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 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.As long as a government can borrow internationally, it can use the borrowed money to stabilize currency 2.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