Financial crises, the IMF, and Mexico
Lecture 17
Housekeeping
• Papers due today
• Professor Bozovic will be lecturing Oct 28
• Professor Graham returns Oct 30
Flexible currencies can avoid crises
One tempting solution to a current account deficit is to:
• Change the exchange rate
• Create inflation (print money) to deflate the value of your
currency
A devalued currency makes your exports cheaper
• Other countries buy more of your goods
Imports into your country become more expensive
• Your citizens buy less from abroad
Current account deficits with
fixed exchange rates
• Some countries have pegged currencies, so they are unwilling
or unable to depreciate.
– The costs of leaving the fixed currency may be too high to consider as
a policy option.
• Euro-zone countries don’t have individual control over the
Euro, so they also can’t depreciate in response to deficits
– Greece is willing to pay a very high price to stay in the Euro
• Mexico in 1994 kept the peso fixed to the dollar
– Wanted to encourage trade with U.S. under newly signed North
American Free Trade Agreement (NAFTA)
– Wanted to keep up appearance of stability to win a critical election
Costly fixes to current account deficit
under a fixed currency
X-M = (S-I) + (T-G)
• Exports – Imports =
(Savings – Investment) + (Taxes – Government consumption)
To fix a current account deficit, they can either
• Boost savings (less spending)
• Reduce investment (less capital per worker, lower
productivity)
• Raise taxes (disincentive to work, reduces private spending)
• Reduce government spending
All of these things reduce GDP growth!
Check-in on current account
Which of the following reduce a current account deficit?
Remember: Exports - Imports =
(Savings - Investment) + (Taxes - Government Consumption)
A) Increasing government spending
B) Increasing investment
C) Increasing household savings
D) A&B
E) B&C
Borrowing abroad:
The temporary fix
If you have a current account deficit:
• You can borrow money from abroad to cover it, or
• Sell off assets to foreigners
This only works for so long. As the debt grows, will or can the borrowing
country repay?
Mexico’s borrowing- 1994
• Fixed and overvalued exchange rate
– This only works as long as the central bank has the foreign currency
reserves to keep buying
• Mexico’s dollar borrowing
– Mexico borrowed dollars using bonds that had to be repaid in dollars
– Used those dollars to buy pesos, keeping value of peso high
– 7% current account deficit
Over-borrowing and debt crises
Step 1: Ominous signs
• Questions arise about a country’s willingness or ability to make payments
on its growing debt
Step 2: Investors grow cautious
• Cautious investors pull out or raise interest to cover the higher risk
Step 3: Higher rates make it harder
• Current account balance gets worse under higher interest payments, debt
rises even faster
Step 4: Downward spiral
• More investors lose faith and pull out, interest rates rise higher, current
account deeper in deficit, cycle repeats and gets worse each time
Peso’s weakness was hidden(?)
• Investors continued to loan Mexico dollars, as
long as they were repaid in dollars
• Interest rates would have been higher if they
had borrowed dollars to be repaid in pesos
• What does this mean? Was Mexico fooling
Wall Street?
Default risk vs. inflation risk
• Lenders were happy to buy Mexican debt, to
be repaid in dollars. They were confident that
they would be repaid, no matter what.
– Why? They knew the U.S. wouldn’t let Mexico’s
economy collapse. That is what the IMF is for.
• But fears that the peso would drop in value
made them less willing to give loans that
would be repaid in pesos.
Tequila crisis
buildup 1994
• Political Risk
– Armed rebellion in Chiapas,
assassination of ruling party
presidential candidate
• Bad political choices
– One-party government facing a real
election threat, high government
spending to win election
– Unwilling to offer higher interest rates
on peso-backed loans
• Foreign reserves depleted by maintaining
overvalued exchange rate and making loan
payments in dollars
Checking understanding
How do debt crises start?
A) As lenders get scared, interest rates fall, giving countries
incentive to borrow more
B) As lenders get scared, interest rates rise, making existing
debt even harder to pay back
C) Undervalued currencies lead to too many exports
Types of crises are related and
interchangeable
Debt crisis
• Interest rates increase sharply, government default imminent
Currency crisis (aka balance of payments crisis)
• Government is low on reserves, currency loses value
1.
2.
As long as a government can borrow internationally, it can use the
borrowed money to stabilize currency
As long as a government can print money, it can pay off its debts
What the IMF does in a crisis
IMF is the “lender of last resort”
• When a government can’t borrow, the IMF steps in with a
subsidized loan
• IMF doesn’t take collateral
• It imposes “conditions” on loans
Conditions: designed to fix the problems that created the crisis
in the first place
• Austerity: raise taxes, cut government spending, tight
monetary policy
• Sell off state assets
IMF: the big picture
Part of the Bretton Woods system
Goal = keep currencies stable, prevent economic collapses, and
promote trade.
Three functions:
• Surveillance: Collecting data, giving governments advice
• Technical Assistance: Guidance and training to poor countries
to help them manage their economies
• Lending: Loans to countries facing balance of payments crises
or otherwise w/o access to other credit
– Smooth out shocks, avoid defaults
– “Concessional” loans available for poor countries
IMF gets Mexico out of crisis
• US govt and IMF step in with $50 billion in loans in 1995
• Conditions:
– New monetary and fiscal policy controls, since the overvalued
currency caused the problem
– Mexico already had liberalized economy so no major structural
conditions such as austerity or privatization
• Major recession but quick economic recovery
• Considered an IMF success story
– Mexico repaid the crisis loans ahead of schedule
– Since then, almost two decades of relatively stable inflation and
exchange rates