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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 rate
In 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 multiyear low on international markets.
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 tenquarter 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.
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 a
services 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
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.
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 Franaise
State Bank of Pakistan
Banco de Moambique
The Bank Supervision Department of the South African Reserve Bank
Central Bank of Seychelles
Hong Kong Monetary Authority
From recent short-term dynamics, measured by annualised q-o-q CPI inflation, the
Banks 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 ongoing 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.
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 Dfi 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 Dfi
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.
References
Internet
McCarthy, J., 1999. Pass through of exchange rates and import prices to domestic
inflation in some industrialized economies.
Menon, J., 1996. The Degree and Determinants of Exchange Rate PassThrough: Market Structure, Non-Tariff Barriers and Multinational
Corporations.
Krugman, P., 1986. Pricing to market when the exchange rate changes.