Your Island in 2008 and Beyond

If you must forecast, forecast often.

Paul A. Samuelson

This is what the tea leaves are saying.

Somebody else will celebrate Halloween at Reduit

SAJ will not get a second term as President because it doesn’t make any sense for Navin Ramgoolam to reappoint him as the MMM and the MSM will most likely go together in the 2010 polls. Indeed the leaders of these two parties will somehow try to convince us as from mid-2009 that our future lies with what they will dub as Federation III. As usual, it is their future that they would be talking about as that’s the only political combination that will allow them to hold the most important office of the land, albeit for about 2½ years each. Of course if you don’t vote for Berenger as PM, you could, again, be accused of being a racist.

Berenger not likely to go first in 2010

Berenger has always lost general elections when he has presented himself as either the only candidate to the post of PM or the first in a power-sharing agreement. This of course lends some credibility to the view that a chunk of the electorate in 2000 thought that SAJ would somehow not have handed power to the Leader of the MMM in 2003. Anyway, a safer bet for Jugnauth Jr. and Berenger would be for the latter to become PM in the second half of the next term.

Meet TAMBO

Patriotism is the last refuge of the scoundrel.

Samuel Johnson, 1775

It stands for There-Are-Much-Better-Options. It’s the response of The Jag! on behalf of the beautiful people of Mauritius to the incompetent bunch that swear only by TINA.[1]

TINA – Position #1: There is no money to fix the severe traffic problems that we face. Debt levels are already way too high. Blah blah blah.

TAMBO – Response #1: It is really not a problem if national debt levels went up a little bit as long we’re using the money to solve real problems. For instance cutting ½ an hour on travelling time every working day for tens of thousands of Mauritians that take the Curepipe-Port-Louis corridor is one area where our tax rupees should go to in priority. Hey, if you have an excellent Public Transportation System that runs till late every day a great number of people will start leaving their cars at home. Spending money in this manner will not only make us more competitive but it will make every square inch of our island more valuable. Another way of looking at it is to realise that standards of living can be raised by reducing the multiple levels of frustration that we face as citizens of our island-state. Of course, we would have to be worried if debt levels were going up and the money were wasted or mysteriously disappearing or if debt levels were going down but new levels of frustration were cropping up. If you are solving problems that really matter both debt levels and frustration levels will eventually go down.

TINA – Position #2: The only priority is deficit and debt reduction. So in his 2006 budget the Minister of Finance decided among other half-baked policies that the school-feeding program was a waste of money, the subsidy on rice and flour would be eliminated, interest income would soon be taxed, personal income tax exemptions would be abolished and the HSC/SC subsidy would be reviewed.

TAMBO – Response #2: The basic practice of government or anything else for that matter requires that we understand the important links of the system we are trying to improve. That is which dots we should connect and how we should connect them. Ignoring the basic principle that understanding how things work is to have control over them, Sithanen managed to seriously upset the whole country for a mere 0.2% difference in the deficit of his first budget. We all remember how Berenger had to apologize for Sam Lauthan’s blunder with respect to means-testing our elder folks. Well, what Sithanen has done is at least 10 times worse and the political cost of such incompetence will be borne by everybody’s favourite uncle, Navin Ramgoolam, who unlike his Finance Minister needs more than 24 hours to shift parties.

TINA – Position #3: Sugar Industry is our mother industry [paragraph 73, Budget speech 2007-2008]

TAMBO – Response #3: If that’s the case then I guess we shouldn’t be surprised if Rama Sithanen came across a Dodo on La Chaussee Street and greet her with a heart-breaking ‘chachi’. It was totally indecent for the bean-counter to have suggested that we should handout Rs 5 billion to that sunset industry especially after making us poorer by depreciating the rupee and viciously going after our hard-earned savings. That was after he announced another economic nonsense on TV from Brussels that the money we would get from EU would be used to subsidise loans to that sector. Sithanen owes us an explanation as to how he moved from subsidised loans to outright gifts. We could definitely use that money much more productively. Our salvation lies in shortening our product and industry life cycles, not in making them last forever. And that’s a good prism through which to look at the Tianli project.

TINA – Position #4: The country never faced such economic upheaval before. Triple External bla bla bla.

TAMBO – Response #4: When you don’t know how to solve problems you just blurt out crap or you go seek help from the Bretton Wood idiots (The IMF and the WB). Sithanen not only does both, he also imagines new problems now and then when he is not creating some really serious structural ones. Meade and Naipaul rightly did not think much of our future when they said what they said after seeing what they saw: rapidly-expanding population, mono-crop economy, the tyranny of distance and a century and a half of divide and rule complimentary of the British on the coat-tail of about a hundred years of French rule which saw the execution of a particularly cruel version of Colbert’s little human resource manual, Le Code Noir. All of this along with the first two oil-shocks surely did not predispose us to the sunniest of tomorrows. But thanks to the vision, dedication and the very hard work of a few mavericks we managed to hold our heads above water and a strong foundation for our country was laid. Regrettably, the latter was left to rot after 1982. It is also interesting to note that the implementation of free education turned 30 last January. At that time, and fortunately for us, doing was not the same as deciding and of course when a Minister resigned, he resigned.

TINA – Position #5: The Minister of Finance does not have a forecast for inflation. That was after the rate of inflation (both the CPI and Core inflation) doubled in a 12 month period mostly on account of budget-related measures and the practice of Faratanomics. There is nothing we can do about rising prices.

TAMBO – Response #5: In the country where both Sithanen and Mansoor studied economics, the law requires the Governor of the Bank of England to write an open letter to the Finance Minister if the target rate of inflation of 2% is missed by more than 1% on either side. That happened last April for the first time in 10 years since the UK’s Monetary Policy Committee was set up in 1997. That letter is a must read to understand why there is no place for Sithanen in the cabinet and that’s before you realise that he is contravening Article 5.2a of the Bank of Mauritius Act 2004. The British rate of inflation has since then been brought back to within target.
TINA – Position #6: The reform is working (a.k.a early harvest). We have to maintain the course. Blah blah blah.

TAMBO – Response #6: At double-digit inflation with double-digit and rising unemployment along with a depreciated currency, entrenched inflationary expectations, a really upset population and not the least sense of direction I don’t think we could call that reform. Nope. What Sithanen has been doing for the past 2¼ years is nothing but screwing up our country big time. Clearly this is a case of things gone worse right from the start before really and rapidly getting out of hand.

TINA – Position #7: Our rupee is overvalued and has not adjusted for the past few years. Rupee is then devalued.

TAMBO – Response #7: Not knowing what to do, our Finance Minister simply followed a flawed IMF report that found our currency overvalued and made everybody, save a few speculators, poorer. This is all the more controversial given that the IMF has come under attack with respect to its core function: exchange rate advice. Indeed its own Independent Evaluation Office (check the May 17) has found the type of advice it has been dishing out wanting at best. And matters have gotten more complicated for the IMF: nobody wants to borrow money from it and nobody wants its poisonous medicine. Furthermore, given all the FDI Sithanen said we have received, that would make Mauritius probably the only country to have experienced what needs to be coined as the Reverse Dutch Disease: the more FDI you receive, the more your currency depreciate.

TINA – Position #8: We’re gonna revolutionize the tax system. Exemptions are going to disappear. Youpi!

TAMBO – Response #8: A lot of people (that includes people who will vote in riding no. 18 in 2010) feel that they have been cheated by the crappy policies of Rama Sithanen. Indeed, when people take loans, insurance policies and craft their investment policies they plan over the long term using their frontal lobe machinery. A responsible government doesn’t make these decisions become irrelevant in one bean-counting budget-speech especially if that’s what another flawed IMF report recommended. Maybe that’s what he meant by early harvest: the population have been harvested of their assets. And the doubling of the rate of inflation and depreciation of the rupee also creates a distortion known as shoe-leather costs: you waste your time into unproductive activities because the environment has become unpredictable. Isn’t that what is precisely happening in our country today? Paul Krugman’s September 10 piece in the New York Times entitled Where is my trickle? makes good reading for those who have mistaken Mauritius for Mount Meru.

A little aside on expectations
Lucas. Not George. Robert E. There was picture of him smiling and holding a bottle of Dom Perignon in the newspapers some 12 years ago. He had every reason to celebrate. He had just been informed by the Royal Swedish Academy of Sciences that he had been awarded the Nobel Prize in Economics mostly for ground-breaking work that he did in his early thirties. So important was this work that some new artillery in econometrics had to be crafted to implement it. And his 1976 critique of models that did not allow expectations and hence behaviour of economic agents to change was so brilliant that it ended up simply being known as the Lucas Critique.

Updating
Essentially, Lucas explained that people process information efficiently (the equivalent in financial markets would of course be Gene Fama’s Efficient Market Hypothesis). That is they update their prior knowledge with new information. They revise their expectations in such a way that they end up having rational expectations – a term coined by John Muth in a paper published in Econometrica when Ali Mansoor was about 5 years old. This is a crucially important concept for policy makers when trying to assess how agents are going to react either following the announcement and/or implementation of a new measure or as the environment evolves. What’s going here is a much more sophisticated version than what B.F. Skinner discovered rats were capable of when subjected to an external stimulus. This is something that is continuously ignored by Sithanen.

TINA – Position #9: Setting the stage for robust growth.

TAMBO – Response #9: Economic growth is obtained by multiplying the growth rate of a sector by its size and then adding everything up. Sugar is a smaller sector than the financial industry and has experienced a natural death while the financial sector has been growing at a brisk pace and can grow at even faster rates. But it is not surprising that so far Rama Sithanen has had little plans for that growth sector except maybe playing some really cheap politics with our national debt numbers. Furthermore it is a well established fact in Economics that taxing interest income will slow down the growth rate (known as the Lucas wedge). Does it look like we are going to get robust growth? And that’s supposed to happen without enhancing our infrastructure? Wow!

TINA – Position #10: We’ve been victim of our own success. We need cheap loans from the Bretton Woods Institutions and the AFD has been brought back in after they’ve been shown our begging-bowls.

TAMBO – Response #10: Mauritius is not desperate for cash to finance its development. There is absolutely no reason for us to borrow money with strings attached be it from the World Bank or the China Development Bank. The Government can borrow money from our local capital markets like it does regularly or it may borrow from international markets at a rate that reflects our credit-worthiness which in turn depends on the way we manage our country. What we urgently need to do is to allocate money to solve one major problem after the other. What we don’t need is money that cannot be used to solve real problems or getting our heads buried in the sand and waiting for these problems to somewhat go away. Also, why pay interest to foreign institutions when that interest could be used to support the deepening of our capital markets which will create more high-paying jobs here? There’s another proof that Sithanen is creating severe structural problems for our country.

A concluding note
I am betting the Prime Minister will cancel the NRPT one way or another in the days to come in order to defuse one of elements of the perfect political storm that his Finance Minister has been brewing. This would have been just another big waste of our collective energy to clean up after the bean-counter.

TAMBO is here to stay
How big is this TAMBO thing going to be? Huge! Africa’s busiest airport has already been named after it!


Comments: density@intnet.mu.

[1] TINA stands for There Is No Alternative.


No. 8 September 2007
© Sanjay Jagatsingh, 2007

Trends in Central Banking

What is the Federal Reserve?
Of the US population
23% think it was an Indian reserve,
26% a wildlife preserve,
51% a brand of whiskey

Remarks of Chairman Miller in Peter Lynch’s One up on Wall Street

Dear readers of The Jag! This edition of the ‘newsletter with teeth’ features an article on central banking that was written around the end of March 1999. We are reproducing it in here as a background article for further analysis that will be featured in forthcoming editions. Happy reading and stay tuned!
__________________________________________________

Central Banks could probably have done without the Y2K problem. The 90s would already have been an unusually busy decade for many of them. Here is how.

Inflation targets, uncertainty and the Monetary Conditions Index
Early on in the decade, mounting deficits and ballooning debt levels in G-7 countries have forced central banks and governments there to opt for low inflation targets. Roughly, between 1% and 5% as captured by the CPI[1]. It’s not that it suddenly dawned upon them that interest payments were eating up 30 cents out of every tax dollar. No. It was more because of a wake up (and smell the coffee!) call from our friendly global capital markets telling them to either put their fiscal houses in order and adopt consistent monetary policies or face a massive sell off of their securities. Some like Canada have listened and have found many virtues to low inflation (which its Central Bankers are likely to have happily shared once a month with their colleagues in Basel, Switzerland) along what was to be a very bumpy road. The good news is that they will turn out a budget surplus this year from a deficit of CAD 42 billions in 1993. Finance Minister Paul Martin, a millionaire from Montreal and strong contender to succeed Jean Chretien as PM, will use part of the surplus to start paying off the national debt.

Why adopt low inflation targets?
First because it shields the purchasing power of pension benefits of a rising share of old folks. It also bolsters confidence in the currency. Next it allows economic agents to get their priorities right by focusing on productivity-enhancing vs. speculation activities like those experienced in Germany in the 30s. Collective bargaining is carried out in an environment of lower inflation uncertainty and is likely to lead to a lengthening of contract maturities. Lower inflation will also ensure lower borrowing costs via lower inflation premium and lower inflation variability (in a GARCH sense). Once inflation is tamed, rates should come down, increasing investments and the general standard of living.

Central banks have not only to reduce year-on-year changes in the CPI index but they also have to drive down expectations of inflation. And they have to do that throughout the whole business cycle. Low inflation credibility will not be sacrificed at the expense of averting an economic slowdown. Besides as Central Bankers have found out, it takes a while for credibility to show up in a markov-switching model (the new darling in central bank research).

How uncertainty can being reduced
By establishing price stability as a goal. The name of the game has been first a systematic reduction in the rate of inflation and the subsequent adoption of specific inflation targets. This is the approach adopted by the Reserve Bank of New Zealand. Once this is achieved, the Central Bank has to stay the course and possibly focus the public’s attention on its use of intermediate keyposts such as the Monetary Conditions Index (MCI) in gauging the stance of monetary policy. Central banks around the world have been making a greater effort to communicate policy actions and intentions through press releases, monetary policy reports, press conferences and of course via their websites.

The MCI
Pioneered by the Bank of Canada, the MCI is a tracking device that is correlated with the ultimate target such as aggregate demand while being sensitive to policy instruments. It is a combination of interest rates and an index of exchange rates that reflects the relative importance of these two channels of monetary policy in affecting nominal spending. A typical vector autoregression result is that interest rates are between 2 (New Zealand) to 3 (Canada) times more important than exchange rates. Which is good news for Central Banks as they have little influence over the exchange rate when their currencies float. The MCI has also found a place in the toolbox of the quantitative asset manager namely in the design of asset allocation models.

Problems with the CPI and the monetary aggregates
The recipe appears simple. Reduce the monetary ease and this will bring the CPI within the targeted band. The snag is that the CPI contains a measurement bias. Reasons advanced by Federal Reserve officials in their testimonies are that current inflation rates imply that there has not been any increase in productivity, the relevant baskets are slow to acknowledge technological advances that modify consumer behaviour and yield productivity gains. The Fed estimates that inflation is overstated by 1% to 1.5%. This makes the case for a positive rate of inflation. To complicate matters growth appears to be overstated by 0.5%. Solutions include the adoption of chain weighted indices, a subjective removal of the bias and developing better methodologies for measuring increases in the general level of prices.

Another show-stopper is that the link between M1 and nominal spending has weakened enough to prompt Feds to reduce its importance among the battery of indicators or abandon it altogether (US, Canada while the Bundesbank watched M3 in the pre-Euro setup). The idea is to identify broader monetary aggregates that provide good informational content of inflation 4-8 quarters hence as monetary policy operates with a lag.

Banking supervision and the management of reserves portfolios
Barings, Credit Lyonnais, Orange County, Daiwa and more recently LTCM. These are financial disasters that had the potential to torment bank regulators in their crusade of ensuring a healthy financial system. These events have since led to the establishment of capital adequacy standards with respect to market risks over and above those that have traditionally been required as a buffer against unpleasant credit risk surprises. But financial institutions have recently been given the option of utilizing their own risk management systems in determining the amount of capital to set aside for these risks. This is essentially because the risk management culture at some of the bigger and more innovative banks have been found to be more sophisticated than anything regulators could have asked for or imagined. One example is JP Morgan’ s 4:15 report that spits out their forecasted global market risk on a daily basis.

And Central Banks are integrating some of these ideas in the active management of the reserves portfolios. Gone are the days of passive management of short-dated instruments. Duration gap models are being replaced by value-at-risk[2] metrics coupled with stress simulations of aggregate market risks. They have found that drawing on the seminal work of Markowitz, Sharpe, Merton and the likes are not inconsistent with their basic objectives. Furthermore optionality at the security and portfolio level matters. And they too are worried that asset and default correlations tend to increase when they are needed most. In sum they want to make sure that the return earned (contribution to the national till) is enough for the level of risk assumed. You wouldn’t want it to be otherwise.

On independence
This is a concept espoused by the Bundesbank in 1924 when the relevant legislation was enacted. Since then Federal elections have been lost and won over the single issue of price stability. The relationship between independence and the inflation record of the Central Bank has been investigated too. The GMT index, a weighted sum of 15 legal provisions that includes the length of the governor’s contract and whether he is a government appointee, has been found to have good predictive value. We can only hope that country-rating agencies will factor this into their analysis of our island once they spot Mauritius on a world map that is.

Implications for the investor
Central banks can have an enormous influence on financial markets. Let us consider fixed-income markets. The Treasury yield curve is the benchmark for corporate debentures (bonds) everywhere in the world. Every corporate issue is priced off this curve as it is considered risk-free. In Mauritius, the curve extends out to a maturity of about two years thanks to the seven-hundred-and-something-day T-bill. Corporate debentures of similar effective maturity (which is the case of all but three debentures) should offer a higher yield than their Treasuries counterpart because of default risk, redemption risk, redemption behaviour, horizon risk and reduced liquidity that characterise these issues. The impact of tax-free interest income should likewise be taken into account. All these factors along with the availability of T-bills to the individual investor explain why corporate debentures appear to trade a bit more consistently with respect to government paper. A closer analysis is however required to find out where they are heading to. Empirical research in the US reveal that the influence of the Fed via the fed funds market on the Treasury yield curve is concentrated mostly at the shorter end, accounting for more than three quarters of the variability of changes in T-bill rates whereas it explains about one only third of the movements in 10-year bonds.

[1] Or core inflation. That is CPI without its volatile components such as food and energy components and indirect taxes. But inflation targets can be more sophisticated. Rules like a 3% annual increase in the monetary base with adjustments for the change in base velocity over the past four years plus for deviation of nominal GNP from target paths have been suggested.
[2] The US Securities and Exchange Commission now requires that all companies with a market capitalization of $2 billion and more (about 25% more than the market cap of the SEM at the time of writing) to disclose any material risk exposures.

Comments: density@intnet.mu.

No. 7 January 2007

© Sanjay Jagatsingh, 2007