Transcript Peso Problems

Peso Problems
A Tale of Two Mexicos

By late 1993, NAFTA was on its way to
ratification by the US. Mexico was considered
by CEOs, journalists, and politicians as the
jewel of the Latin American Crown
A Tale of Two Mexicos
By late 1993, NAFTA was on its way to
ratification by the US. Mexico was considered
by CEOs, journalists, and politicians as the
jewel of the Latin American Crown
 Meanwhile, in Mexico’s southern states, left
wing activists were is the process of staging a
major uprising against the Mexican
establishment.

Two worlds collide…

Throughout 1994, the “two Mexicos”
were able to co-exist. However, in
December 1994, rosy expectations were
met with harsh realities and the Peso
collapsed
The Mexican Peso
Did market reform fail?
The collapse of the Peso and contagion
throughout Latin America brought into
question the merits of market reform
taking place the region.
 However, despite the crash, the region
did not collapse. Instead, growth
returned and inflation continued to fall.

Mexican Reform: 1987-1993
Open the economy to international
competition
 Privatization and deregulation
 Price stabilization
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Dollar Pegging
 Restrictive Fiscal and Monetary Policy
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Agreements between the government,
firms, and labor unions (the Pacto)
The Good News
Government deficits were reduced
 Inflation fell below 10%
 Reduction of regulation and protection
was beginning to promote efficiency
improvements

The Bad News
Real (inflation adjusted) growth was
2.8% annually
 Productivity growth was positive, but
close to zero.
 Real wages fell
 Export growth was slow
 Private saving fell and poverty and
inequality grew.

Reforms vs. Results
While Mexico was doing all the right
things in terms of process, the fruits of
their reforms hadn’t materialized yet.
 Regardless of actual results, Mexico
began attracting foreign capital.

Mexican Capital Flows
Questions
To what extent did the real appreciation
of the Peso represent an overvaluation
that required policy action?
 Were the capital inflows into Mexico
sustainable?
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Nominal Anchor and Real
Appreciation of the Peso
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In 1988, the Peso was pegged to the dollar. The
Mexican central bank was committed to:
 Keeping the Peso within its accepted band
 Keeping interest rates low
However, Mexican inflation expectations remained.
This resulted in a very slow reduction of domestic
inflation
With a positive inflation differential between the US
and Mexico, a real appreciation of the Peso resulted
Trouble on the Way?

By 1993, the Mexican economy was
becoming vulnerable.
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Despite the lack of results, Mexico was attracting
tremendous amounts of foreign capital (7-8% of
GDP). Much of this debt was short term.
Domestic savings dropped as Mexican consumers
increased consumption expenditures
Domestic inflation was creating a real Peso
appreciation.
Strike one…
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January 1st 1994: the Zapatistas rebels
staged an uprising in Southern Mexico.
Strike one……

January 1st 1994: the Zapatistas rebels
staged an uprising in Southern Mexico.
The peso moved to the upper edge of the
exchange band
 However, interest rates did not dramatically
increase
 International reserves were stable
 Capital continued to flow into Mexico
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Strike two……
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On March 23rd, presidential candidate
Luis Donaldo Colosio was assassinated.
Strike two……

On March 23rd, presidential candidate
Luis Donaldo Colosio was assassinated.
Investors panicked and began selling
Mexican securities.
 Mexican authorities used $10B in reserves
to shore up the Peso
 Interest rates on Cetes rose from 10% to
around 16%
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Liquidity Problems
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While Mexico made it through the crisis,
they were having trouble refinancing its
maturing Peso denominated debt.
Should Mexico allow interest rates to rise
further and risk a recession?
 Could Mexico substitute Peso debt with
Dollar debt?
 Could Mexico abandon its exchange rate
system?
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Drawing the Line
In late April, the Mexican government
(informally) capped Peso denominated
debt and increased the use of dollar
denominated debt (Tesebonos)
 At the same time, the central bank
sterilized its currency market
interventions while the government
relaxed its fiscal policy
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The calm before the storm
From April until October, international
reserves stabilized and interest rates
actually fell slightly.
 However, the international community
was becoming increasingly concerned
over growing dollar linked debt. By
August, Tesebonos outstanding were
equal to Mexican reserves of $16-17B
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Meanwhile
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Bank loan defaults began to increase
1990: 2% of total loans
 1992: 4.7%
 1993: 7.3%
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Strike Three….your out!
In September, Jose Francisco Ruiz was
assassinated
 October 21st: The Bank of Mexico announced
that its stock of foreign reserves had fallen to
$17B
 TELMEX announced disappointing third
quarter earnings and the stock market
tumbled
 The Federal Reserve refused to supply credit
to “support an inappropriate exchange rate”
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Expected Devaluation of the
Peso
Risk Premium on Mexican
Assets
Mexico drops the Peg
By December, reserves had dropped to $10B
while short term dollar debt was over $27B
 On Dec. 20th, the exchange band was
widened to allow for a 15% devaluation
 In a panic, investors pulled out en masse.
$4B left Mexico in one day.
 As a result, Mexico had no alternative but to
float.
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The Moral of the Story
Developing countries need to be
extremely careful when opening
themselves to international capital
markets.
 Even with compatible fiscal/monetary
policies, an exchange system can be
unsustainable.
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