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The 1994’ peso crisis in Mexico

Introduction

The aim of this article is to briefly describe and comment the crisis that was faced in Mexico as a consequence of the devaluation of the Mexico currency in December 1994. It seems an interesting event to discuss, in light of what was studied in classes especially in the context of the chapter studied “Capital flows and the real exchange rate”, but also regarding other topics studied in class. It is essential to bear in mind that the analysis made in this article is not a detailed one. The purpose is only to try to explain the main factors and events and discuss an overall view of this crisis.

In the begging of the decade of 1990, Mexico seemed to be doing well. The economy was growing, in contrast to what happen throughout the previous decade. Inflation was being controlled, along with continuous confidence of foreign investors that were pumping money into Mexican economy, and also the central bank was accumulating a large quantity of dollars in their reserves. Along with these good performances (or also as a consequence of them) Mexican and US government agreed to reduce trade barriers between the two countries. The North American Free Trade Agreement (NAFTA) was then extended to the Mexican country, entering in vigor in the beginning of 1994.

But 1994 was a different year. Some events lead to some political instability, which made investors demand for an increasing risk premium on Mexican assets. Ultimately, this lead to a depreciation in peso of about 15 percent (against the dollar) in December 1994. But within days, the new peg of the exchange rate was abandoned and Mexico was doomed to seek for international help from the US, IMF and G7, among others. The consequences were rough on Mexico, with the financial sector bearing several damages. Several banks went bankrupt, revealing low quality assets and fraudulent practices. The country faced a hyperinflation situation with prices going up in about 35%. With these levels of inflation, and with nominal wages remaining constant, real wages faced a several decline. Unemployment almost doubled, and GDP declined about 6,2% throughout 1995.

Precursors

At that time (beginning of the 1990’s), Mexican central bank policy aimed to maintain a fixed exchange rate between pesos and US dollars. They would do so by intervening in the exchange market, buying or selling pesos to maintain the rate within a narrow band.  The strategy was to issue short-term public debt expressed in US dollars. With this borrowed dollars they would buy or sell pesos. The upper limit of the band was increased by a very slight preannounced amount every day, letting pesos depreciate in nominal terms. However, this depreciation in nominal terms was not being reflected in the real terms. The real exchange rate is given by: R = (eP*)/P, where R is the real exchange rate, e stands for the nominal one (e represents the price of foreign currency in units of the domestic one), P* are the foreign prices (in this particular case US Dollars) and P the price level of the home country (Mexico Pesos, in this example). A higher R means that foreign goods are becoming relatively more expensive. In that way, we say that the real exchange rate is depreciating. What was happening in the early 90’s in Mexico was the opposite: Inflation there was consistently higher than the sum of the nominal exchange rate and inflation in the US. Therefore, R was decreasing constantly besides the fact that nominal exchange rate was always maintained constant (within the above mentioned band). Foreign goods were becoming relatively less expensive what lead to an increase in demand for imported goods, and decrease in exports. This lead to a major deficit in the Mexican trade balance. Investors started to believe that pesos were artificially overvalued what translated into a speculative flight of capital. Despite this, Mexico government seemed not to be worried about this deficit since their reserves of US dollars were growing through the end of 1993.

Throughout 1994 several events happened that also triggered this capital flight. Among them are the rebellion in the southern province of Chiapas in the beginning of the year and the assassination of the presidential candidate Luis Donaldo Colosio in March, events that made investors skeptical about the political and financial stability of the country, pressing interest rates to go up (higher risk premiums required) and reinforced the downward market pressure on peso. The efforts that the central bank made to counteract the depreciation of the peso eventually, at the end of 1994, end up emptying out all the US dollars reserves of the central bank.

Crisis

The collapse of the economy came on December 20 with the announcement of the central bank that they would allow peso depreciate about 13% to 15%. This announcement went against all the expectations that investors had about the central bank currency policy, since they did not had left peso depreciate for quite some years. As we studied in the course, in the context of Rational Expectations the mistrust in central bank policy makers made investors fear additional devaluations and made capital flight even bigger and placed even higher risk premium on domestic assets, pressing interest rates to go up. As a response to this capital flight, particularly from debt instruments, the central bank decided to raise interest rates. But as we know, interest rates are negatively correlated with consumption and investment. In that sense, higher interest rate deviates consumption and investment to savings, preventing economic growth to take place. And that was essentially what happened.

When the time for repaying his maturing debt obligations came, few investors were interested in purchasing new debt. To repay the debt that was issued in US dollars (tesobonos), the central bank had to buy dollars in the exchange market with the weakened pesos and this proved to be very expensive. At this point, Mexico government faced imminent sovereign default.

Two days later, on December 24, the central bank allowed the currency to float. Another 15% depreciation took place. The consequences were devastating and at the end of 1995 Mexicos’s hyperinflation had reached more than 50%.

Conclusion

While Mexican’ currency devaluation came as a surprise to many, since it was against all the past decisions of the central bank, a review of the record seems to show that a crisis maybe was inevitable. As plenty of economists have tried to warn at the time, peso was somewhat overvalued. The question was if a devaluation of the peso could take place without initiate a major financial crisis. Despite the fact that the decision of devalue the peso had been really harsh criticized, markets seem to have response quite well, given the circumstances, during that day (December 20). The only sign of trouble was that the amount of weekly sell of tesobonos was less than the amount offered. Besides that, yield and total bids received were quite satisfactory. The next day, the loss in government credibility was noticed, and a $4.5 billion loss in central bank reserves happened because investors shift funds out Mexico. It is my belief that, considering the reserve losses throughout the year of 1994 and the large amount of short-term funds that could potentially leave the country, the government could and should have take measures to avoid this outflow. For example, arranging a short-term loan agreement with the US or IMF prior to the devaluation announcement, instead of afterwards. The next day, government announced that it would let exchange rate flow and a credit line arranged with the US and Canada. A financial crisis of a big scale had started. The reserves were now reduced to less than $6 billion, interest rate went up, peso devaluated a lot, and government access to credit was brutally reduced. The harsh response of the markets at the decision of dropping the fixed exchange rate on December 24, against the not so harsh response of the markets to the devaluation imposed in December 22, suggest that Mexico would probably be better off by increasing the target band’s rate of crawl and making an earlier decision of devaluate while reserves were still quite high, than to decide to let the rate floating. Several policy decisions from Mexico Government and Central Bank were criticized and in 1995 the country had to appeal for a bail-out organized by the US and the IMF.

The interesting part of analyzing this financial crisis is that, in same sense, covers a lot of issues discussed in the Macroeconomics Analysis course. Among them, exchange rate and its implication on the trade balance of one country, interest rates and how economy growth responses to it, animal spirits, rational expectations and flying capital, government debt and sudden stops.

 

Afonso Pereira da Silva Souto de Moura

Student number 3717

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Author: studentnovasbe

Master student in Nova Sbe

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