Powerpoint for Mexican Peso Crisis

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Mandi, Govinda & Jasmine
Blue Skies
Mexican economy seemed healthy in early 90s….
Inflation
Foreign investments
Central banks had $billions in reserves
NAFTA took effect early 1994
What happened?
Current Account Deficit
Current account = balance of trade + net factor income (interest,
dividends) + net transfer payments (foreign aid)
Current account deficit  peso becoming overvalued  exports
foreign reserves
being depleted
, imports

http://www.galbithink.org/topics/mex/cad.htm
A fall in domestic savings and a rise
in domestic consumption contributed
to the current account deficit
http://www.galbithink.org/topics/mex/invest.htm
Real Appreciation & Overvalued Peso
Due to policy reforms and NAFTA, a lot of capital ($102 billion from
1990-1994) (1) was flowing into Mexico making the peso appreciate in value.
The Mexican government kept the value of the peso within a crawling peg
exchange rate with the USD. The exchange rate was controlled within a
narrow target band whose upper limit was raised bit by bit for gradual
nominal depreciation.
But in real, price adjusted terms the peso was appreciating,
contributing to the current account deficit
R = Real exchange rate
P = Domestic price level (pesos)
P* = Foreign price level ($)
E = Mkt exchange rate (peso/$)
%ΔP = domestic inflation rate
%ΔP* = foreign inflation rate
R = P/(P*E)
%ΔR = %ΔP - %ΔP* - %ΔE
In Mexico’s case: R
because %ΔP > %ΔP* + %ΔE
Thus the peso became overvalued, meaning the exchange rate became
too high for a sustainable equilibrium in the balance of payments. 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.
From Problem to Crisis
Rise in U.S. interest rates
Elections
Shift from cetes  tesobonos
Political Shocks
Elections
Because of an upcoming presidential election on August 21, 1994,
Mexican authorities were reluctant to take action in the spring and summer
of 1994 to fix the inconsistencies in the economy. 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 in a presidential election year
because they could have led to a significant downturn in economic activity
and could have further weakened Mexico’s banking system. (PRI wanted
to stay in charge).
Devaluing the peso would have undermined its commitment to maintaining a
stable exchange rate – the basis of its success in attracting foreign capital.
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.
http://www.galbithink.org/topics/mex/uint.htm
Political Shocks
The Central Bank blamed a series of assassinations and other
discouraging acts that
political risk and
investor confidence.(2)
March 1994
Assassination of presidential
candidate Luis Donaldo Colosio
Reserves
in four weeks
$11 billion
June/July
1994
Resignation of Minister of the Interior
Jorge Carpizo who was overseeing
the national election, kidnapping of
prominent businessman Alfredo Harp
Reserves
$2.5 billion
in three weeks
September
1994
Assassination of High official Jose
Francisco Ruiz Massieu
Reserves
$4 billion
December
1994
Renewed pressure on the peso:
Breakdown in talks with Chiapas
rebels? Market worries about current
account deficit? Leaked rumors of
changes in exchange rate policies?
Reserves
in three days
$1.5 billion
Shift from cetes  tesobonos
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
1995.19. (1)
http://www.galbithink.org/topics/mex/pbond.htm
Float and Sink
December 20 – Mexican authorities sought to relieve pressure
on the exchange rate by announcing a widening of the
peso/dollar exchange rate band (peso devalued by 15%.)
December 20-21 – The government did not announce any new
fiscal or monetary measures to accompany the devaluation so
foreign reserves
$4 billion.
December 22 – Mexican government forced
to freely float its currency.
The Mexican Peso Crisis of 1994-95 was now fullblown, and at this point, Mexico was forced to turn to
international sources for assistance.
International Effects
Due to the Mexican Peso Crisis most large Western hemisphere Less Developed
Countries (LDCs) experienced turbulence in their foreign exchange markets and
significant declines in equity markets.
For example Argentina and Brazil experienced heavy trading losses after
the Crisis.
Some of the LDCs experienced discrimination due to the fact that they
had some of the same general characteristics as Mexico:
1. low savings rates
2. large current account deficits
3. weak banking systems
4. significant volumes of short term debt
Solving the Mexican Peso Crisis
•
Due to the magnitude of the Peso Crisis, the United States and the IMF concluded
that outside assistance was required to prevent Mexico’s financial collapse as well as to
prevent the spread of the crisis to other LDCs.
– United States Assistance
• $48.8 billion multilateral assistance package
– This package offered $20 billion to Mexico through the use of the
Exchange Stabilization Facility
– IMF Assistance
• 18-month standby arrangement for up to $17.8 billion
– Other Assistance
• Other countries offered assistance in the form of $ 10 billion under the Bank
of International Settlements
*NOTE: The response to the Peso Crisis was one of the largest multilateral economic assistance packages ever extended to one country.
Goals of Assistance
• Restore financial stability
• Strengthen public finances and the banking
sector
• Regain investor confidence
• Reinforce the groundwork for long-term
sustainable growth
Assistance From the United States in
Detail
• Three Mechanisms:
– Short-term currency swaps for up to 90 days, with
renewals for a maximum term of 1 year for Treasury
swaps and renewals up to three times for the Fed
swaps
– Medium-term currency swaps for up to 5 years
– Securities guarantees under which ESF funds could
be used to back up securities issued by the Mexican
gov’t for up to 10 years
Ways to Respond to a Current
Account Deficit
• 1. Attract more foreign capital
• 2. Allow currency to depreciate
– This makes imports more expensive and exports
cheaper
• 3. Tightening monetary/fiscal policy to reduce
the demand for all goods
• 4. Using foreign exchange reserves to cover
deficit
Post-Crisis

Economic Recovery (1996-1999)
• Sounder macroeconomic decisions/practices
• Improvement of trade balance
• Increase in private consumption
Post Crisis Trade
Balance
(1996-Present)
Post-Crisis


Investor confidence has been
increasing
Economic growth slowly continues
GDP Growth Post-Crisis
Gross Investment Growth Post-Crisis
(1995-Present)
(1995-Present)
Post-Crisis Effects

Lingering Side-Effects?
• Improvement in Mexican banking


Youth of Banking sector
Improvement of regulations
• Distribution of Wealth

Large gap between the rich and poor
remains
• Financial Institutions

IMF double Emergency Funds
Post-Crisis Effects (cont.)

Signs of emergence from Crisis
• Relatively Low Interest Rates

Around 8.5% as of 2006
• Low Inflation Rates

3.3% in 2005
An Expensive Lesson

What can we learn from the crisis?
• An improvement of economic
fundamentals
• Increased transparency of economies

IMF periodic economic and financial
publications by each member nation
• Realization of the speed of capital
mobility
(1) Arner, Douglas. “The Mexican Peso Crisis: Implications for the
Regulation of Financial Markets.” Essays in International
Financial & Economic Law. The London Institute of
International Banking, Finance & Development Law, 1996.
<http://iibf.law.smu.edu/arner.pdf>
(2) Williamson, John. “Causes and Consequences of the Mexican Peso Crisis.”
Institute for International Economics March 14, 1995
http://www.galbithink.org/topics/mex/ps.htm#elections
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