1. The Peso Crash and Financial Market Performance in Mexico José Antonio González Chief of Staff Deputy Minister of Finance in Mexico October 25, 2002

2. Outline Stylized facts about the financial market performance in México. Some basic lessons: –Monetary policy –Good prudential regulation of banks –Corporate governance –Fiscal discipline

3. Looking back The early 1990s financial liberalization had four components (Aspe 1993): –Transparent monetary policy –Liberalization of capital account and financial innovation to mobilize savings –Solid prudential regulation –Strong public finances as foundation

4. Like many other LAC countries, Mexico embarked on an ambitious liberalization program Liberalization Index. Morley et al

5. Financial Development or Credit Boom? Financial sector depth doubled and fixed capital formation increased from 15% to 20% of GDP. However, since1995 financial depth decreased from a high of 100% in 1994 to close to 70% of GDP in 1999.

6. The puzzle: Bank lending fell but investment did not and GDP growth averaged 5.4% from 1996-2000

7. Bank vs market based?: Wrong question

8. Stylized facts conclusions: financial depth is still shallow

9. Looking ahead: Do more of the same…with some twists –Monetary policy based needs to prevent moral hazard in exchange rate behavior (Gil 2000) –Bank recovery: solid banking prudential regulation needs to include banking resolutions and limited deposit insurance. –Sound market and corporate governance regulations to promote stock and bond markets. –Strong public finances (including public banks) is key to allow institutional investors and forced savings turn into private investment.

10. Monetary policy: The probability of a vicious exchange rate- interest rate cycle has diminished.Fondeo Tipo de Cambio Fondeo Indices Abril =100 Abril- Octubre 1998 Abril- Octubre 2001

11. Mexican banks need to recover

12. Policies to reactivate bank lending: (i) Improve repossession laws (2002) and (ii) let go of the past (Gonzalez 2002)

13. At the same time Keep banks healthy with sound prudential regulation that reduces moral hazard (Gil 2000): –Limit deposit insurance and have a credible resolution framework. –Complement monetary policy with liquidity requirements on dollar liabilities to level the playing field

14. The stock market is shallow and needs to develop

15. A clear indicator of regulatory lag is poor minority rights

16. As a result there has been a migration to the US stock market Indicators of migration by legal system

17. In April 2001 Mexico passed changes to the stock market laws which aimed to increase transparency. Minority rights  Corporate governance of stock issuers and intermediaries.  Related transactions  Restricted stock emissions.  Control changes through public offerings  Information standards  Use of inside information.

18.  Accounting practices homologated to U.S. standards  Imitate de SEC in the practice of certifying accounting statements.  Firms with ADRs in the U.S. will have to subject themselves to SEC requirements.  Install a national corporate governance board. New reforms to corporate governance given corporate scandals in the U.S.

19. Pension reform and financial innovation have already and will continue to increase savings Saldo de Activos Manejados por Aseguradoras y Siefores (Miles de Millones de Pesos)

20. Financial Reform is not enough. It needs to be anchored with sound fiscal policies otherwise the public sector consumes most of the financial resources Use of financial resources in México

21. Crowding out has real effects Déficit Financiero y Tasa de Interés (1982-1999) Déficit Financiero e Inversión Privada (1982-1999) Déficit del Sector Público (% del PIB) (miles de millones de pesos de 1993) Déficit del Sector Público (% del PIB) (miles de millones de pesos de 1993) Rendimientos Cetes 28 Inversión Privada (miles de millones de pesos de 1993) Fuente: SHCP y Banco de México

22. Conclusions Initial reforms were in the right direction but they need to be implemented carefully. Looking ahead requires the same basic principles: –Sound fiscal policies –Banking credit needs to recover.