Currency Crisis

Capital Flows  Short-tem and Long-term portfolio investment  Foreign Direct Investment (FDI)  Both increased during the 1990’s  Why? Sound macroeconomic policiesSound macroeconomic policies Legislative changesLegislative changes Reduced political riskReduced political risk

Factors that Contributed to the Crises  Fragile banking sector Sluggish technology advancementSluggish technology advancement Privatization led to high degree of concentration, which is inefficientPrivatization led to high degree of concentration, which is inefficient Political interventionPolitical intervention  Deficient regulatory system and inefficient legal system

Mexican Case  Prelude 1982 nationalization of the banking system1982 nationalization of the banking system 1988 privatization1988 privatization commercial credit expanded more than 100% commercial credit expanded more than 100% Promise of high returns with the signing of NAFTAPromise of high returns with the signing of NAFTA Relatively low foreign interest ratesRelatively low foreign interest rates The optimism created an asset price boomThe optimism created an asset price boom

Reality  Economic performance was below expectations  Political events January 1994: armed uprising in ChiapasJanuary 1994: armed uprising in Chiapas March 1994: official presidential candidate assassinatedMarch 1994: official presidential candidate assassinated A little-known economist was elected PresidentA little-known economist was elected President  Capital flight

To defend or not to defend

 Facts Mexican peso was overvaluedMexican peso was overvalued This overvaluation led to a current account deficitThis overvaluation led to a current account deficit Mexico’s interest rate premium was relatively highMexico’s interest rate premium was relatively high

 Government Intervention Assured investors the instability was transitoryAssured investors the instability was transitory Tight monetary policyTight monetary policy Sterilized interventions in the foreign exchange rate marketSterilized interventions in the foreign exchange rate market Changed the composition of government debt, from CETES to TESOBONOSChanged the composition of government debt, from CETES to TESOBONOS

 Initial devaluation of 15%  December Mistake: capital flight continued  Short-term public debt increased significantly  By the end of December let the peso float

Resolution and Consequences  Foreign intervention: U.S. government, Canada, Europe, and IMF  Deep domestic economic crisis  Tequila effect: speculative attacks Significant in Argentina and Brazil, not in ChileSignificant in Argentina and Brazil, not in Chile