Transcript The Mexican Expirience

FOREIGN RESERVE
ACCUMULATION
THE MEXICAN EXPERIENCE
Manuel Ramos Francia
October 20, 2006
The Mexican Experience

As a result of the currency crisis on December 1994,
Banco de México was forced to abandon the
predetermined exchange rate regime and float the peso,
thus changing the nominal anchor of the economy.

Banco de México withdrew from actively intervening in the
foreign exchange market and gradually converged
towards an inflation targeting regime.
 Fixed exchange rate
 Monetary policy
subordinated to the
exchange rate
regime
 Flexible
Exchange Rate
 Inflation
Targeting
2
The Mexican Experience
The free floating regime has simplified monetary policy
management, since the exchange rate can adjust more rapidly
to domestic and external shocks.
Overnight Interest Rate and Exchange Rate
(Percent and Pesos per Dollar)
100
13
90
80
12
Brazilian
Crisis
Asian
Crisis
09/11
11
70
60
10
Overnight Interest
Rate
Russian
Crsis
50
9
Exchange Rate
(right axis)
40
8
Mexican
Elections
30
7
Iraqi War
20
6
10
Source: Banco de México.
Sep-06
Nov-05
Jan-05
Mar-04
May-03
Jul-02
Sep-01
Nov-00
Jan-00
Mar-99
May-98
Jul-97
Sep-96
5
Nov-95
0
Jan-95

3
The Mexican Experience

Banco de México’s operations in the foreign exchange
market are divided in two categories:
a) Operations with the Federal Government and PEMEX.
b) Operations for international reserve management.
FEDERAL
GOVERNMENT
AND PEMEX
 Federal Government:
external debt service
 PEMEX: export revenues
and external debt proceeds
FX OPERATIONS
OF BANCO DE
MÉXICO
FOREIGN
EXCHANGE
MARKET
 Rule Based Operations
(1996-2001, 2003 onward)
 Discretional Interventions
(last intervention in Sep. 1998)
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The Mexican Experience
1.
Operations with the Federal Government and PEMEX.
 Both are required to undertake all their foreign currency operations with
the Central Bank.
 Although these operations are not carried out in the foreign exchange
market, they are settled at market prices.
 Banco de México sterilizes completely the monetary effect of its foreign
exchange operations.
Flows of Net Foreign Assets:
Decomposition by Source (1996-2006)1/
Total
PEMEX
Federal
Market
Government Operations
-2.7
0.9
0.9
3.8
-3.3
0.3
-6.5
1.8
-6.8
1.8
-2.4
1.4
-6.2
0
-5.8
-3.2
-3.2
-6.7
-7.3
-4.4
-11.4
-5.4
Others*
-0.9
0.4
1.2
1.2
2.1
1.4
2.1
2
1.3
1.2
2.8
1996
6.3
9
1997
13.5
8.5
1998
3.7
5.4
1999
3.9
7.4
2000
8.2
11.2
2001
9.2
8.9
2002
5.9
10
2003
8.3
15.4
2004
5.2
13.8
2005
9.9
20.4
2006**
9.3
23.3
1/ Million dollars.
* Include net income generated by investing Banco de México’s international assets.
** As of September, 2006.
5
The Mexican Experience
2. Operations for international reserve management.
Since the 1994-1995 crisis, several mechanisms have
been adopted for the management of international
reserves:
1. Initial Stage (1995-1998): Low level of international reserves
and highly volatile foreign exchange market. Restore orderly
market conditions.
2. Intermediate Stage (1996-2001): Increase the level of
international reserves and provide liquidity to the foreign
exchange market in face of shocks (high volatility episodes).
3. Current Stage (2001 to date): Promote a cleaner float and
prevent excess accumulation of foreign reserves.
6
The Mexican Experience
The mechanisms adopted allowed for a fast buildup of international
reserves and promoted orderly conditions in the foreign exchange
market in face of different shocks.
This contributed to the
development of a deep foreign exchange market.
International Reserves and Foreign Exchange Rate*
90
16
1
80
3
14
2
70
12
60
10
50
8
40
6
30
4
20
International Reserves
10
Nominal Exchange Rate (right axis)
2
* As defined in the Banco de Mexico Law of 1994.
1: Initial Stage.
2: Intermediate Stage.
3: Current Stage.
Sep-06
Oct-05
Nov-04
Dec-03
Jan-03
Feb-02
Mar-01
Apr-00
May-99
Jun-98
Jul-97
Aug-96
Sep-95
Oct-94
Nov-93
0
Dec-92
0
Jan-92

7
The Mexican Experience
Rule Based Operations:

Between August 1996 and July 2001, the Foreign Exchange
Commission (FEC) developed well defined mechanisms for the
accumulation of international reserves and to limit the volatility of the
exchange rate.
1. Monthly auction of options to sell dollars to Banco de México
(August 1996 to June 2001).
2. Daily dollar auction to financial intermediaries (February 1997
to July 2001).

Once the FEC concluded that the benefits from continuing the
accumulation of international reserves were less significant, a
mechanism to reduce Banco de México’s rate of accumulation was
put in place (since May, 2003).
Discretional Interventions:

Banco de Mexico’s last intervention in the foreign exchange market
took place on September 10th, 1998 for 278 million dollars.
8
30
20
10
0
Red lines represent dates when Moodys improved Mexico’s credit ratings.
Source: Banco de México.
Jul-06
Oct-05
Jan-05
Apr-04
daily auctions
Jul-03 Sell US dollars through
Oct-02
Jan-02
Apr-01
Jul-00
40
Oct-99
50
Jan-99
60
Apr-98
70
Jul-97
80
Suspend put option
auctions
Investment Grade
Buy US dollars through put
options
90
Oct-96
Jan-96
The Mexican Experience
Net International Reserves
(Billion Dollars)
9
The Mexican Experience
International Reserve Accumulation through Automatic Mechanisms
(Billion Dollars)
Options Placed Options Exercised Sales Auctioned Net Accumulation
(A)
(B)
(C)
(B-C)
1996
1/
0.9
0.9
0.0
0.9
1997
3.2
4.4
0.6
3.8
1998
2.8
1.5
0.9
0.6
1999
3.0
2.2
0.4
1.8
2000
3.0
1.8
0.1
1.7
1.5
1.4
0.0
1.4
16.3
12.2
2.0
10.2
2001
2/
1996-2001
1/ Starting August.
2/ Ending June.
Source: Banco de México.
10
The Mexican Experience
Daily Dollar Auctions
Exchange Market Volume*
(Million Dollars)
(Million Dollars; Monthly Average)
50
30,000
40
25,000
30
20,000
20
15,000
10
10,000
5,000
Source: Banco de México.
Jan-06
Sep-04
May-03
Jan-02
Sep-00
May-99
Jan-98
Sep-96
May-95
0
Jan-94
May-Jul 03
Aug-Oct 03
Nov 03 -Jan 04
Feb-Apr 04
May-Jul 04
Aug-Oct 04
Nov 04 -Jan 05
Feb-Apr 05
May-Jul 05
Aug-Oct 05
Nov 05 -Jan 06
Feb-Apr 05
May-Jul 05
Aug-Oct 05
0
*Includes operations in the spot, swap and
forward markets.
11
Source: Banco de México.
The Mexican Experience

Sterilization of International Reserves.
 International reserves have grown more than the monetary base.
Monetary Base
Reserve Accumulation and Monetary
Base Growth
(Percent of GDP)
(Cumulative Flows, Billion Dollars)
5.0
80
International Reserves
Source: Banco de México.
Source: Banco de México.
Sep-06
May-05
Jan-04
Sep-02
May-01
Jan-00
Sep-98
May-97
Monetary Base
Jan-96
Dec-05
-20
Apr-04
2.5
Aug-02
0
Dec-00
3.0
Apr-99
20
Aug-97
3.5
Dec-95
40
Apr-94
4.0
Aug-92
60
Dec-90
4.5
12
The Mexican Experience
Monetary Regulation Bonds (BREMS) and
Compulsory Deposits
(Amounts Outstanding; Billions of Mexican Pesos)
350
BREMS and BONDES 'D'*
300
Compulsory Remunerated Deposits
250
200
150
100
50
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
*Since August 17th, Banco de México uses BONDES “D” for monetary purposes instead of BREMS.
Source: Banco de México.
13
The Mexican Experience
Sources and Uses of Financial Resources
(Effective Flows as Percent of GDP)
2002
2003
2004
2005
Total Sources
M4 (Domestic Financial Savings)
External Financing
3.7
4.3
-0.6
5.4
5.5
-0.1
5.9
5.4
0.5
8.0
7.4
0.5
Total Uses
Banco de México (International Reserves)
Public Sector (RFSP)
States and Municipalities
Private Sector
1/
Other
3.7
1.1
2.7
0.2
1.1
-1.4
5.4
1.5
2.6
0.3
0.9
0.1
5.9
0.6
1.7
0.2
2.0
1.4
8.0
0.9
1.4
0.1
2.8
2.8
4.0
7,104.1
0.0
0.0
4.4
9,450.9
0.5
3,218.0
2.5
4,061.4
1.0
6,712.0
2.4
7,172.6
0.6
4,402.0
Memo:
Banco de México, Pub. sect., States and Mun.
International Reserve Accumulation (md)
Dollar Sales by Banco de México 2/
Dollar Sales by Banco de México 2/
1/ Refers to non-sectorized assets, capital and results accounts, technical reserves accounts, capital reserves, physical assets of financial
intermediaries, preemptive reserves, investment in stocks, commercial banks external resources, financing to non-residents, INFONAVIT
liabilities other than those submitted by workers, financial intermediaries liabilities other than bank credits, net position of trusts
(fideicomisos) with the banking sector, the difference between development banking domestic financing to the private sector and to financial
intermediation, and non-monetary liabilities of IPAB, among others.
2/ Corresponds to dollar sales according to the mechanism for reducing the rate of foreign reserve accumulation (see Foreign Exchange
Commission press release of March 20, 2003).
Source: Banco de México.
14
The Mexican Experience

Benefits and costs of holding reserves in Mexico.
Benefits
 The economy is insured against sudden stops: the
exposure to external shocks is much lower.
 The country’s credit worthiness improves: the country has
Investment Grade since March 2000 and has already
developed a market for long-term instruments in domestic
currency.
Costs
 Carry cost of reserves.
At the margin, increasing reserves holdings is
progressively yielding lower net benefits.
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The Mexican Experience

Optimal Reserves in Mexico: Methodology of Ben-Bassat
and Gottlieb.

The Central Bank chooses the level of reserves to
minimize expected costs of holding them:
min Π R  C0  1  Π R  C1 R 
R
R
Internatio nal reserves
C 0 Cost of crises
Π
Probabilit y of crises
C1 Cost of holding reserves rR
r
Opportunit y cost of reserves
16
The Mexican Experience

FOC:

Logistic function for :
Π R C0  rR   1  Π  r  0
ef
Π
1 e f

 Π 
f  ln 

 1 Π 
Specification for f:
R
 D 
f  a0  a1 ln    a2 exp 

 A
 GDP 
R
Reserves to short - term external public debt
A
D
External public debt to GDP
GDP
17
The Mexican Experience
Optimal Reserves to Actual Reserves Ratio*
(Different Levels for Cost of Crises as Percentage of GDP)
11
August 1996 buy US dollars
through put options
10
May 2003 sell US dollars
through daily auctions
9
8
20%
7
July 2001 suspend put
option auctions
6
40%
60%
5
4
80%
3
100%
2
* The opportunity cost of reserves (r) was assumed at 5%.
I 2006
III 2005
I 2005
III 2004
I 2004
III 2003
I 2003
III 2002
I 2002
III 2001
I 2001
III 2000
I 2000
III 1999
I 1999
III 1998
I 1998
III 1997
I 1997
I 1996
0
III 1996
1
18
The Mexican Experience
Challenges Ahead

Capitalization
and
adequate
management
of
the
oil-
stabilization fund.

Reduce the cost of holding reserves.
 Increase asset returns.
a) Riskier assets: market risk (higher duration) vs. credit risk
(alternative asset types).
b) Improve
risk
management
capabilities:
internal
vs.
outsourcing.
 Limit the growth of reserves.
19
The Mexican Experience
Local Interest Rates and Selected Yields
(Percent)
Cost of Holding Reserves
International reserves/monetary base
7
6
Break
Even
12%
Observed
11%
10%
Break even yield from FX reserves
Overnight Mexican Peso Rate
Broad Corporate Yield
US Treasuries and Agencies Yield
5
9%
4
8%
Central Bank Losses
3
2005
7%
7.0%
6%
5.8%
5%
5.2%
2
5.0%
1
4%
Central Bank Gains
3%
0
0
3
6
9
12
Interest rates differential
Source: Banco de México.
15
2005
2006
The average duration of the AAA-rated U.S. Treasuries and
Agencies Portfolio is 2 years. The average duration of the Arated Corporate Portfolio is 5.7 years.
20
The Mexican Experience

The Government will prepay more than 12.4 billion dollars of
foreign exchange denominated debt (IADB and World Bank
mostly). To finance this transaction, the Government
purchased 12.4 billion dollars from the Central Bank’s
reserves with funds obtained from the issuance of domestic
debt.
Dollars
Central
Bank
Government
BONDES D
External Debt
Cancellation
Dollars
Foreign Creditors
BREMS
BONDES D
Local Market
21
The Mexican Experience: Final Remarks

The criteria to measure the optimal level of reserves has
changed over time, reflecting both the changes in the global
economy and the particular features of each country. Capital
account considerations and external vulnerability issues seem
more relevant in light of recent international experience.

After the financial crisis of 1994-95, Mexico started to build up
international reserves in order to improve investor confidence,
strengthen the access to external capital markets, and reduce
the country’s external vulnerability.

During the last years, the increase in international reserves is
explained by the higher oil revenues.
22
The Mexican Experience: Final Remarks

Several factors explain the reduced need for accumulating
international reserves in Mexico. Macroeconomic stability, the
development
of
domestic
financial
markets,
and
the
substitution of external debt for domestic debt have made the
economy less vulnerable to financial shocks. The floating
exchange rate regime implies that there is no need to hold
reserves to manage the exchange rate.

The net benefits of continuing to accumulate international
reserves at a rapid pace are considered to be limited. In order
to reduce the cost of holding large international reserves,
Mexico decided to reduce their growth rate.
23