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Peso Problems. A Tale of Two Mexicos. By late 1993, NAFTA was on its way to ratification by the US. Mexico was considered by CEOs, journalists, and politicians as the jewel of the Latin American Crown. A Tale of Two Mexicos.
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A Tale of Two Mexicos • By late 1993, NAFTA was on its way to ratification by the US. Mexico was considered by CEOs, journalists, and politicians as the jewel of the Latin American Crown
A Tale of Two Mexicos • By late 1993, NAFTA was on its way to ratification by the US. Mexico was considered by CEOs, journalists, and politicians as the jewel of the Latin American Crown • Meanwhile, in Mexico’s southern states, left wing activists were is the process of staging a major uprising against the Mexican establishment.
Two worlds collide… • Throughout 1994, the “two Mexicos” were able to co-exist. However, in December 1994, rosy expectations were met with harsh realities and the Peso collapsed
Did market reform fail? • The collapse of the Peso and contagion throughout Latin America brought into question the merits of market reform taking place the region. • However, despite the crash, the region did not collapse. Instead, growth returned and inflation continued to fall.
Mexican Reform: 1987-1993 • Open the economy to international competition • Privatization and deregulation • Price stabilization • Dollar Pegging • Restrictive Fiscal and Monetary Policy • Agreements between the government, firms, and labor unions (the Pacto)
The Good News • Government deficits were reduced • Inflation fell below 10% • Reduction of regulation and protection was beginning to promote efficiency improvements
The Bad News • Real (inflation adjusted) growth was 2.8% annually • Productivity growth was positive, but close to zero. • Real wages fell • Export growth was slow • Private saving fell and poverty and inequality grew.
Reforms vs. Results • While Mexico was doing all the right things in terms of process, the fruits of their reforms hadn’t materialized yet. • Regardless of actual results, Mexico began attracting foreign capital.
Questions • To what extent did the real appreciation of the Peso represent an overvaluation that required policy action? • Were the capital inflows into Mexico sustainable?
Nominal Anchor and Real Appreciation of the Peso • In 1988, the Peso was pegged to the dollar. The Mexican central bank was committed to: • Keeping the Peso within its accepted band • Keeping interest rates low • However, Mexican inflation expectations remained. This resulted in a very slow reduction of domestic inflation • With a positive inflation differential between the US and Mexico, a real appreciation of the Peso resulted
Trouble on the Way? • By 1993, the Mexican economy was becoming vulnerable. • Despite the lack of results, Mexico was attracting tremendous amounts of foreign capital (7-8% of GDP). Much of this debt was short term. • Domestic savings dropped as Mexican consumers increased consumption expenditures • Domestic inflation was creating a real Peso appreciation.
Strike one… • January 1st 1994: the Zapatistas rebels staged an uprising in Southern Mexico.
Strike one…… • January 1st 1994: the Zapatistas rebels staged an uprising in Southern Mexico. • The peso moved to the upper edge of the exchange band • However, interest rates did not dramatically increase • International reserves were stable • Capital continued to flow into Mexico
Strike two…… • On March 23rd, presidential candidate Luis Donaldo Colosio was assassinated.
Strike two…… • On March 23rd, presidential candidate Luis Donaldo Colosio was assassinated. • Investors panicked and began selling Mexican securities. • Mexican authorities used $10B in reserves to shore up the Peso • Interest rates on Cetes rose from 10% to around 16%
Liquidity Problems • While Mexico made it through the crisis, they were having trouble refinancing its maturing Peso denominated debt. • Should Mexico allow interest rates to rise further and risk a recession? • Could Mexico substitute Peso debt with Dollar debt? • Could Mexico abandon its exchange rate system?
Drawing the Line • In late April, the Mexican government (informally) capped Peso denominated debt and increased the use of dollar denominated debt (Tesebonos) • At the same time, the central bank sterilized its currency market interventions while the government relaxed its fiscal policy
The calm before the storm • From April until October, international reserves stabilized and interest rates actually fell slightly. • However, the international community was becoming increasingly concerned over growing dollar linked debt. By August, Tesebonos outstanding were equal to Mexican reserves of $16-17B
Meanwhile • Bank loan defaults began to increase • 1990: 2% of total loans • 1992: 4.7% • 1993: 7.3%
Strike Three….your out! • In September, Jose Francisco Ruiz was assassinated • October 21st: The Bank of Mexico announced that its stock of foreign reserves had fallen to $17B • TELMEX announced disappointing third quarter earnings and the stock market tumbled • The Federal Reserve refused to supply credit to “support an inappropriate exchange rate”
Mexico drops the Peg • By December, reserves had dropped to $10B while short term dollar debt was over $27B • On Dec. 20th, the exchange band was widened to allow for a 15% devaluation • In a panic, investors pulled out en masse. $4B left Mexico in one day. • As a result, Mexico had no alternative but to float.
The Moral of the Story • Developing countries need to be extremely careful when opening themselves to international capital markets. • Even with compatible fiscal/monetary policies, an exchange system can be unsustainable.
