When economic decision making including that of monetary policy making is so concentrated in a few hands at the top of the State pyramid, such things as qualifications and relevant experience seldom matter. If the top of the pyramid is manned by wise men who know everything about anything including monetary policy making and global markets investing, this can of course work for a while but what happens when this is not the case? Fortunately for the wise men, the country has been blessed with the reality that such things as monetary policy, central bank balance sheet management and global markets investing are not well understood by the me- dia and by politicians alike. Even major losses when mixed in with some accounting massaging can go under the radar. This article’s goal is to quantify the cost of random nominations at the Bank of Mauritius (BoM).

Good governance is about having the right people in the right places

The BoM is responsible for ensuring price stability which in Mauritius translates to an inflation rate that should be closer to 3% per year, financial stability of the system which includes investor confidence in the national currency and for preserving the real purchasing power of the international reserves portfolio of the country over a full market cycle (3-5 years for central banks). Given the size of international reserves which make up the bulk of the BoM balance sheet and the wider need to have a tail risk insurance policy for the country, the Board of the BoM should have a degree of expertise and understanding in the above mentioned fields, especially in global markets. The Board of the BoM currently has 3 barristers, one optometrist, one development economist, one businessman, one expert in cloud services, business development and in incubation strategies among others. The Monetary Policy Committee itself is also composed of 2 barristers, a former Company Secretary and out of the two economists with advanced degrees in the field including in macroeconomics, one is an advisor to the Ministry of Finance himself. We either do not have the right people at the right places or we do not have independence.

The Mother of all losses

The objective of a central bank when it comes to the management of international reserves is to maintain high levels of liquidity whilst preserving the real purchasing power of international reserves in foreign currency terms (USD or trade and foreign debt weighted terms). Over the past decade, central banks, big and small, have spent a lot of time and money in enhancing the governance frameworks around international reserves management and have increasingly become more active when it comes to managing these assets. They have also hired people with relevant qualifications in the field while Governments have recognized the need to strengthen Boards.

While central banks typically have relatively more conservative risk budgets, their strategic and tactical asset allocation frameworks have increasingly become more dynamic given rising volatility in fixed income markets. Many smaller central banks including Mauritius (as stated in its annual reports) have outsourced the management of part of the international reserves portfolio to external managers but unlike in Mauritius, they also manage the entire portfolio from what is known as a quantitative factor lens where risk factors are adjusted based on the market regime and risk budgets similar to how fund of fund managers outside of Mauritius manage their portfolios. This includes the use of derivatives in order to adjust factor exposures allowing them to take advantage of market opportunities and remain within tail risk budgets such as Value at Risk and Conditional Value at Risk. Not doing this or not even understanding what all this even means can lead to large losses during inevitable market downturns which are part of life.

Secondly, an international reserve portfolio needs to be dynamic. Its goal is to generate adequate risk adjusted returns above global inflation in order to preserve and even enhance if possible the real purchasing power of the country over time. The accounting framework is a secondary thought and should only match this kind of business model which is akin to fair value through profit and loss. Central banks can have different accounting frameworks for things like securities purchased for their quantitative easing programs of course but this should not be confused with international reserves management.

What unfortunately tends to happen in Mauritius however when you put the wrong people at the wrong places is that they try to set the accounting framework to smooth balance sheet volatility without realizing that they are creating more risk including market and liquidity risk. You can do any massaging of accounting buckets you wish and in a country with many accountants, global markets can come second but at the end of the day, global markets give you prices for your securities.

In the context of trying to massage the balance sheet, the BoM has unsurprisingly created different accounting buckets in the international reserves portfolio one of which is the fair value through profit and loss bucket. This is not a bucket that would typically be subject to redemption for the purposes of selling foreign currency in the local market in order to slow the pace of Rupee depreciation. As at December 2021, the BoM held the MUR equivalent of 151.7 Billion in investments in various undisclosed funds. By June 2022, as global market volatility increased and as the BoM passively stood by without any dynamic adjustments of risk factor exposures at the total portfolio level, the value of this sub portfolio fell to MUR 134.5 Billion. The sub portfolio hit a low of MUR 113.1 Billion by December 2022 and recovered slightly to MUR 118.9 Billion in June 2023. Note that international reserves should be looked at in foreign currency terms but this data breakdown is not available and losses in USD terms for example are worse given Rupee depreciation.

These are significant unrealized losses for a small island like Mauritius and showcases the inability of the BoM to dynamically adjust risk factors and any sense of managing a portfolio within a conservative risk budget. At the same time, as global bond yields became volatile, the BoM has been moving hundreds of millions of dollars from its Financial Assets held at Fair Value Through Other Comprehensive Income into its Financial Assets Held at Amortized Cost in a likely attempt to reduce balance sheet volatility and not report more unrealized losses in its internally managed portfolio. The problem with this grand idea is that holding foreign assets to maturity unless you have an exceptional event which you can explain away to local auditors essentially kills off dynamism and liquidity. Liquidity is a major requirement when managing the international reserves of a country. Today, the BoM holds MUR 95 Billion equivalent at amortized cost which is almost one third of all international reserves assets which it cannot sell or actively manage. Not disclosing unrealized losses for this bucket is likely a function of the low level of BoM capital on its balance sheet and this novel idea that accounting should dictate how one manages a portfolio vs. the other way around.

During the same period, the BoM has been borrowing heavily in international markets as global interest rates continue to rise and squeeze its margins further. Borrowing costs for the BoM can currently exceed 6% given the country credit rating. The BoM and the Government like to talk a lot about gross international reserves standing at USD 6.6 Billion but what they do not say is that BoM foreign borrowings stand at USD 1.44 Billion and that total contingent liabilities (to local banks for example) stand at USD 684 Million. When you add this to the unrealized losses in the mark to market sub portfolio, other potential unrealized losses in the HTM books and liquidity problems with holding USD 2 Billion to maturity, no wonder the BoM has had to severely ration access to foreign exchange locally and only conducts infrequent and small foreign exchange interventions.

Mauritius, today, does not have the ammunition to defend the currency should another major global downturn come around. The BoM balance sheet is severely undercapitalized and messed up and worse, few at the top of the house of the BoM probably grasp the depth of the asset liability problem. It has limited ammunition to defend the currency now and the expansive fiscal policy has complicated the situation further. This is why so many Mauritians who earn in foreign currency prefer to keep as much money as possible abroad. (See table 1)

Balance sheet woes and rising foreign borrowing costs impact on monetary policy credibility

Back in December 2022, the BoM announced its new flexible inflation targeting framework with great fanfare. Many including this author wondered how they would do this given fiscal dominance and the extremely low level of economic capital they were left with. Central banks can certainly have negative equity but printing money to fund local liabilities when its negative equity is not consistent with sound monetary policy making. Over the last few months, Government of Mauritius bond yields have continued to fall and beyond the differential between foreign and local rates, real interest rates have remained in negative territory. Between December 2022 and June 2023, the trade weighted rupee index (MERI 2) has depreciated by more than 5%.

While the BoM is attempting as predicted to ride the wave of the base effect induced deceleration in inflation, inflation will remain well above the key level of 3% for a long time to come and will head back to above 4.5% by the middle of next year as the base effect fades. Given its balance sheet woes and given the Government push to overheat the economy by reverting back to its consumer and private and public debt fuelled economic model, the BoM has allowed financial conditions to ease again. The speed at which local yields fell also showcases what can happen when you change the bidding framework after 7 months in a highly fragmented local bond market with too many small issues (See graph below).

Conclusion

When you have complete fiscal dominance over the central bank and when you put the wrong people at the wrong places, it can not only cost the country dearly but worse, once you lose credibility, it is difficult to gain it back. When talking about the BoM balance sheet woes, no mention of its subsidiary, the MIC has been made. This opaque “sovereign wealth fund” with its exotic “scenario based valuation models” for convertible bonds will one day have to explain how the embedded option of a convertible bond which can only be converted at maturity while the issuer can do so at any time has the value that they think it has.

There are also no plans in Mauritius to recapitalize the BoM based on the risks it has on its balance sheet. This price tag is well beyond what we can afford and the choice of letting the Rupee depreciate slowly but surely to bloat the Rupee value of the BoM’s capital seems to be the preferred option. Mauritians, especially the poor, are paying for it via the inflation tax. It will take years with a strong quantitative min- ded team and Governor to fix the BoM and it will take even longer to regain lost credibility. All this of course assumes that politicians will allow the central bank to become independent in the first place.