1. Peso Problems

2. 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 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

3. 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 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. Meanwhile, in Mexico’s southern states, left wing activists were is the process of staging a major uprising against the Mexican establishment.

4. 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 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

5. The Mexican Peso

6. 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. 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. However, despite the crash, the region did not collapse. Instead, growth returned and inflation continued to fall.

7. Mexican Reform: 1987-1993 Open the economy to international competition Open the economy to international competition Privatization and deregulation Privatization and deregulation Price stabilization Price stabilization Dollar Pegging Dollar Pegging Restrictive Fiscal and Monetary Policy Restrictive Fiscal and Monetary Policy Agreements between the government, firms, and labor unions (the Pacto) Agreements between the government, firms, and labor unions (the Pacto)

8. The Good News Government deficits were reduced Government deficits were reduced Inflation fell below 10% Inflation fell below 10% Reduction of regulation and protection was beginning to promote efficiency improvements Reduction of regulation and protection was beginning to promote efficiency improvements

9. The Bad News Real (inflation adjusted) growth was 2.8% annually Real (inflation adjusted) growth was 2.8% annually Productivity growth was positive, but close to zero. Productivity growth was positive, but close to zero. Real wages fell Real wages fell Export growth was slow Export growth was slow Private saving fell and poverty and inequality grew. Private saving fell and poverty and inequality grew.

10. Reforms vs. Results While Mexico was doing all the right things in terms of process, the fruits of their reforms hadn’t materialized yet. 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. Regardless of actual results, Mexico began attracting foreign capital.

11. Mexican Capital Flows

12. Questions To what extent did the real appreciation of the Peso represent an overvaluation that required policy action? To what extent did the real appreciation of the Peso represent an overvaluation that required policy action? Were the capital inflows into Mexico sustainable? Were the capital inflows into Mexico sustainable?

13. Nominal Anchor and Real Appreciation of the Peso In 1988, the Peso was pegged to the dollar. The Mexican central bank was committed to: In 1988, the Peso was pegged to the dollar. The Mexican central bank was committed to: Keeping the Peso within its accepted band Keeping the Peso within its accepted band Keeping interest rates low Keeping interest rates low However, Mexican inflation expectations remained. This resulted in a very slow reduction of domestic inflation 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 With a positive inflation differential between the US and Mexico, a real appreciation of the Peso resulted

14. Trouble on the Way? By 1993, the Mexican economy was becoming vulnerable. 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. 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 savings dropped as Mexican consumers increased consumption expenditures Domestic inflation was creating a real Peso appreciation. Domestic inflation was creating a real Peso appreciation.

15. Strike one… January 1 st 1994: the Zapatistas rebels staged an uprising in Southern Mexico. January 1 st 1994: the Zapatistas rebels staged an uprising in Southern Mexico.

16. Strike one…… January 1 st 1994: the Zapatistas rebels staged an uprising in Southern Mexico. January 1 st 1994: the Zapatistas rebels staged an uprising in Southern Mexico. The peso moved to the upper edge of the exchange band The peso moved to the upper edge of the exchange band However, interest rates did not dramatically increase However, interest rates did not dramatically increase International reserves were stable International reserves were stable Capital continued to flow into Mexico Capital continued to flow into Mexico

17. Strike two…… On March 23 rd, presidential candidate Luis Donaldo Colosio was assassinated. On March 23 rd, presidential candidate Luis Donaldo Colosio was assassinated.

18. Strike two…… On March 23 rd, presidential candidate Luis Donaldo Colosio was assassinated. On March 23 rd, presidential candidate Luis Donaldo Colosio was assassinated. Investors panicked and began selling Mexican securities. Investors panicked and began selling Mexican securities. Mexican authorities used $10B in reserves to shore up the Peso Mexican authorities used $10B in reserves to shore up the Peso Interest rates on Cetes rose from 10% to around 16% Interest rates on Cetes rose from 10% to around 16%

19. Liquidity Problems While Mexico made it through the crisis, they were having trouble refinancing its maturing Peso denominated debt. 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? Should Mexico allow interest rates to rise further and risk a recession? Could Mexico substitute Peso debt with Dollar debt? Could Mexico substitute Peso debt with Dollar debt? Could Mexico abandon its exchange rate system? Could Mexico abandon its exchange rate system?

20. Drawing the Line In late April, the Mexican government (informally) capped Peso denominated debt and increased the use of dollar denominated debt (Tesebonos) 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 At the same time, the central bank sterilized its currency market interventions while the government relaxed its fiscal policy

21. The calm before the storm From April until October, international reserves stabilized and interest rates actually fell slightly. 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 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

22. Meanwhile Bank loan defaults began to increase Bank loan defaults began to increase 1990: 2% of total loans 1990: 2% of total loans 1992: 4.7% 1992: 4.7% 1993: 7.3% 1993: 7.3%

23. Strike Three….your out! In September, Jose Francisco Ruiz was assassinated In September, Jose Francisco Ruiz was assassinated October 21 st : The Bank of Mexico announced that its stock of foreign reserves had fallen to $17B October 21 st : 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 TELMEX announced disappointing third quarter earnings and the stock market tumbled The Federal Reserve refused to supply credit to “support an inappropriate exchange rate” The Federal Reserve refused to supply credit to “support an inappropriate exchange rate”

24. Expected Devaluation of the Peso

25. Risk Premium on Mexican Assets

26. Mexico drops the Peg By December, reserves had dropped to $10B while short term dollar debt was over $27B By December, reserves had dropped to $10B while short term dollar debt was over $27B On Dec. 20 th, the exchange band was widened to allow for a 15% devaluation On Dec. 20 th, 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. In a panic, investors pulled out en masse. $4B left Mexico in one day. As a result, Mexico had no alternative but to float. As a result, Mexico had no alternative but to float.

27. The Moral of the Story Developing countries need to be extremely careful when opening themselves to international capital markets. 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. Even with compatible fiscal/monetary policies, an exchange system can be unsustainable.