## Mauritius—Assessment Letter in the Context of the Aid for Trade Initiative September 8, 2006

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### Background and Economic Challenges
- Two major challenges:
  - A high fiscal deficit and potentially unsustainable public debt.
  - A permanent deterioration of the terms of trade resulting from the loss of trade preferences in textiles and sugar.
- Role of textiles and sugar:
  - These sectors together make up some 12 percent of GDP, 20 percent of employment, and over 50 percent of goods exports (excluding freeport).
- Growth and external shocks:
  - Secular economic slowdown: average real GDP growth slowed from over 7.5 percent in the second half of the 1980s to below 3.5 percent during the past five years.
  - Over the past three years, declines in export prices (in U.S. dollar terms), together with higher oil prices, contributed to a 17 percent reduction in the terms of trade, equivalent to an estimated cumulative loss of income of over 4 percent of GDP.
  - Reform to the European Union’s sugar protocol will lower Mauritius’s sugar export prices by 36 percent during 2006–10, further deteriorating the terms of trade by about 8 percent, equivalent to an income loss of some 3 percent over the next four years.

### Recent Economic Developments (fiscal year 2005/06, July–June)
- Output and labor market:
  - Estimated real GDP growth was 3.5 percent, largely owing to declining output in the textile and sugar sectors.
  - The unemployment rate increased to almost 10 percent.
- Fiscal position and public debt:
  - The fiscal deficit reached an estimated 5.4 percent of GDP, 0.6 percentage points above budget.
  - Public sector debt is estimated at 70 percent of GDP.
  - In June 2006, Moody’s downgraded Mauritius’s local currency rating to Baa1.
- Inflation and monetary policy:
  - Headline inflation rose to 10.1 percent (year-on-year) in July, while core inflation was contained.
  - Causes of headline inflation increases: increases in excise rates for cigarettes and alcoholic beverages, the removal of food subsidies, and higher world oil prices.
  - The Bank of Mauritius (BoM) raised the signaling rate to 12 percent in July 2006.
- External sector and reserves:
  - The current account deficit deteriorated to an estimated 5.5 percent of GDP.
  - Foreign exchange reserves stabilized at about five months of imports of goods following BoM intervention in 2005.
  - The real effective exchange rate has depreciated by 10 percent since early 2004.

### The Authorities’ Reform Program
- Objectives:
  - Address potential fiscal sustainability problems.
  - Reduce balance of payments pressures from the terms of trade deterioration.
  - Raise potential growth through structural reforms.
- Four pillars of the reform agenda:
  - Securing fiscal consolidation and modernizing the public sector: reduce current and capital expenditures, simplify the tax system, make tax administration more efficient, and phase out costly tax exemptions.
  - Improving the investment climate: reduce the cost of doing business, unify existing incentive schemes, and address infrastructure bottlenecks.
  - Mobilizing foreign direct investment: upgrade human capital, draw from the Mauritian diaspora to attract investment and skilled labor, and implement targeted promotional marketing campaigns.
  - Restructuring the economy: transform traditional sectors (textiles and sugar), promote growth in existing sectors (e.g., financial services and tourism), and develop high value-added sectors (e.g., information and communication technology and knowledge and medical hubs).
- Trade and labor market measures:
  - Move to a duty-free island within three years while possibly maintaining tariff protection for sensitive sectors.
  - Tariff reform with the 2005/06 budget reduced the simple average tariff rate from 17 percent to 6 percent and the top rate from 80 percent to 65 percent.
  - During 2006/07, top tariff rates (65 percent, 55 percent, and 40 percent) will all be lowered to 30 percent; the number of nonzero bands will fall from seven to three.
  - Labor market strategy: new mechanism for wage negotiations, labor law reform, and a new workfare program to provide on-the-job training to the unemployed and workers affected by restructuring.

### Risks and Challenges
- Fiscal reforms and uncertainty:
  - Under staff macroeconomic assumptions, announced budgetary measures reduce the budget deficit in 2006/07 by some 1 percentage point of GDP to 4.5 percent of GDP, although this is 0.5 percentage points less than budgeted.
  - Major tax changes include a 15 percent flat tax on personal and corporate income phased in over three years; removal of selected tax exemptions (e.g., the 25 percent investment allowance); new taxes (e.g., tax on pensions, a national residential property tax); and increases in selected excise rates.
  - Revenue loss from tariff reductions is estimated at 0.5 percent of GDP; net revenue effect of all measures is estimated to be slightly negative.
  - Some budgetary measures (for example, higher excise rates) are likely to push headline CPI inflation some 3 percentage points above budgeted levels.
- Need for additional fiscal effort:
  - Without additional fiscal effort, staff projects the budget deficit would remain at about 4½ percent of GDP over the next five years and public debt as a share of GDP would only decline marginally (by some 1.5 percentage points of GDP).
  - Continued high deficits and debt could put pressure on domestic interest rates and crowd out private sector investment.
  - Part of the debt remains sensitive to interest rate and rollover risk; the share of short-term government debt has been reduced to around 30 percent.
- Fiscal adjustment options and medium-term target:
  - IMF Fiscal Affairs Department technical assistance has identified options: phase out the annual allowance in the company income tax and VAT exemptions; better target pensions; consolidate social transfers.
  - Staff estimates that implementing these measures would allow achievement of an appropriate medium-term fiscal target for the budget deficit of about 3 percent of GDP.
- Structural-reform implementation and growth prospects:
  - Without additional structural reforms, staff projects average annual real GDP growth would remain at about 3½ percent over the next few years.
  - Labor market reforms needed: enhance flexibility, including wage flexibility at the firm level; review labor laws and regulations; simplify regulations governing firms’ ability to terminate and redeploy workers.
  - Trade reform concerns: path of further tariff reductions and necessity of maintaining tariffs on certain imports undecided; preference for a simple and transparent tariff with low, uniform rates over a regime with multiple exceptions.
- Competitiveness and exchange rate:
  - Fundamental factors, notably the recent decline in the terms of trade, have significantly lowered the equilibrium real effective exchange rate.
  - Further adjustments would be required if the additional expected terms of trade decline materializes.
  - Wage restraint and improvements in productivity should support strengthening competitiveness.
- Restructuring costs and financing:
  - Authorities’ preliminary estimates put total restructuring costs at some US$4.5 billion over 10 years.
  - Authorities envisage that government, domestic private investors, and foreign direct investment would finance just over half of this amount.
  - Financing sources for the remaining restructuring costs must still be identified; a significant increase in debt-creating financing flows could be problematic on debt sustainability grounds.
- Monetary, financial, administered prices, and human capital:
  - Potential reforms to improve monetary framework transparency: use of the repo rate as an operational target, preannouncing monetary policy meetings, and monetary policy reviews.
  - Concerns about relatively high lending rates, differences in taxation between domestic and foreign-sourced interest income, and limited competition among banks potentially hindering access to credit by domestic corporates.
  - Administered prices may reduce the signaling function of prices in the adjustment process.
  - Education system review recommended to improve human capital development and support growth of high value-added services.

### Fund Relations
- Mauritius has no outstanding use of Fund resources and is not currently seeking a financial arrangement with the Fund.
- The next Article IV consultation is tentatively scheduled for February 2007.
- A Financial Sector Assessment Program update is scheduled for 2007 to assess potential financial vulnerabilities and other financial sector issues.

*IMF staff assessment based on an IMF staff visit to Mauritius in August 2006 and the 2005 Article IV consultation (discussed by the Executive Board on December 2, 2005).*

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