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Mexican Peso Crisis

(The Tequila Crisis)

Investors sold their peso


assets

Five years of prudent


scal and monetary
policy

Mexican peso plunged 50


percent against the U.S.
Dollar

Privatization of
Government Enterprises.

Forced to borrow from IMF


and the United States to
get through a nancial
crisis.

Preparing to enter North


American Free Trade
Agreement (NAFTA) with
Canada and the United
States.

ber

Touted as a model for


developing countries.

By
D
199 ecem
4

At
the
en
d

of
19
93

The Situation in Mexico

Ination in Mexico soared


to 50 percent and real
gross domestic product
(GDP) fell by 4 percent.

Years Leading Up To
The Crisis

The Economic Mindset and


Strategy
The Economy was trying to recover from the
Debt Crisis of 1982

Strategy aimed restoring macroeconomic


stability, reducing the role of the public sector in
the economy and laying the foundations for
private sector led growth.

The key elements of the strategy were

Maintenance of scal and monetary discipline


Major debt restructuring
Comprehensive program of structural reforms
Including privatization and trade liberalization.

Real Exchange Rate

Mexican real
exchange
rate
appreciated
by around
30%

Exchange
rate went
from xed to
a crawling
peg and then
to an
adjustable
band

Appreciation
continued
and was
exacerbated
by the large
capital
inows.

MEXICO: REAL EFFECTIVE EXCHANGE RATE


(1980=100)

94

Capital Inflows- FPI


Majority inows- portfolio investment
Reached 67% of total inows for 1990-93.

Capital inows dominated by ows to the


private sector

Beneted from the internationalization of Mexican


capital markets
Equity and bonds provided inows of US$12 billion and
US$24 billion respectively.

Foreign participation increased rapidly

The net foreign purchases of Mexican equities increased


from $1 Billion to $28 Billion in 1990-93

COMPOSITION (%) OF MEXICAN AND OTHER


COUNTRIES CAPITAL INFLOWS, 1990-93

Capital Inflows- Government


Securities

1980's- Peso
denominated
government
securities were
sold only to
Mexican
residents.

1990- The
Government
allowed direct
sales to foreign
residents.

1991- the rst


year without
restrictions,
foreigners
invested US$3.4
billion in
government
paper.

Purchases rose
rapidly, totaling
over US$18
billion, during
1991-93.

The share of government securities held by


foreigners

199
0

8%
8%

199
3

57%
57%

Current Account Deficit


Rapidly
and
consistentl
y growing
since 1988

7.7% of GDP in 1994.

Primary
Reason

Appreciation of the real exchange rate.

Funded by
the rapidly
growing
net capital
ows.

Even larger than CAD till late 1993


Levels of foreign exchange reserves still
increased.

CURRENT ACCOUNT BALANCE (% OF GDP)

The Government- Chill


Mode

CADapproximately the
same percentage
as during the
1982 debt crisis

Governmen
t simply
neglected
this

Excess
demand in the
economy

Increase in
imports.

Majorly
constituted
Sufficient by the Private
cash reserves
Sector
instead of the
Public sector

CHIL
L

Excess of
Private
Investment
over Private
savings

SAVING-INVESTMENT GAP AND CURRENT


ACCOUNT

CAUSES OF THE CRISIS

CAD and Overvalued Peso


WHY NOT DEVALUE?

undermine
d its
commitmen
t to
maintaining
a stable
exchange
rate the
basis of its
success in
attracting
foreign
capital.

strong
commitmen
t to reduce
rapid
ination.

Shift from Cetes Tesobonos

WHY?

Retain
foreign
investmen
ts.

reduction in
the interest
cost of debt
(6 to 8%)

http://www.galbithink.org/topics/mex/pbond.h
tm

Rise in U.S. interest rates

In February 1994, from


3% to 3.25%.
Further rises were
expected, as the US
monetary authorities were
keen to slow the rapid
pace of growth of the US
economy.
throughout 1994, US
interest rates increased
six times, with yields on
US Treasury Bills
increasing from 3% in
January 1994 to 5.6% in
December 1994.

Uncertainty among
investors
Series of assassinations of political
leaders that time rebellion in the southern province armed uprising only seven months
before a presidential election
ruling partys presidential candidate,
Luis Donaldo Colosio, was
assassinated on March 2
kidnapping of a prominent Mexican
businessman, Alfredo Harp
Ruiz-Massieu's assassination,
governor, Guerrero
At this point, the government decided to
devalue the peso 15 percent, to about
four pesos per dollar. However, within
days Mexico abandoned the new peg and
the peso plummeted, sinking the country
into a nancial crisis

Very quickly multibillion dollar


reserves were used up.

Solution to the crisis

Bailout

The government
got a bailout from
US , International
monetary fund ,
BIS and other
nations . The total
bailout was of
approx. $50 billion

Amount towards bailout ( in billions)

USA
BIS
11
10 20
17.8

Canada

IMF
Latin
american
countries

Contractionary
monetary policy
Money supply was reduced by the following measures
Strict reserve requirements were imposed
Limit on expansion of net domestic credit
Effects on IS-LM-BP equilibrium
LM shifts to the left as money supply decreases in the economy .
There is a surplus in the balance of payments. The exchange rate
falls to clear the foreign exchange market. Imports increase and BP
curve shifts to the left.
Fall in exchange rate also decreases the Aggregate Demand and
shifts the IS curve to the left.
New equilibrium is formed with a higher interest rate , a lower
income and a lower exchange rate.

Contractionary Fiscal
policy
Expenditures by public sector were reduced by 10%
Effects on IS-LM-BP
The IS shifts to the left as aggregate demand is decreased
Case 1 ( LM steeper than BP)
There is a balance of payment decit due to increased Foreign capital
outow and increased imports . The exchange rate rises . This shifts
the BP curve to the right.
The rise in exchange rate causes the IS curve to shift to the right as the
aggregate demand increases. This offsets some of the impact of the
Contractionary scal policy
Case 2 : ( BP steeper than LM)
There is a balance of payment surplus due to increased foreign capital
inow and decreased imports. Exchange rate falls . The BP curve shifts
to the left.
The fall in exchange rate also shifts the IS curve further left increasing
the effect of contractionary scal policy
In both the cases , the new equilibrium will be formed at a lower interest
rate and income .

Impacts of the Crisis


Borrow from the International
Monetary Fund (IMF) and the
United States to get through a
nancial crisis.

Hyperination of around 52%.


Prices increased by 35%.

Poverty skyrocketed as real


wages plummeted and
unemployment nearly doubled.

Mexico's growing poverty affected urban


areas more intensely than rural areas.
Urban citizens relied on a healthy labor
market, access to credit, and consumer
goods.
Consumer price ination and a tightening
credit market during the crisis proved
challenging for urban workers, while rural
households shifted to subsistence
agriculture.

NAFTA and The Crisis

Some policymakers link NAFTA and the peso crisis. They


say that NAFTA caused the Mexican authorities to
manipulate and prop up the value of the peso for political
reasons or that NAFTAs implementation caused capital
ows that brought the peso down.
Did NAFTA cause or exacerbate the devaluation of the
peso? Or did NAFTA help alleviate some of the
consequences of the crisis?
About NAFTA:
Free trade agrrement signed by America, canada and Mexico in 1992.
Focused on lowering the trade barriers between the three countries.
Reduction in tariffs and non-tariff barriers-quotas, licenses.

NAFTA AND THE VALUE OF THE


PESO

This suggests that the value of the peso was deliberately


manipulated to secure political support for NAFTA.
When discussing the value of the peso, it is important to
distinguish between the nominal exchange rate, and the
real exchange rate and take into account ination
Differences in countries.
Law of one price: identical goods should be sold at the
same price when expressed in terms of the same currency,
i.e.

But a more realistic picture is presented by taking into account


ination in an economy. Hence,

Hence, If the Mexican ination rate minus the U.S. ination rate
exceeds the rate of depreciation of the pesothat is, if

then the real exchange rate rises and Mexican goods became more
expensive in terms of U.S. goods; the peso becomes over valued.

Wholesale Price Index Rose steadily from a level of 70 in 1987 to


a peak of about 130 at the end of 1993. Mexican goods had
become almost twice as expensive in terms of U.S.

The real value of the peso for Mexicos trade depended not
only on its value vs. the dollar, but also on its value vs.
Mexicos other trading partners, and therefore they
suggest that multilateral measure of the real exchange rate
is more appropriate.

Another measure of the real exchange rateusing unit


labor costs instead of price indicesdid not show the peso
to be overvalued. that unit labor costs are a better way to
compute real exchange rates because they more closely
reect the relative cost of production in Mexico and abroad.

NAFTA AND THE CAPITAL FLOWS

NAFTA encouraged international capital inows by


national savings and by increasing the desirability

decreasing Mexican
of investment in Mexico.

The lowering of trade barriers, made consumption of imports, especially


consumer durables, cheaper and more attractive relative to saving.
Net savings fell from 10.8 percent of GDP in 1990 to 4.1 percent of GDP in
1994.
This reduction in savings was driven by corresponding increases in private and
government consumption, which rose 2.5 percentage points and 4.1
percentage points, respectively, over the same period.
Nafta developed an investor condence and increased expectations of future
income.

NAFTA Contributed to Capital Outows by creating a


political instability.
The Initial devaluation on December 20, 1994, was
sparked by a run on the peso started by rumors of
renewed ghting in Chiapas.
These political shocks led investors to exchange pesos
for dollars at the Bank of Mexico, causing a series of
falls in Mexicos foreign exchange reserves, limiting its
short-term ability to defend the peso.

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