Download a tale of two mexican currency crises

A TALE OF TWO MEXICAN CURRENCY CRISES
Currency crises are one of the downsides of participating in the global economy. The
recent currency crises in Mexico (1994-95), Asia (1997), Russia (1998), Brazil (1998), and
Turkey (2000) have attracted a lot of publicity, but currency crises also occurred in the 1800's.
The United States was the victim of crises in the 1870's and 1890's. A currency crisis
essentially means that international investors "lose confidence" in the value of a currency. This
loss of confidence causes them to refuse to lend more to the country in question. The factors
that precipitate the 'loss of confidence" seem to differ slightly from crisis to crisis, making it
difficult to predict where a currency crisis will strike next. We will explore this by comparing and
contrasting two recent crises in one country, Mexico, which had a major currency crisis in 1982
and another in 1994-95.
PART 1: What We Know about Currency Crises: The Sequence of Events Leading to
Them and Their Macroeconomic Impact
The Anatomy of Currency Crises (External Balance" Is Destroyed)
While economists have had difficulty pinning down exactly what causes such crises, the
sequence of events leading up to a crisis and the impact on the economy that is the victim of a
crisis are fairly uniform.
Countries that experience such crises have exchange rates that are "pegged" (fixed)
against a foreign currency. Mexico, for example, pegged the peso to the U.S. dollar before
both the 1982 crisis and the 1994-95 crisis. In both crises, Mexican inflation exceeded U.S.
inflation, and, given the virtually fixed nominal exchange rate, the real Mexican exchange rate,
defined as PMEX/(epesos per $1 x PUS), increased. This appreciation of the peso in real terms meant
that the average price of Mexican goods and services increased relative to U.S. goods and
services. The result was a decrease in Mexican exports of goods and services, an increase in
Mexican imports, and a widening current account deficit. For a time, the current account deficit
was financed by international borrowing, i.e. Mexican exports of assets exceeded Mexican
imports of assets in an amount that roughly equaled the current account deficit, and thus "THE"
Balance of Payments was zero:
"THE" Mexican BOP = Autonomous (XGS - IMPGS) + (XA - IMPA) = 0.
This meant that the fixed parity between the peso and the dollar, say $.10 (10 cents) per peso,
was the equilibrium exchange rate as in the diagram below.
Spesos
e$ per 1 peso
$.10
A
Dpesos
Quantity of pesos
2
Eventually, international investors/lenders became concerned about the growing current
account deficits and Mexico's need for foreign financing. They began to believe that the
Mexicans would at some point be unable to repay and would have to devalue the peso. The
expectation that the value of their peso holdings would fall convinced international investors to
reduce lending to Mexicans and to convert peso holdings to dollars. This meant that exports of
Mexican assets decreased relative to imports of foreign assets by Mexicans, so that "'THE"
Mexican Balance of Payments moved toward a deficit:
"THE" Mexican BOP = Autonomous (XGS - IMPGS) + (XA - IMPA) < 0.
In everyday jargon, international investors were no longer willing to finance the Mexican current
account deficits.
Since international investors were converting peso holdings to dollars, there was excess
supply of pesos on the foreign exchange market at the fixed exchange rate. [Show the effect of
this in the diagram on the previous page.] For a while the Mexican government attempted to
maintain the value of the peso by intervening in the foreign exchange market with its foreign
exchange reserves. [What portion of Mexico's Balance of Payments ACCOUNT was affected
by this?].
To reduce the excess supply of pesos or equivalently reduce the deficit in "THE" BOP,
the Mexican government during both crises initially pursued a highly contractionary monetary
policy. This allowed short-term interest rates to rise steeply in order to entice foreign
investors to continue lending. Despite very high interest rates (56.6% in 1983 during the first
Mexican crisis and 35% in January of 1995 during the second crisis), international investors did
not return to Mexico. In fact, as the Mexican government's foreign exchange reserves
diminished, expectations of a devaluation of the peso heightened and international investors
rushed out all the more quickly. Eventually, the government announced it no longer had
sufficient reserves to support the peso at the fixed rate and had to devalue it. Table I below
summarizes the events that moved Mexico toward each of its recent crises. This pattern is
repeated in virtually all currency crises.
TABLE 1
THE ANATOMY OF A CURRENCY CRISIS
The
Domestic inflation > foreign inflation, coupled with pegged exchange rate

Real exchange rate appreciates

Rising current account deficit results in need for ""borrowing" from
international capital markets

International investors are initially willing to "lend"

International investors eventually expect devaluation and begin to move
capital out

Government tries to reverse capital outflows by letting interest rates rise

Government's foreign exchange reserves begin to run out

Government must devalue currency
2
3
Macroeconomic Impact (Effect on 'Internal Balance”)
The steep rise in interest rates due to the highly contractionary monetary policy
wreaked havoc on the Mexican economy. There was a large decrease in Mexican spending,
leading to declines in production and employment. [Use the graph below to demonstrate.]
P
LRAS MRAS
P1
A
AD
Qf
Q
The devaluation of the Mexican peso against the dollar raised the price in Mexico of imported
goods. Because Mexican consumers and producers could not immediately reduce their
purchases of imported goods, they had to reduce their purchases of Mexican-made products.
This reinforced rising interest rates in pushing down Mexican aggregate demand. Further, the
rise in prices prompted Mexican workers to ask for wage increases. Many Mexican producers
complied, which raised costs of production. This produced high inflation and reinforced falling
production. [Use the graph below to demonstrate the Impact of rising Mexican wages and
therefore rising costs of production.]
P
LRAS MRAS
P1
A
AD
Qf
Q
As time passed, the devaluation resulted in a real depreciation of the peso. The prices of
Mexican products relative to those of the U.S. fell. This increased Mexican exports and
decreased Mexican imports, raising aggregate demand once again. However, this latter effect
took many months to play out.
3
4
The data in Table 2 demonstrate the toll that the crises took on the Mexican economy
during the year immediately following each crisis: steep declines in production (real GDP),
household consumption, and business investment, as well as very high inflation.
TABLE 2
THE SEVERITY OF THE MEXICAN CURRENCY CRISES
FIRST CRISIS (1983)
SECOND CRISIS (1995)
REAL GDP GROWTH RATE
- 4.2%
- 6.9%
CHANGE IN PRIVATE:
CONSUMPTION
INVESTMENT
- 5.4%
-24.2%
- 9.5%
-31.2%
INFLATION (CONSUMER PRICES)
101.9%
35.0%
Source:
Lustig, Nora, Mexico: The Remaking of an Economy, Tables 2.4 and 6 1
The macroeconomic impact of currency crises is virtually the same in all countries that
experience them. This is summarized in Table 3.
The Macroeconomic impact of currency crises is virtually the same in all countries that
Experience them. This is summarized in Table 3.
TABLE 3
THE MACROECONOMIC IMPACT OF CURRENCY CRISES
Increase interest rates
(Contractionary monetary policy)
Devaluation/depreciation of currency
vis-a-vis foreign currency
Immediately:
Several months later:
Decrease AD
Decrease output and employment
Increase price of
imports
Reduce domestic
purchasing power
Decrease AD
Increase AD
Increase wages
And production costs
Decease MRAS
Decrease output,employment/
Raise inflation rate
4
Increase exports and
decrease imports
5
The Distributional Impact of Crises: Winner and Losers
The average person living in a nation experiencing a currency crisis typically finds that his
or her economic welfare decreases due to recession and high inflation. As a group, domestic
workers lose because employment and real wages fall. In 1983, during the first crisis, Mexican
real wages in manufacturing fell 22.8%. In 1995, they fell 12.5%. Those who rely on imported
goods lose because devaluation of the domestic currency makes imports more expensive. This
includes consumers and domestic businesses that use large amounts of imported inputs and
parts. Businesses that produce non-tradable goods and services (construction and wholesale
and retail trade) fall into this category because they often buy imported inputs. In addition,
domestic governments and private citizens that borrowed in foreign currency (in Mexico's case,
Mexicans who borrowed dollars) before the crisis and therefore must repay in foreign currency
find themselves worse off. The devaluation of the domestic currency makes repayment of
principle and interest cost more in domestic currency terms.
There are, however, winners as well, though the overall deterioration of the
macroeconomy implies that the number of losers outweighs the number of winners. Domestic
producers of tradable goods (exporting firms and import-competing firms) gain. Industries that
export will find their sales rising since the devaluation makes their products cheaper in overseas
markets. Domestic industries that compete with imports will find that they face less
competition because the devaluation makes imported substitutes more expensive.
PART II. What We Don't Know About Currency Crises: How to Predict the Next Crisis
While Mexico's two most recent currency crises followed the same pattern, as outlined in
Part I, the characteristics of the Mexican economy and Mexican policymaking were very
different before each crisis.
The Mexican Currency Crisis of 1982
About 1970, the Mexican policymakers adopted the stance that in order for the economy
to industrialize and grow in an equitable way, the government needed to play a major role in
directing economic activity. Government spending, government regulation, and the number of
state-owned businesses grew rapidly. In late 1976, when massive reserves of oil were
discovered, the state-run oil company (PEMEX) was put in charge of developing the industry.
Oil quickly became Mexico's top export. In 1979 and 1980, the price of oil rose rapidly on world
markets and oil-exporting nations like Mexico earned huge revenues. The government
assumed the oil-price increases were permanent and embarked on ambitious development
projects. Government spending rose rapidly increasing the fiscal deficit to 14.1 percent of GDP
in 1981. This set in motion the events that typically lead to a currency crisis as summarized in
Table 1.
"Domestic Inflation > foreign Inflation, coupled with pegged exchange rate, results In
appreciation of the real exchange rate." The increase in aggregate demand due to the rapidly
rising government spending, which in turn was fueled by rising oil exports, drove Mexican
inflation up. Given the fixed nominal exchange rate, the Mexican real exchange rate
appreciated, increasing the relative price of Mexican goods and services. The real price of the
peso was about 15 percent higher in 1982 compared to 1980. The trade and current account
deficits increased.
5
6
"Rising current account deficit results in need for 'borrowing’ from international capital
market. International investors are willing to 'lend.’ " During the two periods of rapidly rising oil
prices in the 1970's, the Middle Eastern oil exporters like Saudi Arabia and Kuwait had few
profitable investment opportunities at home, so they put large portions of their earnings from oil
exports into banks in Europe and the United States. The banks, of course, wanted to lend the
funds. Many banks believed that the most profitable lending opportunities were in the
developing world. “Herding” behavior is quite common in financial markets. This means that
once "news" gets around that there is a new profitable investment opportunity, all investors rush
to "get in on the action." As a result, in the 1970's, the banks poured funds into Latin America
and Asia. The banks viewed oil-rich Mexico as a particularly good lending risk; the high export
revenues Mexico earned from oil assured future repayment, they believed. Thus, the Mexican
government and the state-owned enterprises in Mexico had no trouble borrowing on
international capital markets. The spending-spree in Mexico could continue.
"International investors begin to expect devaluation.' The developed countries like the
United States, beset by high inflation, began to pursue contractionary monetary policies that
drove up their interest rates and plunged them into recession. These nations cut back their
international purchases of oil and other natural resources. By mid-1981, oil prices were falling,
reducing Mexican export revenues. For a while the Mexican government was able to continue
financing its burgeoning current account deficit with increasingly short-term bank loans (full
repayment in less than one year). It made attempts to reduce the budget and current account
deficits, but could not decide how to do it. The dithering by Mexican policymakers and the
continued need for borrowing began to concern developed country banks and other investors.
They believed that at some point Mexico would accumulate so much foreign debt that it would
not have enough foreign currency to repay. If that happened, the Mexican government would
have to devalue its currency. As international capital funds flowed out in response to
expectations of a devaluation and "THE" Mexican BOP moved toward deficit, the Mexican
"government's foreign exchange reserves began to run out.' In August of 1982, the Mexican
government announced a 90-day suspension of payments of principle on its loans from foreign
banks.
Analysts typically mark Mexico's suspension of debt repayment in August of 1982 as the
beginning of the "Third World Debt Crisis" of the 1980's. In quick succession, governments in
Brazil, Argentina, and several other countries announced they could not repay loans from U.S.
and European banks. During the rest of the 1980's, most of the countries in Latin America and
Africa suffered the consequences of cutbacks in international lending. This era is sometimes
referred to as the "lost decade of development.'
Developed country governments, like the U.S., feared that some of the debtor countries
would default on the debts they owed the banks, which could have made several large U.S. and
European banks insolvent and endangered the world financial system. To avert disaster and
help the debtor countries, the developed country governments, the commercial banks, and the
international lending agencies (principally the IMF and the World Bank) put together packages
of relief. These packages included debt rescheduling (delaying principle repayments) and new
lending. In return, the debtor countries like Mexico had to revamp their economic policies to
reduce their government and current account deficits. These usually involved some
combination of higher taxes, lower government spending, tight monetary policy, and
devaluation of the domestic currency.
6
7
Mexico, like the other debtor countries, resented international creditors "forcing" them to
pursue policies that weakened their economies. Occasionally, the Mexican government
reneged on its promises to reign in money growth and government spending, but, eventually,
because it needed the foreign exchange that new loans provided, it always agreed to a new
package of reforms. As a result, Mexico experienced six years of slow growth, low
employment, and occasional bursts of high inflation.
In late 1987, after inflation had again accelerated, the Mexican government and formal
representatives of labor, agricultural producers, and the business sector signed the "Economic
Solidarity Pact" in which they agreed to cooperate to reduce inflation and stabilize the economy.
Among other things, the government fixed the exchange value of peso in terms of dollars so
that it would be forced to pursue a tight monetary policy to bring inflation down. (Remember:
with fixed exchange rates and capital mobility, a nation cannot increase the money supply any
time it wants.) This marked the beginning of a period of economic reform in Mexico that
included reducing government budget deficits and reducing the government's intrusive role in
the economy. The latter involved privatizing many government-owned enterprises, lifting the
restrictions on businesses, moving toward free international trade, and allowing more foreign
direct investment. In 1990, as a reward for its reforms, Mexico became the first debtor country
to have some of its commercial bank debt forgiven under a U.S.-sponsored program to offer
relief to the debtor countries.
The Mexican Currency Crisis of 1994-95
The economic reforms in the late 1980's created a Mexican economy that was very
different from that in the late 1970's and early 1980's: lower inflation, a less profligate
government, and more market forces directing economic activity. In January of 1994, Mexico
formally entered into the North American Free Trade Agreement (NAFTA) with the U.S. and
Canada, further freeing trade and investment. To many, this indicated that Mexico was not
likely to backslide in its economic reforms and that it was unlikely to experience an international
currency or debt crisis of the magnitude of those in the 1980's. Nevertheless, some of the
events that typically lead to a currency crisis, summarized in Table 1, began to emerge.
"Domestic inflation > foreign inflation, coupled with pegged exchange rate, results in
appreciation of the real exchange rate." Despite lower inflation in Mexico compared with the late
1980's (9.8 percent in 1993, down from 114.2% in 1988), the inflation rate was still higher than
that of the U.S. Coupled with a fixed nominal exchange rate, the Mexican real exchange rate
appreciated 23.5 percent between 1989 and 1993. The increase in the average price of
Mexican products relative to U.S. products resulted in rising trade and current account deficits.
As a percentage of GDP, the current account deficit rose from 2.8 percent in 1989 to 7.4
percent in 1992.
"Rising current account deficit results in need for 'borrowing’ from international capital
market. International investors are willing to ‘lend.’ "Mexico's economic reforms and its entry
into NAFTA excited international investors who poured funds into Mexico in anticipation of high
growth. This allowed Mexico to finance its growing current account deficits. The composition of
these funds was different than before the 1982 crisis because of the Mexican government's
easing of restrictions on foreign investment. There was relatively less bank lending than in the
1970's and 1980's. There was more foreign direct investment, which grew from $3.2 billion in
1989 to $4.4 billion in 1993. Even more spectacular was the growth of portfolio investment
7
8
(purchases of Mexican stocks and bonds by foreigners) from $0.4 billion in 1989 to $28.9 billion
in 1993. International portfolio investment is sometimes referred to as "hot money" because of
the ease with stocks and bonds can be bought and sold. This allows foreign investors to get
into a market quickly and to get out just as quickly.
Despite the rising real exchange rate and current account deficits, analysts were not
overly concerned about the possibility of Mexico experiencing another currency crisis. The
major causes of the 1980's crisis, huge and growing government budget deficits and therefore
the government's need to borrow increasing sums, were absent. The government ran only
small deficits and therefore had to incur only small increases in its debt. It did, however, alter
the form of its debt. Beginning in early 1994, the government replaced peso-denominated debt
with short-term dollar-indexed debt called tesobonos. That is, the tesobonos guaranteed that a
fixed amount of dollars in interest would be paid to lenders. International investors snatched
them up, along with other Mexican assets. Nevertheless, the major factor driving the current
account deficits was not government deficits but rising private consumption. Mexicans, flush
with higher incomes and good future prospects, imported vast quantities of goods from abroad.
Because the current account deficits were not the result of budget deficits and government
borrowing, analysts argued that international lenders were unlikely to become worried about the
Mexican government having enough foreign currency to repay its debts. They would be
unlikely, therefore, to expect the government to devalue the currency and to turn against
Mexico as in 1982.
However, in 1994, "international investors DID begin to expect devaluation. External
factors and political shocks apparently pushed investors to the brink. In 1994, U.S. monetary
policy shifted from expansionary to contractionary and pushed U.S. interest rates higher.
Foreign capital inflows slowed as investors moved their funds to the U.S., creating a deficit in
"THE" Mexican BOP. Internal political disturbances-a peasant uprising in Chiapas state and the
assassination of the leading presidential candidate-abetted investor uncertainty. Expectations
of a pending devaluation mounted, necessitating continued intervention by Mexican
policymakers to keep the peso within its promised exchange rate band. Such intervention
would normally have reduced the supply of pesos in circulation as the Mexican Central Bank
bought up the excess supply of pesos with dollars. However, partly because it was an election
year, the government did not want Mexican interest rates to rise. It thus "sterilized" its foreign
exchange market intervention. This means that, while the Central Bank was selling dollars out
of its foreign exchange reserves, it was simultaneously buying Mexican government bonds so
that the domestic money supply (pesos) would not contract and result in higher interest rates.
M (pesos) = mm x (GB + FXR)
By not allowing interest rates to rise, the Mexican government gave up the opportunity to entice
international capital back. So foreign funds continued their exodus. By late December 1994,
the Bank of Mexico’s "foreign exchange reserves had fallen' by almost two-thirds from their
March level. Mexico was again in crisis. On December 22, after a devaluation failed to stabilize
the currency, the newly elected government abandoned its promise to peg the peso and
allowed the currency to float. Foreign investors took the government's reneging on its peso
commitment as a signal that in the future the country might reverse many of its economic
reforms and therefore continued to withdraw funds. By January 1995, the peso had
depreciated by more than 40 percent.
8
9
The U.S. government arranged a large rescue package that permitted the Mexican
government to borrow up to $50 billion, mostly from the U.S. government and the IMF. Mexico
eventually borrowed $25 billion, using the money to pay off the tesobonos as they matured and
to replenish its reserve holdings. The rise in Mexican interest rates and the peso depreciation
devastated the economy, however: Mexico fell into recession, and employment and real wages
declined. The Mexican crisis spread to other countries, principally in Latin America, as
investors became concerned that other 'emerging markets" might experience difficulties and
withdrew investment funds. This became known as the 'tequila effect." The good news is that,
by 1998, the government had repaid all that it had borrowed from the U.S. and the IMF and the
economy was well on its way to recovery. However, the average Mexican worker has not
shared in the recent boom: some have predicted that Mexican real wages will not rise back to
their pre-crisis levels until about 2003.
Predicting Future Currency Crises
The Mexican crisis of 1994-95 was a humbling experience for economists. A country
that had undertaken all the economic reforms that economists had been touting since the
1980's debt crisis had experienced severe and unexpected financial problems. The experts
were surprised again in 1997 when important economies in East and Southeast Asia
(Thailand, South Korea, Indonesia, Malaysia) experienced currency crises. The Asian crises
were even more unexpected than that in Mexico three years earlier. Mexico had been an
economically volatile nation with inconsistent government policies for most of the twentieth
century and therefore, in hindsight, it seemed reasonable that international investors in 1994
might be worried that Mexico was not fully committed to continuing its reforms. Most of the
Asian economies, in contrast, had been models of prudent economic management for at least
30 years. Inflation was low and the region had experienced the fastest growth in history over
the last 20 or 30 years. Indeed, the standard of living in South Korea, which had been as poor
as India in 1960, was similar to that in Greece and Portugal. Yet, international investors
engaged in a massive withdrawal of funds from the region in the latter half of 1997,
precipitating a currency crisis and a severe regional recession.
Economists do not have a good track record predicting where currency crises will strike.
As Table 1 indicates, crises usually are preceded by an appreciating real exchange rate. The
country has a fixed nominal exchange rate and domestic inflation is higher than foreign inflation
due to an overly expansionary monetary policy, resulting in an increase in the average price of
domestic goods and services relative to foreign. In turn, this causes a rising current account
deficit. However, not all countries that experience these phenomena fall into crisis. In
analyzing past crises, economists have identified other criteria that seem to make countries
vulnerable to these difficulties. Unfortunately, each new crisis seems to point to factors that
economists did not think of before. Below is list of the most important factors that seem to lead
to problems. The two Mexican episodes indicate most of these features. [See if you can point
to specific characteristics of the two Mexican crises that correspond to these.]
1.
Waves of overlending and overborrowing. There is a tendency for "herding" behavior
on the part of international lenders. They pour funds into a "hot" market en masse.
Once lenders realize that too much has been lent and borrowed, each has an incentive
to stop lending and to try to get repaid as quickly as possible (before foreign reserves
run out). All cannot be repaid quickly, and a financial crisis erupts. This is not unlike a
run on a bank.
9
10
2.
Growing foreign borrowing, represented by a rising current account deficit is not
accompanied by rising domestic investment in plant and equipment. This means that the
nation is not raising its productive capacity. As a result, future incomes may not grow
enough to repay foreign lenders. Instead, growing foreign borrowing is accompanied
by:
a.
Rising government budget deficits, government borrowing, and accumulating
government debt.
b.
Falling private sector saving and therefore rising consumption.
3.
Exogenous international shocks. The fundamentals, especially interest rates, of other
nations change and put pressure on a nation with a great need for international capital.
4.
Fickle international short-term lending and portfolio investment. Short-term debt, debt
that is due to be repaid in less than a year, can cause a major problem because foreign
lenders can refuse to refinance it. In addition, the instruments of portfolio investment,
stocks and bonds, can be quickly and easily sold once international lenders decide to
exit the market.
This is probably not the final word on the subject. Undoubtedly, this list will grow as unpredicted
currency crises in the future reveal new factors that seem to make economies vulnerable to the
changing assessments of international lenders.
REFERENCES
Blanchard, Olivier (2000). Macroeconomics, second edition. Prentice Hall: Upper Saddle
River, New Jersey.
Kinney, Linda (1998). The Anatomy of Currency Crises. Mimeo.
Lustig, Nora (1998). Mexico: The Making of an Economy, second edition. Brookings
Institution: Washington, DC.
Pugel, Thomas A. and Lindert, Peter H. (2000). The International Economy, eleventh edition.
Irwin/McGraw-Hill: Boston.
10