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

Economic Policy in Latin AmericaEconomic Policy in Latin AmericaApril-June, 2008April-June, 2008

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

Alejandro Díaz-Bautista, Alejandro Díaz-Bautista, Ph.D.Ph.D.

[email protected]@hotmail.com

Professor of Economics and Researcher at COLEFVisiting Research Fellow and Guest Scholar 2008, Center for U.S.-Mexican Studies, University of California San Diego (UCSD). April 2, 2008Graduate School of International Relations & Pacific Studies IR/PS University of California, San Diego.

Mexico's Crisis: Looking Back to Mexico's Crisis: Looking Back to Assess the Future Assess the Future

David M. GouldDavid M. Gould In this study by the Fed, David M. Gould In this study by the Fed, David M. Gould

argues that to assess Mexico's future, one argues that to assess Mexico's future, one must look at Mexico's past. must look at Mexico's past.

Although Mexico needed several years to Although Mexico needed several years to regain the investor confidence it lost regain the investor confidence it lost during the 1994 economic crisis, the trend during the 1994 economic crisis, the trend in Mexico's policies is more consistent with in Mexico's policies is more consistent with future low inflation and higher growth than future low inflation and higher growth than with the country's previous closed-market with the country's previous closed-market policies.policies.


David M. GouldDavid M. Gould

Mexico embarked on a new economic policy Mexico embarked on a new economic policy direction in the second half of the 1980s.direction in the second half of the 1980s.

In December 1987, President De la Madrid and In December 1987, President De la Madrid and representatives of the labor, farming, and representatives of the labor, farming, and business sectors signed the Pact for Economic business sectors signed the Pact for Economic Solidarity, which was followed by the Pact for Solidarity, which was followed by the Pact for Stability and Economic Growth under the newly Stability and Economic Growth under the newly elected administration of President Salinas de elected administration of President Salinas de Gortari. These two measures, now jointly referred Gortari. These two measures, now jointly referred to as the Pacto, were designed to combine to as the Pacto, were designed to combine orthodox fiscal and monetary restraint with orthodox fiscal and monetary restraint with structural reforms and an incomes policy structural reforms and an incomes policy (controls on wages and prices).(controls on wages and prices).

Salinas graduated with a degree in economics Salinas graduated with a degree in economics from UNAM. He obtained a master's degree in from UNAM. He obtained a master's degree in Public Administration in 1973, a master's in Public Administration in 1973, a master's in Political Economics in 1976 and a PhD in Political Political Economics in 1976 and a PhD in Political Economics and Government, all from Harvard Economics and Government, all from Harvard University. Upon his return to Mexico he became University. Upon his return to Mexico he became a professor at his alma mater. Although a a professor at his alma mater. Although a member of the PRI since his student days, it was member of the PRI since his student days, it was not until the presidency of Miguel de la Madrid not until the presidency of Miguel de la Madrid that he was assigned a government post as that he was assigned a government post as minister of the Bureau of Planning and Budget minister of the Bureau of Planning and Budget (Secretaría de Planeación y Presupuesto), where (Secretaría de Planeación y Presupuesto), where he served from 1982-1987.he served from 1982-1987.

President Salinas was in office from 1988 to Nov. 30, 1994. President Salinas was in office from 1988 to Nov. 30, 1994. During Carlos Salinas de Gortari's term, significant economic During Carlos Salinas de Gortari's term, significant economic

policy changes were implemented:policy changes were implemented:Renegotiated the external debt, through the Brady Plan. Renegotiated the external debt, through the Brady Plan. Negotiated the North American Free Trade Agreement Negotiated the North American Free Trade Agreement

(NAFTA), with the United States and Canada. (NAFTA), with the United States and Canada. He continued a privatization program initiated by his He continued a privatization program initiated by his

predecessor, by which the government retained only a few predecessor, by which the government retained only a few of the hundreds of companies and small business that were of the hundreds of companies and small business that were nationalized. One of the most important privatizations was nationalized. One of the most important privatizations was Telmex, which remained a monopoly until mid-1990s, and Telmex, which remained a monopoly until mid-1990s, and who was sold to Carlos Slim Helú. who was sold to Carlos Slim Helú.

The number of state-owned industries continued to drop, from The number of state-owned industries continued to drop, from approx. 600 in 1988 to a minimal 250 in 1994. approx. 600 in 1988 to a minimal 250 in 1994.


David M. Gould David M. Gould

In early December 1994, the Organization for In early December 1994, the Organization for Economic Cooperation and Development (OECD) Economic Cooperation and Development (OECD) and many private economists were predicting and many private economists were predicting that Mexico’s real gross domestic product (GDP) that Mexico’s real gross domestic product (GDP) would grow by at least 3.8 percent in 1995.would grow by at least 3.8 percent in 1995.

Mexico appeared to be on the fast track to Mexico appeared to be on the fast track to economic growth and stability. For the first time economic growth and stability. For the first time in many years, its annual inflation rate was down in many years, its annual inflation rate was down to less than 10 percent, the public-sector budget to less than 10 percent, the public-sector budget was nearly balanced, and exports were growing was nearly balanced, and exports were growing at an annual rate in excess of 22 percent. at an annual rate in excess of 22 percent.



In October 1994, Mexico authorized In October 1994, Mexico authorized virtually all the foreign banks, brokerages, virtually all the foreign banks, brokerages, and insurance companies that sought and insurance companies that sought entry into the market. Foreigners would be entry into the market. Foreigners would be able to hold majority interests in all but able to hold majority interests in all but the three largest banks. the three largest banks.

In 1991, Mexico’s three largest banks—In 1991, Mexico’s three largest banks—Banamex, Bancomer, and Serfin—Banamex, Bancomer, and Serfin—accounted for about 62 % of total Mexican accounted for about 62 % of total Mexican banking assets; in late 1994, they banking assets; in late 1994, they accounted for less than 50 %.accounted for less than 50 %.


David M. Gould David M. Gould Low inflation was made credible only Low inflation was made credible only

through sustainable fiscal balances and through sustainable fiscal balances and low and stable monetary growth. low and stable monetary growth.

From 1987 to the end of 1993, Mexico’s From 1987 to the end of 1993, Mexico’s monetary policy was consistent with low monetary policy was consistent with low inflation and maintaining its exchange rate inflation and maintaining its exchange rate targets. Inflation fell from a high of nearly targets. Inflation fell from a high of nearly 160 percent in 1987 to around 7 percent 160 percent in 1987 to around 7 percent at the beginning of 1994. at the beginning of 1994.

Flow of Capital to MexicoFlow of Capital to Mexico

Flows of capital to Mexico grew Flows of capital to Mexico grew during the early 1990s, due to during the early 1990s, due to legislation that allowed foreigners to legislation that allowed foreigners to buy government bonds and (non-buy government bonds and (non-voting) shares in Mexican companies voting) shares in Mexican companies and increased confidence due to the and increased confidence due to the proposed and expected signing of proposed and expected signing of NAFTA. NAFTA.

Private Capital flow to Mexico Private Capital flow to Mexico (in billion USD)(in billion USD)

0

5

10

15

20

25

1987 1989 1991 1993 1995



On the trade side, Mexico started to On the trade side, Mexico started to gradually liberalize in mid-1985, but the gradually liberalize in mid-1985, but the process was solidified in 1988 when the process was solidified in 1988 when the number of goods covered by import number of goods covered by import licenses fell dramatically and the tariff licenses fell dramatically and the tariff structure was simplified. structure was simplified.

In 1983, the share of imports covered by In 1983, the share of imports covered by import permits was close to 100 percent; import permits was close to 100 percent; by 1992, the share had fallen to less than by 1992, the share had fallen to less than 2 percent (Source: Banco de México). 2 percent (Source: Banco de México).


David M. Gould David M. Gould During the initial stages of the Pacto, the ex-During the initial stages of the Pacto, the ex-

change rate was fixed to the dollar; then it was change rate was fixed to the dollar; then it was held to a preannounced daily depreciation. In held to a preannounced daily depreciation. In 1991, the exchange rate was allowed to float 1991, the exchange rate was allowed to float within a widening band. At first, the top of the within a widening band. At first, the top of the band rose 20 centavos (0.0002 new pesos) per band rose 20 centavos (0.0002 new pesos) per dollar a day; then it was increased to 40 centavos dollar a day; then it was increased to 40 centavos (0.0004 new pesos) per dollar a day. (0.0004 new pesos) per dollar a day.

On December 20, 1994, however, under pressure On December 20, 1994, however, under pressure from foreign exchange markets and dwindling from foreign exchange markets and dwindling foreign exchange reserves, Mexico abandoned its foreign exchange reserves, Mexico abandoned its exchange rate band. exchange rate band.

The peso was devalued and then allowed to float The peso was devalued and then allowed to float freely against the dollar.freely against the dollar.

The election of President Ernesto Zedillo in August The election of President Ernesto Zedillo in August 1994 brought new confidence in Mexico’s Economic 1994 brought new confidence in Mexico’s Economic policies and temporarily boosted foreign reserves and policies and temporarily boosted foreign reserves and the peso. Following the elections, because of higher the peso. Following the elections, because of higher U.S. interest rates and increased investor uncertainty, U.S. interest rates and increased investor uncertainty, money began flowing out of Mexico again. money began flowing out of Mexico again.

Without dramatically higher interest rates, foreign Without dramatically higher interest rates, foreign reserves continued to leave the country. Eventually, reserves continued to leave the country. Eventually, foreign reserves fell to such a point that the exchange foreign reserves fell to such a point that the exchange rate band had to be loosened and then completely rate band had to be loosened and then completely abandoned after continued pressure on the peso. abandoned after continued pressure on the peso.

If interest rates had been kept higher after the 1994 If interest rates had been kept higher after the 1994 presidential elections, perhaps the costs of presidential elections, perhaps the costs of abandoning the exchange rate, in terms of lost abandoning the exchange rate, in terms of lost credibility and higher short-run inflation, could have credibility and higher short-run inflation, could have been avoided. In retrospect, this may have been a been avoided. In retrospect, this may have been a better option than the one chosen.better option than the one chosen.

The December MistakeThe December Mistake At the beginning of his administration, President Zedillo At the beginning of his administration, President Zedillo

suddenly announced his government would let the fixed suddenly announced his government would let the fixed rate band to increase 15 percent (up to 4 pesos per US rate band to increase 15 percent (up to 4 pesos per US dollar), by stopping the unorthodox measures employed by dollar), by stopping the unorthodox measures employed by the previous administration to keep it at the previous fixed the previous administration to keep it at the previous fixed level (by selling dollars and assuming debt). level (by selling dollars and assuming debt).

This measure, however, was not enough, and the This measure, however, was not enough, and the government was even unable to hold this line, and decided government was even unable to hold this line, and decided to let it float. While experts agree that devaluation was to let it float. While experts agree that devaluation was necessary, some critics of Zedillo's incumbent 22-day old necessary, some critics of Zedillo's incumbent 22-day old administration, argue that although economically coherent, administration, argue that although economically coherent, the way it was handled was a political and economic the way it was handled was a political and economic mistake. mistake.

By announcing its plans for devaluation, they argue that By announcing its plans for devaluation, they argue that many foreigners withdrew their investments, thus many foreigners withdrew their investments, thus aggravating the effects. aggravating the effects.

Mexico’s Rescue PlanMexico’s Rescue Plan In January 1995, the USA orchestrated a $50bn In January 1995, the USA orchestrated a $50bn

international loan which, in conjunction with a international loan which, in conjunction with a stringent adjustment program and rapid export stringent adjustment program and rapid export growth in 1996 (a rise of 20% from 1995), restored growth in 1996 (a rise of 20% from 1995), restored confidence and growth by 1996. confidence and growth by 1996.

The rescue plan raised fears of moral hazard, but The rescue plan raised fears of moral hazard, but was justified by Mexico’s good economic track was justified by Mexico’s good economic track record and desire to avoid risk of systematic record and desire to avoid risk of systematic repercussions.repercussions.

However, Mexico’s 1994 crisis started to raise However, Mexico’s 1994 crisis started to raise doubts, about poor economic fundamentals in doubts, about poor economic fundamentals in other countries as well as the viability of economic other countries as well as the viability of economic policies.policies.

The Tequila EffectThe Tequila Effect Some emerging markets were hit by financial crises in the Some emerging markets were hit by financial crises in the

wake of the Peso devaluation of 1994, while others were not. wake of the Peso devaluation of 1994, while others were not.

The Tequila Effect was transmitted by a rational The Tequila Effect was transmitted by a rational demonstration effect based on shared macroeconomic demonstration effect based on shared macroeconomic fundamentals. Although the demonstration effect was largely fundamentals. Although the demonstration effect was largely rational in its discrimination between "weak" and "strong" rational in its discrimination between "weak" and "strong" economies, it did, however, contain an element of economies, it did, however, contain an element of irrationality.irrationality.

Nervous investors often withdrew their funds from Latin Nervous investors often withdrew their funds from Latin American economies, based on the expectation that other American economies, based on the expectation that other investors would do likewise. investors would do likewise.

Therefore, the possibility of panic, which has existed before Therefore, the possibility of panic, which has existed before December 1994, became the fact of a panic after December December 1994, became the fact of a panic after December 1994.1994.

The Tequila EffectThe Tequila Effect Between December 1994 and March 1995, Between December 1994 and March 1995,

Argentina suffered badly from the Tequila Argentina suffered badly from the Tequila Crisis Effect. Bank liquidity tightened, Crisis Effect. Bank liquidity tightened, interest rates surged and 15% of deposits interest rates surged and 15% of deposits were withdrawn from the banking system. were withdrawn from the banking system.

International reserves decreased International reserves decreased substantially, while the stock market fell substantially, while the stock market fell by 35%. The authorities reacted by by 35%. The authorities reacted by obtaining international aid and obtaining international aid and establishing lender of last resort facilities, establishing lender of last resort facilities, which eventually led to a restoration of which eventually led to a restoration of confidence and an economic recovery.confidence and an economic recovery.

Balance of Payments CrisisBalance of Payments Crisis Krugman and Obstfeld present a theoretical model in which Krugman and Obstfeld present a theoretical model in which

they state that the balance of payments crisis occurs when they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal price differences between countries) is equal to the nominal exchange rate. exchange rate.

In an open market, the perception that a devaluation is In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs. reserves, a balance of payments crisis occurs.

In practice, the onset of crisis has typically occurred after the In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. real exchange rate has depreciated below the nominal rate.

Speculators sometimes find out that a country is low on Speculators sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very In these circumstances, the currency value will fall very rapidly. This is what occurred during the 1994 economic crisis rapidly. This is what occurred during the 1994 economic crisis in Mexico.in Mexico.

Could the Mexico 1994 Crisis be Could the Mexico 1994 Crisis be prevented?prevented?

An important academic discussion began in and An important academic discussion began in and about Mexico as early as 1993, regarding the about Mexico as early as 1993, regarding the sustainability of the fixed exchange rate. sustainability of the fixed exchange rate. Dornbusch and Werner (1994) estimated 20% Dornbusch and Werner (1994) estimated 20% overvaluation, and issued a controversial call for overvaluation, and issued a controversial call for a “one-time” devaluation. a “one-time” devaluation.

An insistent Finance Ministry led by Dr. Pedro An insistent Finance Ministry led by Dr. Pedro Aspe argued that real exchange rate appreciation Aspe argued that real exchange rate appreciation was consistent with underlying fundamentals was consistent with underlying fundamentals (such as improvements in productivity resulting (such as improvements in productivity resulting from Salinas’s microeconomic reforms), and from Salinas’s microeconomic reforms), and worried privately that a devaluation would worried privately that a devaluation would destroy the hard-won credibility (Aspe, 1993) . destroy the hard-won credibility (Aspe, 1993) .

Dornbusch’s ModelDornbusch’s Model

One of the most influential papers written in the One of the most influential papers written in the field of International Economics since World War II field of International Economics since World War II is Rudiger Dornbusch's, "Expectations and is Rudiger Dornbusch's, "Expectations and Exchange Rate Dynamics“ which was published Exchange Rate Dynamics“ which was published more than 30 years ago in the Journal of Political more than 30 years ago in the Journal of Political Economy, in 1976. Economy, in 1976.

Rogoff has mentioned that the overshooting Rogoff has mentioned that the overshooting paper, marks the birth of modern international paper, marks the birth of modern international macroeconomics. There is little question that macroeconomics. There is little question that Dornbusch's rational expectations reformulation Dornbusch's rational expectations reformulation of the Mundell-Fleming model extended the of the Mundell-Fleming model extended the latter's life for another 25 years, keeping it in the latter's life for another 25 years, keeping it in the forefront of practical policy analysis, and so forefront of practical policy analysis, and so widely used by latin american economists.widely used by latin american economists.

Rudi DornbuschRudi Dornbusch

Rudiger "Rudi" Dornbusch studied at University of Geneva Rudiger "Rudi" Dornbusch studied at University of Geneva and the University of Chicago. In 1975 he moved to MIT, and the University of Chicago. In 1975 he moved to MIT, where he was appointed as Associate Professor in the where he was appointed as Associate Professor in the Department of Economics. Department of Economics.

Throughout his career his main focus was on international Throughout his career his main focus was on international economics, especially monetary policy, macroeconomic economics, especially monetary policy, macroeconomic development, growth and international trade. Expert in development, growth and international trade. Expert in Latin American Economies.Latin American Economies.

He developed models of fluctuations in prices and He developed models of fluctuations in prices and exchange rates (most notably with his Overshooting Model). exchange rates (most notably with his Overshooting Model). He worked also for the IMF, making important contributions He worked also for the IMF, making important contributions to the development of stabilisation policies, especially for to the development of stabilisation policies, especially for Latin American countries. Latin American countries.

Dornbusch’s ModelDornbusch’s Model Two relationships lie at the heart of Dornbusch’s overshooting Two relationships lie at the heart of Dornbusch’s overshooting

Model. The first, equation Model. The first, equation (1) (1)

is the "uncovered interest parity" condition. It says that the home is the "uncovered interest parity" condition. It says that the home interest rate on bonds, i, must equal the foreign interest rate i*, interest rate on bonds, i, must equal the foreign interest rate i*, plus the expected rate of depreciation of the exchange rate, Et plus the expected rate of depreciation of the exchange rate, Et (et+1 - et), where e is the logarithm of the exchange rate (home (et+1 - et), where e is the logarithm of the exchange rate (home currency price of foreign currency), and Et denotes market currency price of foreign currency), and Et denotes market expectations based on time t information. expectations based on time t information.

That is, if home and foreign bonds are perfect substitutes, and That is, if home and foreign bonds are perfect substitutes, and international capital is fully mobile, the two bonds can only pay international capital is fully mobile, the two bonds can only pay different interest rates if agents expect there will be compensating different interest rates if agents expect there will be compensating movement in the exchange rate. movement in the exchange rate.

The economic model assumes that the home country is small in The economic model assumes that the home country is small in world capital markets, so that we may take the foreign interest world capital markets, so that we may take the foreign interest rate i* as exogenous.rate i* as exogenous.

Dornbusch’s ModelDornbusch’s Model

mt – pt = - n(it+1) + v (yt) (2) mt – pt = - n(it+1) + v (yt) (2) where m is the money supply, p is the domestic where m is the money supply, p is the domestic

price level, I interest rate on bonds, and y is price level, I interest rate on bonds, and y is domestic output, all in logarithms; n and v are domestic output, all in logarithms; n and v are positive parameters. positive parameters.

Higher interest rates raise the opportunity cost of Higher interest rates raise the opportunity cost of holding money, and thereby lower the demand holding money, and thereby lower the demand for money. for money.

An increase in output raises the transactions An increase in output raises the transactions demand for money. demand for money.

Finally, the demand for money is proportional to Finally, the demand for money is proportional to the price level. Equation (2) is a simple variant of the price level. Equation (2) is a simple variant of the Goldfeld (1972) money demand function. the Goldfeld (1972) money demand function.

Dornbusch’s ModelDornbusch’s Model So how does "overshooting" work? So how does "overshooting" work? We combine equations (1) and (2) with a few We combine equations (1) and (2) with a few

simple assumptions. simple assumptions. Assume that the domestic price level p does not Assume that the domestic price level p does not

move instantaneously in response to move instantaneously in response to unanticipated monetary disturbances, but adjusts unanticipated monetary disturbances, but adjusts only slowly over time. only slowly over time.

Also assume that output y is exogenous (what Also assume that output y is exogenous (what really matters is that it, too, moves sluggishly in really matters is that it, too, moves sluggishly in response to monetary shocks). response to monetary shocks).

Assume also that money is neutral in the long Assume also that money is neutral in the long run, so that a permanent rise in m leads a run, so that a permanent rise in m leads a proportionate rise in e and p, in the long run.proportionate rise in e and p, in the long run.

Dornbusch’s ModelDornbusch’s Model Now suppose, that there is an unanticipated Now suppose, that there is an unanticipated

permanent increase in the money supply m. permanent increase in the money supply m. If the nominal money supply rises but the price If the nominal money supply rises but the price

level is temporarily fixed, then the supply of real level is temporarily fixed, then the supply of real balances m-p must rise as well. To equilibrate the balances m-p must rise as well. To equilibrate the system, the demand for real balances must rise. system, the demand for real balances must rise. Since output y is assumed fixed in the short run, Since output y is assumed fixed in the short run, the only way that the demand for real balances the only way that the demand for real balances can go up is if the interest rate i on domestic can go up is if the interest rate i on domestic currency bonds falls. According to equation (1), it currency bonds falls. According to equation (1), it is possible for i to fall if and only if, over the is possible for i to fall if and only if, over the future life of the bond contract, the home future life of the bond contract, the home currency is expected to appreciate. currency is expected to appreciate.

Dornbusch’s ModelDornbusch’s Model But how can the home currency appreciate, if we But how can the home currency appreciate, if we

know that the long run impact of the money know that the long run impact of the money supply shock must be a proportionate supply shock must be a proportionate depreciation in the exchange rate? depreciation in the exchange rate?

Dornbusch's model answers the question, by Dornbusch's model answers the question, by making the initial depreciation of the exchange making the initial depreciation of the exchange rate larger than the long-run depreciation. This rate larger than the long-run depreciation. This initial excess depreciation leaves room for the initial excess depreciation leaves room for the ensuing appreciation needed to simultaneously ensuing appreciation needed to simultaneously clear the bond and money markets. The clear the bond and money markets. The exchange rate must overshoot. exchange rate must overshoot.

The result is driven by the assumed rigidity of The result is driven by the assumed rigidity of domestic prices p. Otherwise, e, p, and m would domestic prices p. Otherwise, e, p, and m would all move proportionately on impact, and there all move proportionately on impact, and there would be no overshooting. would be no overshooting.

Dornbusch Overshooting ModelDornbusch Overshooting Model

Overshooting in MexicoOvershooting in Mexico During 1995, under a floating exchange rate, During 1995, under a floating exchange rate,

there was a spread of nearly 49 percentage there was a spread of nearly 49 percentage points in consumer prices between Mexico (with points in consumer prices between Mexico (with an inflation rate of 51.9 %) and the United States an inflation rate of 51.9 %) and the United States (with an inflation rate of 3 %). (with an inflation rate of 3 %).

The classic applied case of exchange rate The classic applied case of exchange rate overshooting occurred in the wake of a brutal overshooting occurred in the wake of a brutal collapse of confidence in the peso and a massive collapse of confidence in the peso and a massive suspension of private capital flows at the end of suspension of private capital flows at the end of 1994. The result: a peso depreciation of over 100 1994. The result: a peso depreciation of over 100 percent, from 3.5 pesos to 7.3 pesos to the dollar. percent, from 3.5 pesos to 7.3 pesos to the dollar.

0 20,000 40,000 60,000 80,000

100,000 120,000 140,000 160,000 180,000

Dec- 93 Feb-94 Apr-94 Jun-94 Aug-

94 Oct-94 Dec- 94 Feb-95 Apr-95 Jun-95 Aug-

95 Oct-95 Dec- 95

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

M1

Díaz Bautista and Olivas Andrade Díaz Bautista and Olivas Andrade (2003)(2003)

The study is centered on the The study is centered on the dynamic model of capital flight from dynamic model of capital flight from Mexico. Some of the variables that Mexico. Some of the variables that are used in the economic crisis are used in the economic crisis econometric model are the current econometric model are the current account, the level of overvaluation of account, the level of overvaluation of the currency, the interest rate the currency, the interest rate differential between Mexico and the differential between Mexico and the United States and political factors.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) Díaz Bautista and Olivas Andrade (2003) Model VariablesModel Variables

where: FC= capital flight. (-*)= interest rate differential (Mexico- United Status). (-*)= Inflation differentual (Mexico- United Status). OV= % of overvaluation of the peso. DCC= current account deficit. FP= political factors. ut-1= error correction term.

(1) itiniiti

niiti

nitt OVu 11

*111111

* )(*)()( *

111111ii

titiniiti

niiti

ni FCFPDCC

(2) iti

niiti

niiti

nitt OVu 2121

*2112

* *)()()( *

212121

titiniiti

niiti

ni FCFPDCC

(3) iti

niiti

niiti

nitt OVuOV )(*)()( *

31313113 OVtiti

niiti

niiti

ni FCFPDCC 313131

(4) iti

niiti

niiti

nitt DCCuDCC )(*)( *

41414114 DCCtiti

niiti

niiti

ni FCFPOV 414141 (4)

(5) iti

niiti

niiti

nitt FCuFC )(*)( *

51515115 FCtiti

niiti

niiti

ni FPDCCOV 515151

Díaz Bautista and Olivas Andrade (2003) Díaz Bautista and Olivas Andrade (2003) Capital Flight VEC ModelCapital Flight VEC Model

Se obtiene que todas las variables tienen raíz unitaria.

Cuadro 1. Prueba de Dickey Fuller y ADF para las Variables de Fugas de Capital (FC) y sus Determinantes (Período de 1970:1 a 1999:4) Serie ADF Test Valores críticos* Serie ADF Test Valores críticos*

FC_BM -2.150935 1% -3.4922 Dif_i -2.161606 1% -3.4861 5% -2.8884 5% -2.8857 FC_Otro -2.222624 10% -2.5809 10% -2.5795 OV -2.622357 1% -4.0373 Dif_infl -2.533118 1% -3.4875

5% -3.4478 5% -2.8863 10% -2.5798

Cta_cte -2.132221 1% -3.4861 5% -2.8857 10% -2.5795 *Valores críticos de MacKinnon (1991) para

rechazar la hipótesis de raíz unitaria. H0: Existencia de raíz unitaria H1: No existe raíz unitaria.

Cuadro 2. Determinación del número de rezagos para las dos metodologías de Estimación de las Fugas de Capital (FC) (Período de 1970:1 a 1999:4)

FC: Metodología del Banco Mundial

Parámetros Determinante LN X tablas

X calculada Rezagos Obs. no restring var-cov determinante 1% 44.31

5% 37.65

74.7584654 1 vs 2 120 14 2.05E+13 30.65145 10% 34.38

4.15E+13 31.35671 34.9738999 2 vs 3 120 19 1.45E+13 30.30517

2.05E+13 30.65145 33.7690492 3 vs 4 120 24 1.02E+13 29.95341

1.45E+13 30.30517

FC: Metodología Alternativa

parámetros determinante LN

X calculada rezagos Obs no restring var-cov determinante

68.1179251 1 vs 2 120 14 2.74E+13 30.94156413 5.21E+13 31.58418606

32.3021514 2 vs 3 120 19 1.99E+13 30.62174085 2.74E+13 30.94156413

13.4412701 3 vs 4 120 24 1.73E+13 30.48172762 1.99E+13 30.62174085

H0: El modelo restringido es mejor que el no restringido. H1: El modelo restringido no es mejor que en no restringido.

Cuadro 3a. Prueba de cointegración para FC con Metodología del Banco Mundial

Series: FC_BM OV CTA_CTE DIF_I DIF_INFL

Series exógenas: CRI_SEXENIO FPOL_94 Período de 1970:1 a 1999:4 Likelihood 5% Critical 1% Critical traza H0

Eigenvalue Ratio Value Value

0.26371 88.88735 68.52 76.07 35.5112 Ninguno** 0.180439 53.37614 47.21 54.46 23.0824 Máximo 1* 0.161277 30.29377 29.68 35.65 20.4015 Máximo 2* 0.061778 9.892324 15.41 20.04 7.3972 Máximo 3 0.02128 2.495155 3.76 6.65 2.4951 Máximo 4

*(**) Denota el rechazo de la H0 al 5% (1%). La prueba L.R. Indica que existen 3 ecuaciones de cointegración al 5% de significancia.

Cuadro 3b. Prueba de cointegración para FC con Metodología Alternativa

Series: FC_Alternativa DIF_INFL DIF_I CTA_CTE OV Series exógenas: FPOL_94 CRI_SEXENIO Período de 1970:1 a 1999:4

Likelihood 5% Critical 1% Critical traza H0 Eigenvalue Ratio Value Value

0.296196 95.65292 68.52 76.07 41.0969 Ninguno** 0.202699 54.55607 47.21 54.46 26.5032 Máximo 1** 0.144654 28.05284 29.68 35.65 18.2812 Máximo 2 0.057113 9.771629 15.41 20.04 6.8806 Máximo 3 0.024406 2.890941 3.76 6.65 2.8909 Máximo 4

*(**) Denota el rechazo de la H0 al 5% (1%). La prueba L.R. Indica que existen 2 ecuaciones de cointegración al 5% de significancia

Cuadro 4. Ecuaciones de Cointegración Normalizadas para la FC y sus

Determinantes. (Período de 1970:1 a 1999:4)

Ecuación de Coint. Eq Coint 1 Ecuación de Coint. Eq. Coint 1

FC_BM(-1) 1 FC_Alternativa(-1) 1 OV(-1) 1894.222 OV(-1) 417.375

(1513.830) (1471.22) (1.251) (0.28369)

CTA_CTE(-1) -0.830 CTA_CTE(-1) -0.736016 (0.187) (0.18076) (-4.43090) (-4.07177)

DIF_I(-1) -19.841 DIF_I(-1) -65.23832 (31.123) (33.727) (-0.63749) (-1.93430)

DIF_INFL(-1) 217.055 DIF_INFL(-1) 386.3632 (128.472) (143.42) (1.690) 2.69394)

C -3284.013 C -2340.529

Los números entre paréntesis representan el error estándar y la t-estadística, respectivamente.

Determinants of Capital Flight in MexicoDeterminants of Capital Flight in Mexico

Díaz Bautista and Olivas Andrade (2003) Díaz Bautista and Olivas Andrade (2003) identified identified the determinants of capital flight in Mexico with the the determinants of capital flight in Mexico with the implementation of a Vector error correction (VEC) implementation of a Vector error correction (VEC) model. Following the methodology used by the model. Following the methodology used by the World Bank, the variables that cause the exodus of World Bank, the variables that cause the exodus of capital were determined to be the degree of capital were determined to be the degree of overvaluation of the currency, followed by the overvaluation of the currency, followed by the current account balance. current account balance.

The differential in interest rates and inflation, The differential in interest rates and inflation, hardly affect the outflow of capital in this model. In hardly affect the outflow of capital in this model. In this model, almost all capital flight reacts the same this model, almost all capital flight reacts the same way to changes in the current account as to way to changes in the current account as to changes in the degree of overvaluation of the peso.changes in the degree of overvaluation of the peso.

ConclusionsConclusions Mexico's 1994 "peso crisis" has been called the Mexico's 1994 "peso crisis" has been called the

first financial crisis of the 21st century.first financial crisis of the 21st century. Financial crises are no longer what they used to Financial crises are no longer what they used to

be and they catch investors, governments, and be and they catch investors, governments, and international organizations by surprise.international organizations by surprise.

The Mexican 1994 events gave us a good lesson, The Mexican 1994 events gave us a good lesson, “economic policy makers (particularly in “economic policy makers (particularly in emerging markets) tend to wait until the last emerging markets) tend to wait until the last moment to modify an exchange rate policy”.moment to modify an exchange rate policy”.

Some of the determinants of capital flight in Some of the determinants of capital flight in Mexico are the degree of overvaluation of the Mexico are the degree of overvaluation of the currency, followed by the current account currency, followed by the current account balance. balance.

ReferencesReferences Aspe, Pedro (1993): Economic Transformation the Mexican Way. (Cambridge: MIT Press).Aspe, Pedro (1993): Economic Transformation the Mexican Way. (Cambridge: MIT Press).

Díaz Bautista, Alejandro and Olivas Andrade, Cesar (2003), “Un Análisis de cointegración con 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 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. Estructurales de la Economía Mexicana” coordinated by Alejandro Díaz Bautista.

Díaz-Bautista, Alejandro (2003), “Los Determinantes del Crecimiento: Convergencia, Instituciones 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 y Comercio Internacional”. Pp. 164, junio de 2003. Colef y Editorial Plaza y Valdes ( The Determinants of Economic Growth: Convergence, Trade and Institutions”). Determinants of Economic Growth: Convergence, Trade and Institutions”).

Dornbusch, Rudiger (1976), "Expectations and Exchange Rate Dynamics," Journal of Political Dornbusch, Rudiger (1976), "Expectations and Exchange Rate Dynamics," Journal of Political Economy, Vol. 84, pp. 1161-76.Economy, Vol. 84, pp. 1161-76.

Dornbusch, Rudiger and Alejandro Werner, 1994. “Mexico: Stabilization, Reform, and No Growth.” Dornbusch, Rudiger and Alejandro Werner, 1994. “Mexico: Stabilization, Reform, and No Growth.” Brookings Papers on Economic Activity 1994 (1), 253-97.Brookings Papers on Economic Activity 1994 (1), 253-97.

Krugman, Paul and Maurice Obstfeld (2003), International Economics: Theory and Policy, 6th Krugman, Paul and Maurice Obstfeld (2003), International Economics: Theory and Policy, 6th edition (Addison Wesley).edition (Addison Wesley).

Rogoff, Kenneth (2001), Dornbusch's Overshooting Model After Twenty-Five Years, Second Annual Rogoff, Kenneth (2001), Dornbusch's Overshooting Model After Twenty-Five Years, Second Annual IMF Research Conference, Mundell-Fleming Lecture.IMF Research Conference, Mundell-Fleming Lecture.

Currency Devaluation and Currency Devaluation and DepreciationDepreciation

Appreciation is a rise of a currency in a floating Appreciation is a rise of a currency in a floating exchange rate.exchange rate.

Currency depreciation is the loss of value of a Currency depreciation is the loss of value of a country's currency with respect to one or more country's currency with respect to one or more foreign reference currencies, typically in a floating foreign reference currencies, typically in a floating exchange rate system.exchange rate system.

Devaluation is a reduction in the value of a currency Devaluation is a reduction in the value of a currency with respect to other monetary units. In common with respect to other monetary units. In common modern usage, it specifically implies an official modern usage, it specifically implies an official lowering of the value of a country's currency within a lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect authority formally sets a new fixed rate with respect to a foreign reference currency.to a foreign reference currency.

Economic Policy in Latin AmericaEconomic Policy in Latin AmericaApril-June, 2008April-June, 2008

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

Alejandro Díaz-Bautista, Alejandro Díaz-Bautista, Ph.D.Ph.D.

[email protected]@hotmail.com

Professor of Economics and Researcher at COLEFVisiting Research Fellow and Guest Scholar 2008, Center for U.S.-Mexican Studies, University of California San Diego (UCSD). April 2, 2008Graduate School of International Relations & Pacific Studies IR/PS University of California, San Diego.

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