Since the 2019-2020 Budget announced that Rs 18 billion of the so-called “accumulated surplus” held by the Bank of Mauritius (BoM) would be used to pay down mounting public sector debt, observers have focused on the legal and accounting arguments. However, the crux of the issue is whether the BoM had a surplus in the form of excess economic capital to transfer to the government.
The economic capital of a central bank includes its paid-in capital, any accumulated and undistributed net profits made from its income generating assets (mainly foreign exchange reserves) known as the General Reserve Fund (GRF), and finally revaluation reserves arising from changes in the value of foreign exchange reserves in local currency terms, known as the Special Reserve Fund (SRF). If the BoM rakes in net profits in a given year (excluding gains made by rupee depreciation), 85% of them are paid to the government while the remainder is transferred to the GRF.The Special Reserve Fund is a different kind of animal. The bulk of the assets of the BoM consists of international reserves. A small and open economy like Mauritius holds foreign currency reserves mainly to defend the rupee and to finance the country’s imports in times of stress. It is a last resort insurance policy.
Let us say that our international reserves were USD 7 billion equivalent when the rupee was at 35 to the dollar, and the following year the rupee depreciated to 36 to the dollar: in order to balance the books in rupee terms, the SRF would increase by Rs 7 billion. This money does not really exist, so it is not an income. In any event, no foreign country would accept Mauritian rupees in exchange for goods. A growing level of SRF simply indicates that the rupee has been depreciating: it is not a sign of economic resilience.
If the BoM wants to transfer these foreign exchange gains to the government, it needs to create (electronically) the money out of thin air. This is akin to money printing to monetise soaring public debt, which is precisely what the transfer of Rs 18 billion is about.
The Board of the BoM has the obligation to determine the appropriate level of economic capital needed by the Bank in order for it to efficiently discharge its functions under the Bank of Mauritius Act. Did the Board assure itself that the BoM had Rs 18 billion in “surplus” economic capital relative to what is needed?
In theory, a central bank does not need any economic capital as long as its liabilities are in local currency, because it can print money. In reality, central banks must show financial resilience in order to credibly and independently discharge their duties especially when it comes to monetary policy. They determine the level of economic capital adequacy based on a complex forward-looking risk-based measure of all the risks they face.
The appropriate level of economic capital rests on an asset and liability study of the balance sheet. The Reserve Bank of India (RBI), which transferred “excess reserves” to the Indian government last year, had constituted an independent expert committee to conduct an assessment of the required level of economic capital. The Board of the RBI acted on the basis of its report, which was made public and subject to scrutiny.
Does the BoM have a framework to determine the adequate level of economic capital? Did the Board act upon a technical report saying that the BoM was over-capitalised by Rs 18 billion? After all, just to have Rs 18 billion of notional money in the SRF thanks to rupee depreciation does not mean that the BoM had “a surplus” in terms of economic capital. If there is no asset-liability study and no framework, on what basis has the Board decided to transfer such a huge sum of money? What are the “exceptional circumstances” as stated in the law that justify the move when the economy is supposedly doing so well?
The level of capital and reserves of the BoM as a percentage of total assets has been on a steady decline, from 35.6% in June 2009 to an estimated 10.7% in June 2019 (the RBI had more than 2.5 times this ratio). Following the transfer of Rs 18 billion, the capital-to-assets ratio is now merely 3.6%, a whopping decline of 7 percentage points. Where is the excess capital?
In the event that the rupee appreciates by 3.5% against the basket of foreign currencies and gold held by the BoM – which can happen given volatility in currency markets in normal times –, the BoM will have no capital left. It would then ask the Finance Ministry to recapitalise it in order to maintain the minimum capital requirement.
Given the low buffer available at the BoM, the rupee will be the invariable victim: a weaker currency allows the central bank to build up its level of economic capital. There is today more excess liquidity in the system (Rs 21 billion) than the BoM has capital to absorb it.
The BoM is likely to go for another cut in the Repo Rate. Savers and pensioners would pay for it all!