Dr. Alejandro Diaz Bautista, Economic Policy and Stabilization in Mexico
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Dr. Alejandro Diaz Bautista, Economic Policy and Stabilization in Mexico

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Economic Policy Stabilization and Mexico’s 1994 Economic Crisis ...

Economic Policy Stabilization and Mexico’s 1994 Economic Crisis
(Also known as “el error de diciembre”, The December Mistake).

Alejandro Díaz-Bautista, Ph.D.
adiazbau@hotmail.com

Professor of Economics and Researcher

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Dr. Alejandro Diaz Bautista, Economic Policy and Stabilization in Mexico Dr. Alejandro Diaz Bautista, Economic Policy and Stabilization in Mexico Presentation Transcript

  • Economic Policy in Latin America April-June, 2008 Economic Policy Stabilization and Mexico’s 1994 Economic Crisis (Also known as “el error de diciembre”, The December Mistake). Alejandro Díaz-Bautista, Ph.D. [email_address] Professor of Economics and Researcher at COLEF Visiting Research Fellow and Guest Scholar 2008, Center for U.S.-Mexican Studies, University of California San Diego (UCSD). April 2, 2008 Graduate School of International Relations & Pacific Studies IR/PS University of California, San Diego.
  • Mexico's Crisis: Looking Back to Assess the Future David M. Gould
    • In this study by the Fed, David M. Gould argues that to assess Mexico's future, one must look at Mexico's past.
    • Although Mexico needed several years to regain the investor confidence it lost during the 1994 economic crisis, the trend in Mexico's policies is more consistent with future low inflation and higher growth than with the country's previous closed-market policies.
  • Mexico's Crisis: Looking Back to Assess the Future David M. Gould
    • Mexico embarked on a new economic policy direction in the second half of the 1980s.
    • In December 1987, President De la Madrid and representatives of the labor, farming, and business sectors signed the Pact for Economic Solidarity, which was followed by the Pact for Stability and Economic Growth under the newly elected administration of President Salinas de Gortari. These two measures, now jointly referred to as the Pacto, were designed to combine orthodox fiscal and monetary restraint with structural reforms and an incomes policy (controls on wages and prices).
    • Salinas graduated with a degree in economics from UNAM. He obtained a master's degree in Public Administration in 1973, a master's in Political Economics in 1976 and a PhD in Political Economics and Government, all from Harvard University. Upon his return to Mexico he became a professor at his alma mater. Although a member of the PRI since his student days, it was not until the presidency of Miguel de la Madrid that he was assigned a government post as minister of the Bureau of Planning and Budget (Secretaría de Planeación y Presupuesto), where he served from 1982-1987.
    • President Salinas was in office from 1988 to Nov. 30, 1994.
    • During Carlos Salinas de Gortari's term, significant economic policy changes were implemented:
    • Renegotiated the external debt, through the Brady Plan.
    • Negotiated the North American Free Trade Agreement (NAFTA), with the United States and Canada.
    • He continued a privatization program initiated by his predecessor, by which the government retained only a few of the hundreds of companies and small business that were nationalized. One of the most important privatizations was Telmex, which remained a monopoly until mid-1990s, and who was sold to Carlos Slim Helú.
    • The number of state-owned industries continued to drop, from approx. 600 in 1988 to a minimal 250 in 1994.
  • Mexico's Crisis: Looking Back to Assess the Future David M. Gould
    • In early December 1994, the Organization for Economic Cooperation and Development (OECD) and many private economists were predicting that Mexico’s real gross domestic product (GDP) would grow by at least 3.8 percent in 1995.
    • Mexico appeared to be on the fast track to economic growth and stability. For the first time in many years, its annual inflation rate was down to less than 10 percent, the public-sector budget was nearly balanced, and exports were growing at an annual rate in excess of 22 percent.
  • Mexico's Crisis: Looking Back to Assess the Future David M. Gould
    • In October 1994, Mexico authorized virtually all the foreign banks, brokerages, and insurance companies that sought entry into the market. Foreigners would be able to hold majority interests in all but the three largest banks.
    • In 1991, Mexico’s three largest banks—Banamex, Bancomer, and Serfin—accounted for about 62 % of total Mexican banking assets; in late 1994, they accounted for less than 50 %.
  • Mexico's Crisis: Looking Back to Assess the Future David M. Gould
    • Low inflation was made credible only through sustainable fiscal balances and low and stable monetary growth.
    • From 1987 to the end of 1993, Mexico’s monetary policy was consistent with low inflation and maintaining its exchange rate targets. Inflation fell from a high of nearly 160 percent in 1987 to around 7 percent at the beginning of 1994.
  • Flow of Capital to Mexico
    • Flows of capital to Mexico grew during the early 1990s, due to legislation that allowed foreigners to buy government bonds and (non-voting) shares in Mexican companies and increased confidence due to the proposed and expected signing of NAFTA.
  • Private Capital flow to Mexico (in billion USD)
  • Mexico's Crisis: Looking Back to Assess the Future David M. Gould
    • On the trade side, Mexico started to gradually liberalize in mid-1985, but the process was solidified in 1988 when the number of goods covered by import licenses fell dramatically and the tariff structure was simplified.
    • In 1983, the share of imports covered by import permits was close to 100 percent; by 1992, the share had fallen to less than 2 percent (Source: Banco de México).
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  • Mexico's Crisis: Looking Back to Assess the Future David M. Gould
    • During the initial stages of the Pacto, the ex-change rate was fixed to the dollar; then it was held to a preannounced daily depreciation. In 1991, the exchange rate was allowed to float within a widening band. At first, the top of the band rose 20 centavos (0.0002 new pesos) per dollar a day; then it was increased to 40 centavos (0.0004 new pesos) per dollar a day.
    • On December 20, 1994, however, under pressure from foreign exchange markets and dwindling foreign exchange reserves, Mexico abandoned its exchange rate band.
    • The peso was devalued and then allowed to float freely against the dollar.
    • The election of President Ernesto Zedillo in August 1994 brought new confidence in Mexico’s Economic policies and temporarily boosted foreign reserves and the peso. Following the elections, because of higher U.S. interest rates and increased investor uncertainty, money began flowing out of Mexico again.
    • Without dramatically higher interest rates, foreign reserves continued to leave the country. Eventually, foreign reserves fell to such a point that the exchange rate band had to be loosened and then completely abandoned after continued pressure on the peso.
    • If interest rates had been kept higher after the 1994 presidential elections, perhaps the costs of abandoning the exchange rate, in terms of lost credibility and higher short-run inflation, could have been avoided. In retrospect, this may have been a better option than the one chosen.
  • The December Mistake
    • At the beginning of his administration, President Zedillo suddenly announced his government would let the fixed rate band to increase 15 percent (up to 4 pesos per US dollar), by stopping the unorthodox measures employed by the previous administration to keep it at the previous fixed level (by selling dollars and assuming debt).
    • This measure, however, was not enough, and the government was even unable to hold this line, and decided to let it float. While experts agree that devaluation was necessary, some critics of Zedillo's incumbent 22-day old administration, argue that although economically coherent, the way it was handled was a political and economic mistake.
    • By announcing its plans for devaluation, they argue that many foreigners withdrew their investments, thus aggravating the effects.
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  • Mexico’s Rescue Plan
    • In January 1995, the USA orchestrated a $50bn international loan which, in conjunction with a stringent adjustment program and rapid export growth in 1996 (a rise of 20% from 1995), restored confidence and growth by 1996.
    • The rescue plan raised fears of moral hazard, but was justified by Mexico’s good economic track record and desire to avoid risk of systematic repercussions.
    • However, Mexico’s 1994 crisis started to raise doubts, about poor economic fundamentals in other countries as well as the viability of economic policies.
  • The Tequila Effect
    • Some emerging markets were hit by financial crises in the wake of the Peso devaluation of 1994, while others were not.
    • The Tequila Effect was transmitted by a rational demonstration effect based on shared macroeconomic fundamentals. Although the demonstration effect was largely rational in its discrimination between "weak" and "strong" economies, it did, however, contain an element of irrationality.
    • Nervous investors often withdrew their funds from Latin American economies, based on the expectation that other investors would do likewise.
    • Therefore, the possibility of panic, which has existed before December 1994, became the fact of a panic after December 1994.
  • The Tequila Effect
    • Between December 1994 and March 1995, Argentina suffered badly from the Tequila Crisis Effect. Bank liquidity tightened, interest rates surged and 15% of deposits were withdrawn from the banking system.
    • International reserves decreased substantially, while the stock market fell by 35%. The authorities reacted by obtaining international aid and establishing lender of last resort facilities, which eventually led to a restoration of confidence and an economic recovery.
  • Balance of Payments Crisis
    • Krugman and Obstfeld present a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate.
    • In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs.
    • In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate.
    • Speculators sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very rapidly. This is what occurred during the 1994 economic crisis in Mexico.
  • Could the Mexico 1994 Crisis be prevented?
    • An important academic discussion began in and about Mexico as early as 1993, regarding the sustainability of the fixed exchange rate. Dornbusch and Werner (1994) estimated 20% overvaluation, and issued a controversial call for a “one-time” devaluation.
    • An insistent Finance Ministry led by Dr. Pedro Aspe argued that real exchange rate appreciation was consistent with underlying fundamentals (such as improvements in productivity resulting from Salinas’s microeconomic reforms), and worried privately that a devaluation would destroy the hard-won credibility (Aspe, 1993) .
  • Dornbusch’s Model
    • One of the most influential papers written in the field of International Economics since World War II is Rudiger Dornbusch's, "Expectations and Exchange Rate Dynamics“ which was published more than 30 years ago in the Journal of Political Economy, in 1976.
    • Rogoff has mentioned that the overshooting paper, marks the birth of modern international macroeconomics. There is little question that Dornbusch's rational expectations reformulation of the Mundell-Fleming model extended the latter's life for another 25 years, keeping it in the forefront of practical policy analysis, and so widely used by latin american economists.
  • Rudi Dornbusch
    • Rudiger "Rudi" Dornbusch studied at University of Geneva and the University of Chicago. In 1975 he moved to MIT, where he was appointed as Associate Professor in the Department of Economics.
    • Throughout his career his main focus was on international economics, especially monetary policy, macroeconomic development, growth and international trade. Expert in Latin American Economies.
    • He developed models of fluctuations in prices and exchange rates (most notably with his Overshooting Model). He worked also for the IMF, making important contributions to the development of stabilisation policies, especially for Latin American countries.
  • Dornbusch’s Model
    • Two relationships lie at the heart of Dornbusch’s overshooting Model. The first, equation
    • (1)
    • is the "uncovered interest parity" condition. It says that the home interest rate on bonds, i, must equal the foreign interest rate i*, plus the expected rate of depreciation of the exchange rate, Et (et+1 - et), where e is the logarithm of the exchange rate (home currency price of foreign currency), and Et denotes market expectations based on time t information.
    • That is, if home and foreign bonds are perfect substitutes, and international capital is fully mobile, the two bonds can only pay different interest rates if agents expect there will be compensating movement in the exchange rate.
    • The economic model assumes that the home country is small in world capital markets, so that we may take the foreign interest rate i* as exogenous.
  • Dornbusch’s Model
    • mt – pt = - n(it+1) + v (yt) (2)
    • where m is the money supply, p is the domestic price level, I interest rate on bonds, and y is domestic output, all in logarithms; n and v are positive parameters.
    • Higher interest rates raise the opportunity cost of holding money, and thereby lower the demand for money.
    • An increase in output raises the transactions demand for money.
    • Finally, the demand for money is proportional to the price level. Equation (2) is a simple variant of the Goldfeld (1972) money demand function.
  • Dornbusch’s Model
    • So how does "overshooting" work?
    • We combine equations (1) and (2) with a few simple assumptions.
    • Assume that the domestic price level p does not move instantaneously in response to unanticipated monetary disturbances, but adjusts only slowly over time.
    • Also assume that output y is exogenous (what really matters is that it, too, moves sluggishly in response to monetary shocks).
    • Assume also that money is neutral in the long run, so that a permanent rise in m leads a proportionate rise in e and p, in the long run.
  • Dornbusch’s Model
    • Now suppose, that there is an unanticipated permanent increase in the money supply m.
    • If the nominal money supply rises but the price level is temporarily fixed, then the supply of real balances m-p must rise as well. To equilibrate the system, the demand for real balances must rise. Since output y is assumed fixed in the short run, the only way that the demand for real balances can go up is if the interest rate i on domestic currency bonds falls. According to equation (1), it is possible for i to fall if and only if, over the future life of the bond contract, the home currency is expected to appreciate.
  • Dornbusch’s Model
    • But how can the home currency appreciate, if we know that the long run impact of the money supply shock must be a proportionate depreciation in the exchange rate?
    • Dornbusch's model answers the question, by making the initial depreciation of the exchange rate larger than the long-run depreciation. This initial excess depreciation leaves room for the ensuing appreciation needed to simultaneously clear the bond and money markets. The exchange rate must overshoot.
    • The result is driven by the assumed rigidity of domestic prices p. Otherwise, e, p, and m would all move proportionately on impact, and there would be no overshooting.
  • Dornbusch Overshooting Model
  • Overshooting in Mexico
    • During 1995, under a floating exchange rate, there was a spread of nearly 49 percentage points in consumer prices between Mexico (with an inflation rate of 51.9 %) and the United States (with an inflation rate of 3 %).
    • The classic applied case of exchange rate overshooting occurred in the wake of a brutal collapse of confidence in the peso and a massive suspension of private capital flows at the end of 1994. The result: a peso depreciation of over 100 percent, from 3.5 pesos to 7.3 pesos to the dollar.
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  • Díaz Bautista and Olivas Andrade (2003)
    • The study is centered on the dynamic model of capital flight from Mexico. Some of the variables that are used in the economic crisis econometric model are the current account, the level of overvaluation of the currency, the interest rate differential between Mexico and the United States and political factors.
  • Vector Error Correction and Cointegration Theory The finding that many macro time series may contain a unit root has spurred the development of the theory of non-stationary time series analysis. Professors Engle and Granger have pointed out that a linear combination of two or more non-stationary series may be stationary. If such a stationary, or I(0), linear combination exists, the non-stationary (with a unit root), time series are said to be cointegrated. The stationary linear combination is called the cointegrating equation and may be interpreted as a long-run equilibrium relationship between the variables. A vector error correction (VEC) model is a restricted VAR that has cointegration restrictions built into the specification, so that it is designed for use with nonstationary series that are known to be cointegrated. The VEC specification restricts the long-run behavior of the endogenous variables to converge to their cointegrating relationships while allowing a wide range of short-run dynamics. The cointegration term is known as the error correction term since the deviation from long-run equilibrium is corrected gradually through a series of partial short-run adjustments.
    • The Error-correction model is used as a way of capturing adjustments in a dependent variable which depended not on the level of some exploratory variable, but on the extent to which an explanatory variable deviate from an equilibrium relationship with the dependent variable.
    • The ”error” representing the deviation from the long-run equilibrium.
  • Díaz Bautista and Olivas Andrade (2003) Model Variables
  • Díaz Bautista and Olivas Andrade (2003) Capital Flight VEC Model
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  • Determinants of Capital Flight in Mexico
    • Díaz Bautista and Olivas Andrade (2003) identified the determinants of capital flight in Mexico with the implementation of a Vector error correction (VEC) model. Following the methodology used by the World Bank, the variables that cause the exodus of capital were determined to be the degree of overvaluation of the currency, followed by the current account balance.
    • The differential in interest rates and inflation, hardly affect the outflow of capital in this model. In this model, almost all capital flight reacts the same way to changes in the current account as to changes in the degree of overvaluation of the peso.
  • Conclusions
    • Mexico's 1994 "peso crisis" has been called the first financial crisis of the 21st century.
    • Financial crises are no longer what they used to be and they catch investors, governments, and international organizations by surprise.
    • The Mexican 1994 events gave us a good lesson, “economic policy makers (particularly in emerging markets) tend to wait until the last moment to modify an exchange rate policy”.
    • Some of the determinants of capital flight in Mexico are the degree of overvaluation of the currency, followed by the current account balance.
  • References
    • Aspe, Pedro (1993): Economic Transformation the Mexican Way. (Cambridge: MIT Press).
    • Díaz Bautista, Alejandro and Olivas Andrade, Cesar (2003), “Un Análisis de cointegración con corrección de errores de las Fugas de Capital y la Inestabilidad Política en México”, in “Problemas Estructurales de la Economía Mexicana” coordinated by Alejandro Díaz Bautista.
    • Díaz-Bautista, Alejandro (2003), “Los Determinantes del Crecimiento: Convergencia, Instituciones y Comercio Internacional”. Pp. 164, junio de 2003. Colef y Editorial Plaza y Valdes ( The Determinants of Economic Growth: Convergence, Trade and Institutions”).
    • Dornbusch, Rudiger (1976), "Expectations and Exchange Rate Dynamics," Journal of Political Economy, Vol. 84, pp. 1161-76.
    • Dornbusch, Rudiger and Alejandro Werner, 1994. “Mexico: Stabilization, Reform, and No Growth.” Brookings Papers on Economic Activity 1994 (1), 253-97.
    • Krugman, Paul and Maurice Obstfeld (2003), International Economics: Theory and Policy, 6th edition (Addison Wesley).
    • Rogoff, Kenneth (2001), Dornbusch's Overshooting Model After Twenty-Five Years, Second Annual IMF Research Conference, Mundell-Fleming Lecture.
  • Currency Devaluation and Depreciation
    • Appreciation is a rise of a currency in a floating exchange rate.
    • Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system.
    • Devaluation is a reduction in the value of a currency with respect to other monetary units. In common modern usage, it specifically implies an official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency.
  • Economic Policy in Latin America April-June, 2008 Economic Policy Stabilization and Mexico’s 1994 Economic Crisis (Also known as “el error de diciembre”, The December Mistake). Alejandro Díaz-Bautista, Ph.D. [email_address] Professor of Economics and Researcher at COLEF Visiting Research Fellow and Guest Scholar 2008, Center for U.S.-Mexican Studies, University of California San Diego (UCSD). April 2, 2008 Graduate School of International Relations & Pacific Studies IR/PS University of California, San Diego.