Mauritius
Selected Issues and Statistical Appendix

The empirical study shows that the equilibrium real exchange rate in Mauritius has been affected by the terms of trade, as well as by other fundamental determinants. It assesses the challenges posed to Mauritius’s trade performance by the expiration of the preferential trade arrangements. It examines the empirical relationship among domestic prices, money, foreign prices, and the nominal exchange rate in Mauritius. The paper highlights Mauritius’s inflation, monetary and exchange rate policies and instruments, and also presents and estimates a model for the determination of domestic prices.

Abstract

The empirical study shows that the equilibrium real exchange rate in Mauritius has been affected by the terms of trade, as well as by other fundamental determinants. It assesses the challenges posed to Mauritius’s trade performance by the expiration of the preferential trade arrangements. It examines the empirical relationship among domestic prices, money, foreign prices, and the nominal exchange rate in Mauritius. The paper highlights Mauritius’s inflation, monetary and exchange rate policies and instruments, and also presents and estimates a model for the determination of domestic prices.

I. Preferential Trade Arrangements And The Equilibrium Real Exchange Rate OF The Rupee1

A. Introduction

1. Mauritius has achieved high growth rates since its independence in 1968 and has become a middle–income developing country. At independence, the economy was entirely dependent on the sugar crop, but its diversification into textile and clothing and tourism permitted sustained high growth and a favorable current account position. Despite fast growth in unit labor costs over the past three decades, the sugar and textile and clothing industries have remained competitive, partly because they have benefited from preferential trade arrangements in the EU (European Union) and United States markets. These arrangements have acted as implicit subsidies on the price of Mauritius’s exports and have affected the real effective exchange rate by improving competitiveness.

2. The empirical study described in the first part of the paper (sections B and C) shows that the equilibrium real exchange rate in Mauritius has indeed been affected by the terms of trade, as well as by other fundamental determinants, such as the current account, output, the interest rate, and the fiscal balance. Furthermore, the study reveals that the real effective exchange rate (REER) has not been significantly misaligned over the past 25 years, indicating that the exchange rate policy has been appropriate.

3. The second part of the paper (section D) assesses the challenges posed to Mauritius’s trade performance by the expiration of the preferential trade arrangements. The terms of trade are expected to worsen, which, in the absence of policy measures, would lead to a current account deficit and a weaker new equilibrium exchange rate. Policies that enhance competitiveness, contain inflation, and restrict the budget deficit would, however, reduce the depreciation of the equilibrium exchange rate and improve the underlying current account.

B. The Real Effective Exchange Rate, the Current Account, and the Fiscal Balance: Evidence 1970–2004

4.During the past three decades, price inflation in Mauritius has been higher than in its trade partners. The figure below plots price indices for Mauritius relative to an aggregate of countries with which it trades.2

uA01fig01

Relative Price, Mauritius’ Prices in terms of those of its Trade Partners,

(Indices, 2000 = 100)

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Source: International Financial Statistics, Information Notice System, and IMF Staff estimates.

5. Despite Mauritius’s rather high inflation rates compared to those of its trade partners, the developments of the real effective exchange rate suggest that competitiveness has increased over the past several decades. Hence, the relative price increase has been more than offset by nominal depreciation. The figure below plots four measures of the real effective exchange rate in Mauritius, each of which shows a real depreciation. The exchange rates adjusted for inflation of consumer prices and unit labor costs reveal a more moderate real depreciation than do the GDP deflator and the export price. The latter two price measures also take into account traded goods and are hence more likely to reflect the favorable prices introduced by preferential trade arrangements.

uA01fig02
Source: International Financial Statistics, Information Notice System, and IMF Staff estimates.

6. Because of high export earnings, Mauritius has posted a sustained high domestic saving rate over the past several decades. However, export revenues are expected to fall with the loss of preferential trade arrangements, and it is questionable whether Mauritius can maintain the saving rate at its current level. A lower saving rate could impede investment and economic growth prospects. The outlook is worsened by a large public deficit, which crowds out domestic investment because it is financed largely by domestic credit.

7. A deterioration in the savings–investment position will be matched by a deterioration in the external current account, as the additional domestic consumption and investment goods will have to be imported from abroad. As seen in the figure above, the fiscal deficit has been positively correlated with the current account deficit. Hence, a sustainable current account balance is intrinsically linked to a sustainable fiscal deficit. In the medium term, therefore, it is indispensable to limit the fiscal deficit in order to constrain the current account deficit.

uA01fig03

Fiscal Balance and External Current Account Balance, in Percent of GDP

(Deficit (–))

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Source: International Financial Statistics and World Economic Outlook.

C. The Macroeconomic Balance Approach

8.The macroeconomic balance approach is used to find the equilibrium real exchange rate that is consistent with domestic and external balances, given the terms of trade subsidy implied by preferential trade arrangements. The approach is based on the accounting identity that, at any point in time, equates a country’s current account balance (CAt) with the excess of domestic saving (St)over domestic investment (It):

CAtSt-It(1)

where St – It is a measure of the net outflow of saving. A current account deficit thus implies a net inflow of private and official capital, which again requires a surplus on the capital and financial account. The current account depends on factors affecting trade and income flows, such as the real exchange rate (reert), the terms of trade (tott), the level of aggregate demand (yt), and other factors (zt).

CAt=α1reert+α2tott+α3yt+α4zt.(2)

The lower the value of the exchange rate and the higher the terms of trade, the more competitive is the economy, which tends to improve the current account balance. The impact of aggregate demand is ambiguous, depending on whether import changes are offset by export changes.

9. The domestic savings–investment balance is determined by domestic factors such as the interest rate (it), aggregate output (yt), and the fiscal position (ft).

St-It=β1it+β2yt+β3ft+β4vt.(3)

A higher interest rate would encourage higher savings and lower investment, hence tending to improve the domestic savings net of investment position. Higher aggregate output would also be expected to have a positive impact on the domestic savings net of investment position. The government’s savings net of investment position is directly affected by the fiscal balance, and would be positively related to the aggregate savings–investment position.

10. The first step of the empirical method is to estimate a long–run model for the underlying current account position based on its long–run determinants (the real effective exchange rate, the terms of trade, and aggregate demand) as in equation (2).3 The second step involves estimating an equilibrium savings–investment position, based on the long–run determinants given in equation (3). The third step is to calculate the real exchange rate that equilibrates the underlying current account position, obtained in the first step, with the long-run savings net of investment position, obtained in the second step.

11. In the short run, the country’s current account and savings–investment position, and the determinants of these positions are highly volatile variables. In the long run, however, the variables are expected to converge to equilibrium relations. The long–run equilibrium in the external and domestic sector is estimated simultaneously in a vector errorcorrection model using annual data from 1980 to 2004.4 The estimated model, with standard errors and likelihood ratio test of the imposed restrictions can be found in the Appendix.

12. The long–run equilibrium of the current account is estimated in a vector errorcorrection model with two vectors, to identify the impact of the long–run determinants on exports and on imports. Exports, measured in terms of GDP, are found to be higher when the economy is more competitive—that is, when the real exchange rate is lower and the terms of trade are higher:5

expt/GDPt=-3.5×reert+6.1×tott+10.0.(4)

13. Imports are found to be lower when the rupee is strong and when terms of trade are unfavorable:

impt/GDPt=-0.8×reert+4.0×tott.(5)

14. Combining equations (4) and (5) yields the equilibrium level of the real effective exchange rate as a function of the equilibrium level of the external current account:

reert=0.8×tott-0.4×cat/GDPt+3.6.(6)

While it is often found that exports decline when the exchange rate is strong, the finding that imports are negatively related to the real exchange rate is less frequent. It implies that the income effect is more important for imports than the substitution effect. The combined effect is, however, the expected negative relation between the real exchange rate and the current account.

15. The long–run equilibrium savings–investment position is assumed to depend on aggregate output, the interest rate, and the government’s budget position. The long–run equilibrium of the savings–investment position is equivalent to the long-run equilibrium of the current account balance and can be described as follows:

cα/GDPt=0.9×f/GDPt+0.1×it+0.6.(7)

16. Hence, a 1 percent increase in the fiscal deficit leads to a 0.9 percent increase in the current account deficit (both in shares of GDP). As expected, the interest rate has a positive impact on the savings–investment position.

17. To find the long–run equilibrium savings–investment position, the long-run stochastic trends of the variables are extracted with a Hodrick–Prescott filter and combined using equation (7).

uA01fig04

Savings–Investment Position, in Percent of GDP

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Source: International Financial Statistics and IMF Staff Estimates.

18. We assume that the equilibrium savings–investment position is domestically determined, in accordance with the theoretical model. Given the accounting identity in equation (1), it can substitute the equilibrium external current account balance. Together with the stochastic long–run trend of the terms of trade, this substitution determines the long–run equilibrium real effective exchange rate. Although the real effective exchange rate is currently stronger than the equilibrium exchange rate, it is not found to be significantly misaligned.

19. The results suggest that, despite the terms of trade distortion introduced by the preferential trade arrangements, exchange rate policy in Mauritius has been adequate. In the following section, the expected impact of, and appropriate policy response to, the reversal of the terms of trade is discussed.

uA01fig05

Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Source: Information Notice System and IMF Staff estimates.

D. Competitiveness and the End of Preferential Trade Agreements

20.The expiration of quotas in world textile and clothing trade on January 1, 2005, and the upcoming phasing out of trade preference agreements for sugar exports to the EU are strongly affecting Mauritius’s economy, given these sectors’ importance (see Table 1).

Table 1.

Mauritius: Contribution of the Export Processing Zone (EPZ) and sugar sector to GDP, Employment, and Exports

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Sources: Central statistics office; and IMF staff estimates.

21. The mainly textile–based export processing zone (EPZ) was established in the late 1970s.6 During the subsequent two decades, annual real growth rates of the EPZ averaged about 10 percent, and the EPZ became a cornerstone of the economy. During this period, Mauritius’s EPZ industry benefited from the Multi–Fiber Agreement (MFA) which was more restrictive toward exports from countries with lower production costs than Mauritius. The phasing out of quotas under the World Trade Organization Agreement on Textiles and Clothing (ATC) started in 1995. However, the quotas for a large share of Mauritius’ textile and clothing export products to the EU and the United States were in place until January 1, 2005. 7 Therefore, Mauritius’s textile and clothing export are expected to decline further.

22. Mauritius is vulnerable to the expiration of the quotas under the ATC because (i) about 90 percent of its EPZ exports go to ATC countries8 (see Table 2) and (ii) its labor costs exceed those of its competitors that were previously restricted by the quotas (see Table 3). Low–cost textile and clothing produced in the People’s Republic of China and India are expected to dominate the market in the ATC countries, lowering the world prices of these products. In the context of Mauritius’s weak external competitiveness, the lower world prices would cause its share of global textiles and clothing exports to drop further.9

Table 2.

Mauritius: Total EPZ Exports by Country of Destination, 2001–04

(In percent)

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Source: Central statistics office.
Table 3.

Textile and Apparel: Hourly Compensation for Selected Countries, 2002 1/

(U.S. dollars)

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Source: U.S. International Trade Commission.

Including wages and fringe benefits.

23. The expiration of textile quotas at end–2004 has already strongly affected Mauritius’s economy. EPZ exports fell by 12 percent in the first quarter of 2005, compared with the same quarter of the previous year, inducing a marked deterioration of the trade balance. However, in anticipation of the expiration, EPZ production fell even more during the same period, by 21 percent, and enterprises shut down, resulting in a 13 percent fall in EPZ employment.

24. The sugar sector in Mauritius is also likely to experience difficulties, because of the phasing out of preferential agreements for sugar exports to the EU.10 These agreements guaranteed sugar prices at more than 300 percent of the world market price for a given quota. Mauritius’s exports to the EU accounted for more than 95 percent of total sugar exports in 2004. Following a proposal from the EU Commission, the price of white sugar could be reduced by 39 percent over the next four years.

25. The difficulties Mauritius’ face in its textile and clothing and sugar sectors are likely to be compounded by the loss of preferential trade agreements with the EU and the United States. Through its former status as a developing county, Mauritius was able to benefit from trade agreements that granted duty–and quota–free access for some products to the EU market (the agreements for African, Pacific, and Caribbean countries, APC) and the U.S. market (the African Growth and Opportunity Act, AGOA). As of 2001, Mauritius is no longer considered a least developed country for the EU; hence, it cannot participate in the Everything But Arms (EBA) Agreement. Furthermore, AGOA III states that Mauritius will not be able to benefit from least developed status in exports to the United States from 2008, implying that it will not be exempted from the third-country fabric provision.11

26. The government has initiated reforms to bolster the country’s competitiveness in the textile and apparel and sugar sectors and to encourage the expansion of tourism, financial services, and information technology. The outlook hinges on Mauritius’s ability to improve efficiency and productivity, but its proven capacity to adapt to a changing economic environment, its strong institutions, and high level of human capital and social cohesion suggest that the country will be able to find ways to adopt its economic structure so as to ensure sustainable growth.

27. If Mauritius does not implement macroeconomic policies, a deterioration of the current account as a result of a negative terms of trade shock would put downward pressure on the exchange rate. If the real exchange rate is allowed to depreciate fully after a terms of trade deterioration, the ratio of the current account to GDP in the new equilibrium is unchanged, see (Figure 1). However, if the real exchange rate is not allowed to depreciate (see Figure 2) the new equilibrium current account and the savings–investment position have to deteriorate.

Figure 1.
Figure 1.

The Real Exchange Rate Depreciates to Adjust to New Equilibrium

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Figure 2.
Figure 2.

The Real Exchange Rate Does Not Depreciate to New Equilibrium

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

28. The estimated equation (6) for the equilibrium real effective exchange rate shows that a terms of trade deterioration would put downward pressure on the exchange rate. Given that exports are more sensitive than imports to terms of trade shocks, the external current account balance would be expected to weaken. Although the Bank of Mauritius’s net international reserves are currently at a comfortable level, reserves clearly cannot finance a current account deficit resulting from a permanent fall in competitiveness. However, to prevent a significant exchange rate depreciation and loss of reserves, the authorities can adopt policies that improve the fundamental determinants of the real exchange rate.

29. In accordance with the estimated model, monetary and fiscal policy can improve fundamentals and, hence, lessen the burden of adjustment on the real exchange rate. First, in line with the estimated model, tight monetary policy through a high interest rate has a favorable impact on the current account. Tight monetary policy also makes assets denominated in domestic currency more attractive and therefore reduces downward pressure on the real exchange rate. Second, tight monetary policy contains domestic inflation and, hence, also tends to limit the need for the exchange rate to depreciate. Third, the fiscal balance positively affects the external current account position because changes in the fiscal position tend to have “non–Ricardian” effect. In particular, an increase in the fiscal surplus is not fully offset by a decline in private saving and therefore has a positive effect on the savings–investment balance.

30. The adverse effect of the terms of trade deterioration can also be offset by measures that directly improve competitiveness. First, productivity can be improved through investments, including in human capital through education and in new technologies. Second, productivity can be further enhanced through an easing of labor market regulations, which would provide workers with stronger incentive systems. A softening of regulations would also encourage investment, including foreign direct investment. Third, decentralization of the wage–setting system could strengthen the link between productivity and wages and avoid high wage inflation in less competitive sectors.

E. Conclusion

31. The equilibrium real exchange rate in Mauritius is determined by the terms of trade, the current account, output, the interest rate, and the fiscal balance. Over the past 25 years, the rate has not been significantly misaligned, indicating that the exchange rate policy has been appropriate. During this period, Mauritius’s terms of trade have been positively affected by preferential trade arrangements for sugar and textile and clothing products.

32. The end of privileged access poses a serious challenge to the macroeconomy, but an adequate policy response could prevent the real exchange rate from bearing the burden of adjustment. Measures to restrict the fiscal deficit, keep monetary policy tight, improve productivity, and create a more competitive economy will be crucial to restore macroeconomic balances.

F. Appendix

Data from the International Financial Statistics

The data, with the exception of the real effective exchange rate, is taken from the International Financial Statistics (IFS) database.

The data for the external sector are exports and imports of goods and services as a share of GDP, the terms of trade, and the real effective exchange rate. All variables are in logarithms. Exports and imports of goods and services and gross domestic product are denominated in billions of current Mauritian Rupees. The terms of trade are defined as the ratio of the unit value of exports to the unit value of imports. The real effective exchange rate has been calculated using the data for Mauritius and its trading partners; GDP deflators and nominal exchange rates from the IFS database and trade weights from the Information Notice System. Mauritius trading partners are (in decreasing order of importance): France, Germany, the United States, the United Kingdom, Japan, South Africa, Italy, Belgium, Singapore, the Netherlands, Taiwan Province of China, Hong Kong SAR, Spain, Switzerland, India, Korea, Canada, People’s Republic of China, and Thailand.

The additional data for the domestic sector are the money market rate (in basis points) and the budget deficit as a share of GDP.

Unit Root Tests

The augmented Dickey–Fuller test finds that all variables can be described as unit root processes, with the exception of the interest rate, for which the test cannot reject stationarity at the 1 percent significance level. In the table below * and ** denote significance at the 5 and 1 percent significance level, respectively.

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Residual Misspecification Tests

Despite the short sample, the residuals are well–behaved. The normality test consists in testing whether the skewness and kurtosis of the variables corresponds to that of a normal distribution. It rejects normality for the vector for the terms of trade series, but this is however not sufficient to induce rejection of normality for the system. The ARCH (Auto Regressive Conditional Heteroscedasticity) test cannot reject normally distributed residuals.

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Estimated Model

The sample is 1980 to 2004.

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II. Inflation and Monetary Policy in Mauritius12

A. Introduction

1. Inflation forecasting, which is a crucial input in any inflation targeting (IT) regime, is still rudimentary in Mauritius. The Bank of Mauritius (BOM) is developing a medium–term analytical framework specifying the monetary transmissions of monetary policy. An IMF study modeled the demand for real money balances in Mauritius13 but did not derive the implications of the model for the determination of inflation and for monetary policy purposes.

2. The goal of this paper is to start filling this gap. It examines the empirical relationship among domestic prices, money, foreign prices and the nominal exchange rate in Mauritius and whether the BOM’s interventions in the foreign exchange market influenced the conduct of monetary policy. The paper also derives policy implications that are applied to Mauritius’ current challenges: the removal of external trade preferences and the planned adoption of a full–fledged IT regime.

3. The paper is organized as follows: Section B is a brief overview of Mauritius’ inflation, monetary and exchange rate policies and instruments during the period under analysis (1977:Q2 to 2004:Q4). Section C presents and estimates a model for the determination of domestic prices. The main findings and policy implications are presented in section D and E.

4. The main findings are as follows:

  • The pass–through of changes in the nominal exchange rate to changes in domestic prices is moderate. This is consistent with the BOM’s previous findings and with the existence of administered prices; however, the recent partial liberalization of domestic petroleum product prices is an important reason to expect a higher passthrough in the immediate future;

  • a one percent shock to money supply would increase prices by 0.70 percent,

  • income elasticity of real money demand is very high, reflecting the process of financial deepening in Mauritius during the period under analysis; a one percent increase in real income would increase real money demand by 2.33 percent;

  • money supply was found to be endogenously determined. This finding is consistent with a focus on achieving exchange rate goals.

5. The main policy implications are as follows:

  • the positive correlation between exchange rate movements (and money supply) and domestic prices is the basis for recommending some tightening of monetary policy to counteract inflationary pressures, derived from the removal of trade preferences, the depreciation of the rupee and higher world oil prices;

  • an important precondition for a successful adoption of a formal IT regime would be to limit BOM interventions in the foreign exchange market to smoothen out short term volatility. This would avoid adopting potentially contradictory (and in the end self–defeating) goals in the foreign exchange and money markets and would increase the efficiency of current instruments of monetary policy.

B. Background

6. Mauritius’ inflation has decreased over time, as a result of an increased commitment by the BOM to price stability, and the introduction of more efficient instruments of monetary policy. However, it remains above inflation in trade partner countries. Although the BOM has started to announce inflation targets in 1998/99, Mauritius has been identified as an “inflation targeting lite” (ITL) country, in light of its specific mix of exchange rate and monetary policies.

Figure 1.
Figure 1.

Mauritius. Domestic Inflation and Inflation in Trade Partner Countries.

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Sources. Bank of Mauritius, IMF, International Financial Statistics and staff estimates. (M3= March).

7. Since its creation in 1967, the BOM has been concerned with price stability. However, during its first years, as in most countries at that time, price stability was not its overriding policy goal.14 The BOM gave high priority to an exchange rate policy that could ensure the competitiveness of Mauritius’ export sectors. More recently, the BOM has increasingly focused on price stability. In its 1996/97 annual report, the BOM began announcing an inflation target for the subsequent year.

Table 1.

Mauritius. Inflation Targets (for one–year-ahead) and actual (year-to-year) inflation

(in percent)

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Source: Sacerdoti and others (2005)

8. The implementation of monetary policy in Mauritius has evolved from a strong reliance on direct monetary instruments, such as credit ceilings, to a gradual introduction of market–based instruments. Weekly auctions of treasury and BOM bills were introduced in 1991. In 1993 the BOM introduced a framework for the programming of reserve money and the forecasting of liquidity. A signaling rate was introduced in 1994.15

9. Although the exchange rate policy has also become more liberal over time, the BOM still intervenes in the foreign exchange market. In 1983, Mauritius moved from a fixed to a managed exchange rate regime, and the BOM has continued intervening in the foreign exchange market through sales, purchases, and repurchase agreements (repos) of U.S. dollars.16 Given the size of the net interventions in terms of the monetary aggregates, their impact on monetary aggregates, on the adoption of high inflation targets (relatively to inflation rates in trade partner countries), and on achieving the targets cannot not be disregarded.17

10. Stone (2003) explains that ITL should be understood as a transitional regime designed to buy time for the authorities to implement the structural reforms needed for a single credible nominal anchor. During this time, ITL countries float their exchange rate and announce an inflation target but are not able to maintain the inflation target as their foremost policy objective.18

Table 2.

Mauritius. Bank of Mauritius’ Interventions in the Foreign Exchange Market

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Sources: BOM and IMF staff estimates

C. Methodology and Data

11. In a small open economy like Mauritius, inflation is expected to be influenced by both monetary and external factors in the long run. The purchasing power (PPP) theory suggests that arbitrage in goods markets in different countries ensures that domestic price levels are equal to foreign price levels, once all prices are converted into a common currency.

(1)p=q-e;

where p is Mauritius’s CPI index; e is the nominal effective exchange rate; and q is a weighted average of CPI indexes in Mauritius’ trade partners

(2)ms-p=md(y,im,inm),

Equilibrium in the domestic money markets would ensure that the real money supply (ms − p ) would be equal to the real money demand md (y, im, inm ), defined as a positive function of real income (y ) and the interest rate on domestic monetary assets (im ); and as a negative function of the interest rate on nonmonetary assets (inm ). Domestic monetary assets were defined as deposits in rupees for up to one year (depav). One–year domestic treasury bills (TB) and one-year deposits in U.S. dollars in the London interbank market (L) are used as competing nonmonetary assets. Summing up, the proposed long-run relations are as follows:

(1')p=a1e+a2qand
(2')p=b1y+b2m2+b3idepav+b4iTB+b5il,

12. Some distortions to the relations defined above are also expected from the existence of administered prices on about one third of the items in the consumer price index (CPI) basket items.19 The main administered prices were: petroleum products, liquefied petroleum gas (LPG), flour and rice, whose importation and domestic commercialization has been monopolized by the State Trade Corporation (STC).

13. The analysis of the time series properties of the variables indicated above suggest that an error–correction representation should be used to estimate the long-run relations among the variables, as well as their short-term responses to specific shocks. The intuition of this approach is that prices change over time in response to deviations from long–term equilibria in the goods and money markets. The vector auto-regression (VAR) included two lags to capture the short-term dynamics of inflation. All the variables are expressed in logs except interest rates. This study used quarterly data for the period 1977:Q2 to 2004:Q4.

D. Long–Term Relations

14. The restricted coefficients obtained were as follows: 20

(1'')p=-0.23e+0.89qand
(2'')p=-1.7y+0.74m2-0.014idepav+0.007iTB+0.001iL

All the coefficients have the right sign and are significant at the 1 percent level, except Libor. The model rejects PPP for Mauritius in equation (1”): a depreciation (appreciation) of the exchange rate increases (decreases) domestic prices by less than the nominal depreciation in the long run; a decrease (increase) in foreign prices, decreases (increases) domestic prices by about 90 percent of the foreign price change. The less–than-perfect pass-through mechanism is consistent with previous findings by the BOM and with the existence of administered prices. Equation (2”) indicates, that in the long-term, 74 percent of the increase in broad money will be reflected in price increases.

15. When the coefficient on m2 is restricted to 1 in equation (2’’’), this equation has all the properties of a real money demand function in that real money demand is positively related to output, negatively related to the return of nonmonetary assets and positively related to the return of monetary assets.

(2''')m-p=2.32y+0.021idepav-0.01iTB-0.001iL

The estimated income elasticity of real money demand is 2.32. This implies that on average the increase in the demand for broad money has been more than twice the increase in real output, which reflects the speed at which financial deepening has taken place in Mauritius.21

E. Policy Implications and Short–Term Dynamics of Adjustment

16. To draw policy conclusions, the issue of whether the variables should be treated as (weakly) exogenous or endogenous and how they interact in the short term becomes important. The analysis of the adjustment parameters indicates that prices are endogenously determined in both equations; that is, prices adjust to restore deviations from long–term equilibria in both the goods and money markets. As expected, foreign prices, broad money, and the interest rates are (weakly) exogenous22 in the first equation.

17. One important finding is that m2 was found to be endogenous in the money demand equation, which is consistent with a policy focus on the exchange rate as well as with possibly insufficient coordination between fiscal and monetary policies. The importance given to the real exchange rate has motivated the BOM’s large (as a proportion of monetary aggregates) interventions in the foreign exchange market. Insufficient coordination between monetary and fiscal policy has also been observed at times.23

18. Output was found to be endogenous in the real demand function whereas interest rates were found to be (weekly) exogenous. The endogeneity of m2 and output draws attention to the need to model these two variables explicitly in order to have a more accurate picture of feed–backs and interactions. The exogeneity of interest rates in the money demand equation is consistent with a deliberate tightening of monetary policy in response to pressures on prices.

19. The analysis of the short–term dynamics of the adjustment indicates that most of the total impact on domestic prices of a shock to the nominal effective exchange rate would take place during the first five quarters. A positive shock to money (an increase in money supply) would lead immediately to a temporary increase in output and, in about five quarters, to price increases.

Figure 2.
Figure 2.

Mauritius: Inflation, m2, and Real GDP Growth Rates.

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Sources. Bank of Mauritius; and IMF staff estimates.
Figure 3.
Figure 3.

Mauritius. Velocity of Monetary Aggregates, Interest Rates and Inflation

Citation: IMF Staff Country Reports 2006, 224; 10.5089/9781451827835.002.A001

Sources: Bank of Mauritius, and IMF staff estimates.

F. Conclusions and Policy Recommendations

20. Like Kandheval (2002), we found that there is a stable relationship among broad money, income, and a set of interest rates over the sample period in Mauritius. The apparent stability of real money demand makes it a useful indicator for policy. However, the endogeneity of broad money (and output) in the money demand equation draws attention to the need to model these two variables explicitly in order to have a more accurate picture of feed–backs and interactions.

21. As expected, inflation in Mauritius is determined by domestic and external factors. However, the pass–through mechanism is affected by the existence of administered prices. Changes in the nominal exchange rate and in money supply are not fully reflected in the CPI. To follow up on these findings, studies of the response of subsets of prices to shocks to the exchange rate or the money supply would be appropriate. The income elasticity of real money demand is very high, reflecting the increased willingness of the Mauritian population to hold broad money, as confidence in the banking system grew over time.

22. The results of this paper also reflect the priority given to the exchange rate policy during the period under analysis. The endogeneity of broad money is consistent with a monetary–exchange rate policy that has prioritized a certain real exchange rate level.

23. Full adoption of an inflation targeting regime in the future would require to switch (from the present managed float) to a freely floating exchange rate regime, with interventions in the foreign exchange market only motivated by short–term volatility. At present, Mauritius’s monetary policy has many of the features that characterize an inflation targeting regime (Box 1), in particular, its long tradition of strong independent public institutions, including an independent central bank; a highly developed banking sector; and a reliable production of the macroeconomic data necessary for inflation forecasting. However, substantive work lies ahead in order to lay the foundation of a successful inflation targeting framework (Box 2).

What is Inflation Targeting?

Inflation targeting has been described by Mishkin (2004) as comprising five elements: 1) the public announcement of medium–term numerical targets for inflation; 2) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated; 3) a model in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments; 4) increased transparency of the monetary policy strategy through communication with the public and the market about the plans, objectives and decisions of the monetary authorities; and 5) increased accountability of the central bank for attaining its inflation objectives. The list clarifies that inflation targeting entails more than a public announcement of numerical targets for inflation for the year ahead. This is important for emerging market countries, many of which routinely report numerical inflation targets or objectives as part of the government’s economic plan for the coming year. However, their monetary policy strategy should not be characterized as inflation targeting, which requires the other four elements to be sustainable over the medium term.

Recommended Preconditions for the Implementation of a Successful Inflation Targeting Regime24

Before launching a full–fledged inflation targeting regime, Mauritius needs to lower its fiscal deficits and debt; improve the coordination between fiscal and monetary policies; implement the structural reforms necessary to help the economy recover from the real terms of trade shock represented by the removal of trade preferences; undertake additional efforts to increase the deepening of financial markets, in particular the money market; and refine its set of monetary instruments.

The literature has agreed on the conditions that need to be in place in countries that wish to implement a formal inflation targeting framework:

Monetary policy should not be dominated by fiscal priorities. Therefore, the government should raise the bulk of its funding in financial markets. Institutional arrangements can help contain concerns that fiscal deficits might be monetized by the central bank (for example, the use by the central bank of treasury bills’ secondary market instead of the primary market for monetary purposes).

Exchange rate objectives must be clearly subordinated to the inflation target. The central bank should make clear that foreign exchange market interventions and changes in the policy interest rate intended to influence the exchange rate are designed only to smooth the effects of temporary shocks. If a country’s external position requires corrections, it should be dealt with through fiscal policy or structural policies.

The financial and corporate sectors should be sound enough to enable the authorities to pursue the inflation target and not be sidetracked by concerns about systemic defaults. Issues that could interfere with the implementation of monetary policy are the probability of a large bail–out of financial institutions, a large debt burden of bank clients, and excessive foreign exchange exposure of banks and/or bank clients. These weaknesses may be reinforced by interest rate increases or a depreciation of the exchange rate and constraint monetary policy choices.

Financial markets should be well developed. They should be enable monetary policy to be implemented using market–based instruments and ensure that the conduct of monetary policy is not complicated by weaknesses in financial market infrastructure. Deep and liquid financial markets help to absorb shocks and contribute to the transmission of monetary policy.

Existence of proper tools to implement monetary policy in support of the inflation target. A central bank should be in a position to influence inflation through its policyinstruments and have a reasonable understanding of the links between the stance of policy and inflation.

Mauritius: Selected Issues and Statistical Appendix
Author: International Monetary Fund