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Mexican Peso and Asian Currency Crisis Crisis Mexican crisis The 1994 economic crisis in Mexico, widely known as the Mexican peso crisis, was triggered by the sudden devaluation of the Mexican peso in the early days of the presidency of Ernesto Zedillo. The crisis is also known in Spanish as el error de diciembre — The December Mistake. In the Southern Cone and Brazil, the impact that the Mexican economic crisis had on the region was labeled the Tequila Effect (Spanish: Efecto Tequila, Portuguese: Efeito Tequila). Economy in Mexico at the time of Crisis In 1993, 64% of capital inflows into Mexico went into portfolio equity, 22% was composed of direct investment, and 14% was in the form of long-term debt. Until the political and economic events of 1994, Mexico could maintain the fixed peso value even though the current account deficit. In the capital account, foreign savers seeking high rates of return in Mexico's soaring equity markets and businesses with direct investments in Mexico kept the peso demand strong. The increased supply of pesos in the current account was offset by higher demand in the capital account. During this period the Mexican government issued large quantities of short-term, dollar-indexed securities known as tesobonos. U.S. Plan to Confine the Crisis The Administration has proposed a package of loan guarantees to help restore investor confidence in the devalued peso and in the Mexican financial markets. These guarantees should enable Mexico to raise long- term funds in private capital markets to pay off its short-term financial obligations. This should help restore financial stability and prevent the crisis from spreading to other markets. What Conditions Must Mexico Meet? Clinton Administration officials state that the loan guarantees will include strict financial conditions imposed on the Mexican government to contain inflation, reduce Mexico's external deficit, restore stability to the peso, and control wage increases. In addition, the United States should insist on continuing Mexican government deregulation and privatization of its economy. If these conditions are not rigorously drawn and enforced, there will be more trouble later. Mexico also will be required to pay a risk fee in cash up front for the right to use the guarantee. Is this Foreign Assistance, a Loan, or a Guarantee? The package is not foreign assistance or a loan. The United States will guarantee new borrowing by Mexico in order to restore investor confidence. These guarantees carry some risks for the Treasury and the U.S. taxpayer, but as long as Mexico repays its debt, as it has in the past, this guarantee will have no effect on the U.S. budget. Does this Crisis Mean NAFTA was a Mistake? The North American Free Trade Agreement (NAFTA) signed by Mexico, the United States, and Canada in 1993 didn't cause the crisis, despite the wild claims of the treaty's opponents. The U.S. relationship with Mexico is such that it would require this kind of special treatment with or without NAFTA. NAFTA is a trade agreement, not a monetary arrangement, and Mexico would probably have experienced this crisis had NAFTA not existed. Thanks to NAFTA, Mexico cannot raise tariffs against increasing U.S. imports in a short-term response to the crisis. In any event, support for a credit package should not be a referendum on NAFTA. Causes of the economic crisis of 1994 (1) The large Mexican current account deficit. (2) A rise in U.S. interest rates resulted in an abrupt reversal of the flow of financial money that had entered Mexico through the capital account. (3) Assassination of Luis Donaldo colosio & Jose Fransisco Ruiz increased anxiety about Mexico's political and social situation. (4) In order to finance the historical deficit (5) A steady drain of foreign exchange reserves. Out Comes of Peso Depreciation: (1) The peso depreciation will lead to a significant jump in the inflation rate. (2) The Mexican current account deficit will fall as exports rise and more costly imports decrease. (3) The peso depreciation leaves the Mexican government no favorable choices. The government can choose to use fiscal and monetary restraint to prevent inflation. Or it can continue positive economic growth. Mexican Economy Rescue Program: In early January, 1995, the new Mexican Finance Minister Guillermo Ortiz announced a program to address the Mexican economic crisis. The program had three components . I. Minimize the inflationary effects of the devaluation. II. Push forward structural reforms that promote the competitiveness of the Mexican private sector. III. Address the short-run concerns of investors and establish a coherent floating exchange rate regime. How the IMF helps to resolve Economic Crisis Balance of payments difficulties can arise and, in the worst case, build into crises—even in the face of strong prevention efforts. IMF has also been encouraging actions by debtor countries and their creditors to facilitate a more orderly process for debt restructuring. The IMF's Role Prior to the 1994-95 Mexican Financial Crisis Many of the participants saw much of the political upheaval of the recent past to be a direct consequence of the financial chaos that had preceded World War II. 1. The IMF's Original Mandate was to Supervise Fixed Exchange Rates 2. The Collapse of the Bretton Woods Par Value System Eliminated a Principal Function of the IMF. 3. The IMF Searched for a New Role to Play on the World's Financial Stage and Moved Toward Greater Surveillance of Member Countries' Economic Policies. 4. The IMF (and the World Bank) Took Center Stage During the Debt Crisis of the 1980s. Rescuing the Mexican Economy From the Crisis of 1994-95 (1) The U.S. Led the IMF Effort to "Save" Mexico and the FreeMarket Model of Development. The United States government organized a multilateral assistance package to the Mexican government with financial commitments approaching $50 billion dollars. The United States government committed nearly $20 billion dollars to the rescue package, while the IMF contributed another $18 billion dollars. Most important, goals of the rescue effort were to restore investor confidence in the long-term prospects of the Mexican economy, and to reassure countries with economies similar to Mexico's that the freemarket model of development was still viable. (2) The United States and the IMF Provided Short-Term Credit to Help Solve the Liquidity Crisis. The Mexican government owed a lot of people a lot of U.S. dollars, and it was obligated to fully repay its creditors in a short amount of time. After the peg collapsed, the peso instantly lost nearly 25% of its value, making it much more difficult for the government to purchase dollars with pesos. The United States government and the IMF put together a multi-tiered rescue package to alleviate the liquidity crisis in Mexico. Mexico needed a cash injection so that it could meet its obligations, and so that confidence could be restored in the short-term stability of the Mexican economy. The United States extended nearly $15 billion dollars to the Mexican government by entering into short- and medium-term currency swap agreements. The United States agreed to give dollars to the Mexican government in exchange for pesos. Three months to a year later the Mexican government would give the United States dollars in exchange for pesos. The IMF and the Mexican government entered into a stand-by arrangement which, in part, provided Mexico with an immediate cash injection (Special Drawing Rights). Of the nearly $18 billion in total IMF commitments, almost $8 billion was available immediately after the agreement was concluded. The other $10 billion was conditioned on Mexico's meeting certain economic performance criteria—a method termed "conditionality." (3) The United States' Plan Attempted to Return Mexico to the International Financial Markets. The United States and the IMF organized their plan to resolve the liquidity crisis in Mexico, a plan was conceived to convert Mexico's remaining short-term obligations to long-term debt, and in the process demonstrate Mexico's financial strength to the world. United States agreed to guarantee long-term Mexican government bonds which were to be sold in the international financial markets. The net effect of this portion of the overall rescue package was that Mexico was able to quickly return to the international financial markets to start rebuilding its reputation as a successful and stable country in which to invest The Economic Crisis of 1997-99 Overviews • Fixed exchange rate system pegged to the USD. When the Dollar rose, consequently the ASEAN currencies grew too, resulting in lower exports. • Decline in Export competitiveness particularly in Electrical goods. • The decrease in exports resulted in increased Trade and Current Account deficit. • The crisis first emerged in Thailand when as a crisis of loan repayment. This led to fears of loan defaults and foreign short-term creditors withdrew funds from Thai financial institutions. • The withdrawal of ST credit led to pressure on forex reserves and the value of Baht. The Bank of Thailand in its attempt to save the Baht lost all its Reserves and had to request assistance from the IMF. • The contagion then spread to Philippines, Malaysia and Indonesi. The Asian financial crisis involves four basic problems or issues: (1) A shortage of foreign exchange in Thailand, Indonesia, South Korea and other Asian countries that has caused the value of currencies and equities to fall dramatically, (2) Inadequately developed financial sectors and mechanisms for allocating capital in the troubled Asian economies, (3) Effects of the crisis on both the United States and the world. (4) The role, operations, and replenishment of funds of the International Monetary Fund. Impact of the crisis The crisis led to weaker, unstable exchange rates and weakened Financial Institutions. To tackle this, the Government imposed higher domestic Interest rates, which led to a slowdown in manufacturing and industrial activity. This brought about huge unemployment and an undesirable social impact – on food, healthcare and education. To make matters worse, the financial crisis coincided with the worst drought conditions in the ASEAN region. Since ASEAN is the fourth largest trading block in the world, the spillover effect was on world trade (mainly ASEAN’s trading partners). Causes of the crisis in 1997 1. Weakness of Macro-Economic fundamentals The basic weaknesses in the Macro-Economic fundamentals itself led to Low productivity and competitiveness vis-à-vis other regions of the world. Weak governments lacked the political autonomy or will to enact the deflationary policies necessary to reduce current account deficits and domestic asset bubbles. They also contributed to the cronyism and ethical problem that encouraged over borrowing, over lending, and over investment in the private corporate sector as well as in state projects. 2.Overvalued Exchange Rate & Openness of Capital Account Overvalued exchange rates tied to an appreciating U.S. dollar led to large current account deficits and inadequate or declining long-term capital inflows. This resulted in heavy dependence on short-term external debt and the depletion of foreign exchange reserves. Borrowed Short-Term funds were invested in the Stock market and in Real Estate. The overall quality of investments declined with reduction investor confidence which was a result of bad news that the export market had slowed down. IMF Financial Support Packages Date Approved (1997) Total Pledged IMF U.S. World Bank Asian Development Bank Japan Others Change in Exchange Rate (7/11/97- 1/22/98) Change in Stock Market (7/1/97-1/19/98) Thailand August 20 $17.2 $3.9 None $1.5 $1.2 $4.0 $6.6 Indonesia November 5 $40 $10.1 $ 3.0 $ 4.5 $ 3.5 $ 5.0 $26.0 South Korea December 4 $57 $21.0 $5.0 $10.0 $ 4.0 $10.0 $ 7.0 -38% -81% -50% -26% -40% -30% Proposed Solutions 1. Stabilizing the Exchange Rate and Debt Management 2. Dealing with the Social impact 3. Strengthening the Financial sector 4. Adjustment of Industrial Structures 5. International Financial markets 6. Revitalizing the Financial Markets ASEAN: Steps to Handle the Crisis The progressive openness of ASEAN economies Sound Financial measures The growing integration of the ASEAN economy The expansion and diversification of ASEAN