Mandi, Govinda & Jasmine

Blue SkiesBlue Skies

Mexican economy seemed healthy in early 90s….Mexican economy seemed healthy in early 90s….

InflationInflation

Foreign investmentsForeign investments

Central banks had $billions in reservesCentral banks had $billions in reserves

NAFTA took effect early 1994NAFTA took effect early 1994

What happened?What happened?

Current Account Deficit

Current account = balance of trade + net factor income (interest, dividends) + net transfer payments (foreign aid)

http://www.galbithink.org/topics/mex/invest.htm

A fall in domestic savings and a rise in domestic consumption contributed to the current account deficit

http://www.galbithink.org/topics/mex/cad.htm

Current account deficit peso becoming overvalued exports , imports foreign reserves being depleted

Real Appreciation & Overvalued Peso

The Mexican government kept the value of the peso within a crawling peg exchange rate with the USD. The exchange rate was controlled within a narrow target band whose upper limit was raised bit by bit for gradual nominal depreciation.

But in real, price adjusted terms the peso was appreciating, contributing to the current account deficit

R = P/(P*E)

R = Real exchange rateP = Domestic price level (pesos)

P* = Foreign price level ($)E = Mkt exchange rate (peso/$)%ΔP = domestic inflation rate%ΔP* = foreign inflation rate

%ΔR = %ΔP - %ΔP* - %ΔE

In Mexico’s case: R because %ΔP > %ΔP* + %ΔE

Thus the peso became overvalued, meaning the exchange rate became too high for a sustainable equilibrium in the balance of payments. Higher interest rates (which causes external debt to rise even more) are needed to prop up an overvalued currency until the inevitable devaluation takes place.

Due to policy reforms and NAFTA, a lot of capital ($102 billion from1990-1994) (1) was flowing into Mexico making the peso appreciate in value.

Shift from cetes tesobonos

Political Shocks

Rise in U.S. interest rates

From Problem to Crisis

Elections

Elections

Because of an upcoming presidential election on August 21, 1994,Mexican authorities were reluctant to take action in the spring and summer of 1994 to fix the inconsistencies in the economy. The choices open to them were to:

raise interest rates even more to bring back capital inflow reduce government expenditures to reduce domestic

demand, decrease imports and relieve pressure on the peso devalue the peso to make exports more competitive

The first two options were unattractive in a presidential election year because they could have led to a significant downturn in economic activity and could have further weakened Mexico’s banking system. (PRI wanted to stay in charge).

Devaluing the peso would have undermined its commitment to maintaining a stable exchange rate – the basis of its success in attracting foreign capital.

http://www.galbithink.org/topics/mex/uint.htm

Rise in U.S. interest rates

In February 1994, the Federal Reserve raised its federal funds rate target because of inflationary pressures.

The Mexican government thought it was only temporary and made no substantial policy changes.

Political Shocks

The Central Bank blamed a series of assassinations and other discouraging acts that political risk and investor confidence.(2)

March 1994 Assassination of presidential candidate Luis Donaldo Colosio

Reserves $11 billion in four weeks

June/July 1994

Resignation of Minister of the Interior Jorge Carpizo who was overseeing the national election, kidnapping of prominent businessman Alfredo Harp

Reserves $2.5 billion in three weeks

September 1994

Assassination of High official Jose Francisco Ruiz Massieu

Reserves $4 billion

December 1994

Renewed pressure on the peso: Breakdown in talks with Chiapas rebels? Market worries about current account deficit? Leaked rumors of changes in exchange rate policies?

Reserves $1.5 billion in three days

Super vulnerable to a financial market crisis; its foreign exchange reserves had fallen to $12.9 billion,18 while it had tesobono obligations of $28.7 billion maturing in 1995.19. (1)

Shift from cetes tesobonos

In response to these investor concerns, the Mexican government issued large amounts of short-term, dollar-denominated bonds (tesobonos). Now any devaluation would be the government’s problem.

http://www.galbithink.org/topics/mex/pbond.htm

Banco de México had tried increasing domestic interest rates (from 10.1 % to 17.8% in March) on short-term (91-day), peso-denominated Mexican government bonds (cetes) in an attempt to stem the outflow of capital.

Didn’t work. Investors too scared of an upcoming devaluation.

Float and Sink

December 20 – Mexican authorities sought to relieve pressure on the exchange rate by announcing a widening of the peso/dollar exchange rate band (peso devalued by 15%.)

December 20-21 – The government did not announce any new fiscal or monetary measures to accompany the devaluation so foreign reserves $4 billion.

December 22 – Mexican government forced to freely float its currency.

The Mexican Peso Crisis of 1994-95 was now full-blown, and at this point, Mexico was forced to turn to

international sources for assistance.

International International EffectsEffects

Due to the Mexican Peso Crisis most large Western hemisphere Due to the Mexican Peso Crisis most large Western hemisphere Less Developed Countries (LDCs) experienced turbulence in Less Developed Countries (LDCs) experienced turbulence in their foreign exchange markets and significant declines in equity their foreign exchange markets and significant declines in equity markets.markets.

For example Argentina and Brazil experienced heavy For example Argentina and Brazil experienced heavy trading losses after trading losses after the Crisis.the Crisis.

Some of the LDCs experienced discrimination due to the Some of the LDCs experienced discrimination due to the fact that they fact that they had some of the same general characteristics as had some of the same general characteristics as Mexico:Mexico:

1. low savings rates1. low savings rates

2. large current account deficits2. large current account deficits

3. weak banking systems3. weak banking systems

4. significant volumes of short term debt4. significant volumes of short term debt

Solving the Mexican Peso Solving the Mexican Peso CrisisCrisis

• Due to the magnitude of the Peso Crisis, the Due to the magnitude of the Peso Crisis, the United StatesUnited States and and the the IMF IMF concluded that outside assistance was required to concluded that outside assistance was required to prevent Mexico’s financial collapse as well as to prevent the prevent Mexico’s financial collapse as well as to prevent the spread of the crisis to other LDCs.spread of the crisis to other LDCs.

– United States AssistanceUnited States Assistance• $48.8 billion multilateral assistance package$48.8 billion multilateral assistance package

– This package offered $20 billion to Mexico through the This package offered $20 billion to Mexico through the use of the Exchange Stabilization Facility use of the Exchange Stabilization Facility

– IMF AssistanceIMF Assistance• 18-month standby arrangement for up to $17.8 billion 18-month standby arrangement for up to $17.8 billion

– Other AssistanceOther Assistance• Other countries offered assistance in the form of $ 10 Other countries offered assistance in the form of $ 10

billion under the Bank of International Settlementsbillion under the Bank of International Settlements

*NOTE: The response to the Peso Crisis was one of the largest multilateral economic assistance packages ever *NOTE: The response to the Peso Crisis was one of the largest multilateral economic assistance packages ever extended to one country.extended to one country.

Goals of AssistanceGoals of Assistance

• RestoreRestore financial stability financial stability • StrengthenStrengthen public finances and the public finances and the

banking sectorbanking sector• RegainRegain investor confidence investor confidence• ReinforceReinforce the groundwork for long- the groundwork for long-

term sustainable growthterm sustainable growth

Assistance From the United Assistance From the United States in DetailStates in Detail

• Three Mechanisms:Three Mechanisms:– Short-term currency swapsShort-term currency swaps for up to 90 for up to 90

days, with renewals for a maximum term of 1 days, with renewals for a maximum term of 1 year for Treasury swaps and renewals up to year for Treasury swaps and renewals up to three times for the Fed swapsthree times for the Fed swaps

– Medium-term currency swapsMedium-term currency swaps for up to 5 for up to 5 yearsyears

– Securities guaranteesSecurities guarantees under which ESF under which ESF funds could be used to back up securities funds could be used to back up securities issued by the Mexican gov’t for up to 10 issued by the Mexican gov’t for up to 10 yearsyears

Ways to Respond to a Ways to Respond to a Current Account DeficitCurrent Account Deficit

• 1. Attract more foreign capital1. Attract more foreign capital• 2. Allow currency to depreciate2. Allow currency to depreciate

– This makes imports more expensive and This makes imports more expensive and exports cheaperexports cheaper

• 3. Tightening monetary/fiscal policy 3. Tightening monetary/fiscal policy to reduce the demand for all goodsto reduce the demand for all goods

• 4. Using foreign exchange reserves 4. Using foreign exchange reserves to cover deficitto cover deficit

Post-CrisisPost-Crisis Economic Recovery (1996-1999)Economic Recovery (1996-1999)

• Sounder macroeconomic decisions/practicesSounder macroeconomic decisions/practices• Improvement of trade balanceImprovement of trade balance• Increase in private consumptionIncrease in private consumption

Post Crisis Trade Balance

(1996-Present)

Post-CrisisPost-Crisis

Investor confidence has been Investor confidence has been increasingincreasing

Economic growth slowly continuesEconomic growth slowly continuesGDP Growth Post-Crisis

(1995-Present)

Gross Investment Growth Post-Crisis

(1995-Present)

Post-Crisis EffectsPost-Crisis Effects

Lingering Side-Effects?Lingering Side-Effects?• Improvement in Mexican bankingImprovement in Mexican banking

Youth of Banking sectorYouth of Banking sector Improvement of regulationsImprovement of regulations

• Distribution of WealthDistribution of Wealth Large gap between the rich and poor Large gap between the rich and poor

remainsremains

• Financial InstitutionsFinancial Institutions IMF double Emergency FundsIMF double Emergency Funds

Post-Crisis Effects (cont.)Post-Crisis Effects (cont.)

Signs of emergence from CrisisSigns of emergence from Crisis• Relatively Low Interest RatesRelatively Low Interest Rates

Around 8.5% as of 2006Around 8.5% as of 2006

• Low Inflation RatesLow Inflation Rates 3.3% in 20053.3% in 2005

An Expensive LessonAn Expensive Lesson

What can we learn from the crisis?What can we learn from the crisis?• An improvement of economic An improvement of economic

fundamentalsfundamentals• Increased transparency of economiesIncreased transparency of economies

IMF periodic economic and financial IMF periodic economic and financial publications by each member nationpublications by each member nation

• Realization of the speed of capital Realization of the speed of capital mobilitymobility

(1) Arner, Douglas. “The Mexican Peso Crisis: Implications for the Regulation of Financial Markets.” Essays in International Financial & Economic Law. The London Institute of

International Banking, Finance & Development Law, 1996. <http://iibf.law.smu.edu/arner.pdf>

(2) Williamson, John. “Causes and Consequences of the Mexican Peso Crisis.” Institute for International Economics March 14, 1995 http://www.galbithink.org/topics/mex/ps.htm#elections