Transcript Mexico

Mexican economy seemed healthy
in early 90s….
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Inflation
Foreign investments
Central banks had $billions in reserves
NAFTA took effect early 1994
Due to policy reforms and NAFTA, a lot of capital ($102 billion from 1990-1994)
was flowing into Mexico making the peso appreciate in value.
• 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
• Thus the peso became overvalued, meaning the exchange rate
became too high for a sustainable equilibrium in the balance of
payments.
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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.
• BUT…
CAUSES OF THE CRISIS
1. Political shocks
*Elections
2. Rise in U.S. interest rates
3. Shift from cetes  tesobonos
Elections
• Because of an upcoming presidential election on August 21, 1994, political
developments caused an increase in Mexico’s risk premium () due to
increases in default risk and exchange rate risk: These events put
downward pressure on the value of the peso, Mexico’s central bank had
promised to maintain the fixed exchange rate, To do so, it sold dollar
denominated assets, decreasing the money supply and increasing
interest rates, To do so, it needed to have adequate reserves of dollar
denominated assets. Did it?
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 because they could have led to a
significant downturn in economic activity and could have further weakened
Mexico’s banking system. Devaluing the peso would have undermined its
commitment to maintaining a stable exchange rate – the basis of its success
in attracting foreign capital.
Shift from
cetes  tesobonos
Political
Shocks
The Central Bank blamed a series of
assassinations and other
discouraging acts that
political
risk and
investor confidence.
March 1994
Reserves
$11
billion in four weeks
June/July 1994
Reserves
$2.5
billion in three weeks
September 1994
Reserves
billion
December 1994
$4
Reserves
$1.5
billion in three days
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
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.
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.
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.
Monetary and Fiscal Expansion Under a Fixed
When the central bank buys and sells
Exchange Rate
foreign assets to keep the exchange
rate fixed and to maintain domestic
interest rates equal to foreign
interest rates, it is not able to adjust
domestic interest rates to attain
other goals.
In particular, monetary policy is
ineffective in influencing output and
employment.
A fiscal expansion increases
aggregate demand
To prevent the domestic currency from
appreciating, the central bank
buys foreign assets, increasing the
money supply and decreasing interest
rates.
RESERVES
CURRENT ACCOUNT
During the Crisis
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Maintain Salina’s popularity
Polarization of income and increased poverty
Mass industrial layoffs
Dec 20: 15% devaluation of the peso
Dec 22: Mexican Gov. forced to let peso float
GDP contracted approx 7.2%
Unemployment
GDP
International Effects
• Tequila Effect
• Contagion: Similar macroeconomic conditions and
economic policies
– Argentina
– Philippines
Solving the Mexican Peso Crisis
• People were skeptical about helping Mexico in fear of
causing moral hazard
• Initial line of credit proposal of $18 billion (half U.S,
half other large institutions)
• On January 12, a second proposal of a $40 billion line
of credit created by Clinton Adm.
• On January 31, they proposed a direct loan package
of 20 billion provided by the U.S, 18 Billion from the
IMF and $13 billion from the Bank of International
Settlement
What Happened to Mexico?
• Peso weakened nonetheless and bottomed
out at 7.45 pesos per U.S dollar
• Prices increased 30% in 1995 alone
• Household income declined by 30%
• Extreme poverty doubled
• Stringent austerity helped peso regain its
strength
Change in GDP
0.08
0.06
0.04
0.02
0
Change in GDP
1994
-0.02
-0.04
-0.06
-0.08
1995
1996
1997
1998
1999
2000
Mexico’s social expenditure as a per
cent of GDP (UNICEF)
Mexico’s biggest mistake?
• Mexican could have avoided such a large crisis
if they would have let the exchange rate float
before December
• There may have still been a recession but a
crisis could still have been avoided