Liza Case Analysis

1. Document the trend in Mexico’s key economic indicators, such as the balance of payments, the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12. a.

The Mexican peso was pegged to the US dollar

i.

Made Mexico attractive destination for foreign Capital and lead to surge in portfolio investment

ii.

Flows initially helped to support Mexico’s economic reforms, but later undermined them

b. The peso’s appreciation combined with unilateral trade liberalization fed a surge in imports, which outpaced exports i.

Trade deficit coincided with foreign investment boom of the US during the early 1990s

ii.

Allowed Mexico to cover growing trade imbalance and run

unprecedented current account deficits c.

Primary component of Mexico’s anti-inflationary policy

was its exchange rate regime i.

Exchange rate regime was effective in curbing inflationary pressures

ii.

But resulted in the appreciation of the peso

2.

Investigate the causes of Mexico’s balance-of-payments difficulties prior to the peso devaluation

a. Political events like Chiapas uprising and political assignation made US Federal Reserve raise interest rates i.

Interest rates altered investment flows away from emerging markets

ii.

Compounded the effect of Mexico’s increased risk premium

b.

After assassination, decline in international investment

i.

Forced to finance deficit through unsustainable depletion of its foreign reserves.

c.

Foreign investment flows to Mexico continued overvaluation of the peso

i.

Fueled greater demand for imports

ii.

Worsened the trade deficit

d. Government’s expansionary monetary and fiscal policies accelerated the depletion of their foreign currency reserves i.

led to a fall in domestic interest rates as those in the U.S. continued to rise

3. Discuss what policy actions might have prevented or mitigated the balance-of-payments problem and the subsequent collapse of the peso. a.

Devalue the exchange rate and relieve the pressure on current Account

4.

Derive lessons from the experience that may be useful for other developing countries

a. Current account deficits should be financed by private capital flows or by a decline in foreign exchange reserves i.

1992 to 1993, Mexico’s current account deficit was $48 billion

ii.

While private capital flows were $57 billion

b.

Do not rely relying on foreign investment to finance current account deficit

i.

This exposes a great deal of risk

c. Mexico’s policymakers were aware of the dangers of growing current account deficit, and reliance on portfolio flows, but were confident on judgment i.

Developing countries should not assume unnecessary risks