenges

1. Mauritius’s social and economic success during the past quarter century has been impressive. This success owes much to the high quality of institutions, including a well-functioning multi-party democracy, an independent judiciary, and a strong sense of the “rule of law.”1 Good institutions and appropriate policies have led to a more than doubling of per capita income, a narrowing of income disparities, and a marked improvement in social indicators. Since the early 1990s, however, unemployment has risen steadily, owing to labor market rigidities and a structural skills mismatch.

2. Remarkably, Mauritius’s development has been financed almost entirely from domestic savings, which have been intermediated through an efficient domestic banking system. Foreign Direct Investment (FDI) has played a minor role (Figure 1).

Figure 1.
Figure 1.

Mauritius: Domestic Saving, Domestic Investment, Foreign Direct Investment, and Public Capital Expenditure, 1980-2001

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

Sources: World Bank, World Development Indicators.

3. Mauritius’s immediate and medium-term challenges are threefold. First, there is a need to diversify and transform the economy, especially in light of the expected loss of trade preferences in the sugar and textile sectors. Second, Mauritius must undertake structural reforms to increase labor market flexibility. Third, persistent budget deficits need to be reduced if medium-term fiscal sustainability and macroeconomic stability are to be preserved.

4. While the timing of the phasing out of textile preferences has been defined, there is less certainty in the case of sugar exports. Textile quotas will be phased out with the expiration of the WTO Agreement on Textiles and Clothing (ATC) in January 2005. Given its relatively high per capita income, Mauritius does not qualify for the third-country fabric provision under the U.S. African Growth and Opportunity Act (AGOA). Therefore, unlike other nations benefiting from preferential access to the U.S. market under AGOA, Mauritius cannot import raw fabric from non-AGOA countries, placing the country at a relative disadvantage. The preferential access afforded to sugar exports by the European Union (EU) is currently under review.2

5. Mauritius’s unemployment has increased rapidly since 1991 primarily among low-skilled workers concentrated in the sugar and textile sectors.3 Unless significant labor market reform takes place, the unemployment rate may worsen in coming years.

6. While external debt remains at a relatively low level, domestic public debt sustainability is a major concern. According to sensitivity tests carried out by staff, total public debt could become unsustainable in the medium-term in the absence of significant fiscal adjustment, thereby jeopardizing growth prospects and macroeconomic stability.

7. The authorities’ response to the challenges identified in Fund surveillance in recent years has been uneven. For example, while some attempt was made to enhance prospects for medium-term fiscal sustainability in 2002/03 through the introduction of revenue-enhancing measures, the tax base remains relatively narrow. The authorities have also been slow to address key structural reforms, particularly with respect to the labor market and the strengthening of the fiscal position of key state-owned enterprises. However, in the last year, some progress was made in addressing the challenges identified by Executive Directors during the 2003 Article IV consultation. Specifically, the authorities have: (i) attempted to revitalize the sugar and textile sectors through the implementation of costsaving measures in the former and the facilitation of the restructuring of viable firms in the latter; (ii) made a number of improvements in line with the FSSA recommendations, and issued guidance notes on AML/CFT; (iii) implemented an automatic pricing mechanism for petroleum products; and (iv) introduced the Bank of Mauritius (BOM) Bill to control liquidity in the banking system. Undertaking further reforms in the near term will prove difficult and will require a strong commitment by the authorities, especially in light of upcoming elections (Box 1).

Political Developments

Mauritius has a multiparty democratic system. The transfer of the premiership took place on September 29, 2003, in line with a coalition agreement reached in 2000 between the Mouvement Socialiste Militant (MSM) of Sir Anerood Jugnauth and the Mouvement Militant Mauricien (MMM) of Mr. Paul Bérenger. As a result, Mr. Bérenger relinquished the finance portfolio to become the new Prime Minister to complete the final two years of the five-year term of office, while Sir Anerood gave up the premiership and became president. The new MSM leader, Mr. Pravind Jugnauth—son of the president—is the new deputy prime minister and finance minister. The opposition Labour Party’s victory in the December 2003 by-election for the National Assembly seat vacated by Sir Anerood has given new impetus to opposition activities. The next general election will take place in 2005.

II. Recent Economic Developments

8. Real GDP growth is expected to rebound to around 4½ percent in 2003/04 (July-June), following a disappointing 2¾ percent in 2002/03. This largely reflects the recovery of tourism and sugar production, the latter due to favorable weather, and continued strong construction and transportation activity. However, high domestic production costs and increased competition have continued to affect adversely the Export Processing Zone (EPZ) sector, which registered negative growth for the second consecutive year. The unemployment rate rose to 10.2 percent in 2003, from 9.7 percent in 2002.

9. Budget execution for the first eight months of 2003/04 (July-February) was broadly in line with the target of reducing the deficit to 5.5 percent of GDP, from 6.2 percent in 2002/03. This improvement reflects primarily higher tax and nontax revenue. Total expenditure remained broadly unchanged at 26½ percent of GDP.

10. There is a danger that public debt could become unsustainable as a result of continuing central government fiscal deficits. The total public debt, which was equivalent to 66 percent of GDP in 1999/00, rose to about 80 percent in 2002/03. At the same time, the debt service burden rose by over 40 percent from 2001/02 to 2002/03, accounting for a large share—20 percent—of current expenditure. Moreover, with most of the debt concentrated in short-term securities, there is significant rollover and interest rate risk. Recognizing these risks, in 2003/04 the government has mostly financed its budget deficit by drawing on its deposits at the BOM. External public debt remains relatively low at a projected 19 percent of GDP in 2003/04.

Central Government Finances, 1999/00-2003/04 1/

(In percent of GDP)

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Sources: Ministry of Finance; and IMF staff estimates and projections.

Fiscal year from July to June.

11. The overall balance of 30 nonfinancial public sector corporations shifted from a deficit of 0.6 percent of GDP in 2001/02 to a surplus of 0.9 percent in 2002/03.4 The Central Electricity Board (CEB) continues to face financial difficulties, in part because of its inability to pass on to consumers the higher international price for fuel oil—a major input in electricity generation. The financial position of the State Trading Corporation (STC) is expected to improve following the introduction in early April 2004 of an automatic mechanism for adjusting the prices of petroleum products.5

Selected Economic and Financial Indicators, 1999/00-2003/04 1/

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Sources: Mauritian authorities; and Fund staff estimates.

Fiscal year from July to June.

Trade-weighted period averages (a negative sign signifies a depreciation). Figure for 2003/04 represent the percentage change from July to December 03.

In months of imports, c.i.f.

Figure 2.
Figure 2.

Mauritius: Real Sector Developments

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

12. Low and stable inflation has generally been achieved, largely due to a relatively successful implementation of an informal inflation targeting framework. Average annual inflation fell to around 4 percent in 2003, from 6.4 percent in 2002, in line with the central bank’s inflation target. The growth of credit to the private sector slowed in 2003, owing in part to the weaker performance of the textile sector. The outlook is for a further moderate fall in inflation over the near term, as demand pressures remain subdued.

13. Key interest rates have been trending downward over the last two years, although real lending rates remain high. The BOM lowered its Lombard rate in five steps by a total of 200 basis points, to 9½ percent in late January 2004. These actions reflect the judgment that inflationary risks have subsided, and a desire to provide a stimulus to economic activity. However, given the weaknesses in key sectors of the economy, banks have been cautious in advancing credit to segments of the private sector. This, together with the drawdown in government deposits, which has not been fully sterilized by the BOM, has led to a situation of excess liquidity in the banking system. As a result, interest rates in the interbank market have fallen to an all-time low of less than one percent at end-March 2004, leading to a steepness at the short end of the yield curve. Declining inflationary expectations over the last two years have led to a gradual decline in interest rates, resulting in a reduction in the differential between the yield curve of Mauritius and that of the U.S.

14. The overall balance of payments surplus is projected to decline from 6½ percent of GDP in 2002/03 to below 2 percent in 2003/04. The current account is projected to remain in surplus in 2003/04, with a recovery of the tourism sector offsetting a widening in the trade deficit. The capital and financial account is projected to register a small deficit of 0.8 percent of GDP in 2003/04, compared with a surplus in 2002/03. FDI flows are expected to weaken in 2003/04.

Figure 3.
Figure 3.

Mauritius: Fiscal Developments

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

Figure 4.
Figure 4.

Mauritius: Monetary Developments

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

Figure 5.
Figure 5.

Mauritius: External Developments

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

III. Report on Policy Discussions

15. The policy discussions centered around the medium-term challenges of diversifying the economy and preserving fiscal sustainability and macroeconomic stability. The main focus was on: (i) the authorities’ medium-term strategy to improve the competitiveness of the economy and strengthen growth prospects; (ii) the budget performance in 2003/04, fiscal polices for 2004/05, and medium-term fiscal consolidation; and (iii) the appropriateness of monetary and exchange rate policies.

A. Medium-Term Growth Sources and Prospects

16. The economy is expected to grow by about 4¾ percent in 2004/05, largely led by a continued recovery in sugar production. Tourism is expected to strengthen further, reflecting an increase in visitor arrivals from the U.K. and India, while the expansion in the construction sector should continue with the building of several new hotels. Other sectors that are expected to contribute to growth include wholesale and retail trade, transport, information and communications technology (ICT), and financial services. However, the outlook for exports from the EPZ sector remains weak, with several large textile firms in the process of relocating their operations to China in anticipation of the ending of the quota system governing world trade in textiles.

17. Medium-term growth is expected to slow to around 4 percent per annum—significantly below the average of almost 6 percent over the past three decades. This reflects a weaker outlook for the traditional pillars of the economy—sugar and textiles (Box 2)—and the effects of persistent rigidities in the labor market. New sectors, such as the ICT sector, are expected to contribute increasingly to growth but their starting point is low.

Growth Impact of the Elimination of Trade Preferences1

The baseline growth projection for the medium term is 4 percent per annum. In 2004/05, this scenario envisages a growth rate of 4.8 percent based on an increase in sugar production of 16 percent following a bumper crop in 2004, and a decline in the EPZ sector of 3.5 percent. However, sugar production is expected to decline the following year. The weak performance of the sugar and EPZ sectors is expected to continue into the medium term, reflecting increased global competition, a reduction in the area used for sugarcane production, and a gradual disinvestment of some foreign textile companies. These developments are expected to be balanced by the capability of the Mauritian economy to adjust partially to the changing international business environment through the restructuring of the economy and the development of other sources of growth, including in the ICT and the financial services sectors.

The baseline scenario, however, faces several downside risks. Structural reforms could take longer than expected; and the shocks to both the sugar and textile sectors could be even more severe. This will depend on the resolution of the challenge to the EU sugar subsidies by Australia, Brazil, and Thailand and developments in the textile market during the post-ATC period.

In a moderately adverse scenario, the shocks are expected to have a more substantial but gradual impact in the next three years. Sugar prices are assumed to fall to US$0.16 per pound in 2005, and further to US$0.10 per pound in 2007. The textile sector would shrink by 8 percent in 2004/05, 15 percent in 2005/06, and 8 percent in 2006/07, stabilizing thereafter. The impact of this scenario, relative to the baseline, would be to reduce GDP growth by about ¾ of a percentage point in 2004/05, 1½ percentage points in 2005/06, and ½ a percentage point in 2006/07.

In an extremely adverse scenario, the shocks would have a much stronger impact on the different sectors of the economy. One assumption—although with low probability—would be for the WTO panel to decide on the complete liberalization of sugar trade starting in 2005. This would most likely cause sugar prices to drop to around US$0.10 per pound. The other assumption is a more dramatic impact on the textile sector following the phasing out of the ATC preferences. This could lead to the closure of all textile firms categorized as either vulnerable or at risk under the Textile Emergency Support Team (TEST) initiative, in addition to the relocation of foreign and some local companies to cheaper production sites. The impact on the textile sector would be a decline of between 20 and 30 percent in 2004/05 and 2005/06. This scenario would lead to a reduction in the baseline medium-term growth projection by an average of between 2-2½ percentage points a year.

1/ Please see accompanying selected issues paper.

18. The authorities expressed concern about the medium-term prospects for the real economy, and indicated that they were taking steps to improve the outlook for the traditional sectors while creating an environment conducive to the development of other sources of growth. The authorities have been preparing for the potential loss of preferences for sugar by implementing reforms to reduce gradually production costs. Major reforms have been the introduction of a voluntary retirement scheme, which has resulted in an almost 30 percent reduction in the workforce (7,900 employees), and the consolidation of milling operations. Efforts are also under way to diversify sugar-related activities, including the production of electricity as by a product of the sugar sector for sale to the national electricity company, and rum and ethanol production. The mission encouraged the government to intensify these efforts and to complete an ongoing mid-term review of the sugar sector strategy.

19. The authorities also indicated that they were assisting the restructuring of the textile sector through technical advice and development finance. The government remains hopeful that AGOA’s third country fabric provision will be extended to Mauritius in the near future. However, many Hong Kong-based textile firms, which account for about 25 percent of textile employment and 30 percent of exports are likely to leave Mauritius in the next two to three years, owing to rising labor costs6 and the removal of quotas that currently constrain exports from countries such as China. This would increase the already high unemployment rate, and its incidence among low-skilled workers (see Box 3).7 The mission welcomed the establishment of the Textile Emergency Support Team (TEST), which is designed to facilitate the rehabilitation of viable textile enterprises through the provision of corporate diagnosis services and the consolidation and streamlining of various initiatives. These initiatives include the provision of financial resources from the National Equity Fund for capitalization and spinning activities, as well as enterprise modernization schemes supported by the Development Bank of Mauritius.8 The authorities agreed that there is a need to intensify the retraining of displaced textile workers so that they can be absorbed by other sectors.

The Mauritius Labor Market1

Reforms in Mauritius’s labor market should include the introduction of decentralized wage bargaining and the elimination of restrictions on worker redeployment and terminations.

The labor market is highly regulated, with restrictions on the redeployment of workers, wages and benefits, and terminations. The government establishes a separate set of labor market regulations—which specify the duties and wages of each narrowly defined occupation—for most industries, which inhibits the ability of firms to redeploy workers.2 The annual tripartite wage setting process typically indexes economy-wide wage growth to inflation, while terminations tend to be both costly and time consuming, usually requiring approval by the Termination of Contracts of Services Board.

In addition to the relatively high unemployment, unemployed workers are facing exceptionally long spells—with an average unemployment duration of 20 months—and a less dynamic labor market, with relatively low quarterly job creation.

Moreover, the highly regulated nature of the labor market unnecessarily reduces the employment opportunities for low-skilled workers. By increasing the relative wages paid to low-skilled workers, these regulations reduce the incentive to create new jobs and make existing jobs more insecure. Limits on the ability of firms to redeploy workers have similar effects, while restrictions on terminations reduce the incentives to create new jobs. Although these restrictions in particular do not apply to some key sectors—such as the EPZ sector—they inhibit the creation of new jobs for low-skilled workers in other areas. This differential regulatory treatment will become increasingly important as the economy adjusts to the loss of trade preferences.

Structural changes in the market for low-skilled workers may already be becoming apparent. The first figure below shows that 2002-03 constitutes a period of historic weakness in EPZ employment, mainly driven by a sharp rise in the rate of job destruction. Moreover, there has been a sharp rise in the average size of EPZ firms closing down.


Decomposition of Quarterly EPZ Employment Growth, 1986-2003 1/

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

1/ Seasonally Adjusted.Source: Fund staff estimates and Central Statistical Office, Mauritius.

Average Size of Closing Firms, 1986-2003

(Number of Employees)

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

Source: Fund staff estimates and Central Statistical Office, Mauritius.
1/ Please see accompanying selected issues paper.2/ These regulations do not cover the EPZ sector, and are not expected to cover new ICT activity.

20. Notwithstanding prevailing uncertainties, the authorities were optimistic about the growth prospects for the tourist sector. Plans are being implemented to construct about 20-25 hotels (representing additional capacity of about 40 percent) in the next three years. This increase in capacity, however, is coming at a time when the hotel occupancy rate has declined. More generally, a consistent strategy needs to be developed to market Mauritius as a tourist destination, since the envisaged rapid expansion may conflict with preserving the country’s image as an “upper-end” tourism product. Moreover, issues related to the expansion of air access may need to be resolved in order to increase tourist arrivals.

21. The government continues to view the emerging ICT sector as providing a new source of growth for the economy over the medium term. Nonetheless, the mission noted that the outlook for the sector appeared less favorable than a year ago, owing to considerable global competition. The authorities indicated that, based on current commitments, the recently completed cyber tower will have an occupancy rate of around 40-60 percent during the first year, and that 3,000 new jobs would be created by end 2004. However, significant uncertainty remains, as many Indian firms that initially expressed interest in establishing operations in Mauritius seem to have changed their plans.

B. Structural Reforms

22. In addition to the sectoral issues described above, the discussion on structural reforms focused on the labor market and private sector involvement in the economy. The mission urged the authorities to move ahead with labor market reforms. The government noted that comprehensive measures had been taken to overhaul the education system in order to increase the access of students to educational facilities, and to improve the quality and relevance of the curriculum at all levels, especially at the secondary school level. Staff acknowledged that these reforms would help alleviate the skills mismatch, but stressed that other important factors affecting the labor market also needed to be addressed. In particular, the mission favored the adoption of firm-level wage bargaining and the simplification of the numerous regulations governing the ability of firms to redeploy and terminate workers. The authorities agreed on the importance of reforming the various labor market institutions, but indicated that it was difficult to carry out substantive changes during an election year. Trade union representatives acknowledged that there was some need for improving labor market flexibility, but cited the importance of wide-ranging consultation among all stakeholders.

23. The authorities recognize that the benefits of labor market reforms are likely to materialize only over the medium to long term. They expressed concern about the present high unemployment rate and its large component of unskilled workers. While there is evidence that the income of this group is being supported to a large extent by informal household transfers, the authorities and staff agreed that additional measures, such as public work programs and training, should be considered to ameliorate their situation.

24. The mission encouraged the authorities to promote further private sector participation in the economy, including foreign direct investment. Private sector development could be enhanced by reducing state involvement in commercial activities, such as electricity, and the importation of petroleum products, rice, and cement. The authorities were of the view that the small size of the domestic market and relatively high labor costs constrained FDI flows. The mission welcomed the draft bill designed to facilitate public-private sector partnerships in infrastructure investments. This initiative will enhance prospects for domestic and foreign direct investments and will relieve the burden on the budget to finance large investment projects.

C. Fiscal Policy

25. The fiscal policy discussions focused on addressing persistent deficits and their impact on medium-term debt sustainability. Without significant policy reform, the fiscal deficit for 2004/05 is expected to rise to about 6½ percent of GDP. If the fiscal deficit remains at this level over the medium term, public sector debt could rise to over 76 percent of GDP by 2007/08. 9 The mission proposed a medium-term path to reduce gradually the deficit to 2 percent of GDP by 2007/08, which would allow the public debt to fall to about 64 percent of GDP by the end of the period. Sensitivity analysis shows that when deficits are reduced, public sector debt would also be resilient to external shocks and would quickly return to a stable level, even in the event of a combination of temporary interest rate and output shocks. Consistent with the proposed medium-term path, the mission proposed that the authorities reduce the fiscal deficit to 4.7 percent of GDP in 2004/05.

26. On the revenue side, the mission suggested a number of measures for 2004/05. These included: (a) broadening the income tax base; and (b) applying the VAT to some items that are currently exempted or zero rated. The mission reiterated the need to include a number of fringe benefits in taxable income, subject interest and dividend income to a withholding tax, and reduce the generous allowance for capital investment. Staff also recommended broadening the base of the VAT to cover electricity and processed and nonraw foods. These reforms, together with some other nontax measures, could yield some 0.7 percent of GDP in 2004/05.

27. Regarding expenditure, the mission highlighted the need to prioritize spending, and to review the effectiveness and coverage of the current generalized subsidies on rice and flour. In addition, the mission suggested: (i) further trimming of the capital budget and phasing some projects over the next several years; and (ii) lengthening the maturity structure of the domestic debt (Box 4). Regarding the latter, the staff urged the government to create a debt management unit. The proposed lower primary deficit would reduce the borrowing requirement of the budget and lower interest payments. A restructuring of domestic debts would also significantly reduce interest costs for the following reasons. First, the fall in the level of the yield curve means that the interest cost of lengthening the maturity of previously accumulated debt—especially given the large issuance of 2-year bonds in 2002/03—will lead to substantial savings. Second, a further moderation of inflationary expectations, and more subdued long term growth, should be accompanied by a further fall and flattening of the yield curve over the coming years, leading to interest savings on newly accumulated debt. Overall, the proposed expenditure measures could save 1.1 percent of GDP.

Domestic Public Debt in Mauritius1

The increase in Mauritius’s public debt can be attributed primarily to: (i) fiscal imbalances that emerged since the late 1990s as the government invested heavily in education and infrastructure for the new ICT sector; and (ii) the issuance of treasury bills for monetary policy purposes. The BOM only began issuing central bank bills as a monetary policy tool in July 2003.

Government Debt Profile (as of end of fiscal year, in millions of MUR)

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A large part of the public debt is in short-term maturities and is largely held by banks.2 This concentration of short-term debt exposes the government to interest rate and rollover risk. The persistent fiscal deficits and the weak state of debt management has resulted in interest payments rising by over 40 percent between 2001/02 and 2002/03. The authorities are burdened with a major rollover of treasury bills amounting to about MUR 40 billion (24 percent of GDP) in 2003/04, compared with MUR 50 billion (33 percent of GDP) in 2002/03.


Holders of Domestic Short-term Debt

(As of June 2002)

Citation: IMF Staff Country Reports 2005, 281; 10.5089/9781451827811.002.A001

The government is in the process of setting up a Debt Management Unit within the Ministry of Finance and is seeking to convert much of the short-term debt to longer term bonds, while smoothing future interest payments. However, unless the fiscal deficit is significantly reduced, lengthening the maturity structure would only postpone the debt problem.

Interest Payments and Rollover of Domestic Debt, 2001/02-2004/05

(In million MUR, unless otherwise indicated)

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1/ Excluding pension fund debt.2/ Short-term securities are mostly held by the banks (including the BOM), while nonbank financial institutions are the major holders of longer-term bonds.

28. The authorities were in general agreement with the proposed fiscal measures, but they acknowledged that there would be political resistance to some of them. They welcomed the revenue proposals and indicated that they were also considering to set up an independent Revenue Authority in line with recent recommendations from an FAD technical assistance mission. As to expenditure policy, the authorities indicated that they were receiving support from the World Bank and the U.S. Treasury to develop a Medium-Term Expenditure Framework. While they agreed in principle to the targeting of subsidies, they noted that reducing these subsides may be difficult in light of the upcoming election. Moreover, the authorities were of the view that putting in place an efficient system of direct transfers would take time and be administratively challenging. They also indicated that they were planning to postpone some capital projects that would save about MUR 500 million (0.3 percent of GDP) in 2004/05. To mitigate the effect of a bunching of maturing treasury bills in 2004/05, the authorities are in the process of implementing a strategy to restructure the debt into longer maturities.

29. To reduce contingent liabilities, the mission stressed the need to address the difficult financial condition of the STC and the CEB. The authorities indicated that the recently implemented automatic pricing mechanism for petroleum products will prevent the STC from accumulating further losses. Prices will be adjusted on a quarterly basis in response to changes in the international price of oil. The initial adjustments on April 2, 2004, which resulted in an increase in diesel prices, are unlikely to cause a significant rise in bus fares.

30. The CEB has been able to reduce its overdraft in the banking system from MUR 1 billion (around one percent of domestic credit) in September 2000 to MUR 300 million (about ¼ of a percent of domestic credit). However, this situation is expected to be reversed as the CEB incurs expenditure related to its transmission and distribution networks during the rest of 2004. Additionally, the CEB has significant debts with the government that it has not been servicing and faces unfunded pension liabilities. The authorities recognize the difficult financial position of the CEB and have been implementing a strategy to corporatize its operations, including through the setting-up of a new governance structure, the possible sale of part of the government’s shares, and the establishment of a utilities’ regulator. The authorities, however, remain noncommittal at this stage regarding an immediate adjustment in electricity tariffs.

D. Monetary and Financial Sector Policies

31. As mentioned above, the authorities have been pursuing an informal inflation targeting framework, and the BOM has established credibility in achieving its inflation objectives. The monetary programs adopted by the central bank have generally been successful, and over the last seven to eight years the BOM has exceeded its publicly announced inflation target only once, and by a small margin. In addition to primary sales of treasury bills/BOM bills, the BOM has used the Lombard rate to signal the direction of monetary policy. However, transactions at the Lombard facility have become infrequent and the Lombard rate has increasingly become disconnected from other interest rates. The mission suggested that the BOM adopt short-term interest rates as its operational target, mainly through the development of an active secondary market in government securities and BOM bills. This would provide a more direct link, through the yield curve, to banks’ lending behavior and the credit markets. It would also transparently indicate the intended direction of monetary policy and support the development of a more formal inflation targeting framework. The authorities responded that they were reviewing their monetary policy framework; they agreed that there was a need to target interest rates at the shorter end of the market.

32. The BOM agreed that the current situation of excess liquidity in the banking system largely reflects the drawdown of government deposits, weak credit demand, and the cautious attitude of banks toward credit risk. The mission argued that this excess liquidity could be a potential source of rapid money growth and inflationary pressures if credit growth was to pick up. The BOM agreed with this view and indicated that it had been attempting to absorb the excess liquidity through the issuance of BOM bills. However, given the weak prospects for some key sectors of the economy, the BOM believes that it is unlikely that credit growth will accelerate quickly and that the risk of an increase in inflation remains low.

33. Monetary policy faces the additional challenge of rising oil and other commodity prices and the impact that such imported inflation could have on the domestic price level. To date, this impact has been partly mitigated by the nominal strengthening of the rupee against the U.S. dollar. Looking forward, the authorities have indicated that their main focus is to prevent a rise in the core inflation rate by keeping inflationary expectations low.

34. The financial system in Mauritius is generally sound, but there is a need to mitigate and diversify the onshore banking sector’s credit risk concentration. Several steps have been taken to enforce limits on large exposures and related-party transactions, to subject deposit-taking nonbanks to BOM regulation and supervision, and to develop a comprehensive credit information bureau.10 The authorities were urged to pass the draft laws to revise the Bank of Mauritius Act—which would strengthen the independence of the central bank—and the Banking Act—to improve supervision and regulation—by the time of the announcement of the 2004/05 budget. The guidance notes on AML/CFT that have been issued are in line with recommendations of the FSSA and cover the strengthening of banks’ internal controls, customer identification procedures, and record keeping, and the identification and reporting of suspicious transactions. In addition, the authorities passed the Convention of the Suppression of the Financing of Terrorism Act 2003.

35. Development of an efficient corporate bond market would be an important alternative for institutional investors and would contribute to the overall stability of the banking sector. It would provide well-developed pension funds and insurance companies the option of investing in long-term Mauritian assets while spreading credit concentration in the banking sector. To encourage market development, the mission stressed that the tax rate on interest earned on corporate bonds should be harmonized with the rates on other financial instruments. The full development of this market, however, would need to be preceded by an active trading of government debts. In this regard, the mission welcomed the recent listing of government treasury bills on the Mauritian Stock Exchange.

E. Exchange Rate and External Sector Policies

36. The authorities agreed with the mission that the current managed float regime has served the country well. The exchange rate does not appear to be misaligned, and the real effective exchange rate has remained relatively stable in the last two years. The mission commended the authorities’ decision to limit intervention in the foreign exchange market to smoothing volatility in the exchange rate. BOM purchases in the foreign exchange market declined in 2003 and during the first three months of 2004 there was no intervention in the market. More generally, the mission supports the authorities’ view that for Mauritius to remain competitive, the best course of action is to achieve real productivity gains, rather than rely on a depreciating exchange rate.

37. The recovery in the tourism sector is expected to contribute to sustaining a current account surplus of 2½ percent of GDP in 2004/05. However, as a result of the expected decline in textile exports from the EPZ and a possible slowdown in sugar exports, the current account is expected to weaken over the medium term.

38. The external debt has been on a declining trend and remains sustainable in the medium term, even when subject to plausible shocks. The external debt is estimated to have declined from 25½ percent of GDP in 1999/00 to 19 percent in 2003/04. Stress tests indicate that even with combined negative shocks to the non-interest current account, real GDP growth, and the GDP deflator in 2004/05 and 2005/06, the external debt would rise to 31¾ percent of GDP in 2005/06 but would fall to 27½ percent in 2007/08.

39. Mauritius has no significant nontariff barriers, except with regard to state trading and monopoly imports of petroleum products. The maximum tariff rate is 80 percent (applicable to more than 10 percent of the total number of imported products), and the unweighted average nominal tariff rate is 18.5 percent. No major changes to the trade system have occurred since last year and the trade restrictiveness index is 6 on a 10-point scale, indicating a moderately open economy. The mission recommended a reduction in the number of nonzero tariff bands from eight to three, and urged the adoption of a preannounced medium-term tariff reform, which should include a lowering of the maximum and average tariff rates.

40. The mission encouraged the government to liberalize further its trade policies within COMESA and SADC agreements. While COMESA is planning to introduce a customs union by end-2004, conflicting areas will emerge concerning countries with dual membership in COMESA and SADC. Thus, the mission urged the authorities to coordinate their trade policies with the two institutions to avoid possible conflicts.

IV. Staff Appraisal

41. Mauritius’s main strength continues to be its public institutions. Strong governance, rule of law, a stable democratic system, and a predictable regulatory environment have served to promote investment and confidence in the economy. These characteristics should support the needed structural transformation of the economy in the face of an increasingly competitive global environment.

42. Growth in the past has been driven mainly by the high rate of domestic savings, with little reliance on external sources of financing. The growth process has also been defined by capital deepening rather than increases in productivity. The staff believes that, going forward, the elimination of trade preferences will imply that foreign direct investment and improvements in productivity will be critical to achieving high rates of growth.

43. The impending loss of trade preferences in sugar and textiles poses significant medium-term downside risks and heightens the need for rapid adjustment to the changing global environment. While some subsectors in the textile industry are likely to grow—where Mauritian firms remain competitive—other subsectors could suffer significant output and employment losses. Against this background, the country faces the challenge of significantly reducing costs and improving competitiveness.

44. The authorities are fully cognizant of these challenges and are taking appropriate steps to strengthen Mauritius’s key sectors. In this regard, it would be important to review the initial phase of the Sugar Sector Strategy in order to determine whether production costs have been reduced sufficiently to improve long-term viability, and to adopt any additional actions that might be warranted. The establishment of TEST to support the rehabilitation of viable textile enterprises is timely, and the proposed restructuring of corporate debts should provide firms the breathing space necessary to carry out the required reforms.

45. One of the fundamental reasons for the decline in competitiveness in the textile sector is the persistent rise in unit labor costs. For the restructuring of the sector to succeed, the current centralized wage setting system must be replaced by a system based on collective bargaining at the firm level. This would help ensure that there is a closer link between wage increases and productivity growth. In addition, the numerous regulations governing the conditions of employment in various sectors, which limit the ability of firms to redeploy and create jobs for low-skilled workers, should be promptly streamlined.

46. The authorities should be commended for their efforts to diversify the economy. Although the ICT sector is expected to grow more slowly than previously envisaged, the authorities rightfully see it not just as a pillar of medium-term growth but also as a platform that could transform the overall economy. While recognizing the importance of the leading role of the government in providing the necessary infrastructure for the sector, it will be critical to ensure that the risks are appropriately balanced between the public and private sectors. Additional efforts by the government to support growth in financial services, free port activities and tourism are also praiseworthy. However, greater opportunities for private sector participation should be provided for in the utilities, transportation, and commercial sectors. In this regard, the initiation of a public-private sector partnership framework is welcome.

47. Mauritius faces the challenge of achieving medium-term fiscal sustainability. Addressing this challenge requires a strong commitment on the part of the authorities, particularly in the run up to the election. Given the downside risks facing the economy, it is important not to postpone the difficult decisions that have to be made on the budget. Slower economic growth combined with a sudden rise in real interest rates could very quickly lead to unsustainable debt dynamics unless the fiscal deficit is brought down in the next several years. In particular, there is scope for broadening the tax base and prioritizing and rephasing capital expenditures. The adjustment path to fiscal sustainability is gradual, which would ensure that fiscal policy does not become unduly contractionary in the face of a possible slowdown in economic activity.

48. The credibility achieved by the BOM in reducing inflation is praiseworthy, especially in light of the relatively large budget deficits. Looking ahead, efforts are required to absorb the high levels of excess liquidity in the banking system, which poses the risk that inflationary pressures may reemerge. In addition, the monetary policy framework, in particular the use of the Lombard rate as a signaling rate, should be reviewed with a view to moving gradually toward targeting short-term interest rates, which would provide a more direct link to banks’ lending behavior and credit markets.

49. The mission welcomes the BOM’s policy of allowing the exchange rate to be mainly market determined. Despite the appreciation of the rupee against the U.S. dollar, the current level of the real effective exchange rate appears to be broadly appropriate. The staff agrees with the authorities on the need to foster external competitiveness through real productivity gains.

50. Staff welcomes the many steps that have been taken to strengthen the financial system. The authorities have responded positively to the recommendations of the FSAP carried out in 2003. Other actions should be considered to address potential vulnerabilities in the sector, such as encouraging greater participation by foreign banks in the domestic market. Further, development of an efficient corporate bond market would present an important alternative to bank financing and would contribute to the overall stability and soundness of the financial system by allowing institutional investors to diversify their portfolio and contributing to a reduction of credit concentration in the banking sector.

51. Staff recommends that the number of tariff bands be reduced, and that a preannounced medium-term tariff reform be adopted. This should include a lowering of the maximum and average tariff rates. Moreover, trade policies within COMESA and SADC should be coordinated to avoid conflicts.

52. It is proposed that the next Article IV consultation with Mauritius be held on the standard 12-month cycle.

Table 1.

Mauritius: Selected Economic and Financial Indicators, 1999/00-2003/04 1/

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Sources: Bank of Mauritius; Central Statistics Office; Ministry of Finance; and IMF staff estimates and projections.

Fiscal year from July to June.

Sugar crops and milling included in fiscal year harvested; otherwise, averages of calendar-year data.

Excluding changes in stocks.

Excluding the acquisition of aircraft and ships.

Unemployment rate as of the beginning of the FY.

Trade-weighted period averages (a negative sign signifies a depreciation). Figure for 2003/04 represent the percentage change from July to December 03.

In 2000/01, net lending includes the repayment of US$33 million and US$117 million of the FRN.

Changes in indicated aggregates as percent of broad money at the beginning of the period.

End-of-period maximum interest rate offered by banks on time deposits with maturities of between six and twelve months.

Since domestic savings are reported, savings minus investment do not equal the current account balance.

Including transfers, aircraft, and ships.

The reserves of the Bank of Mauritius are not pledged as collateral for short-term liabilities, nor are they sold forward.

Table 2.

Mauritius: Balance of Payments, 1999/00- 2007/08 1/

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Bank of Mauritius; Ministry of Finance; Mauritius Sugar Syndicate; and IMF staff estimates and projections.

Fiscal year from July to June.

In 2000/01, portfolio investment outflows include the repayment of the balance (US$117 million) of the floating rate note.

Including movements in international reserves of commercial banks.

Including valuation adjustments.

End of period.

Excluding the acquisition of aircraft and ships.

Market rate.

Table 3.

Mauritius: Summary of Government Finances, 1999/00-2004/05 1/

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Sources: Ministry of Finance; Bank of Mauritius; and IMF staff estimates and projections.

Budgetary central government, Government Finance Statistics basis, unless otherwise indicated; fiscal year from July to June. For 2004/05, the projection is based on the premise of acceptance of the fiscal measures proposed by the staff in Table 9.

In 2000/01, and 2001/02 net lending includes the repayment of US$33 million, US$111 million, and US$6 million of the international floating rate note (FRN) of US$150 million, respectively.

Exceptional factors include the repayment of the FRN on-lending equivalent to 1.4 percent of GDP in 2000/01, and 0.1 percent of GDP in 2001/02, as well as the proceeds from the sale of fixed assets equivalent to 0.4 percent of GDP in 1999/2000.

Overall balance after grants, excluding interest payments.

Table 4.

Mauritius: Monetary Survey, 2000-2004

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Sources: Bank of Mauritius; and Fund staff estimates.

Including claims on public enterprises.

The central bank bills hold by the non-banking financial institutions.

Table 5.

Mauritius: Indicators of External Vulnerability, 1999/00-2003/04 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Mauritian authorities; and IMF staff estimates and projections.

Fiscal year from July to June.

the figure of 2003-04 is related to the baseline scenario adopted in the fiscal framework.

End of period; maximum interest rate offered by banks on time deposits with maturities of between six and twelve months.

Excluding the acquisition of aircraft and ships.

The reserves of the Bank of Mauritius are not pledged as collateral for short-term liabilities, nor are they sold forward.

End of period. For 2002/03, as of end-Feb. 2004.

Bonds rated “Baa2” by Moody’s are considered as medium-grade obligations. For 2003/04, as of March 2004.

Table 6.

Mauritius: Financial Soundness Indicators for the Banking Sector, 1998-2003

(In percent, unless otherwise indicated)

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Source: Mauritian authorties and IMF/WB staff estimates.

Total of Tier 1 and Tier 2 capital, less investments in subsidiaries and associated companies.

Does not reflect deductions for investments in subsidiaries and associated companies.

The sectoral classification was changed in 2001. An attempt has been made to make a time-consistent series, but the numbers from 2001 onward may not refer to the exact same industries as those from before the date.

Refers to hotels and hotel management certificate companies only up to 2000, entire tourism industry after that date.

Part of the core set of financial soundness indicators.