Case SummaryMexican Economy BackgroundThe CrisisDomestic DimensionLessons Learned

o Mexico tends to have a higher inflation and interest than the United States.

o Persistent depreciation of the Peso.o Although interest rates in Mexico are high,

this didn’t strengthen the Peso.o Bid/Ask spread for the Peso is higher than

that of industrialized countries.

1940-1988

The Mexican Miracle (1940 to 1970)o Supported and backed by the earlier government focus on

providing primary education starting in the 1920s which led to tripling the enrollment levels.

o Nationalizing the oil and railroad companies.o Free land distribution to peasants.o Applying the Import Substitution Industrialization model which

protects and promotes local industries to substitute for imports.o Maintained an average annual GDP growth of 5-7% and an

average inflation rate of 3-4%.o Increase in production of goods and services of 870% between

1940-1980, while population only increased by 370%.o Direct foreign investments increased from $450M in 1940 to over

$4.5B in mid-1970s.

1970s – 1980so 1970s international economic crisis reached Mexico, slowing

down the economy and the industrial development.o Viability of Mexican development model questioned.o By 1976 the unmanageable balance of payment disequilibrium

caused the government to devaluate the Peso by 58% after maintaining a fixed exchange rate for 20 years.

o Huge increase in oil prices along with the important discoveries of new oil fields in 1976 prevented an expected economic crisis.

o Between 1978-1981, annual economic growth averaged 8% with the government increasing the spending on energy, transportation and basic industries mostly through foreign debt.

o Mexico’s debts kept rising and the Peso became increasingly over-valued hurting non-oil exports, this caused a further devaluation of the Peso by 1980.

o During 1981, Mexico was deeply hurt by the decreasing oil prices, increasing world interest rates, higher inflation, continuing over-valued Peso and the loss of trust from foreign investors.

o Deteriorating balance of payment along with the dramatic drop in international reserves caused the Peso to be devaluated 3 times during 1982, with the government reaching the point of suspending payments of international debts.

o Between 1982-1988 GDP average GDP annual growth was 0.1%, annual inflation rate of 100%, with total investments falling 4% annually.

o Economy started stabilizing in 1989 with the introduction of the 1989-94 national development plan.

In 1994, Mexico used special pegged exchange rate system linking the Peso to the Dollar but allowing Peso to fluctuate within a certain limit against the USD.

In order to support the very weak Peso, the Mexican government was issuing short-term $ debt securities and using this funds to purchase the Peso trying to limit its depreciation. The result was very high foreign debt, further much of the international reserves were lost supporting the continually weakening Peso.

This process overstated the value of the Peso, leading to a considerable increase in imports and causing a large trade deficit.

Investors realized that the Peso was maintained artificially at high levels and so converted their investment from Peso to the $ putting more pressure on the Peso.

On the 20th of December 1994, Mexico central bank devalued the Peso by 13%. The stock prices were sharply affected, foreign investors withdrew their funds in anticipation of further devaluation putting additional pressure on the currency.

On the 22nd of December, the Peso was allowed to float freely, causing a further decline of 15%.

In an attempt to maintain the foreign investment, the central bank of Mexico increased the interest rate, however the target of the action was not achieved moreover it backfired by increasing the cost of borrowing consequently slowing the economic growth, additionally nonperforming loans started to increase rapidly

After only 4 months from the December Mistake (El Error De Diciembre) the Peso lost around 50% of its value.

Although high interest rates are commonly expected to strengthen the country’s currency but they are not the only drivers in this regard, otherwise the country offering the highest interest rate would attract all investments.

According to Fisher, interest rate can be regarded as combination of three elements: time, risk and inflation.

Currently, In the Mexican – American context, time and risk should be the same between the Peso and $ while the only difference would be the inflation.

• What Does Bid-Ask Spread Mean?

The amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.

Determinant of the Spread:

Ordering Size and cost: The Cost of order processing and re order.

Inventory carrying costs: Carrying maintaining inventory of a currency.

Market Competition(No. of dealers): The more no of dealers leads higher competition and results lower spread.

Liquidity: This refers to the volume or amount of stocks that are traded on a daily basis. Currencies that have large trading volume are said to be liquid and deep so that is not easily affected even by large transactions (numerous buyers and sellers at a given time)

Currency risk: Economic and political conditions cause the demand and Supply of a currency change dramatically.

Most obvious economic reasons for the persistent depreciation of the peso:

The Peso rate is set and artificially high by using fixed/Pegged exchange rate system.

Government effort to curb the current inflation. Expectations of the investors due to increase in the risk factor. A sizable current-account deficit resulting to a large extent from a

huge credit expansion

WHY US investors don’t try to capitalize on the high interest rate in Mexico?

The inflation variance between Mexico & America. The risk from the continual depreciation of the weak peso.

Why bid/ask spread is higher for the peso than for currencies for the industrialized countries?

Because the peso is volatile and very weak as it’s market is not deep with a low trading volume can easily affected by a large transaction .

Free Float: The exchange rate should be controlled according to the market force of supply and demand, it will eventually reach its equilibrium value. Governments should intervene only in case of un-normal fluctuations.

Appreciate/Depreciate: Artificial appreciation will lead to an inevitable crisis. While depreciation in some circumstances can play a role in maintaining the foreign reserves.

Abrupt Actions: Sudden actions affecting the exchange rates regime , Interest rates ,… etc, can give a wrong signal to foreign investors. These kind of actions should be taken wisely and gradually.

Political Stability: Governments should prepare a suitable and stable environment for the investors. Any political instability will affect the economy, encouraging the investors to exit the market.

Transparency: Maintain the transparency in the disclosure of financial information .

Learning: we can learn from previous crisis, to guide us in our future decisions actions.

Thank You