Currency Crisis

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Currency Crisis
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Capital Flows

• Short-tem and Long-term portfolio investment
• Foreign Direct Investment (FDI)
• Both increased during the 1990s
• Why?
• Sound macroeconomic policies
• Legislative changes
• Reduced political risk

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Factors that Contributed to the Crises

• Fragile banking sector
• Sluggish technology advancement
• Privatization led to high degree of
  concentration, which is inefficient
• Political intervention
• Deficient regulatory system and inefficient legal
  system

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Mexican Case

• Prelude
• 1982 nationalization of the banking system
• 1988 privatization
• 1987-1994 commercial credit expanded more than
  100
• Promise of high returns with the signing of NAFTA
• Relatively low foreign interest rates
• The optimism created an asset price boom

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Reality

• Economic performance was below expectations
• Political events
• January 1994 armed uprising in Chiapas
• March 1994 official presidential candidate
  assassinated
• A little-known economist was elected President
• Capital flight

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To defend or not to defend
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• Facts
• Mexican peso was overvalued
• This overvaluation led to a current account
  deficit
• Mexicos interest rate premium was relatively
  high

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• Government Intervention
• Assured investors the instability was transitory
• Tight monetary policy
• Sterilized interventions in the foreign exchange
  rate market
• Changed the composition of government debt, from
  CETES to TESOBONOS

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• Initial devaluation of 15
• December Mistake capital flight continued
• Short-term public debt increased significantly
• By the end of December let the peso float

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Resolution and Consequences

• Foreign intervention U.S. government, Canada,
  Europe, and IMF
• Deep domestic economic crisis
• Tequila effect speculative attacks
• Significant in Argentina and Brazil, not in Chile