(Tiểu luận) midterm reportthe 1994 mexican peso crisis and its lessons forvietnam

Economic and financial reforms in Mexico since 1988Since 1988, the Mexican government has embarked on comprehensive reformefforts to make the economy more open, efficient, and competitiv

FOREIGN TRADE UNIVERSITY

FACULTY OF BANKING AND FINANCE

-o0o -MIDTERM REPORT THE 1994 MEXICAN PESO CRISIS AND ITS LESSONS FOR

VIETNAM

Class: TCHE414(GD2-HK1-2324).1 Group: 19

Group members: Đỗ Minh Hải - 2113790024

Nguyễn Thế Giang - 2113790022Lương Quỳnh Anh - 2113790003Hoàng Thu Trang - 2113790062Đinh Diệu Anh - 2112790005

Instructor: Assoc Prof., PhD Mai Thu Hien

Hanoi, December 17th, 2023

Content: Logical analysis, direct addressing of

the issue, real-world connections, up-to-date

data, fulfilling 80-100% of the content

requirements (50%)

References: Diverse, engaging, complete

citations, valid (10%)

Format: Proper presentation, clear language

expression, readability, error-free spelling; clear

and appropriately formatted illustrations, tables

(20%)

7-8,4 (B) Meet 70 to under 80% of grade A’s requirements

5,5-6,9 (C) Meet 50 to under 70% of grade A’s requirements

4-5,4 (D) Meet 40 to under 50% of grade A’s requirements

Below 4 (F) Meet under 40% of grade A’s requirements

In the early 1990s, Mexico implemented a highly robust economicrestructuring program, attracting significant inflows of foreign capital to boostthe nation’s economic development However, in 1994, the Peso (Mexico’snational currency) experienced significant depreciation The Mexicangovernment, burdened by a massive trade deficit, witnessed the withdrawal ofinternational capital from Mexico due to the weakened economy and escalatingpolitical risks As a result, it was unable to maintain the exchange rate stabilitybetween the peso and the US dollar With the aim of drawing lessons forVietnam in the modern age, this essay will provide an overview of the crisis,delve into the root causes, and examine the measures that the Mexicangovernment took to resolve the crisis

TABLE OF CONTENTS

1.1 The economy of the world and Mexico before the 1994 crisis 71.1.1 Changes in international investment and the global financial

1.1.2 Mexico’s economic policies before 1988 71.1.3 Economic and financial reforms in Mexico since 1988 91.2 The unfolding of the 1994 crisis in Mexico 13

2.1.2 Reduced savings in the private sector 17

2.1.4 Mexico's relatively young banking system 192.2 Contradictions in Mexico's macroeconomic policies 192.2.1 Pegged exchange rate and the overvaluation of the currency 192.2.2 Monetary policy which encourages economic development 202.2.3 Monetary policy which regulates economic growth 21

3 How the crisis was dealt with and lessons for Vietnam 22

3.2 Lessons for Vietnam 24

3.2.4 Weakness in management and speculation 25

This research paper will walk readers through the primary causes of theMexican crisis, the factors that contributed to the crisis's severity relative toprevious financial upheavals, and more importantly, how the Mexicangovernment dealt with the crisis through the implementation of specificpolicies, therefore, how other nations could prevent other currency crises fromhappening including Vietnam.

Our team also consulted previous research documents and supplemented someloose information Therefore, our team hopes that this paper will providereaders with a better grasp of the crisis's root causes, the actions that have beentaken, and the necessary lessons for developing countries other countries,especially Vietnam

Tiểu-luận-TCQT - Tiểu luận môn Tài chính…International

International

12

Chuỗi cung ứng 7 Eleven - quản trị…

1 Overview of the crisis

1.1 The economy of the world and Mexico before the 1994 crisis

1.1.1 Changes in international investment and the global financial market.

Due to the impact of opening up their economies to foreign investment, manydeveloping countries achieved significant milestones in attracting foreigndirect investment (FDI) during the first half of the 1990s The capital inflowinto these countries amounted to around $40 billion in 1990, reaching a recordhigh of $155 billion in 1993 In emerging economies in the Westernhemisphere, the capital was increasingly concentrated in sensitive profit areaswith high liquidity portfolios From 1990 to 1994, these investments accountedfor 66% of the total capital inflow, in contrast to 30% for foreign directinvestment The strong increase in capital flow to these emerging economiescan be attributed to the following reasons:

- Developing countries undertook restructuring debts from commercial banksand implemented comprehensive macroeconomic policies, notably financialreforms such as removing barriers to capital flow between countries

- National border barriers and banking transaction costs were reduced,making it more affordable and accessible

- Institutional investors, including reserve funds, insurance companies,pension funds, banks, and securities agencies, diversified their foreigninvestment portfolios

- The decrease in investment interest rates in developed countries, such as theUnited States, increased the attractiveness of high-yield investments inemerging economies

1.1.2 Mexico’s economic policies before 1988.

From the mid-1970s to the late 1980s, Mexico was trapped in a cycle ofinflation and currency devaluation, making economic development difficult toachieve Controlling inflation and restoring the economy, with a particularfocus on exchange rate stability, became a top priority for the Mexicangovernment

International

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From 1954 to 1976, Mexico maintained a fixed exchange rate of peso/dollar =12.5 This period coincided with significant economic development,accompanied by moderate inflation However, from the early 1970s, the pesoweakened significantly due to a current account deficit and rising inflation ByDecember 1976, mounting pressure on the balance of payments anduncontrollable capital flight led to the devaluation of the peso By the end ofthe year, the exchange rate had risen to 21 pesos per dollar, with an inflationrate of 60% Mexico plunged into a severe recession.

Under the management of President José Lopez Portillo (1976-82), thedomestic currency continued to depreciate, reaching 27.25 pesos per dollar.During this period, a sudden surge in oil prices left the Mexican governmentunable to implement economic recovery policies, forcing it to borrowextensively from abroad From 1982, global oil prices declined, reducingMexico's external debt Faced with declining foreign exchange reserves andmassive capital outflows, policymakers once again devalued the peso Thistime, the peso was devalued by 500% against the dollar, plunging the countryinto a devastating economic and financial crisis Inflation soared to over 60%,foreign exchange reserves dried up, and by August, Mexico temporarilysuspended principal payments on its foreign debt In September, the bankingsystem was nationalized, the exchange rate began to be adjusted, and by theend of the year, it had decreased to 160 pesos per dollar

Under President Miguel de la Madrid (1982-88), Mexico adapted to a dualexchange rate policy One controlled rate for trade in goods and official debts,and one free-floating rate for other transactions The controlled ratedepreciated daily under the scrutiny of the Mexican government Gradually,the controlled rate approached the free-floating rate By the end of 1986, thesetwo rates were nearly equivalent, around 920 pesos per dollar

During President de la Madrid's tenure, prioritizing payments on massive debtsbecame a major focus Mexico became a net capital exporter The economygradually lost its primary sources of financing, and economic developmentcame to a halt under the burden of depreciating domestic currency, bothinternal and external debts, as well as inflationary pressures on the economy Inmid-1987, Mexico faced another inflation crisis with sharply rising prices InNovember, Mexican banks stopped intervening in the foreign exchangemarket, and cash devalued significantly at 3000 pesos per dollar Once again,the stock market halted, and the inflation rate rose to 159%

1.1.3 Economic and financial reforms in Mexico since 1988

Since 1988, the Mexican government has embarked on comprehensive reformefforts to make the economy more open, efficient, and competitive

The Mexican Pacto

In the late 1980s, Mexico faced escalating inflation and the threat ofhyperinflation due to unsuccessful policies implemented during the 1983-87period to address a debt crisis Inflation was driven by credit expansion, fiscaldeficits, and adjustments in official prices, exacerbating the economicchallenges In response, authorities initiated a new stabilization strategy inNovember 1987, introducing a program called the “Pacto” in December 1987,which initially focused on freezing prices and wages, with wages serving as thenominal anchor and did not entail any exchange rate commitment However,from March to December 1988, the authorities explicitly adopted a fixedexchange rate (MXN/USD) This was modified in 1989 to a tablita-type policy

to avoid a possible overvaluation of the currency as progress continued inbringing inflation under control This flexible system led to an annualdepreciation of the peso by 16.7% in 1989, 11.4% in 1990, and 4.5% in 1991.Starting from November 1991, the peso/dollar exchange rate was allowed tofluctuate within a daily expanding limit The switch to the new regime waslargely motivated by the occasional pressures for the currency to appreciate,induced by strong foreign capital inflows This limit permitted the depreciationrate of the peso against the dollar to range from 0.0002 to 3.05 pesos per dollar.The depreciation rate for 1992 was 2.9% In October 1992, the upper limit ofthis rate was set at 0.0004 peso/dollar, resulting in a depreciation rate of 4.5%

in 1993 Therefore, from late 1991 to August 1994, the exchange rate of thepeso against the dollar depreciated within the range of 3.08 to 3.24 pesos perdollar

Mexico: Exchange Rate Regimes, 1985–94

The appreciation of the Peso

Before the initial Mexican Pacto, the yearly consumer price inflation wasincreasing and surpassed 140 percent in October 1987 After reaching a peak

of nearly 180 percent per annum in February 1988, which was influenced bythe devaluation in November 1987 and subsequent official price adjustments,the inflation rate decreased relatively rapidly over the following 18 months.However, by the conclusion of 1989, the inflation rate appeared to bepersistently hovering around 20 percent A new trend towards lower inflationcommenced by the end of 1990, representing a disinflationary period thatproved to be more extended but less severe than the one observed in 1988 Bythe end of 1993, the Mexican economy began to achieve single-digit annualinflation rates (8%), marking the first time in two decades

Mexico: Inflation Rate, 1985–94

However, while this index decreased in Mexico, it increased relatively in theUnited States Consequently, the peso/dollar exchange rate gradually rose,even though the peso had been devalued in the preceding period This has led

to different perspectives Some economic analysts argue that, until 1994, thepeso was overvalued and needed to be devalued for Mexico to achieveeconomic development On the other hand, key financial figures in Mexicocontend that the peso was not overvalued, pointing to the strong growth inMexico's exports as evidence

Activities to open up foreign investment in Mexico

Mexico not only liberalized international trade regulations but also relaxedforeign investment rules to increase inflows to $5 billion annually in the early1990s Efforts to attract foreign direct investment intensified through a moreflexible interpretation of the 1973 Foreign Investment Law (LFI) andregulatory revisions in 1989 Since 1983, approval and licensing proceduresfor foreign investment have been streamlined, emphasizing non-oil exports andtechnology transfer As a result, over 150 projects with 100 percentforeign-owned capital were approved from 1983 to 1985 In May 1989,significant regulatory changes aimed at boosting investment capital inflowwere enacted, simplifying authorization procedures, relaxing ownershiplimitations, and extending permit durations These changes allowed foreigninvestors to own 100 percent of enterprises valued up to $100 million without

the need for National Foreign Investment Commission approval Theregulations also facilitated entry into the Mexican stock market, as foreignersmay hold certificates of participation in neutral investment trusts, whichprovide holders with pecuniary rights As a result of the adoption of theseregulations, nearly 73 percent of the economy was open to 100 percent offoreign ownership without prior government approval.

The reforms in Mexico that attract investment

Financial reforms attracted significant capital inflows into Mexico in the early1990s, especially $93 billion from 1990 to 1993 (according to the IMF).However, 60% of foreign capital entering Mexico took the form of indirectinvestment (mainly focusing on the financial sector), with only 18% in theform of direct investment The Mexican stock market law in December 1989paved the way for massive foreign investment to access the domestic capitalmarket, quickly accounting for 6% of the total capital From 1990 to 1993, thecapital market attracted $23 billion in foreign investment At the end of thisperiod, 27% of the capital in the stock market came from foreign investors Asinterest rates increased, corporate bonds also became attractive, attracting $14billion during the same period

Relaxing the trade laws

Over the past decade, Mexico has gradually transformed and reformed itsinternational and regional trade management system This restructuring tookplace between 1985 and 1986 when trade laws were amended to pave the wayfor entry into the General Agreement on Tariffs and Trade (GATT) InDecember 1987, tax laws were enacted, reducing the highest rates of all taxes

to 20% As a result, the protection of over 90% of domestic products by thepre-reform import licensing system quickly decreased to only 20%

The signing of numerous trade agreements

Over the past decade, Mexico has made significant strides in expandinginternational trade Before 1982, competition with foreign businesses wasvirtually nonexistent due to tariff and non-tariff barriers However, sinceofficially joining the General Agreement on Tariffs and Trade (GATT) in 1986,Mexico has gradually removed protections for domestic goods Importsubstitution policies and reliance on oil exports for foreign exchange earningswere replaced with policies aimed at attracting foreign investment, lowering

trade barriers, and generally making the country more competitive in non-oilexports Simultaneously, they had signed bilateral and multilateral agreements

to develop trade relations with other countries within the same organization.Starting in 1992, Mexico signed free trade agreements with Latin Americancountries, including Chile, Costa Rica, El Salvador, Guatemala, Honduras, andNicaragua Mexico has also strengthened its trade relations with economicregions outside Latin America, such as joining the Asia-Pacific EconomicCooperation (APEC) forum in November 1993 and becoming the 25th member

of the Organisation for Economic Co-operation and Development (OECD) inApril 1994 In January 1994, Mexico took a significant step by establishing theNorth American Free Trade Agreement (NAFTA) with the United States andCanada, creating the largest free trade area with 380 million people, producingabout $800 billion worth of goods and services This allowed U.S financialservice providers to access the Mexican market with benefits similar todomestic investors According to the International Trade Commission (ITC),NAFTA experienced robust trade growth and increased investment in its firstyear Mexican banks emphasized exceptional growth in all trade transactionsbetween Mexico and NAFTA member countries Half of the U.S exportvolume went to Mexico This event opened a new phase for Mexico toeliminate trade barriers on goods, services, and foreign direct investment

1.2 The unfolding of the 1994 crisis in Mexico

On January 1, 1994, the armed forces of the Zapatistas uprising By the end ofFebruary, the exchange rate between the peso and the dollar soared to the limit

of fluctuation However, foreign investors remained optimistic about thesituation in Mexico, and foreign capital continued to pour in

On March 23, 1994, Mexican presidential candidate Luis Donaldo Colosio wasassassinated This event created political tension in Mexico Consequently,both domestic and foreign investors reduced their demand for Mexican stocks

By March 24, U.S authorities had approved the provision of a temporaryshort-term credit facility amounting to $6 billion Mexico's foreign currencyreserves experienced a decrease of $7.1 billion, dropping from $24.4 billion atthe close of March to $17.3 billion by the close of April

Mexican leaders believed that the drop in investor confidence was mostly due

to the shock of the assassination To mitigate the outflow of foreign exchangereserves, they decided to prompt a series of actions Firstly, the Mexican peso

was allowed to depreciate by just under 1 percent against the U.S dollar,adhering to the prescribed limit within the exchange rate band This adjustmentfollowed a preceding 7-percent depreciation in the month leading up to theassassination Secondly, in April 1994, as part of establishing the NorthAmerican Financial Group, a consultative body consisting of finance ministriesand central banks of the United States, Canada, and Mexico, these threepartners entered into a trilateral agreement The agreement aimed to establish ashort-term credit facility, with the United States contributing $6 billion andCanada offering one billion Canadian dollars Simultaneously, the Bank ofMexico implemented a strategy to counteract the capital outflow by elevatingdomestic interest rates Specifically, rates on short-term, peso-denominatedMexican government notes known as "cetes" were raised from 9 percent to 18percent.

However, despite higher interest rates, investor demand for cetes continued to

be stagnant Investors were demanding higher interest rates on newly issuedcetes because of their perception that the peso would eventually be subject to arelatively large devaluation Options available to the Mexican government atthis time included: (1) offering even higher interest rates on cetes; (2) reducinggovernment expenditures to reduce domestic demand, decrease imports, andrelieve pressure on the peso; or (3) devaluing the peso From the perspective ofMexican authorities, all these three options were unattractive to them Theywere afraid that these options would lead to either a downturn in economicactivity or a disruption to the policy that aims to maintain a stable exchangerate As a result, in the spring of 1994, the government chose to increase its

issuance of tesobonos Because tesobonos were dollar-indexed, holders could

avoid losses that would otherwise result if Mexico subsequently chose todevalue its currency The Mexican government promised to repay investors anamount, in pesos, sufficient to protect the dollar value of their investment.Tesobono financing effectively transferred foreign exchange risk from

investors to the Mexican government Tesobonos proved attractive to domestic and foreign investors However, as sales of tesobonos rose, Mexico became

vulnerable to a financial market crisis because many tesobono purchasers wereportfolio investors, who were very sensitive to changes in interest rates and

risks Moreover, tesobonos had brief maturity periods, implying that their

holders might opt against renewing them if they perceived an elevated risk of apotential default by the Mexican government or anticipated higher returns inalternative investments However, Mexican authorities considered tesobono

financing as the most effective means to stabilize short-term foreign exchangereserves and circumvent the immediate expenses associated with alternativeoptions Indeed, Mexico's foreign exchange reserves stabilized atapproximately $17 billion between the end of April and August, coincidingwith the conclusion of the presidential elections Authorities anticipated thatinvestor confidence would be reinstated after the August presidential election,leading to a resurgence of investment flows substantial enough to obviate thenecessity for ongoing, extensive tesobono financing.

Contrary to expectations, foreign investment flows did not reboundsignificantly after the election, partly because peso interest rates declined inAugust and remained at that level until December By the fall of 1994, itbecame increasingly evident to some Mexican government officials thatadjustments were needed in Mexico's combination of monetary, fiscal, andexchange rate policies The current account deficit had worsened during theyear, partly due to economic strengthening linked to a moderate easing offiscal policy, including increased development lending Imports had surged asthe peso became increasingly overvalued Mexico faced a heightened risk of arun on its foreign exchange reserves due to substantial tesobono financing.Outstanding tesobono obligations surged from $3.1 billion at the end of March

to $29.2 billion in December Additionally, between January 1994 andNovember 1994, U.S 3-month Treasury bill yields had risen from 3.04 percent

to 5.45 percent, substantially enhancing the appeal of U.S governmentsecurities

In mid-November 1994, Mexican authorities had to dip into foreign currencyreserves to meet the demand for dollars On November 15, in response to U.S.economic conditions, the U.S Federal Reserve increased the federal funds rate

by three-quarters of a percentage point, elevating the overall level of U.S.interest rates and further heightening the allure of U.S bonds to investors.Subsequently, in late November and early December, renewed conflict in theMexican state of Chiapas and a developing scandal surrounding the September

1994 assassination of Institutional Revolutionary Party Secretary GeneralFrancisco Ruiz Massieu revived investor concerns regarding Mexico's politicalstability These worries intensified on December 9, when the new Mexicanadministration revealed an anticipated higher current account deficit in 1995but signaled no change in its exchange rate policy This decision resulted in afurther erosion of investor confidence, increased redemptions of Mexican