Financial crises, the IMF, and MexicoLecture 17

Housekeeping

• Papers due today• Professor Bozovic will be lecturing Oct 28• Professor Graham returns Oct 30

Flexible currencies can avoid crises

One tempting solution to a current account deficit is to:• Change the exchange rate• Create inflation (print money) to deflate the value of your

currencyA devalued currency makes your exports cheaper• Other countries buy more of your goodsImports into your country become more expensive• Your citizens buy less from abroad

Current account deficits with fixed exchange rates

• Some countries have pegged currencies, so they are unwilling or unable to depreciate. – The costs of leaving the fixed currency may be too high to consider as

a policy option.

• Euro-zone countries don’t have individual control over the Euro, so they also can’t depreciate in response to deficits– Greece is willing to pay a very high price to stay in the Euro

• Mexico in 1994 kept the peso fixed to the dollar – Wanted to encourage trade with U.S. under newly signed North

American Free Trade Agreement (NAFTA)– Wanted to keep up appearance of stability to win a critical election

Costly fixes to current account deficitunder a fixed currency

X-M = (S-I) + (T-G)• Exports – Imports =

(Savings – Investment) + (Taxes – Government consumption)To fix a current account deficit, they can either• Boost savings (less spending)• Reduce investment (less capital per worker, lower

productivity)• Raise taxes (disincentive to work, reduces private spending)• Reduce government spendingAll of these things reduce GDP growth!

Check-in on current account

Which of the following reduce a current account deficit? Remember: Exports - Imports = (Savings - Investment) + (Taxes - Government Consumption)

A) Increasing government spendingB) Increasing investmentC) Increasing household savingsD) A&BE) B&C

Borrowing abroad:The temporary fix

If you have a current account deficit:• You can borrow money from abroad to cover it, or• Sell off assets to foreigners

This only works for so long. As the debt grows, will or can the borrowing country repay?

Mexico’s borrowing- 1994

• Fixed and overvalued exchange rate– This only works as long as the central bank has the foreign currency

reserves to keep buying

• Mexico’s dollar borrowing– Mexico borrowed dollars using bonds that had to be repaid in dollars– Used those dollars to buy pesos, keeping value of peso high– 7% current account deficit

Over-borrowing and debt crisesStep 1: Ominous signs• Questions arise about a country’s willingness or ability to make payments

on its growing debtStep 2: Investors grow cautious• Cautious investors pull out or raise interest to cover the higher riskStep 3: Higher rates make it harder • Current account balance gets worse under higher interest payments, debt

rises even fasterStep 4: Downward spiral• More investors lose faith and pull out, interest rates rise higher, current

account deeper in deficit, cycle repeats and gets worse each time

Peso’s weakness was hidden(?)

• Investors continued to loan Mexico dollars, as long as they were repaid in dollars

• Interest rates would have been higher if they had borrowed dollars to be repaid in pesos

• What does this mean? Was Mexico fooling Wall Street?

Default risk vs. inflation risk

• Lenders were happy to buy Mexican debt, to be repaid in dollars. They were confident that they would be repaid, no matter what.– Why? They knew the U.S. wouldn’t let Mexico’s

economy collapse. That is what the IMF is for.• But fears that the peso would drop in value

made them less willing to give loans that would be repaid in pesos.

Tequila crisis buildup 1994

• Political Risk– Armed rebellion in Chiapas,

assassination of ruling party presidential candidate

• Bad political choices– One-party government facing a real

election threat, high government spending to win election

– Unwilling to offer higher interest rates on peso-backed loans

• Foreign reserves depleted by maintaining overvalued exchange rate and making loan payments in dollars

Checking understanding

How do debt crises start?A) As lenders get scared, interest rates fall, giving countries

incentive to borrow moreB) As lenders get scared, interest rates rise, making existing

debt even harder to pay backC) Undervalued currencies lead to too many exports

Types of crises are related and interchangeable

Debt crisis• Interest rates increase sharply, government default imminent

Currency crisis (aka balance of payments crisis)• Government is low on reserves, currency loses value

1. As long as a government can borrow internationally, it can use the borrowed money to stabilize currency

2. As long as a government can print money, it can pay off its debts

What the IMF does in a crisis

IMF is the “lender of last resort”• When a government can’t borrow, the IMF steps in with a

subsidized loan• IMF doesn’t take collateral• It imposes “conditions” on loansConditions: designed to fix the problems that created the crisis

in the first place• Austerity: raise taxes, cut government spending, tight

monetary policy• Sell off state assets

IMF: the big picturePart of the Bretton Woods systemGoal = keep currencies stable, prevent economic collapses, and

promote trade.Three functions:• Surveillance: Collecting data, giving governments advice• Technical Assistance: Guidance and training to poor countries

to help them manage their economies• Lending: Loans to countries facing balance of payments crises

or otherwise w/o access to other credit– Smooth out shocks, avoid defaults– “Concessional” loans available for poor countries

IMF gets Mexico out of crisis

• US govt and IMF step in with $50 billion in loans in 1995• Conditions:

– New monetary and fiscal policy controls, since the overvalued currency caused the problem

– Mexico already had liberalized economy so no major structural conditions such as austerity or privatization

• Major recession but quick economic recovery• Considered an IMF success story

– Mexico repaid the crisis loans ahead of schedule– Since then, almost two decades of relatively stable inflation and

exchange rates