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FOREIGN RESERVE ACCUMULATION THE MEXICAN EXPERIENCE Manuel Ramos Francia October 20, 2006 The Mexican Experience As a result of the currency crisis on December 1994, Banco de México was forced to abandon the predetermined exchange rate regime and float the peso, thus changing the nominal anchor of the economy. Banco de México withdrew from actively intervening in the foreign exchange market and gradually converged towards an inflation targeting regime. Fixed exchange rate Monetary policy subordinated to the exchange rate regime Flexible Exchange Rate Inflation Targeting 2 The Mexican Experience The free floating regime has simplified monetary policy management, since the exchange rate can adjust more rapidly to domestic and external shocks. Overnight Interest Rate and Exchange Rate (Percent and Pesos per Dollar) 100 13 90 80 12 Brazilian Crisis Asian Crisis 09/11 11 70 60 10 Overnight Interest Rate Russian Crsis 50 9 Exchange Rate (right axis) 40 8 Mexican Elections 30 7 Iraqi War 20 6 10 Source: Banco de México. Sep-06 Nov-05 Jan-05 Mar-04 May-03 Jul-02 Sep-01 Nov-00 Jan-00 Mar-99 May-98 Jul-97 Sep-96 5 Nov-95 0 Jan-95 3 The Mexican Experience Banco de México’s operations in the foreign exchange market are divided in two categories: a) Operations with the Federal Government and PEMEX. b) Operations for international reserve management. FEDERAL GOVERNMENT AND PEMEX Federal Government: external debt service PEMEX: export revenues and external debt proceeds FX OPERATIONS OF BANCO DE MÉXICO FOREIGN EXCHANGE MARKET Rule Based Operations (1996-2001, 2003 onward) Discretional Interventions (last intervention in Sep. 1998) 4 The Mexican Experience 1. Operations with the Federal Government and PEMEX. Both are required to undertake all their foreign currency operations with the Central Bank. Although these operations are not carried out in the foreign exchange market, they are settled at market prices. Banco de México sterilizes completely the monetary effect of its foreign exchange operations. Flows of Net Foreign Assets: Decomposition by Source (1996-2006)1/ Total PEMEX Federal Market Government Operations -2.7 0.9 0.9 3.8 -3.3 0.3 -6.5 1.8 -6.8 1.8 -2.4 1.4 -6.2 0 -5.8 -3.2 -3.2 -6.7 -7.3 -4.4 -11.4 -5.4 Others* -0.9 0.4 1.2 1.2 2.1 1.4 2.1 2 1.3 1.2 2.8 1996 6.3 9 1997 13.5 8.5 1998 3.7 5.4 1999 3.9 7.4 2000 8.2 11.2 2001 9.2 8.9 2002 5.9 10 2003 8.3 15.4 2004 5.2 13.8 2005 9.9 20.4 2006** 9.3 23.3 1/ Million dollars. * Include net income generated by investing Banco de México’s international assets. ** As of September, 2006. 5 The Mexican Experience 2. Operations for international reserve management. Since the 1994-1995 crisis, several mechanisms have been adopted for the management of international reserves: 1. Initial Stage (1995-1998): Low level of international reserves and highly volatile foreign exchange market. Restore orderly market conditions. 2. Intermediate Stage (1996-2001): Increase the level of international reserves and provide liquidity to the foreign exchange market in face of shocks (high volatility episodes). 3. Current Stage (2001 to date): Promote a cleaner float and prevent excess accumulation of foreign reserves. 6 The Mexican Experience The mechanisms adopted allowed for a fast buildup of international reserves and promoted orderly conditions in the foreign exchange market in face of different shocks. This contributed to the development of a deep foreign exchange market. International Reserves and Foreign Exchange Rate* 90 16 1 80 3 14 2 70 12 60 10 50 8 40 6 30 4 20 International Reserves 10 Nominal Exchange Rate (right axis) 2 * As defined in the Banco de Mexico Law of 1994. 1: Initial Stage. 2: Intermediate Stage. 3: Current Stage. Sep-06 Oct-05 Nov-04 Dec-03 Jan-03 Feb-02 Mar-01 Apr-00 May-99 Jun-98 Jul-97 Aug-96 Sep-95 Oct-94 Nov-93 0 Dec-92 0 Jan-92 7 The Mexican Experience Rule Based Operations: Between August 1996 and July 2001, the Foreign Exchange Commission (FEC) developed well defined mechanisms for the accumulation of international reserves and to limit the volatility of the exchange rate. 1. Monthly auction of options to sell dollars to Banco de México (August 1996 to June 2001). 2. Daily dollar auction to financial intermediaries (February 1997 to July 2001). Once the FEC concluded that the benefits from continuing the accumulation of international reserves were less significant, a mechanism to reduce Banco de México’s rate of accumulation was put in place (since May, 2003). Discretional Interventions: Banco de Mexico’s last intervention in the foreign exchange market took place on September 10th, 1998 for 278 million dollars. 8 30 20 10 0 Red lines represent dates when Moodys improved Mexico’s credit ratings. Source: Banco de México. Jul-06 Oct-05 Jan-05 Apr-04 daily auctions Jul-03 Sell US dollars through Oct-02 Jan-02 Apr-01 Jul-00 40 Oct-99 50 Jan-99 60 Apr-98 70 Jul-97 80 Suspend put option auctions Investment Grade Buy US dollars through put options 90 Oct-96 Jan-96 The Mexican Experience Net International Reserves (Billion Dollars) 9 The Mexican Experience International Reserve Accumulation through Automatic Mechanisms (Billion Dollars) Options Placed Options Exercised Sales Auctioned Net Accumulation (A) (B) (C) (B-C) 1996 1/ 0.9 0.9 0.0 0.9 1997 3.2 4.4 0.6 3.8 1998 2.8 1.5 0.9 0.6 1999 3.0 2.2 0.4 1.8 2000 3.0 1.8 0.1 1.7 1.5 1.4 0.0 1.4 16.3 12.2 2.0 10.2 2001 2/ 1996-2001 1/ Starting August. 2/ Ending June. Source: Banco de México. 10 The Mexican Experience Daily Dollar Auctions Exchange Market Volume* (Million Dollars) (Million Dollars; Monthly Average) 50 30,000 40 25,000 30 20,000 20 15,000 10 10,000 5,000 Source: Banco de México. Jan-06 Sep-04 May-03 Jan-02 Sep-00 May-99 Jan-98 Sep-96 May-95 0 Jan-94 May-Jul 03 Aug-Oct 03 Nov 03 -Jan 04 Feb-Apr 04 May-Jul 04 Aug-Oct 04 Nov 04 -Jan 05 Feb-Apr 05 May-Jul 05 Aug-Oct 05 Nov 05 -Jan 06 Feb-Apr 05 May-Jul 05 Aug-Oct 05 0 *Includes operations in the spot, swap and forward markets. 11 Source: Banco de México. The Mexican Experience Sterilization of International Reserves. International reserves have grown more than the monetary base. Monetary Base Reserve Accumulation and Monetary Base Growth (Percent of GDP) (Cumulative Flows, Billion Dollars) 5.0 80 International Reserves Source: Banco de México. Source: Banco de México. Sep-06 May-05 Jan-04 Sep-02 May-01 Jan-00 Sep-98 May-97 Monetary Base Jan-96 Dec-05 -20 Apr-04 2.5 Aug-02 0 Dec-00 3.0 Apr-99 20 Aug-97 3.5 Dec-95 40 Apr-94 4.0 Aug-92 60 Dec-90 4.5 12 The Mexican Experience Monetary Regulation Bonds (BREMS) and Compulsory Deposits (Amounts Outstanding; Billions of Mexican Pesos) 350 BREMS and BONDES 'D'* 300 Compulsory Remunerated Deposits 250 200 150 100 50 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 *Since August 17th, Banco de México uses BONDES “D” for monetary purposes instead of BREMS. Source: Banco de México. 13 The Mexican Experience Sources and Uses of Financial Resources (Effective Flows as Percent of GDP) 2002 2003 2004 2005 Total Sources M4 (Domestic Financial Savings) External Financing 3.7 4.3 -0.6 5.4 5.5 -0.1 5.9 5.4 0.5 8.0 7.4 0.5 Total Uses Banco de México (International Reserves) Public Sector (RFSP) States and Municipalities Private Sector 1/ Other 3.7 1.1 2.7 0.2 1.1 -1.4 5.4 1.5 2.6 0.3 0.9 0.1 5.9 0.6 1.7 0.2 2.0 1.4 8.0 0.9 1.4 0.1 2.8 2.8 4.0 7,104.1 0.0 0.0 4.4 9,450.9 0.5 3,218.0 2.5 4,061.4 1.0 6,712.0 2.4 7,172.6 0.6 4,402.0 Memo: Banco de México, Pub. sect., States and Mun. International Reserve Accumulation (md) Dollar Sales by Banco de México 2/ Dollar Sales by Banco de México 2/ 1/ Refers to non-sectorized assets, capital and results accounts, technical reserves accounts, capital reserves, physical assets of financial intermediaries, preemptive reserves, investment in stocks, commercial banks external resources, financing to non-residents, INFONAVIT liabilities other than those submitted by workers, financial intermediaries liabilities other than bank credits, net position of trusts (fideicomisos) with the banking sector, the difference between development banking domestic financing to the private sector and to financial intermediation, and non-monetary liabilities of IPAB, among others. 2/ Corresponds to dollar sales according to the mechanism for reducing the rate of foreign reserve accumulation (see Foreign Exchange Commission press release of March 20, 2003). Source: Banco de México. 14 The Mexican Experience Benefits and costs of holding reserves in Mexico. Benefits The economy is insured against sudden stops: the exposure to external shocks is much lower. The country’s credit worthiness improves: the country has Investment Grade since March 2000 and has already developed a market for long-term instruments in domestic currency. Costs Carry cost of reserves. At the margin, increasing reserves holdings is progressively yielding lower net benefits. 15 The Mexican Experience Optimal Reserves in Mexico: Methodology of Ben-Bassat and Gottlieb. The Central Bank chooses the level of reserves to minimize expected costs of holding them: min Π R C0 1 Π R C1 R R R Internatio nal reserves C0 Cost of crises Π Probabilit y of crises C1 Cost of holding reserves rR r Opportunit y cost of reserves 16 The Mexican Experience FOC: Logistic function for : Π R C0 rR 1 Π r 0 ef Π 1 e f Π f ln 1 Π Specification for f: R D f a0 a1 ln a2 exp A GDP R Reserves to short - term external public debt A D External public debt to GDP GDP 17 The Mexican Experience Optimal Reserves to Actual Reserves Ratio* (Different Levels for Cost of Crises as Percentage of GDP) 11 August 1996 buy US dollars through put options 10 May 2003 sell US dollars through daily auctions 9 8 20% 7 July 2001 suspend put option auctions 6 40% 60% 5 4 80% 3 100% 2 * The opportunity cost of reserves (r) was assumed at 5%. I 2006 III 2005 I 2005 III 2004 I 2004 III 2003 I 2003 III 2002 I 2002 III 2001 I 2001 III 2000 I 2000 III 1999 I 1999 III 1998 I 1998 III 1997 I 1997 I 1996 0 III 1996 1 18 The Mexican Experience Challenges Ahead Capitalization and adequate management of the oil- stabilization fund. Reduce the cost of holding reserves. Increase asset returns. a) Riskier assets: market risk (higher duration) vs. credit risk (alternative asset types). b) Improve risk management capabilities: internal vs. outsourcing. Limit the growth of reserves. 19 The Mexican Experience Local Interest Rates and Selected Yields (Percent) Cost of Holding Reserves International reserves/monetary base 7 6 Break Even 12% Observed 11% 10% Break even yield from FX reserves Overnight Mexican Peso Rate Broad Corporate Yield US Treasuries and Agencies Yield 5 9% 4 8% Central Bank Losses 3 2005 7% 7.0% 6% 5.8% 5% 5.2% 2 5.0% 1 4% Central Bank Gains 3% 0 0 3 6 9 12 Interest rates differential Source: Banco de México. 15 2005 2006 The average duration of the AAA-rated U.S. Treasuries and Agencies Portfolio is 2 years. The average duration of the Arated Corporate Portfolio is 5.7 years. 20 The Mexican Experience The Government will prepay more than 12.4 billion dollars of foreign exchange denominated debt (IADB and World Bank mostly). To finance this transaction, the Government purchased 12.4 billion dollars from the Central Bank’s reserves with funds obtained from the issuance of domestic debt. Dollars Central Bank Government BONDES D External Debt Cancellation Dollars Foreign Creditors BREMS BONDES D Local Market 21 The Mexican Experience: Final Remarks The criteria to measure the optimal level of reserves has changed over time, reflecting both the changes in the global economy and the particular features of each country. Capital account considerations and external vulnerability issues seem more relevant in light of recent international experience. After the financial crisis of 1994-95, Mexico started to build up international reserves in order to improve investor confidence, strengthen the access to external capital markets, and reduce the country’s external vulnerability. During the last years, the increase in international reserves is explained by the higher oil revenues. 22 The Mexican Experience: Final Remarks Several factors explain the reduced need for accumulating international reserves in Mexico. Macroeconomic stability, the development of domestic financial markets, and the substitution of external debt for domestic debt have made the economy less vulnerable to financial shocks. The floating exchange rate regime implies that there is no need to hold reserves to manage the exchange rate. The net benefits of continuing to accumulate international reserves at a rapid pace are considered to be limited. In order to reduce the cost of holding large international reserves, Mexico decided to reduce their growth rate. 23