On March, 11, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mauritius.

Mauritius has continued to grow at a moderate rate of 3.4 percent in 2015, as weak external demand, protracted decline in construction, and the collapse of a large financial conglomerate group more than offset the positive impact of favorable terms of trade. Inflation remains low (0.4 percent in January 2016), reflecting in part declining oil prices and shipping costs. Unemployment hovers around 8 percent, although it is higher among women and the youth. The external current account deficit narrowed to about 5 percent of GDP and international reserves increased to 6.5 months of imports, supported by continued capital inflows.

The monetary policy stance remains broadly appropriate against the backdrop of subdued inflation. The Bank of Mauritius reduced its key policy rate by 25 bps in November 2015, to 4.40 percent, in order to support the domestic economy, while making progress in mopping up excess domestic currency liquidity.

In the financial sector, credit growth is gradually recovering and overall, the banking system remains well capitalized. Nonetheless, domestic non-performing loans have been rising and provisioning has not kept pace with the decline in asset quality. In addition, the authorities face macro-financial challenges stemming from risk exposures and potential spillovers from the very large offshore sector and its sizeable inter-linkages with domestic banking activities.

The budgetary performance turned more prudent in 2015, reversing the deterioration of recent years. In 2015, both the overall consolidated deficit and the primary deficit remained below earlier budget projections, and improved relative to 2014. Nonetheless, public debt continued to increase (by more than 2 percentage points of GDP) due to the government’s interventions in the financial sector and the impact of the depreciating rupee on external debt.

The country’s statistical capacity continues to be strengthened as the authorities actively pursue efforts to improve the coverage of the offshore sector in official data, and to introduce a real estate price index.

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Staff Report

Introduction

Mauritius’s strong development record has reflected a remarkable ability to adapt to changing economic and financial conditions. Economic growth has been commendable, and financial stability has been maintained, even under challenging circumstances. After successfully transitioning from an agricultural to a manufacturing and tourism based-economy, the country has continued to develop and diversify with a vibrant financial sector – including a very large offshore industry. A careful macroeconomic policy response helped Mauritius weather the global financial crisis. The economy has remained resilient to the recent increased volatility in emerging and frontier markets, and has benefitted from declining commodity prices.

Mauritius is facing the challenge of avoiding the “middle-income trap” and moving to a higher income status. Competitiveness, productivity and investment rates have been declining in recent years, and the labor force is projected to shrink over time. Infrastructure bottlenecks are a constraint to further development, and the authorities envisage large public investment programs with complementary private investment to boost port capacity, transportation, connectivity and other advanced technologies.

The country is also seeking a strategic re-orientation of its large offshore sector to channel foreign investment into mainland Africa. Currently, the global business company (GBC) sector is a source of economic dynamism on the back of a Double-Taxation Avoidance Agreement (DTAA) Treaty with India, legal and accounting expertise, bilingualism and the record of political stability. Going forward, the authorities seek to position the country as a prime route for foreign investment into Africa and to depart from the tax-centered model to attract capital inflows. This strategy entails even stronger inter-linkages between the GBC sector, the domestic economy and the financial sector, providing further development momentum but also stronger potential spillovers from volatile external conditions.

MACRO-FINANCIAL LINKAGES AND SPILLOVER RISKS

Macro-Financial Structure of the Mauritian Economy

The striking feature of Mauritius’ financial system relates to the enormous size of the GBC sector, intrinsically linked to the domestic economy through the balance of payments and the banking system. Profiting from tax exemptions on foreign-sourced income, GBCs have become a key pillar of the economy6 , and account for assets estimated at over US$630 billion, some 50 times the level of GDP. This massive order of magnitude has become evident following the authorities’ efforts, supported by IMF technical assistance, to collect survey data on GBC1s for use in balance of payments (BOP) and international investment position (IIP) statistics. Nonetheless, GBCs’ statistical coverage has still important gaps as GBC2s remain largely unmonitored.

The GBC sector plays a vital role in financing the balance of payments, offsetting the large current account deficit for the rest of the economy (13 percent of GDP in 2014). Net capital inflows (15 percent of GDP) and investment income from GBC investments in the rest of the world (10 percent of GDP) are used to finance the large current account deficit of the non-GBC economy, allowing for the observed net accumulation of international reserves.

There are also other inter-linkages between the GBCs and the domestic economy. While GBCs’ domestic assets account for only a tiny fraction of their massive total assets (most of GBCs’ activities are with non-residents), they still represent close to 100 percent of Mauritius’ GDP – largely in the form of domestic bank deposits. In addition, there are very large (and poorly understood) domestic cross-holdings within the GBC sector (around 300 percent of GDP). GBCs also contribute to tax revenues, paying almost 1.3 percent of GDP in taxes in 2014 (around 6½ percent of total tax collection). In contrast, the GBCs’ direct contribution to domestic employment remains modest. 13. GBCs’ foreign currency deposits are a key funding source for banks, which also have other large cross-border exposures. GBCs deposits account for 30 percent of the banking sector balance sheet (bank assets stood at around 300 percent of GDP) and bank claims on GBCs represent about 10-15 percent of domestic credit. GBCs can also hold equity stakes in banks. In addition, banks have large exposures to non-residents, with deposits equivalent to 22 percent of total liabilities, and cross-border loans in excess of 100 percent of GDP (mostly to borrowers in India and other countries in Africa and Asia). For the banking system as whole, foreign currency liabilities to GBCs and non-residents are mostly matched by foreign currency assets.

However, exposures to GBCs and non-residents vary significantly across banks. Under Mauritius’ single licensing regime, banks are free to operate in both Segment A business (domestically-sourced income) and Segment B business (foreign-sourced income, including GBCs and non-residents). Large foreign banks tend to focus on Segment B, drawing deposits from the most reputable GBCs and lending to their global network of customers with established credit records. The two large domestic banks are currently concentrated on Segment A. Medium-sized banks have a mix of Segment A and Segment B operations, potentially constituting a greater channel of spillover to domestic activity. Reflecting the considerable tax advantage for Segment B activities (80 percent reduction in the 15 percent corporate tax rate), many banks are planning to increase their Segment B operations going forward. This is a risky strategy given the challenges associated with assessing the funding risk from GBCs and non-resident sources, and the credit and counterparty risks involved in cross-border lending.

Potential Spillover Risks

The balance sheet inter-linkages noted above are a source of systemic vulnerabilities. A decline in GBC or non-resident foreign currency funding, for instance triggered by a significant revision of the DTAA Treaty with India or by an intensification of initiatives against tax base erosion and avoidance, could worsen Mauritius’ balance of payments position, lead to exchange rate pressure, a weakening of reserves, and rising inflation and external debt servicing costs. The associated decline in GBC deposits in domestic banks could create deleveraging pressures , particularly in any small and medium-sized banks with liquidity-risk management systems insufficient to quickly mobilize foreign currency assets. The resulting funding need could trigger a cutback of foreign and domestic credit, and broader confidence effects , which would impact the domestic economy. Indeed several banks operate within financial groups/holdings or mixed conglomerates with activities in other domestic sectors. Similarly, the large cross-holdings within the GBC sector could act as contagion channel. There could also be regional spillovers, given Mauritius’ role as financial hub for foreign investments in Africa. Yet, data and non-bank supervisory gaps prevent a full analysis of the GBC sector and the risks it poses.

Further integration of the offshore sector with the domestic economy entails benefits, but also increases potential spillover risks. The authorities aim at promoting the GBC sector as a conduit for investment into Africa, while encouraging a greater involvement of the GBC sector in the domestic economy by the introduction of “substantial presence conditions”. Although this greater interconnection with GBCs may have beneficial effects on domes tic economic activity, the strategy also raises the risk of inward spillovers from GBC-related volatility.

RAISING GROWTH BY BOOSTING COMPETITIVENESS AND GENDER EQUITY

Mauritius faces important challenges as it seeks to escape the middle-income trap. Mauritius has lost seven places in the 2015-16 Global Competitiveness Report, now ranking 46 among 140 economies. Productivity is eroding, unit labor costs have been rising, infrastructure needs upgrading, and labor regulation is relatively complex. The population (and labor force) is projected to start shrinking in the longer run. In addition, income inequality has been rising: The income share of the top 20 percent earners is nine times as high as that of the bottom 20 percent earners, and gender inequality remains relatively high. A reform program needs to address constraints on factor accumulation including by mitigating the projected decline of the labor force through skilled workers‘ immigration or an increase in female labor force participation – as well as productivity improvement, including by investments in human and infrastructure capital.

The 2015/16 budget outlines several measures to deal with these challenges. To strengthen the business climate, the authorities envisage, among other things, expanding the powers of the Fast Track Committee to expedite the approval and implementation of major investment projects and abolishing a large number of licenses and permits which have become obsolete. The authorities also target to boost infrastructure through a large investment program. As part of their program, smart cities would be developed which are environmentally friendly, highly connected and generate their own energy and water. As part of the authorities’ ambition to create an ocean economy, major investments in the port infrastructure are planned, expanding the connectivity of Port-Louis to other ports.

Raising female labor force participation rates could help address the challenges of population aging and enable the attainment of higher income status. Mauritius possesses a large pool of educated women who currently do not participate in the labor market. According to a staff study, this has led to an estimated income loss in the range of 22 to 27 percent compared to a situation without gender gaps in the labor force. The following options may be considered to increase female labor participation: (i) promoting part-time work and flexible work arrangements; (ii) increasing the number of childcare centers compliant with minimum quality standards; (iii) increasing financial inclusion for women by expanding financial literacy training targeted at micro-enterprises; and (iv) considering the introduction of paternity leave to level the playing field in hiring decisions and pay of women and men.

The authorities agreed with the thrust of staff’s analysis but pointed to constraints to implement policies related to traditional gender roles. They intend to continue addressing the skills mismatch in the economy and plan large investment programs to mitigate infrastructure bottlenecks. Measures to increase female labor force participation, including through training and employment programs, are ongoing. However, the authorities suggested that some family policies, such as paternity leave, might be difficult to implement.

STATISTICAL ISSUES

Mauritius’s main macroeconomic statistics are adequate for surveillance. The coverage and quality of key statistics, especially BOP and IIP statistics, have significantly improved, but there are important remaining gaps in offshore sector data. The GBC survey needs to cover GBC2s as well as GBC1s and collect better information on linkages between GBCs and domestic economy, including on GBCs’ cross-holdings and GBCs’ role in conglomerate groups. The authorities are undertaking efforts to introduce a real estate price index and to strengthen the coverage and accuracy of statistics regarding other financial corporations and sectoral balance sheets, supported by IMF technical assistance.