Sustainability of Current Account Deficit in Mauritius: Towards a Reversal? By

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1 Sustainability of Current Account Deficit in Mauritius: Towards a Reversal? By A J Khadaroo and I Ramlall Department of Economics and Statistics University of Mauritius March 2012 Abstract Using quarterly data over the period 1999Q1 2011Q3, this paper investigates the sustainability of the current account deficit of Mauritius by applying cointegration and errorcorrection modelling. Total exports, that is goods and services combined, and total imports are not cointegrated but the inclusion of income plus transfers, on a net basis, leads to a cointegrating vector which is, strictly, not compatible with a sustainable current account. The absence of sustainability stems mainly from a growing imbalance between exports and imports of goods. The implied vector-error-correction-model (VECM) suggests that total exports and total imports behave like random-walks while net income plus transfers is the only variable that adjusts to maintain the validity of the estimated cointegrating vector. The analysis highlights the occurrence of unfavourable exports shocks during the period under investigation and attributes these to the dismantling of trade preferences that Mauritius was enjoying with the EU in respect of sugar and textile products. Based on the estimated VECM these adverse exports shocks, expressed in relation to GDP, lead to a permanent fall in the exports potential of the island with no accompanying reduction in imports which have remained stubbornly high. The prevailing Euro crisis, which could probably constitute another significant negative exports shock, may further increase the divergence between total exports and imports. Moreover a prolonging of the observed deceleration in inward foreign direct investment (FDI) shall further reduce the capacity of Mauritius to finance the prevailing current account deficit, which of course cannot be indefinitely funded by external debt and international reserves. In the absence of effective policies to boost exports in the near-term, this unsustainable situation is much likely to trigger a current account reversal. Keywords: Current Account Deficit, Sustainability, Reversal, Cointegration, Error-correction

2 1. Introduction The Current Account is a component of the Balance of Payments (BOP) and the current account balance (CAB) is a key macroeconomic indicator for an open economy. A healthy and sustainable current account arises when a country generates sufficient export revenue to pay for its imports or does not rely excessively on foreign currency inflows, usually in the form investment or external debt, for settling the imports bill. Freund (2000) studies 25 episodes of current account reversals in industrialised countries between 1980 and 1997 and identifies a CAD/GDP threshold of 5% beyond which a current account reversal tends to happen. She finds that domestic real income plays a significant role in the reversal process for industrialised countries and conjectures that foreign investment and external factors could be more important in the reversal process for developing countries. Milesi-Ferretti and Razin (1998) examine the current account in 105 low- and middle-income countries and conclude, inter alia, that current account adjustments are more likely to occur in countries having persistent deficits, low reserves and unfavourable terms of trade and less likely to occur in countries receiving high official transfers and whose debts are largely on concessional terms. Imam (2008) investigates current account adjustment in micro-states following negative terms of trade shocks and finds that adjustment is more likely to occur when the current account deficit is already large, the budget is in surplus, the real effective exchange rate (REER) depreciates, terms of trade improve and GDP growth declines. The present paper studies the current account dynamics of the small island developing state (SIDS) of Mauritius with a view to find out whether the Mauritian current account is sustainable and if it is not, whether a reversal is likely in the light of prevailing economic conditions. Section 2 outlines the theoretical economic framework for the study of current account sustainability and Section 3 provides a review of the empirical literature. Section 4 shows the evolution of the Mauritian current account and its components during the period of investigation. Section 5 contains the econometric methodology and findings. Section 6 concludes and considers policy implications. 2. Economic Model The theoretical framework for the study of current account sustainability is based on the Inter-temporal Budget Constraint (IBC), as described in Trehan and Walsh (1991) and Husted (1992): C t + I t + G t + B t = Y t + (1 + r t ) B t 1 (1)

3 where C t, I t, G t, B t, Y t and r t are respectively consumption, investment, government expenditure, stock of debt, income and interest rate Given that: Y t = C t + I t + G t + X t M t (2) where X t is exports and M t is imports Then: B t (1 + r t ) B t 1 = NX t (3) where NX t = (X t M t ) is net exports The above equation implies that additional debt should be matched by positive net exports. Moreover, negative net exports are not compatible with increased debt burden and should not be financed by additional borrowing. After making some assumptions, including that the interest rate is stationary, Husted (1992) derives a testable model of current account sustainability from the IBC: X = α+ β M + ε (4) t t t where α andβ are parameters andε t is an error term A necessary condition for sustainability is that εt is stationary, i.e. exports and imports move together over time and do not diverge. However, a sufficient condition requires thatβ = 1, i.e. the difference between exports and imports is stationary aroundα. The next section provides a review of the empirical literature wherein the concept of cointegration has been applied to investigate current account sustainability.

4 3. Empirical Review Husted (1992) tests for cointegration between US exports and imports, inclusive of interest payments abroad, and fails to find evidence of cointegration over the period Fountas and Wu (1999), using quarterly US data for the period , also do not find cointegration and conclude that the current is not sustainable. Apergis et al. (2000) test for sustainability of the Greek current account using annual data and conclude that it is sustainable. Bahmani-Oskooee (1994) finds that Australian exports and imports cointegrate and therefore do not diverge over time. Bahmani-Oskooee and Rhee (1997) using quarterly data also find evidence of cointegration between Korean exports and imports. Arize (2002) uses quarterly data between 1973 and 1998 for 50 OECD and developing countries. He finds that exports and imports for 35 of these 50 countries cointegrate. Holmes (2003) investigates stationarity of the current account deficits of a sample of 26 African countries using a panel data unit root test and finds evidence of current account mean-reversion for 21 of these countries. Tang (2003) uses the bounds testing approach to investigate the presence of a long-run relationship between exports and imports of five ASEAN economies and finds that exports and imports are cointegrated for Malaysia and Singapore only. Narayan and Narayan (2004) also using the bounds testing approach find that a long-run relationship between exports and imports exists for Fiji and Papua New Guinea a unit coefficient is estimated in the case of Fiji. Using the Johansen (1995) technique, Irandoust and Ericsson (2004) find a cointegrating relationship between exports and imports for Germany, Sweden and US but not for UK. Narayan and Narayan (2005) investigate a long-run relationship between exports and imports for 22 least developed countries (LDCs) and find evidence of cointegration in only 6 countries. Herzer and Felcitas (2006) find a long-run equilibrium between Chilean exports and imports. In light of the above empirical findings, this paper examines current account sustainability for Mauritius by applying cointegration and error-correction techniques to quarterly data over the period 1999Q1 2011Q3. 1 Before moving to the econometric methodology and findings, a descriptive analysis of the data is provided in the next section. 1 Quarterly macroeconomic data is not available prior to 1999.

5 4. Mauritius: Evolution of Current Account 1999Q1 2011Q3 For this analysis, the current account data is obtained from the Bank of Mauritius, the Central Bank, and GDP data is obtained from Statistics Mauritius, the Central Statistical Office. The main components of the Current Account, namely exports and imports of goods and services as well as income and transfers exchanged between Mauritius and the rest of the world, are expressed as a percentage of GDP. The X12 method is then applied to adjust for seasonality and the resulting quarterly series used in the analysis are: XG_Y_SA exports of goods as a percentage of GDP, seasonally adjusted MG_Y_SA imports of goods as a percentage of GDP, seasonally adjusted XS_Y_SA exports of services as a percentage of GDP, seasonally adjusted MS_Y_SA imports of services as a percentage of GDP, seasonally adjusted X_Y_SA exports of goods and services as a percentage of GDP, seasonally adjusted M_Y_SA imports of goods and services as a percentage of GDP, seasonally adjusted CURRENT_Y_SA current account balance as a percentage of GDP, seasonally adjusted VISIBLE_Y_SA net exports of goods as a percentage of GDP, seasonally adjusted INVISIBLE_Y_SA net exports of services as a percentage of GDP, seasonally adjusted INCTRANS_Y_SA net income and transfers as a percentage of GDP, seasonally adjusted 2 The current account balance and its trend component obtained by applying the Hodrick- Prescott filter are graphed below. 2 Income comprises basically investment income and Transfers comprise government and private transfers.

6 Current Account Balance as a Percentage of GDP, seasonally adjusted (including Tre nd Se rie s obtaine d from Hodrick-Pre scott Filte r) CURRENT_Y_SA CURRENT_Y_SA_HP The current account balance as a percentage of GDP, seasonally adjusted, has varied between a surplus of 7.1% in 2002Q3 and a deficit of 12.8% in 2006Q4. However, the trend deteriorates over time and a deficit has been recorded consistently since 2004Q1. The current account is next decomposed into the visible balance (net exports of goods), invisible balance (net exports of services), and income plus transfers.

7 Visible Balance, Invisible Balance and Income & Transfers (percent of GDP, seasonally adjusted) VISIBLE_Y_SA INVISIBLE_Y_SA INCTRANS_Y_SA The visible balance has constantly been in deficit, improving from 16.6% of GDP in 1999Q2 to 1.2% in 2003Q2 but thereafter worsening to 23.5% in 2008Q1 and fluctuating in the range of 15% 21% since. The invisible balance, conversely, has been in surplus consistently, ranging from 4.4% of GDP in 2006Q3 to 10.8% in 2007Q4. Income & Transfers on a net basis have been in the negative territory only in 3 out of the 51 observed quarters, ranging between a deficit of 1.7% of GDP in 2006Q3 and a surplus of 6.7% in 2009Q4. This shows that the visible balance is the component that mainly accounts for the observed deficit trend in the current account.

8 Exports and Imports of Goods (percent of GDP, seasonally adjusted) (including Tre nd Serie s obtaine d from Hodrick-Pre scott Filte r) XG_Y_SA XG_Y_SA_HP MG_Y_SA MG_Y_SA_HP Exports of goods have varied between 20.2% of GDP in 2009Q4 and 39.0% in 2002Q2, showing a declining trend. Imports of goods have been stubbornly higher, ranging from 34.2% of GDP in 2003Q2 to 57.1% in 2006Q4. The trends have been diverging continuously since 2002Q3, indicating an underlying deterioration in the visible balance which has in turn adversely affected the overall current account balance Econometric Methodology and Findings The Johansen technique is applied to investigate current account sustainability by testing for cointegration among the components of the current account. However the order of integration of the variables, in levels and in first-difference, is first established using the Augmented Dickey Fuller [ADF] (1979) and the Kwiatkowski, Phillips, Schmidt, and Shin [KPSS] (1992) tests. 4 3 The trends in exports and imports of goods and services also diverge since 2002Q3. 4 To save space, detailed results are not presented. However, they shall all be made available upon request.

9 Variable Table 1: Unit Root Tests ADF [Null of Unit Root] KPSS [Null of Stationarity] Statistic Conclusion Statistic Conclusion CURRENT_Y_SA Accept Null 2.59 Reject Null D(CURRENT_Y_SA) Reject Null 0.05 Accept Null X_Y_SA Accept Null 0.35 Reject Null D(X_Y_SA) Reject Null 0.04 Accept Null M_Y_SA Accept Null 0.93 Reject Null D(M_Y_SA) Reject Null 0.07 Accept Null INCTRANS_Y_SA Accept Null 0.74 Reject Null D(INCTRANS_Y_SA) Reject Null 0.02 Accept Null D (1 L) is the first-difference operator Critical values at 5% significance level: ADF in levels form KPSS in levels form 0.15 ADF in first-difference form KPSS in first-difference form 0.46 The above unit root tests show that the overall current account balance is not stationary and therefore does not revolve around a stable mean. Moreover total exports, total imports and income plus transfers are all integrated of order 1 [I(1)]. The Johansen technique is first applied in the context of equation (4) to test for cointegration between total exports and total imports. The trace and maximum eigenvalue tests do not reveal the presence of a cointegration vector at the 5% significance level,

10 neither at the 10% level. 5 However when income plus transfers on a net basis, which are a component of the current account, are added to the vector-error-correction model (VECM), the trace and maximum eigenvalue tests point to a cointegrating vector at the 5% significance level and even at the 1% level: Table 2: Unrestricted Cointegrating Vector Variable X_Y_SA M_Y_SA INCTRANS_Y_SA Constant Coefficient (SE) (0.45) (6.59) A sustainable current account, conceptually, implies a cointegrating vector where the exports coefficient is 1, imports coefficient is -1, net income plus transfers coefficient is 1, and the constant is in the light of the empirical literature at most 5. The theoretical coefficients may be assessed by imposing restrictions on the above estimated cointegrating vector. The imports coefficient of -1.6 is first restricted to -1. The likelihood ratio test produces a chi-square statistic of 0.68 with 1 degree of freedom and a p-value of Therefore this restriction is highly valid at the 5% significance level and the resulting cointegrating vector is: Table 3: Restricted Cointegrating Vector Variable X_Y_SA M_Y_SA INCTRANS_Y_SA Constant Coefficient (SE) (0.87) While the above restricted cointegrating vector denotes an equilibrium relationship between total exports, total imports and net income plus transfers, it is strictly not 5 Based on the AIC and SIC, all corresponding VECMs in this paper contain only the lagged disequilibrium term and no lagged first-differenced variables. Detailed results are available upon request.

11 compatible with current account sustainability as the estimated coefficient for net income plus transfers is far from 1. 6 Intercept (SE) Table 4: Error-Correction Equations D(X_Y_SA) D(M_Y_SA) D(INCTRANS_Y_SA) (0.44) (0.622) (0.240) ε t 1 (SE) (0.044) (0.063) * (0.024) 2 R *: significant at 5% level The error-correction equations imply that net income plus transfers is the only variable which adjusts, at the rate of 13% every quarter, to maintain the estimated long-run equilibrium. Exports and imports as a percentage of GDP, seasonally adjusted, do not adjust and in fact behave like random-walks without drift. The exports and imports shocks are therefore permanent while the shock to net income plus transfers is transitory. The shocks in the present framework are all measured relative to GDP. 6 The coefficient on net income plus transfers was also restricted to 1 but the likelihood-ratio test produced a chi-square statistic of 24.3 with 2 degrees of freedom, implying clear rejection. See Khadaroo (2000) for details on testing restrictions on cointegrating vectors.

12 Exports and Imports of Goods and Services (percent of GDP, seasonally adjusted) (including Trend Series obtained from Hodrick-Pre scott Filte r) X_Y_SA X_Y_SA_HP M_Y_SA M_Y_SA_HP Total exports exhibit a continuously declining trend from 60% of GDP in 1999 to 50% in The trend in total imports at first declines but picks up in 2003 and stabilises around 64% of GDP since These trends indicate that the island has over the last five years been experiencing negative exports shocks and virtually no imports shocks. In the context of the estimated VECM, a negative exports shock leads to a permanently lower exports-to-gdp ratio, an unchanged imports-to-gdp ratio and a higher net income plus transfers-to-gdp ratio. This scenario is not far from reality, as operators of the exports sector have indeed been disinvesting in Mauritius to invest abroad and repatriate their investment income back to Mauritius. An unfavourable exports shock therefore has an everlasting negative impact on the exports potential of the island. Policymakers need to address the widening exports-imports gap urgently otherwise the situation may become unsustainable to the point of triggering a current account reversal. The current Euro crisis complicates the matter further as Mauritian exports are Euro-centric. A supplementary analysis whereby visible and invisible trade are investigated separately is also performed. 7 Invisible exports and imports are cointegrated such that the invisible 7 The detailed findings are not reported here but are available upon request.

13 balance is stationary around an implied surplus mean of 7% of GDP. Moreover both exports and imports of services adjust to maintain the estimated long-run equilibrium. However, visible exports and imports per se are not cointegrated but the inclusion of net income plus transfers produces a cointegrating vector which is maintained through adjustment by the latter variable only. Therefore the crux of the exports-imports gap issue relates to exports and imports of goods. Policy should be geared towards improving the visible trade balance in the near-term. 6. Conclusions and Policy Implications This paper shows that exports and imports of goods and services, as a percentage of GDP, are not cointegrated and therefore do not converge over time. With the inclusion of net income plus transfers, as a percentage of GDP, a cointegrating vector is found among the three variables. However, the estimated vector is, strictly, not compatible with current account sustainability. Moreover, net income plus transfers is the only variable which adjusts to maintain the estimated long-run equilibrium. Total exports and imports, on the other hand, each behave like a random walk. Therefore shocks to exports and imports in the estimated VECM have a permanent effect while a shock to net income plus transfers has a transitory effect. The trend in exports reveals that the Mauritian economy has systematically experienced unfavourable exports shocks over the period under investigation. This period witnessed the phasing out of the Sugar Protocol and the Multi- Fibre Agreement under which the island had preferential access to the EU market respectively for sugar and textile products. The estimated econometric model suggests that these negative exports shocks have an everlasting adverse effect on the exports potential of Mauritius. The Africa Growth and Opportunity Act (AGOA) certainly mitigates these adverse effects by opening-up the US market to Mauritian exports, but so far this does not seem to be sufficiently strong to counter the unfavourable situation. Attempts by the Mauritian authorities to diversify exports markets and products are undoubtedly commendable but are not likely to be effective in the short-run, similarly for efforts to raise productivity. In light of the glaring worsening imbalance between exports and imports, particularly of goods, and the implication that the current account deficit is not sustainable, this paper is a wake-up call to the authorities in view of a possible current account reversal in Mauritius. A glooming of the near-term outlook for exports, mainly due to the prevailing

14 Euro crisis, coupled with stubbornly high imports may provoke a current account adjustment anytime in the near future. The adjustment may occur sooner given the deceleration observed in inward foreign direct investment in the context of subdued global economic perspectives. 8 Of course, external debt and international reserves cannot be used to finance the current account deficit indefinitely. The authorities should therefore be wary of a possible current account reversal and take the necessary anticipatory measures to ensure that current account adjustment occurs smoothly without adversely affecting macroeconomic indicators and living standards drastically. Research on the determinants of the current account deficit should help uncover variables that are likely to drive the adjustment process potential candidates should include the exchange rate of the rupee and domestic income. 8 FDI into Mauritius reached a peak of Rs. 13.9bn in 2010 and fell to Rs. 9.5bn in 2011.

15 References - Apergis, N., K.P. Katrakilidis, and N.M. Tabakis, Current account deficit sustainability: The case of Greece, Applied Economic Letters, 7: Arize, A., Imports and Exports in 50 Countries: Tests for Cointegration and Structural Break, International Review of Economics and Finance, Vol. 11: Bahmani-Oskooee, M. and Rhee, H.-J.,1997. Are exports and imports of Korea Cointegrated? International Economic Journal, Vol. 11: Bahmani-Oskooee, M.,1994. Are Imports and Exports of Australia Cointegrated? Journal of Empirical Integration, Vol. 9 No. 4: Dickey, D.A., Fuller, W. A., Distribution of the Estimators for Autoregressive Time Series with a Unit Root. Journal of the American Statistical Association, 74, Fountas, S., Wu, J-L.,1999. Are The U.S. Current Account Deficits Really Sustainable? International Economic Journal, 13(3), Autumn: Freund, C., Current account adjustment in industrialized countries. International Finance Discussion Paper 692, Board of Governors of the Federal Reserve System. - Herzer, D. and Felcitas, N. L. D., Is there a Long-run Relationship between Exports and Imports in Chile?. Applied Economic Letters, Vol. 13: Holmes, M.J., Are the Trade Deficits of Less Developed Countries Stationary? Evidence from African Countries, Applied Econometrics and International Development, Vol 3-3: Husted S The Emerging U.S. Current Account Deficit in the 1980s: A Cointegration Analysis. The Review of Economics and Statistics, February: Imam, P, Rapid Current Account Adjustments: Are Micro-states different. IMF Working Paper 08/ Irandoust, M and Ericsson, J., Are Imports and Exports Cointegration? An International Comparison. Metroeconomica, Vol. 55(1), pp Johansen, S., Likelihood-Based Inference in Cointegrated Vector Autoregressive Models, Oxford University Press, Oxford. - Khadaroo, A J, Testing Restrictions on Cointegrating Vectors: A Comment, Journal of Macroeconomics, 22(4), Kwiatkowski, D., Phillips,P, C. B., Schmidt, P.,Shin, Y., Testing the Null Hypothesis of Stationary against the Alternative of a Unit Root, Journal of Econometrics 54,

16 - Milesi-Ferretti, Gian Maria, and Assaf Razin, Current Account Reversals and Currency Crisis Empirical Regularities. IMF Working Paper No Narayan, P.K. and S. Narayan, Is there a long-run relationship between exports and imports? Evidence from two pacific island countries. Economic Papers, Vol.23, No.2: Narayan, P.K. and S. Narayan, Are exports and imports cointegrated? Evidence from 22 least developed countries. Applied Economic Letters, 12, pp Tang, T.C., Are Exports and Imports of the Five ASEAN Economies Cointegrated? An Empirical Study. International Journal of Management, Vol. 20, No.1: Trehan, B. and Walsh, C., Testing Intertemporal Budget Constraints: Theory and Applications to US Federal Budget Deficits and Current Account Deficits. Journal of Money, Credit and Banking, May, pp

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