Mexican Peso Crisis

1
Mexican Peso Crisis
Mandi, Govinda Jasmine
2
Blue Skies
Mexican economy seemed healthy in early 90s.
What happened?
3
Current Account Deficit
Current account balance of trade net factor
income (interest, dividends) net transfer
payments (foreign aid)
4
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 ?P - ?P - ?E
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.
5
From Problem to Crisis
Rise in U.S. interest rates
Elections
Shift from cetes ? tesobonos
Political Shocks
6
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 Mexicos
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.
7
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.
8
Political Shocks
9
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.
Didnt 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 governments
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)
10
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 22 Mexican government forced to freely
float its currency.
The Mexican Peso Crisis of 1994-95 was now
full-blown, and at this point, Mexico was forced
to turn to international sources for assistance.
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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

12
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 Mexicos
  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.

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Goals of Assistance

• Restore financial stability
• Strengthen public finances and the banking sector
• Regain investor confidence
• Reinforce the groundwork for long-term
  sustainable growth

14
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 govt for up to 10 years

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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

16
Post-Crisis

• Economic Recovery (1996-1999)
• Sounder macroeconomic decisions/practices
• Improvement of trade balance
• Increase in private consumption

Post Crisis Trade Balance (1996-Present)
17
Post-Crisis

• Investor confidence has been increasing
• Economic growth slowly continues

GDP Growth Post-Crisis (1995-Present)
Gross Investment Growth Post-Crisis (1995-Present)
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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

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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

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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

21
(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. lthttp//iibf.law.smu.edu/arner.pdfgt
(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.htmelec
tions