FIN444(Case Mexico)

1) Investigate the causes of Mexico’s balance of payments difficulties prior to the peso devaluation.

ANS:

From the past data on Mexico’s current account deficit, we saw a gradual rising trend

of it. In 1989 it was $6 billion; in 1991 it was $ 15 billion and rose to $20billion in 1992 and 1993. By 1994, the deficit was estimated to be $28 billion. Such a large deficit in the current account let some observers to reflect the fact that Peso was being appreciated. And we know, as a currency appreciates, the country’s export becomes expensive while import gets cheap. Such a circumstance would dampen export and stimulate imports, and then eventually lead to a crisis. At that time Mexico was under the crawling peg exchange rate system, and in real terms when peso was appreciating that lead to a current account deficit.

Moreover during the early 1990 Mexico was experiencing a higher inflation rate than that of U.S. which caused the real exchange rate to go upward. Mexican goods got relatively expensive which encouraged Mexican residents to import goods at a cheaper rate.

External economic shocks were said to contribute in the peso value to appreciate. The Mexican government seemed unconcerned about the current account deficit, partially because its reserves of dollars were rising through the end of 1993. Moreover excessive budget deficit were said to cause the currency appreciation at that time. Another serious political shock came under notice when the ruling party’s presidential candidate, Luis Donaldo Colosio, was assassinated. His death at that time created financial panic and political instability. So prior to peso devaluation policy taken the above reasons contributed to balance of payment difficulties for Mexico.

2) Discuss what policy actions might have prevented or mitigated the balance of payments problem and the subsequent collapse of the peso. ANS: Effective policy actions should have been taken in proper time, in order to prevent the BOP problem and subsequent collapse of the peso. A few of them are discussed below: ➢ Mexico could have tightened its monetary policy in order to defend the peso from

devaluating. Even though the Mexican central bank claims to have pursued such a policy, some analysts questioned this claim. After the Colosio assassination, the central bank did push up interest rates. However, the tightening was limited. ➢ Mexico could have abandoned the exchange rate peg and allow the peso to float. This policy would have eliminated the need for reserves to support the currency. As a result, even though peso would have sharply declined and fallen to a level near its long-run equilibrium, it would eventually have stabilized. ➢ The government could have devalued the peso. Ideally, the new value chosen by the government would have been consistent with the long run equilibrium, and hence, public confidence would have remained high enough to prevent a speculative attack on the new peg. ➢ In addition to devaluing the peso, Mexico could have switched to a new monetary institution, a currency board. A currency board is used to convert domestic money into international reserves at a fixed rate on demand. Unlike central banks, the currency board cannot create money or domestic credit through some discretionary policy. Rather, domestic money is only issued in exchange for international reserves. Through this practice, Mexico could have ensured that the currency board always had enough international reserves to meet any demand to convert base money into international reserves at the fixed rate. ➢ Once the peso was devalued, nervous investors started shifting their funds out of Mexico. This resulted in a $4.5 billion loss in central bank reserves. Government should have prepared for such a major outflow of funds. Before announcing the devaluation, they should have arranged a swap line, probably a short term credit line with USA or a loan from IMF.

1) Derive lessons from the Mexican experience that may be useful for other developing countries. ANS: The Mexican crisis can be set as a useful example for other developing countries in order to derive lessons in preventing their economies from facing a similar crisis. A few of these lessons are discussed below: ➢ Mexico highly relied on foreign capital inflow in the form of direct foreign investment and foreign portfolio investments. However, what most people failed to realize was that most of this capital inflow was in a form where it could easily flow out of the country. While short term debt was increasing, the amount of foreign reserves in Mexico was slowly reducing by the day, resulting in enormous losses in the central bank reserves. One very important lesson for developing countries would be Mexico’s mistake in highly depending on short term foreign portfolio capital for its economic growth. Mexico should rather have depended more on long term portfolio capital by maintaining higher domestic savings. ➢ Developing countries should note that reliable and transparent disclosure of economic

data is very important to prevent a crisis similar to the one faced by Mexico. Lack of such economic data was another factor that contributed to the peso crisis. Had the Government of Mexico not been so reluctant in disclosing the true economic condition of the country, investors would have had a clear idea on the serious trade deficits and the high rate of depletion on foreign exchange reserves that the country had been experiencing over the years. As such, the depreciation in peso would have been more slow and steady, rather than a sudden collapse. ➢ A crisis of this sort needs to be handled at its early stage. In order to do so, a multinational net should be properly managed and controlled. After all, it is very important to protect the world financial system from such a crisis.

References: http://www.frbatlanta.org/filelegacydocs/J_whi811.pdf http://www.cato.org/pubs/journal/cj17n3-14.html http://worldeconomiccrisis.blogspot.com/2007/12/1994-mexico-economic-crisis.html

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