18 July 2007
opinion
Port Louis — We often hear about depreciation and appreciation figures for our local currency, but very rarely do we ever assess its fair value. Currencies tend to be a measure (amongst many) of economic performance.
Countries with deteriorating economic growth rates, high inflation rates and worsening current account deficits (imports higher than exports) tend to have depreciating currencies. It hence becomes very important to assess the fair value of the rupee and present an outlook based on fundamentals.
The MUR/USD exchange rate is useful in this analysis because banks in Mauritius first adjust the rupee against the US dollar, taking into account the movement of this currency in the international market (as it appreciates or depreciates vs other currencies) and of course, the liquidity situation of the domestic foreign exchange market.
A recent Bank of Mauritius research study* entitled "Determination of an equilibrium Rs/US$ rate according to purchasing power parity and uncovered interest rate parity" highlighted two major factors that contribute to the deviation of the MUR/USD from its equilibrium rate: (1) The difference between the Mauritian inflation rate and the US inflation rate and, (2) The difference between our interest rates and US interest rates.
According to the same study, the misalignment of our rupee to its equilibrium rate stood at almost 10% by 2005. Hence one could argue that our rupee was overvalued. Between January of 2001 and February of 2004, the rupee had on average appreciated vs the US dollar due to a favorable differential between our rates and US rates (US rates headed down following Sept 11 as the US Federal Reserve (Fed) attempted to stimulate economic growth). Inflation in the domestic market was also at relatively low levels and our domestic FOREX market had ample liquidity.
However, after February 2004, domestic yields headed down with increased demand by banks, spurred by excess liquidity in the economy. Consequently, the interest rate differential decreased (US rates were also on the rise), eventually leading to a switch by major investors from local assets to foreign denominated assets. The economy was also not doing well, despite a relatively more expansionary monetary policy simply because money could not generate growth when the structure of the economy needed to be reformed.
The end of trade preferences and rising oil prices also created a current account deficit situation, which essentially meant that more FOREX had to leave to pay our import bill. These factors caused the rupee to depreciate at a fast rate over the subsequent few months.
By June 2004, however, the BoM, rather than allowing the rupee to freely depreciate to reflect the economic reality of the country, intervened in the FOREX market to hold the rate of depreciation near its long term trend rate. This kept our rupee at an artificial level. Then came 2006 with rising inflation and a still worsening current account deficit, which when added to a thin FOREX market ripe with speculators, created what we choose to call "depreciation galore"!
The outlook for 2007 and 2008 in our view remains relatively more stable. The liquidity of the domestic FOREX market has improved and the Repo Rate has been increased to 9.25% in order to control domestic inflation and to preempt the possibility that the Fed may increase US rates later this year. Even though yields have fallen since January, Government bonds still offer attractive yields.
All these factors combined together are likely to create a certain degree of stability for the rupee in the near term. Based on our calculations, the currency still remains around 4-6% overvalued against the US dollar. The current account deficit is still high and the inflation rate remains a concern. The BoM is likely to allow the rupee to head towards its equilibrium in the longer term while easing out shorter term volatility. All in all, we are closer to the equilibrium rate today than in 2005 and that is cause enough for relief.
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