Introduction

The exchange rate of the rupee carries tremendous importance in a small open economy like Mauritius where there likely exist significant pass-through of changes in the value of the rupee onto domestic macroeconomic variables such as inflation and output. Since the suspension of the Exchange Control Act in July 1994, the rupee has been on a managed exchange rate float and has undergone large cycles, from about Rs17.50 per US$ at around this period to more than Rs30.00 per US$ currently.

According to the Bank of Mauritius Act 2004, it is the responsibility of the Bank of Mauritius to manage the exchange rate taking into account the orderly and balanced economic development of the country. In so doing, the Bank has to tread a fine line in seeking to reconcile the often-divergent interests of the different sectors of the economy and steer the exchange rate of the rupee towards an appropriate level. Of particular interest, therefore, is whether the exchange rate is consistent with some kind of fundamental equilibrium or not. Although short-term foreign exchange movements can often appear erratic, it is often believed that there are basic forces that push a currency towards an equilibrium exchange rate.

The aim of is to determine such an equilibrium exchange rate for the rupee. This would allow an assessment of how under- or over-valued the exchange rate is, in order to evaluate any potential future effects on the economy. It focuses on the short term where equilibrium exchange rate can be defined as the exchange rate that would pertain when its fundamental determinants are at their current settings after abstracting from the influence of random effects. In general, monetary models such as the “Behavioural Equilibrium Exchange Rate (BEER)”, “Intermediate Term Model Based Equilibrium Exchange Rate (ITMEER)” and “Capital Enhanced Equilibrium Exchange Rates (CHEER)” are most closely related to short-run equilibrium concepts.

We follow Stephens (2004) and rely on a CHEER, which combines the Purchasing Power Parity (PPP) theory and the Uncovered Interest Parity (UIP) condition into a single relationship and yields a nominal equilibrium exchange rate that is consistent with current price levels and interest rates. The idea underlying this approach is that while PPP may explain long-run movements in real exchange rates, the real exchange rate may be away from equilibrium as a result of non-zero interest rate differentials.

Exchange rateIn the second half of 2008, the exchange rate of the rupee was driven mostly by international economic developments whilst local factors had rather mitigated effects. The intensification and deepening of the crisis, which enhanced risk aversion, pushed investors towards safe havens like the US dollar and the Japanese yen. These currencies remained well-supported as a result. This was mirrored in a depreciation of the rupee on the local foreign exchange market. The rupee depreciated against major currencies from July to December 2008, with the exception of the Pound sterling which tumbled to multi-year low on international markets.

Interventions by the BankIn an attempt to smooth out the increased volatility prevailing on the domestic foreign exchange market, driven mostly by international factors, the Bank intervened on eight occasions between August and November 2008 to sell a total of US$172 million. Transactions were carried out at exchange rates ranging from Rs27.95 to Rs31.90. This was synonymous to mopping up around Rs5.2 billion from the money market. Furthermore, with a view to countering possible adverse effects of the ongoing global economic crisis on the domestic economy and to support the initiatives taken by the government to stimulate the economy, the Bank, on 20 December 2008, introduced a Special Foreign Currency Line of Credit for US$125 million equivalent to approximately Rs4 billion. The objective was to support banks which might be facing non availability, or inadequacy, of foreign exchange credit facilities from their usual sources, which may adversely affect banks’ ability to finance the country’s requirements in trade. On 24 December 2008, one bank was granted a loan of US$5.0 million under the facility.

Exchange Rate Pass-Through to Prices

Exchange rate pass-through, broadly defined as the responsiveness of prices to movements in the nominal exchange rate, is a complex mechanism. Any appreciation or depreciation of the exchange rate is expected to impact not only on the prices of imported finished goods but also on the prices of imported inputs that affect the cost of finished goods and services. Knowledge of the degree and timing of exchange rate pass-through is considered essential for a proper assessment of the monetary policy transmission as well as for inflation forecasting. Using a VAR approach, an internal study has been carried out to examine the extent of exchange rate pass-through in Mauritius over the period 1994Q3 to 2008Q3. This approach allows the quantification of exchange rate pass-through directly from the data in terms of impulse responses that trace the speed and extent of the pass-through of an exchange rate shock to other variables in the model. The study has also assessed whether estimates of pass-through are symmetric or not. Variables used in the VAR include a recursive distribution chain of pricing, which maps out the dynamic effect of an exchange rate shock along three pricing stages in the following order: (i) import prices, (ii) production prices, and (iii) consumer prices. The ordering and choice of the price variables are motivated by the idea that prices are set at each of three different stages – import, production and consumption – which together make up a stylized distribution chain for goods and services. In addition to the distribution chain of pricing, variables such as oil prices, output gap and broad money or interest rates have been incorporated in the VAR model to estimate exchange rate pass-through. These variables act as proxies for supply and demand shocks, and for monetary policy, respectively. To derive impulse responses, variables in the model have been ordered in a particular sequence so that those placed higher in the ordering have contemporaneous impact on those placed lower in the ordering, but not vice-versa. The most exogenous variable, oil prices, has been placed first on the premise that oil price shocks affect all other variables in the system contemporaneously but oil prices are not themselves affected contemporaneously by any of the other shocks. The next variables in the system are the output gap and the exchange rate. With this ordering, a contemporaneous impact

of the demand shocks on the exchange rate is implicitly assumed while a certain time lag on the impact of exchange rate shocks on output is also recognised. The price variables have been ordered next and are thus contemporaneously affected by all of the preceding variables. Following the pricing chain, import prices have been placed before producer prices and consumer prices implying that pricing decisions at the import and production stages can have a contemporaneous impact on consumer prices, but not vice versa. The interest rate has been ordered last, allowing for the money market, and in particular monetary policy, to react contemporaneously to all variables in the model. Over a ten-quarter horizon, it has been found that the maximum impact of the exchange rate shock is immediately felt in the case of import prices and producer prices while it takes two quarters for the maximum impact of the exchange rate shock to be reflected onto consumer prices. Thereafter, the effect of the shock on all price variables diminishes substantially, turning negative after 2-4 quarters partly reflecting the adjustment process by consumers in the domestic economy to the shock. Pass-through to import prices amounts to about 100 per cent of the exchange rate shock in the first two quarters after the shock, meaning that the elasticity of import prices with respect to the exchange rate is approximately unity. The extent of pass-through to producer prices is considerably less but still significant, with 35 per cent of the exchange rate shock reflected in producer prices after one quarter and 28 per cent after two quarters. The response of consumer prices is also quite significant and persistent as well. From about 13 per cent at the end of the first quarter pass-through rises to some 38 per cent in the second quarter, and peaks at around 40 per cent three quarters after the shock before gradually subsiding. The chart below shows the pass-through elasticities of a one per cent shock in the exchange rate.

Effective Exchange Rate of the Rupee

Exchange rate pass through is the percentage change in local currency import prices resulting from a per cent change in the exchange rate between the exporting and importing countries (Goldberg and Knetter 1996). Exchange rate pass through can be either incomplete or complete and refers not only to the effect of exchange rate changes on import and export prices but also on consumer prices, producer prices, investments and trade volumes. The extent and degree of exchange rate pass through points out the importance of exchange rate fluctuations on domestic price inflation and also the extent to which exchange rates and import prices influence domestic inflation.

Like many developing countries, Mauritius depends on the rest of the world and the level of interdependence has increased in the last decade. Mauritius being a small island economy with a domestic market insufficiently large to support large scale production depends on imports from other countries to supply a large part of domestic consumption and on exports to other countries to provide markets for much of its output. It is highly vulnerable to any adverse economic changes in other economies. Mauritius has increasingly liberalized its trade frontiers leading to lower barriers to trade, for both goods and services. This has increased trade and intensified international competition. In addition to greater trade and financial liberalisation, two specific changes have impacted significantly the Mauritian economy namely the phasing out of the preferential access

obtained on the EU market for sugar exports and the dismantling of the Multi Fibre Agreement for our textile products in 2005. In addition, currency markets show different degrees of volatility, reflecting the particular economic circumstances that the country faces through time. Exchange rate volatility is another crucial element that needs to be considered for small countries that depend extensively on trade – the case of Mauritius. Exchange rate changes have thus important implications on both producer and consumer price inflation. To our knowledge, there are no studies analysing exchange rate pass though for the small island economy of Mauritius which is highly dependent on trade and where food imports presently consists of 77 per cent of the total import bill.

Mauritius is a small open economy which is affected by movements in the domestic exchange rate against various foreign currencies and the path of the rupee against the trading currencies will determine the consequences on the economy. It is important that an exchange rate index is calculated based on the several bilateral exchange rates that apply to a particular currency in order to gauge the average value of that currency against others. The index excludes mistaken generalizations that can result from changes peculiar to a single currency. A weighted-average measure of the relevant bilateral exchange rates has been computed to build an ‘effective exchange rate’ (EER). The computation of the proposed effective exchange rate index of the Bank of Mauritius, which will be known as the MERI (Mauritius Exchange Rate Index) is described. Since two indices are being suggested, they will be termed MERI1 and MERI2. The Bank may, in future, introduce various other measures of an exchange rate index reflecting specific concerns for various sectors of the economy.

MERI 1 is the Mauritius Exchange Rate Index, a nominal effective exchange rate introduced in July 2008, based on the currency distribution of merchandise trade.

MERI 2 is the Mauritius Exchange Rate Index, a nominal effective exchange rate introduced in July 2008, based on the currency distribution of merchandise trade and tourist earnings.

Constructing the EER: To build any EER, the following issues need to be addressed: (i) the choice and number of bilateral currencies to include, (ii) a measure of international trade to use to weigh these currencies, (iii) the use of bilateral or multilateral exchange rates, (iv) the use of arithmetic or geometric weight, and lastly (v) the base year for the index.

Which Currencies: This choice has been influenced by the importance of the currency distribution of trade flows of Mauritius with the rest of the world. While there are some merits in including services, given that Mauritius is rapidly developing into aservices economy, data constraints prohibit the use of all services traded to be included in deriving the currency distribution of services traded. Nonetheless, some of the foreign exchange flows emanating from the services traded are considered. Tourist arrivals are

available by country of residence, and a currency distribution of tourist receipts can be proxied using the total receipts based on the strict assumption that tourists would obviously pay for their expenditures using the currency of their respective countries. While this assumption is quite debatable, it nevertheless provides for a rational proxy.

Choosing the Measure of Trade: Traditionally, most EERs are weighted by some measures of traded goods and services, the sum of exports plus imports. The total trade of goods, that is, the sum of exports and imports of goods, has been used to derive the weights for the MERI1. The weights for MERI2 have been calculated using the total trade of goods and a proxy derived from tourism receipts. The approach that is mostly followed to derive the EER is the use of multilateral weights, whereby each currency receives a weight equal to its proportion of total trade. This method captures the impact of major currencies on trade flows. The same approach is followed for deriving MERI 1 and MERI 2. Further, the geometric weights technique has been used to derive the two weighted exchange rates MERI 1 and MERI2.

Base Period: The choice of the base year typically reflects the most recently available data and has been chosen so that the weights characterise the structure of trade throughout the period of analysis. The base period chosen for computing the EER is January – December 2007 = 100. The approach followed is to use continually updated weights in an attempt to portray current trade patterns. That is, weights will be updated annually to ensure that they reflect the most recent structure of trade flows.

The MERI: The MERI is designed to be a summary measure of the rupee’s movements against the currencies of its important trading partners. MERI1 and MERI2 differ from each other in the sense that MERI1 uses the currency distribution of trade as weights, while MERI2 includes the currency distribution of tourism receipts combined with the currency distribution of trade as weights.

Tables 1 and 2 give the weights that have been used to derive MERI1 and MERI2 respectively. Table 3 shows the MERI1 and MERI2 since January 2007, while Chart 1 plots their evolution since the same period. Chart 2 shows the monthly appreciation/depreciation of the rupee vis-à-vis US dollar, pound sterling and Euro together with the change in the MERI1 and MERI2.

Memoranda of Understanding The Memoranda of Understanding entered into between the Bank of Mauritius and other authorities are listed below:

Local

Financial Services Commission

Foreign

Jersey Financial Services Commission

Commission Bancaire Française

State Bank of Pakistan

Banco de Moçambique

The Bank Supervision Department of the South African Reserve Bank

Central Bank of Seychelles

Hong Kong Monetary Authority

January 2009 Communiqué on Basel II

On 21 September 2007, at a special meeting of the Banking Committee∗, it was decided that banks in Mauritius would be required to report as from the quarter ending March 2008, on a parallel-run basis, their capital adequacy ratio (CAR) under the Basel II framework along with their CAR under the Basel I framework. Following on from this decision, the Bank issued a series of guidelines required for the implementation of Basel II and commenced parallel run from quarter ended March 2008, as scheduled. The Bank monitored the performance of banks under the parallel-run exercise and assessed the impact of the new framework on their capital requirements. The Bank is satisfied that the banking sector in Mauritius has made significant progress and is adequately prepared to move on to the Basel II framework. Accordingly, in consultation with representatives of all banks in Mauritius and the Mauritius Bankers Association Ltd, the Bank has decided to do away with the parallel-run exercise and move over to the full implementation of the Standardised Approaches of the Basel II framework as from the quarter ending 31 March 2009.

Domestic Financial Markets DevelopmentsReflecting the generally weaker US dollar as well as domestic demand and supply conditions, the dealt rupee exchange rate had appreciated by 0.81 per cent against the US dollar, but had depreciated by 1.31 per cent and 0.19 per cent against the Pound sterling

and euro, respectively. In nominal effective terms, as indicated by the MERI1, the rupee had remained broadly stable. Staff Economic Outlook The Bank’s Staff anticipated that domestic economic conditions would improve in 2014 as global economic activity recovered. Real output was projected to grow close to its potential over the forecast horizon. Consumption and investment were expected to pick up during the year as consumers and businesses became more confident about the recovery and adjusted their behaviour accordingly. Downside risks to the domestic growth outlook remained, however, from the continued process of fiscal consolidation and the need for private sector deleveraging. Moreover, the weak recovery in the Eurozone might still constrain external demand while the low Eurozone inflation could impact on the euro and, consequently, rupee exchange rates.

From recent short-term dynamics, measured by annualised q-o-q CPI inflation, the Bank’s Staff assessed that it was likely that inflation would sustain its current momentum over the next quarter. Going forward, demand and external pressures on inflation were expected to be subdued. However, higher wages in the public sector could still have some spill-over effects as trade unions demand a similar increase for the private sector. It was noted that wages had already increased in the transport sector and negotiations were on-going for an upward revision in the sugar sector while 14 remuneration orders were under review. While the domestic exchange rate had remained range-bound, the continued dependence on foreign savings to finance the pronounced current account deficit constituted a major risk factor.

The Monetary Policy Decision The MPC concurred that the global economy had picked up since the September 2013 MPC meeting, with recovery taking hold in advanced economies, particularly the US and UK. The Eurozone appeared likely to stay out of recession, although growth was expected to remain weak and uneven. Emerging market economies were expected to continue facing downside risks from the US Fed tapering and internal rebalancing in China. Concurrently, while the global inflation outlook remained benign, it was noted that a number of emerging economies had experienced increases in inflation as a result of the depreciation of their domestic exchange rates. They had consequently raised their policy rates while advanced economies had maintained an accommodative monetary policy stance.

Mauritius: Mauritian rupee increasingly depreciates against the dollar

The Mauritian rupee has again lost its value between August and September 2014 against the dollar according to figures from the Central Bank of Mauritius.   The latest report of the Central Bank of Mauritius indicates that the weight of the currencies (index MERI * 1) in the trade in goods valued at 94.508 points in August has reached 94.948 points last September.

  Distribution of currency in trade and the income from tourism on the island (index MERI 2) encrypted on its side 94.187 points in August rose to 94.538 points in September.   The dollar is thus currently trading at about 31.80 rupees against 31.21 rupees in early September.   A strong dollar against the Mauritian rupee should drain in its wake the higher import prices and more expensive products by the end of the year for consumers, as reported the Le Défi Quotidien newspaper.   * Index MERI: Mauritius Exchange Rate Index (MERI), represents a weighted average of the exchange rate of the rupee.   This index assesses the movements of the rupee against the currencies of major trading partners of Mauritius.

Conclusion

This study examines the degree and extent of exchange rate pas through to import and domestic prices and also the effect of external shocks such as oil price shocks and import price shocks on domestic prices. So as to understand which shock better explains the variance in import and domestic prices, the forecast error variance decomposition of each price index have equally been studied. Another investigation carried out in this study is on the existence and degree of causality from exchange rate to domestic and import prices and vice versa. Using a structural VAR model that incorporates a distribution chain, the results from granger causality test indicate that bidirectional causality exist is one case where producer price granger causes nominal effective exchange rate and vice versa while in other cases unidirectional causality is found. It is equally found that nominal effective exchange rate, import and producer prices do not granger cause consumer prices. The impulse response functions of the structural VAR are used to calculate exchange rate pas through elasticity and the results indicate that exchange rate pas through to consumer prices is highest and not complete. The second larger impact of an exchange rate shock is felt on producer prices and the smallest on import prices. Therefore pass through increases as one goes along the distribution chain. The findings especially for the case of consumer and import prices are not in line with other studies. But this can be explained by the fact that main sources of imports being China and India, lower import prices can be expected given the cheap labor and the low quality products from China. Moreover, the pricing to market practice can explain the low pass through to import prices. As far as consumer prices are concerned the reason behind the high pass through is the dependence of households’ consumption on imported consumer goods where most of them are not subsidized. The increasing cost of living in Mauritius and the change in the exchange rate regime can also explain the high pass through in consumer prices. Externals shocks equally have an effect on import and domestic prices. The results suggest that oil price shocks have a larger impact on import prices compared to producer and consumer prices while import price shocks have

a larger influence on producer prices. The examination of external shocks in explaining the variance in the price indices pointed out that the variance of import and producer prices are explained mainly by oil price shock while for the case of consumer prices, import prices explain most of its variance. External shocks thus play an important role in the Mauritian economy whereby prices are exposed to external shocks. However, Mauritius being a small island developing state is vulnerable to external shocks and thus cannot do much to reduce the impact of these external shocks on the economy given the extent of openness of the country. The study can be useful for policy makers such as Central Bank, in controlling the price level in Mauritius. The indication that exchange rate pass through to consumer prices is highest but still incomplete implies that domestic policies such as monetary policy have a significant role in controlling consumer price inflation. Given that import price shocks have an important impact on producer prices, managing inflation at the level of imports could be effective to reduce producer price inflation. Moreover, the variance of consumer prices is explained mainly by import prices. Thus, managing inflation at import level and the monitoring of pricing technique by importers can contribute in reducing consumer price inflation.

The Mauritian rupee, after having stabilised against the euro and the dollar on the exchange between December 2013 and January 2014, depreciated again in April in the wake of major foreign currencies.   The latest report of the Central Bank of Mauritius indicates that the weight of the currencies (index MERI * 1) in the trade of goods valued at 94.053 points in March reached 94.190 points in April.   Distribution of currency in trade and tourism on the island (index MERI 2) income was 93.811 points in March against 93.960 points in January, as reported by the Le Défi Quotidien newspaper.   The Mauritian rupee is trading this week at 30.58 rupees per dollar and 41.95 rupees to the euro following the increase of these two indices referents.   * Index MERI: Mauritius Exchange Rate Index (MERI), represents a weighted average of the exchange rate of the rupee. This index assesses the movements of the rupee against the currencies of major trading partners of Mauritius.

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