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Policy Brief further. The action is expected to lower interest rates further and put pressure on the peso to depreciate. Moreover, although not quite at international levels, inflation for the year is expected to be close to or below the official target of 6.5%, giving monetary authorities room to maneuver. Starting July 2, 2001, the Central Bank will lower the intervention amounts in the exchange market to zero and let the peso float freely. In theory, given the surplus in the balance of payments, the measure should pressure the peso to appreciate, which is the opposite effect to the reduction in the corto. However, with a freely floating peso, investors will expect higher volatility, which might lower capital flows to Mexico. There are two short-term developments to consider if Mexico loosens monetary and tightens fiscal policy. The first is that the About the author J osé Antonio González is a Senior Research Associate at the Center for Research on Economic Development and Policy Reform (CREDPR) at SIEPR. He is also the Coordinator for the Latin American Program at CREDPR and a Lecturer in Economics. Prior to joining Stanford University, José Antonio was a Senior Country Economist at the World Bank working in Peru, Bolivia, Paraguay, and Panama. He also worked in the Mexican President’s staff from 1989-1991. He received his Ph.D. from Harvard University. Stanford Institute for Economic Policy Research Mexico’s Macroeconomic Policy Dilemma: How to deal with the “super-peso?” José Antonio González M approval of fiscal measures renews New York’s (irrational?) exuberance toward Mexico and capital flows increase despite lower interest rates. The second is that loosening monetary policy might be insufficient to abate portfolio flows and elimi- His research focuses on development issues in Latin America. He has written on macroeconomic, trade, private finance and labor market policy issues. question is relevant because FDI is large and, at least in the short term, unresponsive to interest rates. Figure 3 shows that the current account deficit has been larger than FDI since 1998, implying that portfolio investment is what throws the overall balance of payments into a surplus and puts pressure on the peso to appreciate. If monetary policy could reduce or elimi- traumatic balance-of-payments crisis in 1976. Crises reappeared every six years with almost clockwork regularity, coinciding with presidential transitions, and all were blamed on an overvalued peso. Six years after 1994, the peso has again appreciated to historical highs and the same old questions arise: Is the peso overvalued? How could this happen with nate the balance-of-payments surplus without further appreciation of the peso and deterioration of the current account. The exico’s relationship with its real exchange rate has been tumultuous since its first The Stanford Institute for Economic Policy Research (SIEPR) conducts research on important economic policy issues facing the United States and other countries. SIEPR’s goal is to inform policy makers and to influence their decisions with long-term policy solutions. a floating exchange rate? How has the economy been affected and why are we talking about it now? How does the situation today differ from 1994, and can Mexico avoid another sixyear crisis? With this goal in mind SIEPR policy briefs are meant to inform and summarize important research by SIEPR faculty. Selecting a different economic topic each month, SIEPR will bring you up-to-date information and analysis on the issues involved. SIEPR Policy Briefs reflect the views of the author. SIEPR is a non-partisan institute and does not take a stand on any issue. nate portfolio flows through lower returns on peso instruments, the balance of payments would be thrown into a deficit putting pressure on the peso to depreciate. Policy Brief SIEPR NON-PROFIT ORG. U.S. POSTAGE PAID PALO ALTO, CA PERMIT NO. 28 Has the peso become overvalued again despite a free-floating exchange rate regime? A publication of the Stanford Institute for Economic Policy Research Stanford University 579 Serra Mall at Galvez Street Stanford, CA 94305 MC 6015 Measuring overvaluation is difficult because the equilibrium real exchange is an elusive concept. By historical standards, however, the peso is overvalued. Figure 1 shows two alternative measures of the real exchange rate. The first is the conventional index published by Banco de Mexico (Mexico’s Central Bank) based on the ratio of Mexico’s consumer price index (CPI) to Will there be a crisis? The answer is "no," as long as there is not its 111 largest trading partners. The second measure is based on unit labor costs, a measure of another "December mistake" when faced with volatility, and export competitiveness. For both indexes the lines move up for a real depreciation, and they Mexican authorities continue to loosen monetary policy and track each other closely. tighten fiscal policy enough to prevent further appreciation of the peso and deterioration of the current account. If Mexico At the end of March 2001, the CPI-based real exchange rate was 27%, more appreciated in real fails to do so, the current account deficit will continue to grow terms than in November 1994 just prior to that crisis and close to the previous all-time high. so long as it can be financed with portfolio investment. As in The unit labor costs real exchange rate is also high by historical standards. A disturbing fact is the past, confidence will decline abruptly and Mexico will face that November 1994 is a poor benchmark. After all, many argued that the real exchange rate a liquidity sudden stop again. was grossly overvalued then and that it was a main cause of the 1994 crisis. June 2001 For additional copies, please see SIEPR website at: http://SIEPR.stanford.edu Nominal Spot Exchange Rate and International Reserves 140 CPI Real Exchange Rate Labor Cost Real Exchange Rate 40000 International Reserves Nominal Exchange Rate 60 quarter of 2001 slowed to 1.9% over the first quarter in 2000. 2001, the lowest interest rate since March 1994. By compari- However, if Mexico were to follow the U.S. methodology of son U.S. interest rates fell 230 basis points. ments, then Mexico would have had two successive quarters To ride out the U.S. slowdown and return to rapid growth, with negative growth. The official growth estimate for 2001 Mexico needs to change its macroeconomic policy mix: Mon- has been revised downwards from 4.5% to 2%. etary policy needs to be eased and fiscal policy needs to be tightened. Easier money will lower the returns on peso-de- 9.00 30000 25000 (Pesos Per Dollar) 80 17.9% in January 2001 to 10.2% in the last auction in May comparing output in successive quarters after seasonal adjust10.00 35000 (Millions of U.S. Dollars) (Pesos Per Dollar) 100 nominated instruments, making portfolio investment in Mexico Monetary policy options less attractive. Tighter fiscal policy will accommodate priWhile at the end of 2000 the U.S. economy was slowing and there was no danger of inflation, in Mexico there was still strong wage pressure, the exchange rate was expected to de- 8.00 preciate, a president from a different party was being inaugurated for the first time in 70 years and memories of the "De- 20000 cember 1994 mistake" were strongly felt. The Central Bank 01/2001 07/2000 01/2000 07/1999 01/1999 07/1998 01/1998 07/1997 7.00 01/1997 15000 07/1996 Figure 1: Real Exchange Rates: CPI and Unit Labor Cost Based (source Banxico) correctly acted cautiously during the transition. Monetary 01/1996 01/2000 01/1998 01/1996 01/1994 01/1992 01/1990 01/1988 01/1986 01/1984 01/1982 01/1980 01/1978 01/1976 01/1974 01/1972 40 01/1970 policy remained restrictive until May 2001. Nevertheless, the fall in aggregate demand and lower international interest rates allowed Mexican interest rates to fall 770 basis points from vate capital inflows and prevent a rise in inflation. It is encouraging that Mexican authorities are moving appropriately on both fronts. On the fiscal side, the Ministry of Hacienda (Treasury) is spending much political capital in getting approval for a fiscal package that eliminates all exemptions to the Value Added Tax. The objective is to reduce the current fiscal deficit of over 3% of GDP by a percentage point per year. On May 18, the corto was reduced for the first time since March 1998 and there is speculation that monetary policy will ease Each balance-of-payments crisis witnessed a pronounced real appreciation of the peso. Is there cause for concern now? As Monetary and Exchange Rate Policy in Mexico Since 1995 Capital Account Composition and the Current Account Figure 2: Nominal Exchange Rate and Reserves (source Banxico) in all previous pre-crisis periods, Mexican policy makers and the U.S.-Mexico links and flows, capital controls are probably not an option. Finally, if flows are sustained, sterilization is The previous crises, especially in 1982 and 1994, were marked by a sudden lack of liquidity due to a rise in U.S. interest rates. By contrast, the current U.S. slowdown is accompanied by 1994. Compared to 1994, the downside is that this time ex- 10000 5000 ports are falling. The upsides are that external deficits are -5000 the capital flows come from Foreign Direct Investment (FDI, see Figure 3 below). -10000 Figure 3: Decomposition of Capital Inflows and the Current Account 2000 1999 rent account deficit; there are no dollar liabilities; and most of 1998 0 implying a smaller proportional movement can close the cur- 1997 smaller as a proportion of GDP; exports and imports are larger, 1996 with the United States of close to 10%. first quarter of 2001 was the largest since the last quarter of 1995 is the same as in June 1998, despite an inflation differential The current account deficit in the last quarter of 2000 and the 15000 1994 nal rates have an immediate detrimental effect on exports. Given nal exchange rate appreciation. The spot exchange rate today U.S. slowdown and the appreciation of the real exchange rate. 1993 ply and increasing inflation (i.e., sterilization). Higher nomi- ever, in the last year and half, there actually has been a nomi- while imports continue to grow vigorously due to both the 20000 1992 reserves and prevent capital flows from expanding money sup- ized much of the capital inflow since 1996 (see Box 1). How- A sharp slowdown in export growth started in November 2000, 1991 change rate appreciate, install capital controls, or accumulate The U.S. slowdown exacerbates Mexico’s situation. 1990 regime. Countries have three options: Let the nominal ex- Why are we talking about this now? 1989 inflow problem that is hard to resolve under any exchange rate 25000 an obvious choice. Figure 2 shows that Mexico accumulated reserves and sterilCentral Bank interventions in the exchange market are aimed at avoiding short-term volatility. The Central Bank can sell up to 200 million dollars per day and only if the rate rises 2% above the previous day’s close. This eliminates the possibility of a large run on reserves. Similarly, to prevent appreciations and accumulate reserves, the Central Bank places futures options to buy dollars. Although there is no explicit amount, it has always placed 250 million dollars. The Central Bank also has been "absorbing" Pemex’s dollar surpluses. Loans, Portfolio & Other Flows Foreign Direct Investment Current Account Deficit turned to emerging markets for higher returns and Mexico was 1988 The cause of the current overvaluation is a classical capital 30000 1987 economy has to restructure rapidly to increase exports. export demand. With falling U.S. interest rates, investors 1986 to finance the deficit and, is forced to devalue, and the rily resolves the policy dilemma. 1985 tal markets dries up, the country runs out of foreign exchange Mexican economy is through higher capital flows and lower 1984 to a "Calvo sudden stop" where liquidity in international capi- terest rates and attracting more capital. No option satisfacto- 35000 1983 pattern: A large current account deficit exposes the country falling interest rates. As a result, this time the effect on the 1982 high real appreciation levels resulted in an all-too-familiar ineffective and can exacerbate matters by raising domestic in- 1981 the peso is justified. But the crises happened and historically Since 1995, the Central Bank has attempted to base monetary and exchange rate policy on explicit rules that limit exposure to international volatility. The Central Bank estimates short-term base money demand and leaves the supply "short" (corto in Spanish) by a pre-announced amount. The Central Bank pays the Cetes rate (Mexico’s equivalent of U.S. Treasury bills) if the financial institution is long and twice the Cetes rate if the institution is short with the Central Bank. Thus the "corto" applies upward pressure on interest rates. 1980 international investors argue that the current appreciation of (millions of U.S. Dollars) (Index 1990=100) 120 As a result of the fall in exports, output growth in the first Nominal Spot Exchange Rate and International Reserves 140 CPI Real Exchange Rate Labor Cost Real Exchange Rate 40000 International Reserves Nominal Exchange Rate 60 quarter of 2001 slowed to 1.9% over the first quarter in 2000. 2001, the lowest interest rate since March 1994. By compari- However, if Mexico were to follow the U.S. methodology of son U.S. interest rates fell 230 basis points. ments, then Mexico would have had two successive quarters To ride out the U.S. slowdown and return to rapid growth, with negative growth. The official growth estimate for 2001 Mexico needs to change its macroeconomic policy mix: Mon- has been revised downwards from 4.5% to 2%. etary policy needs to be eased and fiscal policy needs to be tightened. Easier money will lower the returns on peso-de- 9.00 30000 25000 (Pesos Per Dollar) 80 17.9% in January 2001 to 10.2% in the last auction in May comparing output in successive quarters after seasonal adjust10.00 35000 (Millions of U.S. Dollars) (Pesos Per Dollar) 100 nominated instruments, making portfolio investment in Mexico Monetary policy options less attractive. Tighter fiscal policy will accommodate priWhile at the end of 2000 the U.S. economy was slowing and there was no danger of inflation, in Mexico there was still strong wage pressure, the exchange rate was expected to de- 8.00 preciate, a president from a different party was being inaugurated for the first time in 70 years and memories of the "De- 20000 cember 1994 mistake" were strongly felt. The Central Bank 01/2001 07/2000 01/2000 07/1999 01/1999 07/1998 01/1998 07/1997 7.00 01/1997 15000 07/1996 Figure 1: Real Exchange Rates: CPI and Unit Labor Cost Based (source Banxico) correctly acted cautiously during the transition. Monetary 01/1996 01/2000 01/1998 01/1996 01/1994 01/1992 01/1990 01/1988 01/1986 01/1984 01/1982 01/1980 01/1978 01/1976 01/1974 01/1972 40 01/1970 policy remained restrictive until May 2001. Nevertheless, the fall in aggregate demand and lower international interest rates allowed Mexican interest rates to fall 770 basis points from vate capital inflows and prevent a rise in inflation. It is encouraging that Mexican authorities are moving appropriately on both fronts. On the fiscal side, the Ministry of Hacienda (Treasury) is spending much political capital in getting approval for a fiscal package that eliminates all exemptions to the Value Added Tax. The objective is to reduce the current fiscal deficit of over 3% of GDP by a percentage point per year. On May 18, the corto was reduced for the first time since March 1998 and there is speculation that monetary policy will ease Each balance-of-payments crisis witnessed a pronounced real appreciation of the peso. Is there cause for concern now? As Monetary and Exchange Rate Policy in Mexico Since 1995 Capital Account Composition and the Current Account Figure 2: Nominal Exchange Rate and Reserves (source Banxico) in all previous pre-crisis periods, Mexican policy makers and the U.S.-Mexico links and flows, capital controls are probably not an option. Finally, if flows are sustained, sterilization is The previous crises, especially in 1982 and 1994, were marked by a sudden lack of liquidity due to a rise in U.S. interest rates. By contrast, the current U.S. slowdown is accompanied by 1994. Compared to 1994, the downside is that this time ex- 10000 5000 ports are falling. The upsides are that external deficits are -5000 the capital flows come from Foreign Direct Investment (FDI, see Figure 3 below). -10000 Figure 3: Decomposition of Capital Inflows and the Current Account 2000 1999 rent account deficit; there are no dollar liabilities; and most of 1998 0 implying a smaller proportional movement can close the cur- 1997 smaller as a proportion of GDP; exports and imports are larger, 1996 with the United States of close to 10%. first quarter of 2001 was the largest since the last quarter of 1995 is the same as in June 1998, despite an inflation differential The current account deficit in the last quarter of 2000 and the 15000 1994 nal rates have an immediate detrimental effect on exports. Given nal exchange rate appreciation. The spot exchange rate today U.S. slowdown and the appreciation of the real exchange rate. 1993 ply and increasing inflation (i.e., sterilization). Higher nomi- ever, in the last year and half, there actually has been a nomi- while imports continue to grow vigorously due to both the 20000 1992 reserves and prevent capital flows from expanding money sup- ized much of the capital inflow since 1996 (see Box 1). How- A sharp slowdown in export growth started in November 2000, 1991 change rate appreciate, install capital controls, or accumulate The U.S. slowdown exacerbates Mexico’s situation. 1990 regime. Countries have three options: Let the nominal ex- Why are we talking about this now? 1989 inflow problem that is hard to resolve under any exchange rate 25000 an obvious choice. Figure 2 shows that Mexico accumulated reserves and sterilCentral Bank interventions in the exchange market are aimed at avoiding short-term volatility. The Central Bank can sell up to 200 million dollars per day and only if the rate rises 2% above the previous day’s close. This eliminates the possibility of a large run on reserves. Similarly, to prevent appreciations and accumulate reserves, the Central Bank places futures options to buy dollars. Although there is no explicit amount, it has always placed 250 million dollars. The Central Bank also has been "absorbing" Pemex’s dollar surpluses. Loans, Portfolio & Other Flows Foreign Direct Investment Current Account Deficit turned to emerging markets for higher returns and Mexico was 1988 The cause of the current overvaluation is a classical capital 30000 1987 economy has to restructure rapidly to increase exports. export demand. With falling U.S. interest rates, investors 1986 to finance the deficit and, is forced to devalue, and the rily resolves the policy dilemma. 1985 tal markets dries up, the country runs out of foreign exchange Mexican economy is through higher capital flows and lower 1984 to a "Calvo sudden stop" where liquidity in international capi- terest rates and attracting more capital. No option satisfacto- 35000 1983 pattern: A large current account deficit exposes the country falling interest rates. As a result, this time the effect on the 1982 high real appreciation levels resulted in an all-too-familiar ineffective and can exacerbate matters by raising domestic in- 1981 the peso is justified. But the crises happened and historically Since 1995, the Central Bank has attempted to base monetary and exchange rate policy on explicit rules that limit exposure to international volatility. The Central Bank estimates short-term base money demand and leaves the supply "short" (corto in Spanish) by a pre-announced amount. The Central Bank pays the Cetes rate (Mexico’s equivalent of U.S. Treasury bills) if the financial institution is long and twice the Cetes rate if the institution is short with the Central Bank. Thus the "corto" applies upward pressure on interest rates. 1980 international investors argue that the current appreciation of (millions of U.S. Dollars) (Index 1990=100) 120 As a result of the fall in exports, output growth in the first Nominal Spot Exchange Rate and International Reserves 140 CPI Real Exchange Rate Labor Cost Real Exchange Rate 40000 International Reserves Nominal Exchange Rate 60 quarter of 2001 slowed to 1.9% over the first quarter in 2000. 2001, the lowest interest rate since March 1994. By compari- However, if Mexico were to follow the U.S. methodology of son U.S. interest rates fell 230 basis points. ments, then Mexico would have had two successive quarters To ride out the U.S. slowdown and return to rapid growth, with negative growth. The official growth estimate for 2001 Mexico needs to change its macroeconomic policy mix: Mon- has been revised downwards from 4.5% to 2%. etary policy needs to be eased and fiscal policy needs to be tightened. Easier money will lower the returns on peso-de- 9.00 30000 25000 (Pesos Per Dollar) 80 17.9% in January 2001 to 10.2% in the last auction in May comparing output in successive quarters after seasonal adjust10.00 35000 (Millions of U.S. Dollars) (Pesos Per Dollar) 100 nominated instruments, making portfolio investment in Mexico Monetary policy options less attractive. Tighter fiscal policy will accommodate priWhile at the end of 2000 the U.S. economy was slowing and there was no danger of inflation, in Mexico there was still strong wage pressure, the exchange rate was expected to de- 8.00 preciate, a president from a different party was being inaugurated for the first time in 70 years and memories of the "De- 20000 cember 1994 mistake" were strongly felt. The Central Bank 01/2001 07/2000 01/2000 07/1999 01/1999 07/1998 01/1998 07/1997 7.00 01/1997 15000 07/1996 Figure 1: Real Exchange Rates: CPI and Unit Labor Cost Based (source Banxico) correctly acted cautiously during the transition. Monetary 01/1996 01/2000 01/1998 01/1996 01/1994 01/1992 01/1990 01/1988 01/1986 01/1984 01/1982 01/1980 01/1978 01/1976 01/1974 01/1972 40 01/1970 policy remained restrictive until May 2001. Nevertheless, the fall in aggregate demand and lower international interest rates allowed Mexican interest rates to fall 770 basis points from vate capital inflows and prevent a rise in inflation. It is encouraging that Mexican authorities are moving appropriately on both fronts. On the fiscal side, the Ministry of Hacienda (Treasury) is spending much political capital in getting approval for a fiscal package that eliminates all exemptions to the Value Added Tax. The objective is to reduce the current fiscal deficit of over 3% of GDP by a percentage point per year. On May 18, the corto was reduced for the first time since March 1998 and there is speculation that monetary policy will ease Each balance-of-payments crisis witnessed a pronounced real appreciation of the peso. Is there cause for concern now? As Monetary and Exchange Rate Policy in Mexico Since 1995 Capital Account Composition and the Current Account Figure 2: Nominal Exchange Rate and Reserves (source Banxico) in all previous pre-crisis periods, Mexican policy makers and the U.S.-Mexico links and flows, capital controls are probably not an option. Finally, if flows are sustained, sterilization is The previous crises, especially in 1982 and 1994, were marked by a sudden lack of liquidity due to a rise in U.S. interest rates. By contrast, the current U.S. slowdown is accompanied by 1994. Compared to 1994, the downside is that this time ex- 10000 5000 ports are falling. The upsides are that external deficits are -5000 the capital flows come from Foreign Direct Investment (FDI, see Figure 3 below). -10000 Figure 3: Decomposition of Capital Inflows and the Current Account 2000 1999 rent account deficit; there are no dollar liabilities; and most of 1998 0 implying a smaller proportional movement can close the cur- 1997 smaller as a proportion of GDP; exports and imports are larger, 1996 with the United States of close to 10%. first quarter of 2001 was the largest since the last quarter of 1995 is the same as in June 1998, despite an inflation differential The current account deficit in the last quarter of 2000 and the 15000 1994 nal rates have an immediate detrimental effect on exports. Given nal exchange rate appreciation. The spot exchange rate today U.S. slowdown and the appreciation of the real exchange rate. 1993 ply and increasing inflation (i.e., sterilization). Higher nomi- ever, in the last year and half, there actually has been a nomi- while imports continue to grow vigorously due to both the 20000 1992 reserves and prevent capital flows from expanding money sup- ized much of the capital inflow since 1996 (see Box 1). How- A sharp slowdown in export growth started in November 2000, 1991 change rate appreciate, install capital controls, or accumulate The U.S. slowdown exacerbates Mexico’s situation. 1990 regime. Countries have three options: Let the nominal ex- Why are we talking about this now? 1989 inflow problem that is hard to resolve under any exchange rate 25000 an obvious choice. Figure 2 shows that Mexico accumulated reserves and sterilCentral Bank interventions in the exchange market are aimed at avoiding short-term volatility. The Central Bank can sell up to 200 million dollars per day and only if the rate rises 2% above the previous day’s close. This eliminates the possibility of a large run on reserves. Similarly, to prevent appreciations and accumulate reserves, the Central Bank places futures options to buy dollars. Although there is no explicit amount, it has always placed 250 million dollars. The Central Bank also has been "absorbing" Pemex’s dollar surpluses. Loans, Portfolio & Other Flows Foreign Direct Investment Current Account Deficit turned to emerging markets for higher returns and Mexico was 1988 The cause of the current overvaluation is a classical capital 30000 1987 economy has to restructure rapidly to increase exports. export demand. With falling U.S. interest rates, investors 1986 to finance the deficit and, is forced to devalue, and the rily resolves the policy dilemma. 1985 tal markets dries up, the country runs out of foreign exchange Mexican economy is through higher capital flows and lower 1984 to a "Calvo sudden stop" where liquidity in international capi- terest rates and attracting more capital. No option satisfacto- 35000 1983 pattern: A large current account deficit exposes the country falling interest rates. As a result, this time the effect on the 1982 high real appreciation levels resulted in an all-too-familiar ineffective and can exacerbate matters by raising domestic in- 1981 the peso is justified. But the crises happened and historically Since 1995, the Central Bank has attempted to base monetary and exchange rate policy on explicit rules that limit exposure to international volatility. The Central Bank estimates short-term base money demand and leaves the supply "short" (corto in Spanish) by a pre-announced amount. The Central Bank pays the Cetes rate (Mexico’s equivalent of U.S. Treasury bills) if the financial institution is long and twice the Cetes rate if the institution is short with the Central Bank. Thus the "corto" applies upward pressure on interest rates. 1980 international investors argue that the current appreciation of (millions of U.S. Dollars) (Index 1990=100) 120 As a result of the fall in exports, output growth in the first Policy Brief further. The action is expected to lower interest rates further and put pressure on the peso to depreciate. Moreover, although not quite at international levels, inflation for the year is expected to be close to or below the official target of 6.5%, giving monetary authorities room to maneuver. Starting July 2, 2001, the Central Bank will lower the intervention amounts in the exchange market to zero and let the peso float freely. In theory, given the surplus in the balance of payments, the measure should pressure the peso to appreciate, which is the opposite effect to the reduction in the corto. However, with a freely floating peso, investors will expect higher volatility, which might lower capital flows to Mexico. There are two short-term developments to consider if Mexico loosens monetary and tightens fiscal policy. The first is that the About the author J osé Antonio González is a Senior Research Associate at the Center for Research on Economic Development and Policy Reform (CREDPR) at SIEPR. He is also the Coordinator for the Latin American Program at CREDPR and a Lecturer in Economics. Prior to joining Stanford University, José Antonio was a Senior Country Economist at the World Bank working in Peru, Bolivia, Paraguay, and Panama. He also worked in the Mexican President’s staff from 1989-1991. He received his Ph.D. from Harvard University. Stanford Institute for Economic Policy Research Mexico’s Macroeconomic Policy Dilemma: How to deal with the “super-peso?” José Antonio González M approval of fiscal measures renews New York’s (irrational?) exuberance toward Mexico and capital flows increase despite lower interest rates. The second is that loosening monetary policy might be insufficient to abate portfolio flows and elimi- His research focuses on development issues in Latin America. He has written on macroeconomic, trade, private finance and labor market policy issues. question is relevant because FDI is large and, at least in the short term, unresponsive to interest rates. Figure 3 shows that the current account deficit has been larger than FDI since 1998, implying that portfolio investment is what throws the overall balance of payments into a surplus and puts pressure on the peso to appreciate. If monetary policy could reduce or elimi- traumatic balance-of-payments crisis in 1976. Crises reappeared every six years with almost clockwork regularity, coinciding with presidential transitions, and all were blamed on an overvalued peso. Six years after 1994, the peso has again appreciated to historical highs and the same old questions arise: Is the peso overvalued? How could this happen with nate the balance-of-payments surplus without further appreciation of the peso and deterioration of the current account. The exico’s relationship with its real exchange rate has been tumultuous since its first The Stanford Institute for Economic Policy Research (SIEPR) conducts research on important economic policy issues facing the United States and other countries. SIEPR’s goal is to inform policy makers and to influence their decisions with long-term policy solutions. a floating exchange rate? How has the economy been affected and why are we talking about it now? How does the situation today differ from 1994, and can Mexico avoid another sixyear crisis? With this goal in mind SIEPR policy briefs are meant to inform and summarize important research by SIEPR faculty. Selecting a different economic topic each month, SIEPR will bring you up-to-date information and analysis on the issues involved. SIEPR Policy Briefs reflect the views of the author. SIEPR is a non-partisan institute and does not take a stand on any issue. nate portfolio flows through lower returns on peso instruments, the balance of payments would be thrown into a deficit putting pressure on the peso to depreciate. Policy Brief SIEPR NON-PROFIT ORG. U.S. POSTAGE PAID PALO ALTO, CA PERMIT NO. 28 Has the peso become overvalued again despite a free-floating exchange rate regime? A publication of the Stanford Institute for Economic Policy Research Stanford University 579 Serra Mall at Galvez Street Stanford, CA 94305 MC 6015 Measuring overvaluation is difficult because the equilibrium real exchange is an elusive concept. By historical standards, however, the peso is overvalued. Figure 1 shows two alternative measures of the real exchange rate. The first is the conventional index published by Banco de Mexico (Mexico’s Central Bank) based on the ratio of Mexico’s consumer price index (CPI) to Will there be a crisis? The answer is "no," as long as there is not its 111 largest trading partners. The second measure is based on unit labor costs, a measure of another "December mistake" when faced with volatility, and export competitiveness. For both indexes the lines move up for a real depreciation, and they Mexican authorities continue to loosen monetary policy and track each other closely. tighten fiscal policy enough to prevent further appreciation of the peso and deterioration of the current account. If Mexico At the end of March 2001, the CPI-based real exchange rate was 27%, more appreciated in real fails to do so, the current account deficit will continue to grow terms than in November 1994 just prior to that crisis and close to the previous all-time high. so long as it can be financed with portfolio investment. As in The unit labor costs real exchange rate is also high by historical standards. A disturbing fact is the past, confidence will decline abruptly and Mexico will face that November 1994 is a poor benchmark. After all, many argued that the real exchange rate a liquidity sudden stop again. was grossly overvalued then and that it was a main cause of the 1994 crisis. June 2001 For additional copies, please see SIEPR website at: http://SIEPR.stanford.edu