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Effects of fiscal policy on the conduct and transmission mechanism of monetary policy in
Mauritius
Abstract
In view of analyzing the effects of fiscal policy on the conduct and transmission mechanism of
monetary policy in Mauritius, this paper reviews key features of the operational framework for
fiscal and monetary policies and interaction between the two main policy authorities, providing a
brief description of the evolution over the years. The trend in monetary policy as well as fiscal
policy and their impact on various macroeconomic variables are analyzed to identify the
effectiveness and constraints of the current macroeconomic framework.
By Dooneshsingh Audit1
The views expressed in this paper are those of the author and do not necessarily reflect those
of the Bank of Mauritius. I am grateful to colleagues participating at the validation workshop
organized by the COMESA Monetary Institute, in particular, Mr. Chileshe Mumbi Patrick and Dr.
Mustafa Mohamed Abdalla, for their valuable comments and suggestions on the draft version
of this paper. General disclaimer applies.
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Contents
Introduction
Section I: Theoretical and Empirical Literature
Section II: Evolution and features of Monetary Policy
Section III: Evolution and features of Fiscal Policy
Section IV: Analysing the interaction between Monetary Policy and Fiscal Policy
Section V: Comparing current monetary policy framework with best practice
Section VI: Monetary policy framework and Inflation expectations
Section VII: Has monetary policy accommodated fiscal policy?
Section VIII: Putting all the pieces together and Policy Recommendations
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Introduction
The macroeconomic policy practice in Mauritius has undergone several transformation during
the course of its development. The evidence until now suggests that those changes have worked
well for the country with each stage of development being somewhat well-prepared by conscious
decision-making in terms of policy design and implementation.
While the design and practice of monetary and fiscal policies have undergone several
conversions over the course of the economic development of Mauritius, the country has
maintained an overall policy mix that is credible and delivered a number of positive outcomes.
The evolution of the structure of coordination between monetary and fiscal policies has adapted
to the different needs of the stages of development. The current structure of coordination
between monetary and fiscal policies rests upon a well-developed banking and financial sector
that has allowed the price discovery process for the government debt securities to work relatively
efficiently. This essential feature allows monetary policy to operate independently focusing on
the objective of maintaining price stability and promoting orderly and balance economic
development.
Section I: Theoretical and Empirical Literature
The very existence of fiscal and monetary policies of a country is to generate welfare gains for
its citizens. Welfare gains could be in terms of full employment, low inflation, contained income
inequalities and sustainable development. Most of the decisions related to achieving these
objectives rest with the fiscal authorities while monetary authorities provide service to these
objectives by ensuring that some of the conditions for fulfillment for these objectives are put in
place. This assertion can be traced back to the origins of monetary policy. However, the limits
of fiscal action are set by the resources available to the country, more precisely, the intertemporal budget of the country. When government revenues fall short of government
expenditure for its efforts towards desirable objectives, the government borrows in one time
period for repayment in later time periods. This process is sustainable as long as the government
commands credibility over the ability to repay its debts, which in turn depends on the level of
existing debt, proposed size of fiscal deficit, debt servicing conditions, size of the economy and
the rate at which it is growing.
The government can thus borrow as long as there is a demand for its bonds or other forms of
securities. If investors perceive the fiscal path of the government as unsustainable, they would
rate government bonds as too risky and would thus either limit their exposure to such assets or
lend at higher interest rates. Government borrowing thus is constrained by the real stock of
government bonds investors are willing to hold and the interest rate on those bonds. The
monetary authorities can influence these two constraints by adjusting the money base or
influencing short-term interest rates. An increase in money supply, ceteris paribus, would cause
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inflation to rise and the real stock of government bond held by investors to fall and thus induce
them to demand more government bonds.
Alternatively, an increase in money supply or through the adjustment of the key policy interest
rate of the economy, interest rates could be depressed to relax the constraint on fiscal authorities.
An increase in money supply could simultaneously have implications for the exchange rate, in
terms of depreciation of the domestic currency that could lead to pick-up in inflation and again a
fall in the real stock of government bonds held by investors. A depreciated currency also allow
the government to reduce its financing cost with past debt having lower real value and increase
its nominal revenue through ‘seignorage’, the inflation tax. Seignorage has its origins in ancient
times when it represented a fee that the royal mint collected from the public to convert their
holdings of bullion into coins. Other governments resorted to debasement, wherein government
would call in the coins, melt them down and mix them with cheaper metals. The practice of
debasement was widespread in the later years of the Roman empire and the French monarchs in
the fifteenth century, unable to collect more normal taxes, used debasement as a form of inflation
tax to finance the ‘Hundred Years War with the English’. Intrinsically, the modern time
‘seignorage’ is no different from those practices, with government debt contracted at a value of
money more than the value of money that it is being repaid through inflation, although the net
effect is partly mitigated through payment of interest.
With seignorage providing support to fiscal policy, the policy debate moved to whether fiscal
policy and monetary policy were independent or some form of influence was being exerted by
the fiscal authority on monetary policy or some coordination prevailed between monetary and
fiscal authorities with both having predetermined objective. This literature revolves around the
issue of ‘rules versus discretion’ and ‘independence of the central bank’. Another strand of this
literature builds on the seminal paper by Sargent and Wallace (1981) that argues that even if
fiscal policy and monetary policy are set independently, the monetary authority will have to
adjust to restore equilibrium after some lags. Sargent and Wallace (1981) introduce the concept
of “monetary dominant” regime, where the monetary authorities independently set monetary
policy and “fiscal dominant” regime, where the fiscal authority independently sets the budget
with implications for inter-temporal budget constraints on monetary policy. They show that even
under monetary dominance, tighter monetary policy in one time period leads to loose monetary
policy in later period due to the need to pay interest on bonds issued and the continuous growth
of the economy. With tighter monetary policy and continuously expanding economy, fiscal
levers might become exhausted, constrained by either higher interest cost or ability to issue
additional government bonds. Ultimately, the monetary authority has to respond by making
monetary policy loose.
Sargent and Wallace (1981) rational has been deepened and been confirmed by other models and
growing mix of empirical and theoretical papers. Canzoneri, Cumby and Diba (1997) and others
show that when the inter-temporal budget constraint is set, the price level remains the only
variable that can adjust to restore equilibrium. Along these lines, papers in the literature attempt
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to provide answers to whether the price level is determined by the needs of fiscal solvency – this
group of literature has been referred as ‘the fiscal theory of the price level’. The first-generation
models of balance of payments crises show how the inconsistency between fiscal policy
fundamentals and the exchange rate peg leads to abandonment of the peg (Krugman, 1979). The
impact of fiscal fundamentals on the exchange rate has been shown in the literature, not only
through theoretical models, but also in documentation of various crises. Even with managed
floating regime, if an important part of the government debt is in foreign currency, fiscal
mismanagement has ultimately led to crises. Directly or indirectly, fiscal policy has important
implications for monetary policy.
Fiscal solvency have various implications for the overall credibility of the policy framework in
place in a country and weighs significantly on the prices in the economy, including interest rate,
sovereign spreads and the exchange rate. Higher deficits are generally associated with higher
medium term and long-term interest rates. Unsustainable fiscal path, if not resolved lead to
crises. Government debt to GDP that exceeds a certain threshold causes the country’s sovereign
ratings to worsen and thus lead to wider spreads and higher interest rates. This in turn leads to
depreciation of its currency and ultimately to higher inflation.
The advent of inflation-targeting, emergence of ‘Taylor’s rule’ and more work on the benefits of
independent central bank have brought new light on the coordination framework between
monetary policy and fiscal policy. Investigating how fiscal policy affects monetary policy
through estimates of their respective reaction functions over time, the literature essentially tries
to verify whether fiscal policy directly influence monetary policy. Within an inflation-targeting
regime, such direct effect can be safely ruled out, but the indirect effects are nonetheless present.
For instance, Blanchard (2004) show that an increase in interest rate could lead to a deprecation
of the domestic currency rather than its appreciation if the fiscal path becomes unsustainable and
the risk of default increases following higher borrowing cost. Monetary policy cannot remain
indifferent to such possibilities. While abuse in terms of influence on monetary authority should
be avoided to protect the credibility of monetary policy and the overall policy regime,
coordination between monetary policy and fiscal policy is a precondition to ensure objectives of
both fiscal and monetary regimes are met.
Therefore, a key objective of this paper is to verify whether monetary policy has been influenced
by fiscal policy to accommodate the latter through the channels elaborated above. The paper will
investigate whether decisions on the policy rate or the exchange rate were motivated by fiscal
considerations. It will also try to evaluate whether the monetary authority has sacrificed its
inflation objectives in favour of generating additional fiscal space. In this quest, the standards of
independent monetary policy will be compared to the current practice to indicate whether the
prerequisites of independent monetary policy have been in place or not.
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Section II: Evolution and features of Monetary Policy
Prior to 1991, monetary policy was conducted primarily by establishing an annual ceiling for the
expansion of credit by banks and by imposing reserve requirements. The Bank also issued
interest rate guidelines to banks. Lower lending rates were set for priority sectors. The Minister
of Finance announced the Bank Rate and yield on Treasury Bills was set in relation to the Bank
Rate. Over time such a system of direct controls brought in rigidities to the banking growth
prospects and ultimately constrained economic prospects of the country.
Mauritius embarked on a gradual process of financial liberalisation in the late 1980s. Exchange
controls were removed in gradual steps until the suspension of the Exchange Control Act in July
1994 and a more flexible exchange regime replaced the previous basket-peg regime.
Concomitantly, the Bank of Mauritius switched from direct control to indirect monetary
management. In fiscal year 1996-97, the Bank started announcing an inflation objective in its
annual report.
To establish open market operations for monetary policy purposes and to improve liquidity
management, the Bank of Mauritius in December 1999 introduced a Lombard facility and a
framework for repurchase and reverse repurchase transactions. The Lombard facility was a
standing facility to provide overnight collaterised advances to banks at preannounced interest
rate. It was used by the Bank as a signalling mechanism for its monetary stance. Transactions
under the Lombard facility halted around mid-2003 as the interbank rate fell below the Lombard
rate. The regime that prevailed, however, was far from being an inflation targeting regime as the
targets changed every year and there was no clear link between the changes in policy rates and
the inflation outcomes. On 18 December 2006, the Bank introduced a new framework for the
conduct of monetary policy with the Key Repo Rate (KRR) acting as the policy rate to signal its
monetary stance.
The promulgation of the Bank of Mauritius Act 2004 in June 2005 allowed for institutional
independence for the conduct of monetary policy with provisions included in the Act for the
setting-up of a Monetary Policy Committee (MPC) and on 23 April 2007, the MPC was
launched. In view of providing further independence to the MPC, the Bank of Mauritius Act
2004 was amended in August 2007 to empower the MPC to formulate and take final decision on
the monetary policy instead of having to submit its findings and recommendations to the Board
of Directors of the Bank, which took the final monetary policy decision. As the experience of the
MPC grew, its composition and proceedings have been fine-tuned to improve its performance
and the Bank of Mauritius Act 2004 was accordingly amended.
Table 1 provides in brief the inflation outcomes registered in Mauritius.
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Table 1: A historical perspective on headline inflation
Note: December and June figures used for computing the Means and Standard Deviations.
The analytical Table 1 on headline inflation is to provide an overall view of the experience of
economic agents with inflation in Mauritius and have comparable historical figures.




The period 1990-2009 limits the time frame so as to include only the liberalised phase of
the economy.
The period 1994-2009 is included in the table to note the difference in average inflation
since exchange control was abolished in 1994.
The period 1999-2009 marks a remarkable attempt on embarking on inflation-targeting
approach in the conduct of monetary policy.
Another break is introduced in 2007, the year of the introduction of the MPC.
Due to exceptional events in 2007 and 2008 with significant hikes in commodity prices and
outbreak of global financial crisis, the period 2009-2013 is considered to have a better sense of
the ‘normalised’ inflation rate. Post the global financial crisis, monetary policy globally has
been significantly accommodative with the focus on reviving growth and as a result of the later
years of mild inflation and vulnerable growth revival. This backdrop has allowed Mauritius to
pursue accommodative monetary policy and adjust the structure of interest rate downward. The
MPC occasionally used its change in monetary stance to build its credibility as an inflation7
fighter. The focus of the MPC on its mandate has allowed inflation expectations to be anchored.
Chart 1 shows the evolution of the KRR and inflation (Headline and Year-on-year) in Mauritius.
Chart 1: The KRR and Inflation (Headline and Year-on-year)
Section III: Evolution and features of Fiscal Policy
Fiscal policy in Mauritius has been guided by the needs of the country at the different stages of
its development. In the late 1970’s, like many underdeveloped countries in the world at that
time, Mauritius was a monocrop economy, largely dependent on sugar production and exports.
Government revenue was thus constrained by the size of the economy and averaged around 22%
of GDP. Government expenditure, however, as a percentage of GDP was around 30% of GDP.
The almost 8% gap between government revenue and government expenditure made the country
vulnerable to the price of a single exports on the world market – Sugar. Overall fiscal deficit
averaged 11% of GDP and a major fall in the price of sugar led to an economic crisis.
Mauritius sought and obtained support from IMF stand-by facility in 1982-83 to the tune of
Rs728.6 million, representing 6% of GDP to undertake several reforms and embarked into a
phase of market liberalisation and diversification of the economy. As part of the reform
package, the Mauritian rupee was devalued twice, sales tax was introduced and subsidies were
reduced. The reforms paid off handsomely with the economy growing at over 5.5% annually
and government expenditure brought down to around 25% of GDP, resulting into significant
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improvement of the fiscal path. The fiscal deficit decreased from a peak of 13.7% of GDP in
1980/81 to a trough of 1.1% of GDP in 1987/88. Within that time frame, the government also
repaid a sizable share of its foreign debts, in particular that owed to the IMF. Budgetary central
government external debt declined from 33.6% of GDP in 1984/85 to 16.2% of GDP in 1989/90
while budgetary central government internal debt decreased from 45.6% of GDP to 38.8% of
GDP over the same period.
Chart 2: Government Revenue and Expenditure as a % of GDP
Chart 3: Fiscal Deficit as a % of GDP and Inflation
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The improvement of the fiscal path and reforms undertaken led to a more diversified economy
and restored macroeconomic balance in the economy. Inflation that had shot to a peak of 26.5%
in 1980/81, following the devaluation of the domestic currency, fell to a low of 0.7% in 1986/87.
From an average fiscal deficit of 6.3% in the 1980’s, the 1990’s recorded an average fiscal
deficit of almost half of that size at 3.3%.
Chart 4: Budgetary Central Government Debt as % of GDP
Over the course of the evolution of the fiscal path, the authorities undertook continuous
improvement of the tax regime by enhancing tax collection and administration and rationalizing
various levers of the tax. Introduction of new tax policies and rationalization of government
expenditure have generally been perceived as adverse to the public, even those that were meant
to actually reduce the number of tax payers and the per unit cost of government expenditure of
the economy. Strong leadership at the helm of governments and proper implementation of
various tax reforms have succeeded in demonstrating the positive impact on the economy of
several reforms carried out. These include the introduction of Sales tax in 1982, Pay As You
Earned (PAYE) in early 1990’s, Value-Added-Tax in 1998 and the ‘single-rate’ tax system in
2006-07. Along with these reforms, the income and corporate taxes were significantly reduced
from rates as high as 30-40% in the 1980’s and 1990’s to the current single rate of 15%, in line
with the focus of encouraging work, production and efforts. The rationalization of the tax
regime allowed the direct tax rates to be reduced, while those of indirect taxes to be contained.
Simultaneously, inefficient price controls and subsidies were eliminated.
Post-1990’s Mauritius was endowed with a more diversified economy and developed financial
system with more liquid and sound banks and the emergence of several type of other financial
intermediaries. These led to the development of deeper money markets and allowed the country
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to rely less on foreign borrowing and seek its financing needs internally. The 2006-07 reforms
appear to have caused another important break in fiscal management in Mauritius – interest
payments on government debt fell from 17.8% of total government expenditure to 11.0% of total
government expenditure as shown in Chart 5, thus allowing government expenditure on other
items to increase.
Chart 5: Share of Interest Payments and Current Expenditure in Total Government Expenditure
Chart 6: Share of foreign grants in Total Government Revenue
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Another key development in fiscal policy has been the promulgation of the Public Debt
Management Act 2008 that limits the ratio of public debt to GDP to 60% and has a provision that
requires that this ratio be reduced to 50% by 31 December 2018 and remains so for subsequent
years. It also provides for any rise in the percentage at the end of a fiscal year not to exceed 2%
by reference to the percentage in respect of the previous fiscal year. These provisions strengthen
fiscal discipline in the country and ensure that the country remains on a prudent fiscal path.
During the course of its economic development, Mauritius has benefitted from foreign grants in
support of reforms that have been undertaken. In the 1980’s, they helped the economy cope with
the market reforms under way in liberalising the economy and in 2000’s, supported the economy
to manage sugar sector reforms and the transition phase following the end of the Multi-Fibre
Agreement and ACP-EU Sugar Protocol. Foreign grants have supported the government budget,
but have been temporary features of the budget, in important size. As shown in Chart 6, foreign
grants as a share of total revenue peaked at 5.7% in 1985/86 before falling to around 1% and
then rising to 4.4% in 2008/09.
Section IV: Analysing the type of coordination between monetary policy and fiscal policy
In order to evaluate the type of coordination between monetary policy and fiscal policy, we apply
models that have been documented in the literature review to the Mauritian economy. Annual,
quarterly and monthly data have been used to verify different possibilities and make appropriate
conclusion over the nature of coordination between monetary policy and fiscal policy.
Annual analysis
Using Annual data between 1977 and 2014, the relationships among fiscal deficit, inflation,
exchange rate have been investigated. The variables used for the annual analysis are fiscal
balance as a percentage of GDP, interest rate, inflation and log of the exchange rate of the dollar
vis-à-vis the Mauritian rupee. The interest rate used is the estimate of an implied interest rate
based on interest payments and government debt.
A deterioration of the fiscal path is expected to lead to higher interest rates to compensate for
higher risks and higher inflation. Depreciation of the domestic currency, i.e. an increase in
Rs/USD, as has been shown in the literature, could support fiscal balance through the impact of
‘seignorage’ and raising revenue through higher import duties collected and added taxes on
profits of export enterprises. While the negative correlation with inflation and positive
correlation with LOG(Rs/USD) is confirmed for the years 1977 to 2014, interest rate and fiscal
balance have been weakly positively correlated with a coefficient of 0.18. Ordinary least squares
(OLS) regressions were estimated with inflation as the dependent variable in Equation 1(a) and
with fiscal balance as the dependent variable in Equation 2. All variables in the regressions have
been tested for unit root and observed not to have unit root.
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INFLATION= 5.16 – 0.730 FISCAL+ 1.093 INTEREST – 2.924 LOG(RS/USD)
(t-statistics)
(0.51)
(-2.24)
(1.50)
R2 = 0.39
(-1.32)
Equation 1(a)
D.W. = 1.53
Given that the constant term in Equation 1(a) is not statistically significant, it is dropped to
estimate Equation 1(b). However, the inferences drawn remain the same except that interest rate
become statistically significant and the fit improves mildly.
INFLATION= - 0.849 FISCAL+1.345 INTEREST – 1.975 LOG(RS/USD)
(t-statistics)
(-3.84)
(2.55)
(-1.687)
R2 = 0.38
Equation 1(b)
D.W. = 1.54
Correlation Matrix I
FISCAL
BALANCE
FISCAL
BALANCE
IMPLIED
INTEREST
INFLATION
MURUSD
LMURUSD
IMPLIED
INTEREST
INFLATION MURUSD
LMURUSD
1.00
0.18
-0.54
0.55
0.66
0.18
1.00
0.15
-0.17
-0.04
-0.54
0.15
1.00
-0.49
-0.53
0.55
-0.17
-0.49
1.00
0.98
0.66
-0.04
-0.53
0.98
1.00
FISCAL = -18.90 – 0.176 INFLATION +0.720 INTEREST – 3.527 LOG(RS/USD)
(t-statistics)
(-4.91)
(-2.24)
(2.06)
R2 = 0.55
(3.76)
Equation 2
D.W. = 0.63
The expected inverse relationship between fiscal balance and inflation is verified in both
Equation 1 and 2 at 5% level of significance. However, the inverse relationship between interest
rate and inflation, and the impact of depreciation of the domestic currency on inflation have not
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been confirmed. Even the sign of their respective coefficients are opposite to what would have
been expected. The reason for the non-significance and abnormal sign of the coefficient could
be due to the fact that the interest rate and exchange rate used in the regressions are annual
averages such that the short-term dynamism registered by them during the year could have been
offset. Another reason could be the restrictive sample size of only 38 observations.
Reaction function of the central bank since the setting-up of the MPC
Using quarterly data between 2008Q3 and 2015Q1, the reaction function of the central bank has
been estimated with the Key Repo Rate (KRR) as the dependent variable, and inflation,
log(GDP) and primary balance as a percentage of GDP (PB) as independent variables. Equation
3 shows that both inflation and LGDP depict the expected relationships reflecting KRR
adjustments were guided by inflation and growth concerns. Higher inflation caused the KRR to
go up while lower GDP growth led to cuts in the KRR. Primary balance as a percentage of GDP
is not found to be significant in the regression, indicating monetary policy might not have
accommodated fiscal needs. The regression nonetheless has some shortcoming with LGDP
having a unit root and the sample size being 27 variables only. But, the tentative conclusions
from the regression can be substantiated by the minutes of the Monetary Policy Committee
(MPC) meetings and the fact that for some period the yield on treasury bills were disconnected
with the KRR as a result of lingering excess liquidity.
KRR = 30.68 + 0.206 INFLATION - 2.370 LGDP + 0.055 PB
(t-stat) (2.50)
(3.95)
(-2.16)
(1.82)
R2 = 0.60
Equation 3
D.W. = 1.21
In Equation 4, a model closer to Taylor’s rule is estimated with the dependent variable KRR and
independent variables inflation gap, output gap and primary balance as a percentage of GDP.
Only inflation gap is found to be statistically significant in the estimated reaction function of the
Central Bank. All variables in Equation 4 regressions have been tested for unit root and
observed not to have unit root.
KRR = 5.36 + 0.191 INFLATION GAP + 0.480 OUTPUT GAP + 0.066 PB
(t-stat) (39.06)
(3.00)
(0.26)
R2 = 0.36
(1.69)
D.W. = 0.47
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Equation 4
These results suggest that for under the current structure in place, monetary authority has been
functioning independently and not tried to accommodate fiscal policy. The coordination
between monetary and fiscal authorities is more to do with macroeconomic objectives than the
financing needs of the government. This arrangement provides confidence to financial markets
and investors in general, and dismisses any risk of crowding out.
Analysing short-term dynamics impacting on inflation outcome
Monthly data for the period June 2006 to January 2015 have been collected to assess the impact
of external factors, in particular, international commodity prices and monetary variables, namely,
growth in broad money liabilities and the exchange rate on inflation. Compared to the annual
and quarterly estimations, this model has the advantage of a larger sample size of 104
observations and it is expected to make up for the limitations of the other two models in
capturing short-term dynamics that influence inflation. All variables in Equation 5 regressions
have been tested for unit root and only YTM3 has been observed to have unit root.
FAO = Monthly FAO food price index
BML = 12-month moving average of monthly growth rates of Broad Money Liabilities
RS_USD = Monthly Average Exchange rate of the US dollar vis-à-vis the Mauritian rupee
YTM3 = Monthly weighted average yield on 91-day Treasury Bills
INFLATION = -15.38 + 3.68 BML + 0.29 RS_USD + 0.72 YTM3 + 0.03 FAO
(t-statistics)
(-3.87)
(12.64)
(3.14)
R2 = 0.91
(16.67)
(5.24)
Equation 5
D.W. = 0.45
In Equation 5, all the independent variables are statistically significant indicating that they could
impact on inflation. However, the positive coefficient that is again observed for interest rate,
here with a coefficient of +0.72 for YTM3, is intriguing. The correlation coefficient between
INFLATION and YTM3 is also positive at 0.85. One explanation could be that both the
aggregate demand channel through which lower borrowing costs cause prices to rise and the
exchange rate channel through which lower returns on domestic bonds cause the exchange rate to
depreciate as a result of capital outflows have not been working during the period under study.
Instead, it could be that lower borrowing cost could in effect be reducing cost of production and
doing business such that businesses were able to keep prices contained or even lower prices to
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adapt to the lackluster conditions prevailing globally post the global financial crisis. These
tentative conclusions could explain part of the reason why persistently low borrowing cost did
not lead to higher prices. The coefficients obtained in Equation 5 could however be biased and
inconsistent due to the presence of serial correlation as depicted by the low Durbin-Watson
statistics. Moreover, persistence of low inflation could have anchored inflation expectations at a
lower range that had, in turn, built into a virtuous cycle of low inflation and low borrowing cost.
For Mauritius, this could in effect be very much the case and the work of Blanchard (2004)
provides theoretical underpinnings for such a possibility. But these outcomes are dependent on
several factors at work simultaneously and need not hold permanently.
Correlation Matrix II
INFLATION
FAO
YTM3
LUSD
RS_USD
BML
INFLATION
1.00
-0.36
0.85
-0.03
-0.01
0.77
FAO
-0.36
1.00
-0.62
-0.73
-0.74
-0.17
YTM3
0.85
-0.62
1.00
0.15
0.17
0.49
LUSD
-0.03
-0.73
0.15
1.00
1.00
-0.15
RS_USD
-0.01
-0.74
0.17
1.00
1.00
-0.14
BML
0.77
-0.17
0.49
-0.15
-0.14
1.00
Mauritius is a small open economy that imports most of its food and energy needs and act as
price taker in all markets. The impact of international commodity prices weighs considerably on
inflation as depicted by the high statistical significance of FAO, despite a negative correlation
coefficient between FAO and INFLATION at -0.36 for the period under study. But without
money growth and exchange rate effect, the impact on inflation could be restricted. Indeed,
BML and RS_USD cause inflation to rise and if they both were to evolve in opposite direction to
FAO, inflation would overwhelmingly be contained.
The presence of serial correlation in Equation 5 was expected given the fact that the data used
are monthly time series. Some of the relationships observed could be the result of a combination
of factors rather than indicating causality and might not therefore hold in the long run. Pairwise
graphs of each factor as well as pairwise Granger causality tests have been undertaken to
evaluate the relationships between the independent variables in Equation 5 and inflation.
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Chart 7: Credit to private sector growth, BML and Inflation
2
12
10
1.5
8
1
6
0.5
4
Oct-14
May-14
Dec-13
Jul-13
Feb-13
Sep-12
Apr-12
Nov-11
Jun-11
Jan-11
Aug-10
Mar-10
Oct-09
May-09
Dec-08
Jul-08
Feb-08
Sep-07
Apr-07
Nov-06
Jun-06
0
-0.5
2
0
Credit to Private sector growth
BML
INFLATION
Pairwise Granger Causality Tests: BML and Inflation
Sample: 2006M06 2015M01
Lags: 3
Null Hypothesis:
Obs
F-Statistic
Prob.
BML does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause BML
101
2.73367
3.66557
0.0480
0.0151
Obs
F-Statistic
Prob.
98
1.40991
2.08121
0.2203
0.0638
Sample: 2006M06 2015M01
Lags: 6
Null Hypothesis:
BML does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause BML
Chart 7 suggests that broad money liabilities growth (BML) could influence inflation
significantly as depicted by the similar trends in BML and Inflation. Credit to private sector
growth, a component of BML, is also illustrated in Chart 7 in view of its importance in driving
economic activities in the country. Granger causality tests indicate that BML could cause
inflation in the short run, but in the relatively longer run, the influence would decrease.
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Chart 8: Exchange rate (Rs/USD) and Inflation
35
12
34
10
33
32
8
31
30
6
29
4
28
27
2
26
Rs/USD
Oct-14
May-14
Dec-13
Jul-13
Feb-13
Sep-12
Apr-12
Nov-11
Jun-11
Jan-11
Aug-10
Mar-10
Oct-09
May-09
Dec-08
Jul-08
Feb-08
Sep-07
Apr-07
Nov-06
0
Jun-06
25
INFLATION
Pairwise Granger Causality Tests: Rs/USD and Inflation
Sample: 2006M06 2015M01
Lags: 3
Null Hypothesis:
Obs
F-Statistic
Prob.
RS_USD does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause RS_USD
101
1.50303
0.07326
0.2188
0.9742
Obs
F-Statistic
Prob.
98
3.28609
0.87151
0.0059
0.5194
Sample: 2006M06 2015M01
Lags: 6
Null Hypothesis:
RS_USD does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause RS_USD
Chart 8 illustrates an ambiguous relationship between the exchange rate (Rs/USD) and inflation
with no clear association of their respective trends. However, Granger causality tests indicate
that Rs/USD could cause inflation with six months lag, but not in three months.
18
Chart 9: Weighted interest rate on 91-day Treasury bills (YTM3) and Inflation
14
12
10
8
6
4
2
INFLATION
Oct-14
May-14
Dec-13
Jul-13
Feb-13
Sep-12
Apr-12
Nov-11
Jun-11
Jan-11
Aug-10
Mar-10
Oct-09
May-09
Dec-08
Jul-08
Feb-08
Sep-07
Apr-07
Nov-06
Jun-06
0
YTM3
Pairwise Granger Causality Tests: Interest rate and Inflation
Sample: 2006M06 2015M01
Lags: 3
Null Hypothesis:
Obs
F-Statistic
Prob.
YTM3 does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause YTM3
101
1.87938
2.45371
0.1384
0.0680
Obs
F-Statistic
Prob.
98
1.74483
1.61626
0.1205
0.1525
Sample: 2006M06 2015M01
Lags: 6
Null Hypothesis:
YTM3 does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause YTM3
Chart 9 illustrates a close relationship between the interest rate (YTM3) and inflation, but the
positive correlation is intriguing and could be the result of a combination of factors during the
time under study than depicting a regular relationship. It will be investigated further. At 5%
level of significance, Granger causality tests indicate that YTM3 might not cause inflation.
19
Chart 10: FAO food price index and Inflation
260
12
240
10
220
8
200
180
6
160
4
140
2
120
FAO
Oct-14
May-14
Dec-13
Jul-13
Feb-13
Sep-12
Apr-12
Nov-11
Jun-11
Jan-11
Aug-10
Mar-10
Oct-09
May-09
Dec-08
Jul-08
Feb-08
Sep-07
Apr-07
Nov-06
0
Jun-06
100
INFLATION
Pairwise Granger Causality Tests: FAO food price index and Inflation
Sample: 2006M06 2015M01
Lags: 3
Null Hypothesis:
Obs
F-Statistic
Prob.
FAO does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause FAO
101
0.94550
0.63577
0.4220
0.5938
Obs
F-Statistic
Prob.
98
2.50672
1.23716
0.0278
0.2956
Sample: 2006M06 2015M01
Lags: 6
Null Hypothesis:
FAO does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause FAO
Chart 10 shows a close relationship in the trends of FAO food price index and inflation. Granger
causality tests indicate that FAO food price index could cause inflation in the relatively longer
run, but not in three months.
20
Chart 11: ICE Brent and Inflation
160
12
140
10
120
8
100
80
6
60
4
40
2
20
ICE Brent
Oct-14
May-14
Dec-13
Jul-13
Feb-13
Sep-12
Apr-12
Nov-11
Jun-11
Jan-11
Aug-10
Mar-10
Oct-09
May-09
Dec-08
Jul-08
Feb-08
Sep-07
Apr-07
Nov-06
0
Jun-06
0
INFLATION
Pairwise Granger Causality Tests: Oil prices (ICE Brent) and Inflation
Sample: 2006M06 2015M01
Lags: 3
Null Hypothesis:
Obs
F-Statistic
Prob.
ICE_BRENT does not Granger Cause HEADLINE_INFLATION
HEADLINE_INFLATION does not Granger Cause ICE_BRENT
101
2.75509
0.29808
0.0468
0.8267
Chart 11 shows a close relationship in the trends of ICE Brent and inflation. Granger causality
test indicates clearly that ICE Brent could cause inflation.
The next step is to carry out a Vector Error Correction Model (VECM) for the monthly variables
to discern more precisely the short term and long term dynamics among the variables that impact
on inflation outcomes. The benefits of estimating a VECM is that it addresses the issue of serial
correlation, captures the information contained in lagged variables and produces more robust
regression coefficient estimates.
21
Vector Error Correction Estimates
Sample (adjusted): 2006M10 2015M01
Included observations: 100 after adjustments
Standard errors in ( ) & t-statistics in [ ]
Cointegrating Eq:
CointEq1
HEADLINE_INFLATION(-1)
1.000000
BML(-1)
-1.117495
(0.62350)
[-1.79229]
RS_USD(-1)
0.308043
(0.08439)
[ 3.65045]
YTM3(-1)
-0.801826
(0.07322)
[-10.9515]
D(HEADLINE_I
NFLATION)
D(BML)
D(RS_USD)
D(YTM3)
-0.073519
(0.01500)
[-4.89985]
-0.003772
(0.01318)
[-0.28628]
-0.016151
(0.06112)
[-0.26425]
0.123834
(0.05909)
[ 2.09586]
0.646562
(0.09935)
[ 6.50812]
-0.108960
(0.08725)
[-1.24887]
0.278880
(0.40470)
[ 0.68910]
0.610428
(0.39121)
[ 1.56034]
0.169381
(0.12301)
[ 1.37696]
0.078357
(0.10803)
[ 0.72534]
-0.206227
(0.50110)
[-0.41155]
0.313398
(0.48440)
[ 0.64698]
-0.049066
(0.09237)
[-0.53121]
0.107009
(0.08112)
[ 1.31920]
0.028019
(0.37627)
[ 0.07446]
-0.680013
(0.36373)
[-1.86957]
D(BML(-1))
0.063912
(0.12621)
[ 0.50638]
-0.028232
(0.11084)
[-0.25471]
-0.057952
(0.51414)
[-0.11272]
-0.142994
(0.49701)
[-0.28771]
D(BML(-2))
0.382830
(0.11628)
[ 3.29240]
0.018195
(0.10212)
[ 0.17818]
-0.478641
(0.47367)
[-1.01050]
-0.093234
(0.45788)
[-0.20362]
D(BML(-3))
0.341404
(0.11858)
[ 2.87914]
-0.050754
(0.10414)
[-0.48738]
-0.594636
(0.48304)
[-1.23102]
-0.445318
(0.46695)
[-0.95368]
D(RS_USD(-1))
-0.022545
(0.02596)
[-0.86832]
0.025846
(0.02280)
[ 1.13352]
0.581366
(0.10577)
[ 5.49659]
0.031636
(0.10224)
[ 0.30941]
Error Correction:
CointEq1
D(HEADLINE_INFLATION(
-1))
D(HEADLINE_INFLATION(
-2))
D(HEADLINE_INFLATION(
-3))
22
D(RS_USD(-2))
0.037743
(0.02837)
[ 1.33024]
-0.045587
(0.02492)
[-1.82956]
-0.302235
(0.11558)
[-2.61493]
-0.181816
(0.11173)
[-1.62730]
D(RS_USD(-3))
-0.015446
(0.02629)
[-0.58746]
-0.011921
(0.02309)
[-0.51626]
0.327066
(0.10711)
[ 3.05360]
-0.046679
(0.10354)
[-0.45083]
D(YTM3(-1))
-0.034468
(0.02579)
[-1.33668]
-0.034409
(0.02265)
[-1.51945]
0.262322
(0.10504)
[ 2.49726]
0.505068
(0.10154)
[ 4.97392]
D(YTM3(-2))
0.013737
(0.02855)
[ 0.48121]
-0.032626
(0.02507)
[-1.30136]
0.036553
(0.11629)
[ 0.31432]
-0.142734
(0.11242)
[-1.26969]
D(YTM3(-3))
0.029278
(0.02737)
[ 1.06986]
0.020382
(0.02403)
[ 0.84809]
-0.161873
(0.11148)
[-1.45206]
0.123994
(0.10776)
[ 1.15062]
LFAO
0.142294
(0.02946)
[ 4.82939]
0.006955
(0.02588)
[ 0.26878]
0.034466
(0.12003)
[ 0.28715]
-0.249629
(0.11603)
[-2.15150]
R-squared
Adj. R-squared
Sum sq. resids
S.E. equation
F-statistic
Log likelihood
Akaike AIC
Schwarz SC
Mean dependent
S.D. dependent
0.892063
0.875747
1.152767
0.115777
54.67393
81.25639
-1.345128
-0.980404
-0.040000
0.328449
0.181819
0.058140
0.889063
0.101676
1.470089
94.24403
-1.604881
-1.240157
-0.001152
0.104767
0.395445
0.304059
19.12944
0.471631
4.327191
-59.19677
1.463935
1.828659
0.000894
0.565348
0.328175
0.226620
17.87571
0.455913
3.231508
-55.80749
1.396150
1.760874
-0.063600
0.518425
Determinant resid covariance (dof adj.)
Determinant resid covariance
Log likelihood
Akaike information criterion
Schwarz criterion
5.48E-06
3.00E-06
68.32669
-0.166534
1.396568
The VECM shows that broad money growth (BML) influences inflation with two and three
months lag, but become insignificant over time and counterproductive at 10% level of
significance. In contrast, exchange rate (Rs_USD) and interest rate (YTM3) become significant
in the long run. Ceteris paribus, one unit of increase in Rs_USD (depreciation) causes inflation
to rise by 0.31 unit while one unit increase in YTM3 causes inflation to fall by 0.80 unit in the
long run. Further, FAO food price index has been observed to add to inflation. This would also
be true for oil prices too, which is not included in the VECM due to the high correlation between
ICE Brent and FAO that could cause multicollinearity problem. The results suggest that interest
rate is the appropriate monetary instrument to control inflation, while exchange rate
developments should be consistently monitored to achieve desirable inflation outcomes.
23
24
30
-.8
25
-.8
20
-.4
-.4
15
.0
.0
10
.4
.4
5
.8
.8
Response of YTM3 to HEADLINE_INFLATION
30
-0.4
25
-0.4
20
0.0
0.0
15
0.4
0.4
10
0.8
0.8
5
1.2
1.2
Response of RS_USD to HEADLINE_INFLATION
-.08
30
-.08
25
-.04
-.04
20
.00
.00
15
.04
.04
10
.08
.08
5
.12
.12
Response of BML to HEADLINE_INFLATION
30
-.8
25
-.8
20
-.4
-.4
15
.0
.0
10
.4
.4
5
.8
.8
Response of HEADLINE_INFLATION to HEADLINE_INFLATION
5
5
5
5
15
20
15
20
15
20
10
15
20
Response of YTM3 to BML
10
Response of RS_USD to BML
10
Response of BML to BML
10
25
25
25
25
30
30
30
30
-.8
-.4
.0
.4
.8
-0.4
0.0
0.4
0.8
1.2
-.08
-.04
.00
.04
.08
.12
-.8
-.4
.0
.4
.8
15
20
10
15
20
Response of BML to RS_USD
10
25
25
5
5
15
20
25
10
15
20
25
Response of YTM3 to RS_USD
10
Response of RS_USD to RS_USD
5
5
30
30
30
30
Response of HEADLINE_INFLATION to RS_USD
Response to Cholesky One S.D. Innovations
Response of HEADLINE_INFLATION to BML
-.8
-.4
.0
.4
.8
-0.4
0.0
0.4
0.8
1.2
-.08
-.04
.00
.04
.08
.12
-.8
-.4
.0
.4
.8
5
5
5
5
15
20
15
20
25
25
15
20
10
15
20
Response of YTM3 to YTM3
10
25
25
Response of RS_USD to YTM3
10
Response of BML to YTM3
10
Response of HEADLINE_INFLATION to YTM3
30
30
30
30
25
30
30
-20
25
-20
20
-10
-10
15
0
0
10
10
10
5
20
20
Accumulated Response of YTM3 to HEADLINE_INFLATION
30
-10
25
-10
20
0
0
15
10
10
10
20
20
5
30
30
Accumulated Response of RS_USD to HEADLINE_INFLATION
-2
-2
30
-1
-1
25
0
0
20
1
1
15
2
2
10
3
3
5
4
4
Accumulated Response of BML to HEADLINE_INFLATION
25
-20
20
-20
15
-10
-10
10
0
0
5
10
10
15
20
25
10
15
20
25
10
15
20
25
5
10
15
20
25
Accumulated Response of YTM3 to BML
5
Accumulated Response of RS_USD to BML
5
Accumulated Response of BML to BML
5
30
30
30
30
-20
-10
0
10
20
-10
0
10
20
30
-2
-1
0
1
2
3
4
-20
-10
0
10
10
15
20
25
10
15
20
25
30
30
10
15
20
25
5
10
15
20
25
Accumulated Response of YTM3 to RS_USD
5
30
30
Accumulated Response of RS_USD to RS_USD
5
Accumulated Response of BML to RS_USD
5
Accumulated Response of HEADLINE_INFLATION to RS_USD
Accumulated Response to Cholesky One S.D. Innovations
Accumulated Response of HEADLINE_INFLATION to BML
10
Accumulated Response of HEADLINE_INFLATION to HEADLINE_INFLATION
-20
-10
0
10
20
-10
0
10
20
30
-2
-1
0
1
2
3
4
-20
-10
0
10
10
15
20
25
10
15
20
25
10
15
20
25
5
10
15
20
25
Accumulated Response of YTM3 to YTM3
5
Accumulated Response of RS_USD to YTM3
5
Accumulated Response of BML to YTM3
5
30
30
30
30
Accumulated Response of HEADLINE_INFLATION to YTM3
Flowchart 1: Factors impacting on Transmission Mechanism of Monetary Policy
The transmission mechanism depicted in Flowchart 1 is helpful to recapitulate the findings from
the empirical analysis. The regression analysis indicates that in the short run, the central bank
can contain inflation by anchoring inflation expectations through its policy decisions, but that
changes in policy rate become effective over time. It has further been shown that exogenous
changes in fiscal policy, global economy and commodity prices influence price developments
and thus impairs the functioning of the transmission mechanism. The regression results also
confirm the considerable impact of exchange rate developments on inflation. It has also been
shown that in the long run, interest rate is an appropriate monetary instrument for controlling
inflation while control in money supply is effective only in the very short run. Persistence in
tightening of money supply growth could over time become counterproductive – This is in line
with Sargent and Wallace (1981) postulate.
26
Section V: Comparing current monetary policy framework with best practice
Current arrangements in place for monetary policy are in line with international best practice as
shown by Table 2. Nonetheless some further improvement need to be brought, on which the
Bank is currently working on.
Table 2: Comparing Current arrangements with Best Practices
Best
Rationale
Current
Practices
Comments
Arrangements
Institutional Building Blocks
Price stability enshrined in law
as primary objective of the CB.
Prevent developmental objectives
from undermining the price stability
objective.
Section 5(2) of the Bank of Mauritius Act 2004
stipulates that the primary objective of the Bank is to
maintain price stability and promote orderly and
balanced economic development.
Section 54 of the Bank of Mauritius Act 2004 provides
for mandate of the MPC to formulate and determine the
monetary policy to be conducted by the Bank in order
to implement Section 5(2).
Independence and Objectivity
of the Monetary Policy
Committee
Independence, transparency and
accountability are pillars of Central
Bank governance that ensures that
decisions are motivated by the
objectives and mandate of the
Bank.
MPC members consist of the Governor, two Deputy
Governors, five external members appointed by the
Government. In case of a tie in voting, the Chairman of
the MPC, the Governor, has the determining vote.
MPC members have to adhere to a Code of Conduct
and the Chairman of the MPC reports to the Bank of
Mauritius Board on compliance to the Code by MPC
members once a year.
Macro-financial Building Blocks
Clear separation between
monetary and fiscal policy.
Curtail fiscal dominance to contain
uncertainties in monetary policy
conduct.
Ability to articulate the role of
the exchange rate in the
monetary strategy.
Clear objectives and strategy for
official intervention consistent with
the monetary regime.
27
The Bank may grant advances to the Government to
cover negative net cash flows at a rate to be agreed
with the Government. The total amount of such
advances outstanding is subject to a quantitative limit
and repayment obligations as per Section 58 of the
Bank of Mauritius Act 2004.
The Bank's department responsible for the liquidity
management is also responsible for the organization of
government securities auctions. Decisions on the
amount to put on tender and bids to accept are jointly
made by the Bank and the Treasury. The yield that
prevails reflects market rate.
Exchange rate interventions in the market are limited to
remove excess volatility and correct for any departure
from fundamentals. The IMF classifies Mauritius
exchange rate regime as "floating".
Stable, sound and deep
financial sector.
Central Bank manages liquidity at
aggregate level (allocation among
banks via interbank market).
The Mauritian banking system is well-capitalised and
resilient against a range of shocks according to stress
tests carried out by the Bank. Banks’ profitability and
comfortable capitalisation provide valuable cushions
against a range of shocks to their credit portfolios.
Technical and Organizational Building Blocks
The Central Bank ensures stable
liquidity conditions in the money
markets.
The Bank of Mauritius issue Bank of Mauritius
Bills/Notes and make use of other instruments like the
Cash Reserve Ratio to manage liquidity. However, in
recent years, chronic excess liquidity has lingered.
A set of monetary policy
instruments aligned with the
level of money market
development.
Effective monetary operations
allow the Central Bank to steer
effectively money market rates in
the short term.
The Bank has used a broad range of monetary
instruments to alleviate the build-up of excess liquidity,
but have had limited success in bringing money market
rates in line with the Key repo Rate (KRR). The
persistence of excess liquidity has thus resulted into
some disconnect between the monetary policy stance
decided by the MPC and the actual monetary policy
stance as reflected in money market conditions. The
Bank is currently looking into various alternatives to
remedy this problem.
Adequate financial markets
infrastructure (FMIs)
Support the functioning of financial
markets and monetary operations
The Bank has developed a robust financial market
infrastructure to support the functioning of financial
markets and monetary operations.
Adequate statistical data.
Provide the Bank with the
necessary data to support its
analytical work, and macromodeling.
Statistics Mauritius and the Bank have developed a
comprehensive set of statistical data to support
analytical work and macro-modeling.
Tools to communicate
effectively monetary policy.
Help anchor inflation expectations
through a transparent
communication policy strategy.
Much has been done to enhance communication of
monetary policy in Mauritius: a MPC Statement is
released after each MPC meeting to explain the gist of
the decision on the monetary policy stance; The
Governor holds a press conference to provide more
information on the MPC decision and answer question
of the press; the minutes of the MPC meeting are
published with a two-week lag, disclosing the voting of
each member of the committee; an inflation report
detailing analytical work on inflation is published twice
a year; The Governor highlights key points of monetary
policy during the financial year in the Annual Report of
the Bank.
Proven Central Bank analytical
capacities to support an
understanding of the
transmission channels.
Ability to assess the role of money,
interest rates, and the exchange
rate.
With the support of the IMF, the Bank has over the
years upgraded its macro-modelling capacity.
Effective liquidity forecasting
framework.
28
Clear decision-making process
and Central Bank organisation
suited to support policy
implementation.
Ensure that monetary policy
decisions are made according to a
formal structure to ensure the
effectiveness of the MPC decision.
MPC Briefing papers are provided to MPC members
along with presentations of key issues. The law also
provide for other stakeholders, including the Ministry of
Finance and Economic Development to make
representation to the MPC to provide important
information that may support the MPC decision making
process.
Section VI: Monetary policy framework and Inflation Expectations
Notwithstanding several significant shocks to the global economy during the period 2007 to
2014, prudent fiscal policy and timely monetary policy seem to have well supported the
economy. An important achievement of the current monetary policy framework in place has
been the anchoring of inflation expectations, reduction in the variability of inflation and lower
inflation rates. Prior to the establishment and work of the MPC, inflation expectation in the
economy varied across different economic stakeholders.
Chart 12: Inflation expectations and Actual inflation
7.0
6.0
Expected Inflation
one year ahead
Per cent
5.0
Actual Inflation during
the survey month
4.0
3.0
2.0
1.0
Sep- Dec- Feb- May- Aug- Nov- Feb- May- Aug- Nov- Feb- May- Aug- Nov- Feb- May- Aug- Nov- Feb- May- Aug10
10
11
11
11
11
12
12
12
12
13
13
13
13
14
14
14
14
15
15
15
Survey Months
With greater transparency, increased communication of monetary policy, commitment to fiscal
discipline, and persistence of low global inflation post the global financial crisis, inflation
expectations have been anchored at a lower range. Given the small open economy case of
Mauritius, with Mauritius being a net food and energy importer – two items having much
29
weightage in the Consumer Price Index basket – global prices have considerable impact on the
final outcomes of inflation as shown by the regression results in earlier sections. The most
effective means by which monetary authorities are able to control domestic inflation in the short
run are by anchoring inflation expectations and containing excessive growth of money supply.
In the longer run, interest rate changes become more effective.
Section VII: Has monetary policy accommodated fiscal Policy?
To evaluate whether monetary policy has accommodated fiscal policy over the period under
review, the first point considered is the extent to which domestic debt had been held by the
Central Bank. The share of domestic budgetary debt held by the Central Bank peaked at 62.4%
in 1981/82 at the onset of the macroeconomic crisis that Mauritius faced. The plot was pretty
evident from what preceded the crisis: rising fiscal deficit with limited revenue collection for the
treasury, growing government expenditure and eroding confidence in the policy framework in
place. The increasing share of domestic budgetary debt held by the Central Bank implied that
money supply must have increased and should have been inconsistent with the peg in place at
that time. The only way out of the crisis that followed was to devalue the Mauritian rupee and,
as mentioned earlier that was what was done. It all appears that in that era the central bank might
have been under a regime of fiscal dominance.
Chart 13: Domestic Budgetary Debt held by the Central Bank
30
Following the double devaluation of the domestic currency in the early 1980’s, fiscal
consolidation and government debt held by the central bank was sharply reduced. In the late
1980’s and very early 1990’s, the share of domestic budgetary debt held by the Central Bank was
almost nil with domestic private banks and pension funds holding over 80% of domestic
budgetary debt. The occasional increases in central bank holding of government bonds were
more the result of open market operations than for the purpose of financing the deficit since the
market grew confident in the ability to pay of the Government. Moreover, with the promulgation
of the Bank of Mauritius Act 2004, advances to Government have been subject to a quantitative
limit of 10% of government revenue.
Even if central bank financing is excluded, fiscal dominance could still be practiced if the
exchange rate or policy rate were pushed in a direction to satisfy the needs of the fiscal stance.
Although the regression results are inconclusive on the effect of exchange rate on fiscal balance,
the positive correlation coefficient of 0.66 between exchange rate (LMURUSD) and fiscal
balance suggests that depreciation of the rupee have supported fiscal consolidation. Exchange
control has been suspended in Mauritius since July 1994 and exchange rate interventions have
been limited to remove excess volatility from the market and to keep it in line with
macroeconomic fundamentals. Since the exchange rate is determined by the market, the
likelihood of controlling the exchange rate for fiscal needs is limited. Nonetheless, in the small
open economy of Mauritius, the Central Bank has significant influence on the exchange rate
through its interventions and could have acted to meet fiscal needs at times. But, disentangling
exchange rate interventions for macroeconomic balance from fiscal reasons are complex given
the limited available tools and information set.
The next point we investigate is whether the policy rate, more particularly the KRR had been
reduced to cut down borrowing cost or in line with the mandate of the MPC. In this case, the
regression results demonstrate quite clearly that the main concerns for adjustment in the KRR
related to the inflation and growth outlook. Furthermore Chart 14 confirms the fact that when
the inflation outlook was on the upside, the monetary stance was tightened by hikes in the KRR
while when the inflation outlook was on the downside, the KRR was cut to support growth.
The low inflation outcomes, anchored inflation expectation, loose monetary policy globally and
heightened risk aversion prevailing worldwide amid vulnerable growth outlook have resulted in
domestic money markets being very liquid. The bid-cover ratios have been high in recent years
with Treasury Bills yields plummeting and reaching record lows as shown in Chart 15. Open
market operations to reduce excess liquidity has had limited impact given the chronic nature of
excess liquidity and its size, under current economic conditions and risk averse environment
globally. It can thus be safely concluded that monetary policy has not tried to unconditionally
help fiscal policy.
31
Chart 14: KRR, Headline Inflation and Money market rates
Chart 15: Bid-cover and Money market rates
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It is however true that in Mauritius, monetary and fiscal policies are coordinated, but they are for
maintaining macroeconomic and financial equilibrium. The country has through various reforms
improved fiscal management and has consistently tried to stay on a prudent fiscal path even in
the midst of the global financial crisis whose spillover effects were partly contained by a
stimulus package and timely loose monetary policies. Fortunately for Mauritius, the fiscal
reforms were initiated and implemented prior to the onset of the global financial crisis.
Section VIII: Putting all the pieces together and Policy Recommendations
All estimation results indicate that fiscal policy in Mauritius has significant impact on inflation
and other macroeconomic variables. Without proper fiscal management, governments lack fiscal
space to counter the adverse effects of economic shocks and tend to move from one bad
equilibrium to another. Unsustainable fiscal path ultimately leads to economic crises. Mauritius
has been able to weather the global financial crisis relatively well, principally due to its fiscal
reforms in 2006-07. Fiscal outcomes have important implications for sovereign ratings and risk
premium and in turn for borrowing cost and inflation in an economy. The Government is a
major player in small open economy Mauritius such that economic activities get a boost through
multiplier effects of government expenditure and induced business optimism by Government
actions. Fiscal discipline has been enshrined in the law of the country with the Public Debt
Management Act 2008. Fiscal discipline is reinforced with Central Bank independence. The
promulgation of Bank of Mauritius Act 2004 set the stage for the move towards central bank
independence and the study demonstrates that the institutional changes brought about have
succeeded in building credibility of the overall policy framework and considerable payoffs have
been obtained in terms of anchored inflation expectations, low inflation rate and inflation
volatility. It is noteworthy, however, that independence of the Central Bank would not have
been effective without a well-functioning coordination between fiscal and monetary authorities.
In the absence of fiscal discipline, for instance, the outcome could have been much different.
Fiscal policy has been prudent. In spite of the stimulus package offered after the adverse shock
of the global financial crisis started impacting on the performance of the Mauritian economy,
fiscal deficit has remained on a prudent path, thus, supporting the conduct of monetary policy.
Major fiscal reforms were undertaken in 2006-07 that have led to improved revenue collection.
Additionally, low interest rates on public debt have contained government expenditure growth to
a large extent. The excess liquidity that has prevailed in recent years suggest that crowding out
has been absent. In effect, there is evidence of government spending being supportive of private
investment through multiplier effects on aggregate demand and business optimism.
In recent years, external debt financing has increased noticeably as a result of the low borrowing
cost conditions that prevailed. However, the increased budget central government external debt
could have been an important source of excess liquidity in the economy. To paraphrase Sargent
33
and Wallace (1981), the monetary authorities might be subject to some “unpleasant monetarist
arithmetic”. The fiscal authorities in their quest to ensure fiscal discipline, have to remain in line
with the target of keeping government debt as a percentage of GDP around 50% by 2018 and
cannot have huge fiscal deficits. So the need for public debt financing is limited to repayment of
existing debts and potentially an annual deficit of 3% of GDP. GDP growth has been less than
4% annually, demand for private sector credit has been slowing down and private investments
even contracting. The end result is that new government debt issues are unable to absorb the
excess liquidity in the market. The issue of monetary authority debt securities can only provide
short term temporary solutions, and might in effect add to the excess liquidity after some lags
with initial excess liquidity absorbed returning into the market along with the added interest
payments. In face of such a situation, increasing share of foreign borrowing can only complicate
the matter with less supply of government bonds to the market and added liquidity from external
sources. Additional government debt could have been used to generate new growth in the
economy, which could have in turn partly absorbed new supplies of liquidity. But, issue of Bank
of Mauritius bills only tend to defer the problem of excess liquidity to a later date if growth does
not pick-up adequately in the intervening time. In face of low GDP growth, the chronic excess
liquidity is unlikely to be resolved. The first recommendation is about the issue of Bank of
Mauritius bills, which is proposed to be kept for short-term management of excess liquidity since
it cannot address the problems of chronic excess liquidity. The second recommendation is to
consider an exchange of part of the foreign debt for domestic debt to resolve partially the
problem of chronic excess liquidity. This would also shield the economy from exchange rate
risks.
The third policy recommendation is about controlling inflation through changes in interest rates.
It has been shown that in the long run, interest rate is an appropriate monetary instrument for
controlling inflation while control in money supply is effective only in the very short run.
Persistence in tightening of money supply growth could over time be counterproductive, in line
with Sargent and Wallace (1981) postulate. Further, it was observed that exogenous shocks like
food and oil price shocks weigh on price developments and therefore have important
implications for the transmission mechanism of monetary policy. The regression results also
confirm the considerable impact of exchange rate developments on inflation. It is recommended
that all these considerations be included in the decision-making process to enhance the
effectiveness of monetary policy.
In sum, fiscal discipline and independence of the Central Bank that have been put in place in
Mauritius have worked well for the country. But, the limits that the size of the economy imposes
on fiscal and monetary practice must be upheld to further improve the coordination between the
two.
34
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