Why is the Rupee Depreciating Uncontrollably?

And what will it take to stop the decline?

By Vinaye Ancharaz

On July 8, the Bank of Mauritius intervened on the foreign exchange market, selling a total amount of USD 50 million. This was the third intervention by the Bank this year, following a sale of USD 5 million on April 1 and, oddly enough, a purchase of USD 200,000 on February 2. Sales of foreign currency are meant to plug shortages of the currency on the market and relieve pressure on the currency to appreciate, or the rupee to depreciate. Despite recent foreign exchange interventions by the Bank, the rupee’s slide has continued.

Between November 8, 2019, when this government took office, and July 9, 2024, the rupee has depreciated by 30% against the US dollar, 28% against the euro, and 30.5% against the pound. Since December 11, 2014, when the MSM government first came to power, the rupee has lost 50% of its external value against the dollar, the steepest decline among all major currencies. This reflects the weight of the dollar in our foreign exchange dealings, which is also the reason for the Bank’s interventions to be mainly in USD. Mauritius pays for much of its imports in terms of USD, but its exports of goods and services are EU-centric, hence the perpetual shortage of US dollars relative to other currencies. 

A bit of theory

If a currency is treated as a commodity, then its price, measured in another currency – that is, the exchange rate – can be determined just like the price of any good, that is, in terms of the market forces of demand and supply. Just like excess demand for a good will push its price up, similarly a shortage of dollars on the domestic market will cause the USD to appreciate. This perspective sheds light on the factors underlying the constant tendency for the rupee to depreciate against the dollar. It suggests that there is a permanent shortage of dollars, which itself is due to Mauritius not generating enough USD through exports and inflows of investment.

However, the demand-and-supply view is a classical theory, not particularly suited to explain exchange rate movements in modern times where a significant amount of foreign exchange transactions is due to speculation. The interest rate parity (IRP) theory has emerged as an alternative theory of exchange rates. Suppose you have USD 10,000. Do you hold the dollars in a foreign currency (FCY) account that pays, say, 1% interest p.a.? Or do you convert your dollars into rupees at the prevailing exchange rate (called spot rate) and hold them in a savings account that offers 3% p.a.?

The choice is not a simple one – for various reasons. One is that the total dollar rate of return is not 1%. If you expect the dollar to appreciate over the course of the year, then each dollar will be worth more rupees at the end of the year. If, for example, you expect the dollar to appreciate (or the rupee to depreciate) by x%, then your USD account will earn you (1+x)%. How does this compare with the interest rate of 3% on your rupee account? If x is greater than 2%, then the total return on your dollar account will be higher than on your rupee deposit, and dollars will be more attractive as an asset to hold. Only when the rupee-denominated interest rate (3%) is equal to the aggregate return on dollars (1+x)% – that is, interest rate parity holds – that the rupee-USD exchange rate will be in ‘equilibrium’.

The IRP theory suggests that the persistent depreciation of the rupee is because market agents (ordinary people, businesses, investors and, especially, speculators) expect the rupee to continue to depreciate. When you expect the rupee to depreciate against the dollar, you would want to dump your rupees and hold dollars instead. This will increase the demand for dollars and the supply of rupees on the forex market, causing the rupee to depreciate. That is, depreciation is a self-fulfilling prophecy.

A second reason for the inexorable weakening of the rupee is inflation. Inflation erodes the internal value of the rupee; it also reduces the currency’s external value (that is, it causes the rupee to depreciate). With inflation, the prices of all goods rise, making our exports less competitive to foreigners. As the demand for exports falls, the supply of dollars to Mauritius (since we require to be paid in foreign currency) will also decrease, putting upward pressure on the dollar. The widening trade deficit in Mauritius, with merchandise imports about three times higher than goods exports, has a similar effect.

How did we arrive here?

This situation has been long in the making. Figure 1 shows the evolution of the rupee-dollar exchange rate over the past 10 years. When the MSM-led government first took office in December 2014, the dollar was trading at Rs 31.66 and, while the dollar appreciated in the following 5 years, it averaged an ‘acceptable’ Rs 35 per USD. The dollar was already in ascent when the current government came to power in November 2019. The pandemic only accentuated the rupee’s fall as border closures drastically reduced foreign exchange earnings from tourism. In 2020, the dollar shot above Rs 40.

Figure 1. MUR-USD exchange rate, July 2014-July 2024

Source: xe.com

However, the pandemic is now a thing of the past. Tourist arrivals have returned to pre-pandemic levels and gross earnings from tourism are expected to reach Rs 100 billion at the end of 2024. And yet the rupee continues to depreciate. Why? The root causes go back to before Covid-19 even though the pandemic aggravated them.

In December 2019, the newly elected MSM government made good on its promise to raise the basic retirement pension to Rs 9,000. This, along with the payment of the end-of-year bonus, required a substantial amount of resources (about Rs 2 billion), which the government mobilized by drawing Rs 18 billion from the Bank of Mauritius’ reserves in January 2020. This was a major policy blunder, akin to opening the flood gates.

During 2020, the government kept plundering the Bank’s reserves. It coerced the Bank into giving a ‘grant’ of Rs 60 billion to support the 2020-21 budget and, in June 2020, the Bank drew down an additional Rs 80 billion from its reserves to set up the MIC. Thus, in just one year, Rs 158 billion was squeezed out of the Bank’s reserves.

In a managed exchange rate system like ours, the level of international reserves signals the central bank’s ability to maintain a stable currency. When reserves are depleted, market agents become nervous and start to doubt the Bank’s capacity to defend the rupee. They expect the rupee to depreciate, and their actions only precipitate the depreciation. Unfortunately, this is the current situation.

Confounding factors

Currency depreciation has now become systemic because confidence in the central bank as a guarantor of financial stability has waned. There are several reasons for this. First, the government has embraced ‘inflation tax’ as a strategy to support its spending frenzy, rendering the central bank’s inflation target irrelevant. The twin evils of inflation and depreciation will continue to haunt us as long as the current government stays in power.

Second, although tourism receipts have increased substantially, foreign exchange shortages persist. This is because those earning forex (hotels, travel agencies, etc.) prefer to hold on to it as a safe asset in the face of a rupee whose real value is being eroded by ongoing inflation. Can we blame these operators for not playing by the ‘rules of the game’ and relinquishing their forex earnings when holding a foreign currency account has become a new trend among Mauritians? Moreover, if they expect the rupee to depreciate further, aren’t they better off keeping their dollars to pay for future imports than obtaining them – if they could – at a higher spot rate?

Third, IRS/RES/PDS projects are not generating much forex. The prices of luxury villas are quoted in foreign currency and most of it may not even be received in Mauritius. If property prices were in rupees, acquirers would necessarily have to convert their foreign currency into rupees to pay for an acquisition. This would ensure an inflow of foreign exchange.

Last, but not least, the central bank’s international reserves have increased by 27% over the last 12 months, reaching Rs 389.6 billion at the end of June 2024. This is a comfortable level of reserves, so why are dollars and euros such a rare commodity? Why is BoM not doing enough to appease the forex shortage and prevent the rupee’s slide? Unless it is a deliberate strategy to let the rupee depreciate so that the Bank accumulates revaluation gains, and the government continues to collect inflation tax…

What should be done?

With expectations of inflation and depreciation now entrenched, there is an urgent need for a systemic change that signals a departure from inflation tax as a revenue-generating machine for the government. Only a new government that commits to prudent financial management and expenditure control while rebuilding fiscal buffers, as recommended by the IMF in its latest Article V Consultation report, can signal such a paradigm shift and anchor low-inflation expectations.

Macroeconomists have long touted the value of an independent central bank in maintaining a low-inflation target, and hence a stable currency. The current incestuous relationship between the central bank and the government is much to blame for the inflation-depreciation spiral that has afflicted the Mauritian economy.

Over the medium to long term, there is a need to boost exports of goods and services, review pricing of IRS/PDS projects, and strengthen measures to detect and sanction foreign exchange hoarding.

Vinaye Ancharaz, PhD, FCMI, formerly a principal economist at the African Development Bank and a senior lecturer and Head of Department at the University of Mauritius, is an international economic consultant specializing in trade and development.

Mauritius Times ePaper Friday 12 July 2024