MEXICO 1994-2000’s: From Crawling to Crisis to Floating

NBA 595 Financial Economics (Global Emerging Markets) Mario Felipe Campuzano – May 9, 2004 mfc27@cornell.edu

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The International Reserves and Exchange Rate (Problem Summary) 1. From 1990 to 1993 Mexico received 1/3

of all global portfolio inflows (second to China). About $75B.

2. Exchange rate dep. 10% within a band in the 1st ½ of 1994.

3. Bank used inflows for consumer lending ( 55% non-performing!). More than ½ of the nation’s loans written off.

4. Additional Problem: External Shock in the form of an increase in US interest rates (i.e. reversal of inflows)

Source: Banco de Mexico; Federal Reserve Bank (Atlanta); IMF (Latham Reviews – 2003)

1. Capital inflow dried up and Mexico’s wealthy moved their money out.

2. Then, government borrowed dollars via short-term dollar denominated debt (i.e. TesoBonos = US Treasury Notes)

3. Devaluate the peso by another 15% by Dec. 20, 1994. Peso devaluated 50% by Jan. 1995.

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Current Account and Inflows Structure

1. Current Account financed by large inflows of foreign capital

2. Fiscal, Monetary, Investment and Trade policies, together with high IR in Mexico and low IR in the US caused inflows.

3. Capital inflow from 1990 through 1994 totaled $95 billion

• FDI: Higher in 1994 even as total capital flow slowed (NAFTA) - $24 billion.

• Stock market inflow: $28 billion

• Cetes @ 13.27% US Treasury @ 3.27% (but depreciation no more than 2.3% -11% Return!)

Source: Banco de Mexico; Federal Reserve Bank (Atlanta); IMF (Latham Reviews – 2003)

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Mexico’s Debt Structure (Fiscal Accounts – No Leverage of FX Markets – Debt a little leveraged via hedging of Pemex oil reserves, no more than 3%)

1. Tesobonos replaced Cetes (i.e. pesos denominated bonds).

2. Short-term debt: private and public.

3. By Dec. 1994 Tesobonos amounted to almost 50% of outstanding Gov. Sec.

4. Tesobonos: denominated government. Securities in dollars. (i.e. a big hit among the investment banks on Wall Street).

Source: Banco de Mexico; Federal Reserve Bank (Atlanta); IMF (Latham Reviews – 2003)

Billion (New Pesos)

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Mexican Government Options to Face the Crisis

1. Option 1 (Mid-1994): To deplete international reserves, maintaining the fixed exchange rate while expanding domestic credit to keep monetary policy the same. This will avoid recession and banking crisis. BUT currency crisis could not be avoided as speculators/investors realized int’l reserves were down at $6 billion.

At first Peso devaluated by 15%, but this triggered more speculation, and finally the Peso had to be floated (Dec. 1994)

Following floating (in a very short time) the Peso lost 50% of its value (within 6 months). Consequence: deep recession and massive banking crisis

2. Option 2 (Mid-1994): Replace short term government bonds (Cetes) with short-term government bonds denominated in dollars (Tesobonos), thus effectively taking over exchange rate risk from the domestic banks that had large unheeded dollar liabilities with foreign investors (signaling that they did not intend to devalue).

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Outcome

3. The Government took over short-term dollar liabilities that exceeded its foreign exchange reserves. Investors panicked and decided not to roll over debt that became due in January 1995.

4. Default would have been inevitable had it not been by the combined intervention of the IMF, the US Treasury, the BIS and the Canadian Government. A package of US$50 billion was made available to Mexico ($20 billion (US), $20 billion (IMF), $10 billion (Can. Gov. and BIS). Collateralized with Mexican oil receipts.

5. Economic rationale for rescuing Mexico: It was not a solvency crisis (ratio: debt/GDP was 51%, lower than the one prevailing in some OECD countries), it was a liquidity crisis.

6. Economic growth only recovered in 1996 (export-driven, not consumption driven as before), due to NAFTA.

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Outcome, cont.

Why was the recession so long? Government financial policy transformed what could have been a private sector crisis with partial government intervention in the banking system into a mess across the board, including the treasury, the central bank, the corporate sector, and the banking system.

Since 1995 Mexico has adopted a floating system and

complements it with a target for the rate of inflation set by the independent central bank. There is little intervention, but of course, the exchange rate has to be taken into account when monetary policy decisions are made, given its impact on the rate of inflation.

Various measures to improve the supervision of banks were

also introduced.

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Mexican Economy Since the Crisis (Data generated from Latin Focus)

Interest Rates Exchange Rate. Mexican Peso vs. US Dollar

Balance of Payments (current and capital account) 1. Interest rates near 8%, down from 90%

since crisis.

2. Floating Peso devaluated near 300% since crisis

3. Deficit of $3 billion. (overseas competition for US market). 0.3% of GDP, compared to 6% of GDP US trade deficit. US trade deficit is 20 times higher.

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Mexican Economy Since the Crisis (Data generated from Latin Focus)

Trade Balance (Exports and Imports) International Reserves

Balance of Payments (current and capital account)

External Debt 1. International Reserves up to $60 billion. An increase of 1000% since crisis

2. External debt more than double international reserves BUT still only 20% of GDP

3. Current trade deficit of $8 billion (lack of commercial credit and overseas markets competition)

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Mexican Economy Since the Crisis (Data generated from Latin Focus)

Index, 1995 = 100

Mexican Output per Capita is Slow

1. Mexican industrial production outgrows US, Argentina and Brazil

2. 6.8% growth for Mexico vs. 48% growth for the US

3. International financial markets more comfortable with Mexican debt

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Mexican Economy Since the Crisis

Basis Points Growth rate

1. Spread of rates of rates on long-term Brady bonds over US long rates. Mexican rates are about 400 BP below Venezuela, Argentina, Brazil

2. Exports: principal engine of Mexico’s growth since the crisis. Since NAFTA, Mexican export growth has averaged about 20% per year and Mexican exports to the US accounted for 80% of Mexico’s total export growth.

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Mexican Economy Since the Crisis

1. Although consumption growth has been catching up, overall GDP growth has outstripped that of domestic consumption.

2. The problem here is not just a lag of domestic consumption, though. There are also impediments to growth in some no export sectors of production (it is not enough to produce we also need to be able to consume).

3. Domestic consumption low because hard to get loans at Mexican banks.

4. Large conglomerates (CEMEX, Grupo Carso/Modelo, Televisa) go to global fin. markets but consumers and med. Companies can’t get enough loans.

Real Commercial bank Loans to the Private Sector

Real GDP growth and aggregate consumption

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Mexican Economy Since the Crisis

Unemployment Rate

1. Inflation decreased drastically to 4%. Down from 100% since the crisis.

2. Unemployment at all time low, less than 2%

3. Income distribution (zero=everyone get the same income to one.)

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Mexico 10 Years after the Crisis (2004)

1. Budget deficit has fallen steadily – 0.2% of GDP for 2004

2. Moody’s, Standard & Poor’s, gave Mexico an investment grade credit rating since 2002 and upgraded the country further in 2004.

3. Corporate bond market raised $12B by private investors in 2004.

4. Government is building 700,000 houses each year to 2010 to accommodate its people. A growing domestic MBS market is emerging.

5. Almost all banks are privatized. Consumer lending rose 45% in 2004 while corporate lending increased by 20%.

6. Increased consumer activity has led to a sharp worsening of Mexico’s trade deficit.

7. Pemex (cash cow for the government) but is highly leveraged by $85B

8. Need to diversify exports (80% to the US)

9. Low inflation, new independent central bank and current debt management should insulate the government’s liquidity from shocks during the 2006 election.

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Differences between Mexico and Brazil Crisis

• The crisis was so much worse in Mexico, because most of Brazilian debt was held by domestic residents (banks or corporations). Instead most of the Tesobonos were being held by foreign investors. Foreign investors tend to be more “interest-sensitive”, domestic investors tend to be more “liquidity driven”.

• So even when the depreciation was much larger in Brazil (450% vs. 50%), the effects on the financial system were much milder. Because Brazilian investors were willing to keep holding so more government debt than foreign investors were in the case of Mexico, the illiquidity and insolvency triggered by the run on government debt were not so devastating. Indeed, the Brazilian devaluation of 1999 was expansionary (i.e. expands the supply of money) while the Mexican devaluation of Dec. 20, 1994 was contractionary.