International Finance 09’ 092SIS83 Hee Hyun Kim 5. November. 09 The Mexican Peso Crisis

The Mexico Crisis: Background Origins of the Financial Crisis The Crisis The rescue package Lessons from the Mexico crisis Outline

The Mexico Crisis: Background Early 1990s – Mexico becomes attractive place for foreign investment  Major structural reforms by the government 1994 – Mexico enters NAFTA with the U.S. & Canada  Bolstered foreign investor confidence  Mexico’s long-term prospects for stable economic growth

The Mexico Crisis: Background Mexico adopted an exchange rate system  1988 – nominal exchange rate of the peso was fixed temporarily  1989 – system replaced by “crawling peg” system  1991 – the crawling peg was replaced with a band Exchange rate system = Anchor for economic policy

Until 1994  Inflation ↓, government spending ↓  Large foreign capital investment  Experiencing very large current account deficit  Mexico’s foreign currency reserves were plentiful  Its exports were growing rapidly, and  Not seem to be significant risk that Mexico soon would have trouble attracting and retaining foreign investment Situation changes in late 1994 The Mexico Crisis: Background

Exchange Rate (USD/Peso)

Origins of the Financial Crisis Interplay of a number of complex factors during 1994 Mexico’s monetary and fiscal policies inconsistent with its exchange rate policy PoliticalEconomicFinancial

Origins of the Financial Crisis During 1994, pre-presidential election:  Raised U.S. interest rates several times to prevent U.S. inflation  Assassination of leading presidential candidate  Several actions to stem the outflow of foreign exchange reserves  Increased interest rate 9% → 18% on short term, peso dominated Mexican government notes called “cetes” Options available to Mexican government ① Offering even higher interest rates on cetes; ② Reducing government expenditures to reduce domestic demand, decrease imports, and relieve pressure on the peso; or ③ Devaluing the peso

Origins of the Financial Crisis Government choose to increase its issuance of tesobonos Were dollar-indexed, holders could avoid losses Best way to stabilize foreign exchange reserves “ Expected investor confidence would restore following the August presidential election” by Government Did not recover, low interest rate continues till Dec. Increasingly clear that Mexico’s mix of monetary, fiscal and exchange rate policies need to be adjusted

Origins of the Financial Crisis Post-presidential election:  Mexican authorities draw down foreign currency reserves in order to meet the demand for $  Renewed fighting in the Mexican state of Chiapas  New Mexican administration expected even higher current account deficit in 1995, but no plan in change in exchange rate policy  Led further loss in confidence by investors  Mexico’s tesobono obligations reached $30 Billion These events put downward pressure on the peso

Dollar reserves of Mexico’s central bank December 1993 ………………$28 billion August 17, 1994 ………………$17 billion December 1, 1994 ……………$ 9 billion December 15, 1994 …………$ 7 billion December 1993 ………………$28 billion August 17, 1994 ………………$17 billion December 1, 1994 ……………$ 9 billion December 15, 1994 …………$ 7 billion During 1994, Mexico’s central bank hid the fact that its reserves were being depleted

The Crisis

Dec. 20: Mexico devalues the peso by 13% (fixes the exchange rate at 4.0 pesos/dollar instead of 3.4 pesos/dollar) This is a surprise to many investors - revealed that the central bank is running out of reserves Investors dump their Mexican assets and pull their capital out of Mexico Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets the currency float In a week, the peso depreciates by another 30% to about 5.7 pesos/dollar

The Peso crisis didn’t just hurt Mexico U.S. goods more expensive to Mexicans  U.S. firms lost revenue  Hundreds of bankruptcies along U.S.-Mexican border Mexican assets worth less in dollars  Reduced wealth of millions of U.S. citizens

The rescue package 1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s government  To help Mexico overcome its short-term liquidity crisis  To limit the effects of the crisis spreading to other emerging market This helped restore confidence in Mexico, enable Mexico to begin to return to international capital market. After a hard recession in 1995, Mexico began a strong recovery from the crisis  Mexican goods were relatively inexpensive, allowing production to increase  Increased demand of Mexican products relative to demand of foreign products stabilized the value of the peso and reduced exchange rate risk

Lessons from the Mexico crisis The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. 3 lessons emerge: The exchange rate must be adequate to bring equilibrium both in the goods markets as well as in the financial markets. Weaknesses in the domestic banking sector can increase the risk of poor lending that can precipitate the crises. If a country enters in a financial crisis, the only way to bring back confidence is with a very strong fiscal and economic adjustment program, backed up by significant financial resources from abroad.

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