Peso ProblemsPeso Problems

A Tale of Two MexicosA Tale of Two Mexicos

By late 1993, NAFTA was on its way to By late 1993, NAFTA was on its way to ratification by the US. Mexico was ratification by the US. Mexico was considered by CEOs, journalists, and considered by CEOs, journalists, and politicians as the jewel of the Latin politicians as the jewel of the Latin American CrownAmerican Crown

A Tale of Two MexicosA Tale of Two Mexicos

By late 1993, NAFTA was on its way to By late 1993, NAFTA was on its way to ratification by the US. Mexico was ratification by the US. Mexico was considered by CEOs, journalists, and considered by CEOs, journalists, and politicians as the jewel of the Latin politicians as the jewel of the Latin American CrownAmerican Crown

Meanwhile, in Mexico’s southern states, Meanwhile, in Mexico’s southern states, left wing activists were is the process of left wing activists were is the process of staging a major uprising against the staging a major uprising against the Mexican establishment. Mexican establishment.

Two worlds collide…Two worlds collide…

Throughout 1994, the “two Throughout 1994, the “two Mexicos” were able to co-exist. Mexicos” were able to co-exist. However, in December 1994, rosy However, in December 1994, rosy expectations were met with harsh expectations were met with harsh realities and the Peso collapsedrealities and the Peso collapsed

The Mexican PesoThe Mexican Peso

Did market reform fail?Did market reform fail?

The collapse of the Peso and The collapse of the Peso and contagion throughout Latin America contagion throughout Latin America brought into question the merits of brought into question the merits of market reform taking place the market reform taking place the region. region.

However, despite the crash, the However, despite the crash, the region did not collapse. Instead, region did not collapse. Instead, growth returned and inflation growth returned and inflation continued to fall. continued to fall.

Mexican Reform: 1987-Mexican Reform: 1987-19931993

Open the economy to international Open the economy to international competitioncompetition

Privatization and deregulationPrivatization and deregulation Price stabilizationPrice stabilization

Dollar PeggingDollar Pegging Restrictive Fiscal and Monetary PolicyRestrictive Fiscal and Monetary Policy

Agreements between the Agreements between the government, firms, and labor unions government, firms, and labor unions (the Pacto)(the Pacto)

The Good NewsThe Good News

Government deficits were reducedGovernment deficits were reduced Inflation fell below 10% Inflation fell below 10% Reduction of regulation and Reduction of regulation and

protection was beginning to protection was beginning to promote efficiency improvementspromote efficiency improvements

The Bad NewsThe Bad News

Real (inflation adjusted) growth Real (inflation adjusted) growth was 2.8% annuallywas 2.8% annually

Productivity growth was positive, Productivity growth was positive, but close to zero.but close to zero.

Real wages fellReal wages fell Export growth was slow Export growth was slow Private saving fell and poverty and Private saving fell and poverty and

inequality grew.inequality grew.

Reforms vs. ResultsReforms vs. Results

While Mexico was doing all the While Mexico was doing all the right things in terms of process, right things in terms of process, the fruits of their reforms hadn’t the fruits of their reforms hadn’t materialized yet. materialized yet.

Regardless of actual results, Regardless of actual results, Mexico began attracting foreign Mexico began attracting foreign capital.capital.

Mexican Capital FlowsMexican Capital Flows

QuestionsQuestions

To what extent did the real To what extent did the real appreciation of the Peso represent appreciation of the Peso represent an overvaluation that required an overvaluation that required policy action?policy action?

Were the capital inflows into Were the capital inflows into Mexico sustainable?Mexico sustainable?

Nominal Anchor and Real Nominal Anchor and Real Appreciation of the PesoAppreciation of the Peso

In 1988, the Peso was pegged to the dollar. In 1988, the Peso was pegged to the dollar. The Mexican central bank was committed to: The Mexican central bank was committed to: Keeping the Peso within its accepted bandKeeping the Peso within its accepted band Keeping interest rates lowKeeping interest rates low

However, Mexican inflation expectations However, Mexican inflation expectations remained. This resulted in a very slow remained. This resulted in a very slow reduction of domestic inflationreduction of domestic inflation

With a positive inflation differential between With a positive inflation differential between the US and Mexico, a real appreciation of the the US and Mexico, a real appreciation of the Peso resultedPeso resulted

Trouble on the Way?Trouble on the Way?

By 1993, the Mexican economy was By 1993, the Mexican economy was becoming vulnerable. becoming vulnerable. Despite the lack of results, Mexico was Despite the lack of results, Mexico was

attracting tremendous amounts of foreign attracting tremendous amounts of foreign capital (7-8% of GDP). Much of this debt was capital (7-8% of GDP). Much of this debt was short term.short term.

Domestic savings dropped as Mexican Domestic savings dropped as Mexican consumers increased consumption expendituresconsumers increased consumption expenditures

Domestic inflation was creating a real Peso Domestic inflation was creating a real Peso appreciation. appreciation.

Strike one…Strike one…

January 1January 1stst 1994: the Zapatistas 1994: the Zapatistas rebels staged an uprising in rebels staged an uprising in Southern Mexico. Southern Mexico.

Strike one……Strike one……

January 1January 1stst 1994: the Zapatistas 1994: the Zapatistas rebels staged an uprising in Southern rebels staged an uprising in Southern Mexico. Mexico. The peso moved to the upper edge of The peso moved to the upper edge of

the exchange bandthe exchange band However, interest rates did not However, interest rates did not

dramatically increasedramatically increase International reserves were stableInternational reserves were stable Capital continued to flow into Mexico Capital continued to flow into Mexico

Strike two……Strike two……

On March 23On March 23rdrd, presidential , presidential candidate Luis Donaldo Colosio candidate Luis Donaldo Colosio was assassinated.was assassinated.

Strike two……Strike two……

On March 23On March 23rdrd, presidential , presidential candidate Luis Donaldo Colosio was candidate Luis Donaldo Colosio was assassinated.assassinated. Investors panicked and began selling Investors panicked and began selling

Mexican securities.Mexican securities. Mexican authorities used $10B in Mexican authorities used $10B in

reserves to shore up the Pesoreserves to shore up the Peso Interest rates on Cetes rose from 10% Interest rates on Cetes rose from 10%

to around 16%to around 16%

Liquidity ProblemsLiquidity Problems

While Mexico made it through the While Mexico made it through the crisis, they were having trouble crisis, they were having trouble refinancing its maturing Peso refinancing its maturing Peso denominated debt.denominated debt. Should Mexico allow interest rates to Should Mexico allow interest rates to

rise further and risk a recession?rise further and risk a recession? Could Mexico substitute Peso debt with Could Mexico substitute Peso debt with

Dollar debt?Dollar debt? Could Mexico abandon its exchange Could Mexico abandon its exchange

rate system?rate system?

Drawing the LineDrawing the Line

In late April, the Mexican government In late April, the Mexican government (informally) capped Peso (informally) capped Peso denominated debt and increased the denominated debt and increased the use of dollar denominated debt use of dollar denominated debt (Tesebonos)(Tesebonos)

At the same time, the central bank At the same time, the central bank sterilized its currency market sterilized its currency market interventions while the government interventions while the government relaxed its fiscal policyrelaxed its fiscal policy

The calm before the stormThe calm before the storm

From April until October, international From April until October, international reserves stabilized and interest rates reserves stabilized and interest rates actually fell slightly.actually fell slightly.

However, the international However, the international community was becoming community was becoming increasingly concerned over growing increasingly concerned over growing dollar linked debt. By August, dollar linked debt. By August, Tesebonos outstanding were equal to Tesebonos outstanding were equal to Mexican reserves of $16-17B Mexican reserves of $16-17B

MeanwhileMeanwhile

Bank loan defaults began to Bank loan defaults began to increaseincrease 1990: 2% of total loans1990: 2% of total loans 1992: 4.7%1992: 4.7% 1993: 7.3%1993: 7.3%

Strike Three….your out!Strike Three….your out! In September, Jose Francisco Ruiz was In September, Jose Francisco Ruiz was

assassinatedassassinated October 21October 21stst: The Bank of Mexico : The Bank of Mexico

announced that its stock of foreign reserves announced that its stock of foreign reserves had fallen to $17Bhad fallen to $17B

TELMEX announced disappointing third TELMEX announced disappointing third quarter earnings and the stock market quarter earnings and the stock market tumbledtumbled

The Federal Reserve refused to supply The Federal Reserve refused to supply credit to “support an inappropriate credit to “support an inappropriate exchange rate”exchange rate”

Expected Devaluation of Expected Devaluation of the Pesothe Peso

Risk Premium on Mexican Risk Premium on Mexican AssetsAssets

Mexico drops the PegMexico drops the Peg

By December, reserves had dropped to By December, reserves had dropped to $10B while short term dollar debt was $10B while short term dollar debt was over $27Bover $27B

On Dec. 20On Dec. 20thth, the exchange band was , the exchange band was widened to allow for a 15% devaluationwidened to allow for a 15% devaluation

In a panic, investors pulled out en In a panic, investors pulled out en masse. $4B left Mexico in one day. masse. $4B left Mexico in one day.

As a result, Mexico had no alternative As a result, Mexico had no alternative but to float.but to float.

The Moral of the StoryThe Moral of the Story

Developing countries need to be Developing countries need to be extremely careful when opening extremely careful when opening themselves to international capital themselves to international capital markets.markets.

Even with compatible Even with compatible fiscal/monetary policies, an fiscal/monetary policies, an exchange system can be exchange system can be unsustainable.unsustainable.