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The Mexican Peso Crisis of 1994 and 1995

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The Mexican Peso has decadented and as a result; It had elements of a crisis arising from macroeconomic inadequacies and variable capital inflows and weaknesses in the financial sector. There were unlimited signs of macroeconomic disability, including the overvalued real exchange rate and a large current account. Moreover, if the Mexican government followed a relatively simple policy and did not take into account the external interest payments on its debt, the government budget was not much. In the early 1990s, this decline declined, from 22.7 percent in 1991 to a total of 7 percent in 1994. Between 1990 and 1993, Mexico lived an annual capital of $ 91 billion, or an average of $ 23 billion per year. Owned capital was private portfolio investments ($ 61 billion), direct investments ($ 16.6 billion) and bank loans ($ 13.4 billion). President Salinas’s management allowed foreign capital to support mexican savings. (1988-1994)

Mexico realized a large current account deficit equal to 5 percent of GDP in 1991 and 6.5 percent in 1992 and 1993. The voluminously input of foreign goods and services allowed further investment by providing capital goods that Mexico could not be on ones’s own and satisfying depletion, and it allowed domestic factories to produce investment goods through foreign goods and thus the strategy of the Salinas government and it worked. On January 1994, The North American Free Trade Agreement (NAFTA) between Canada, the USA and Mexico entered into force and US-Mexican trade expanded (23.7 percent). NAFTA relied on the institutional stability of Mexico and guaranteed access to the US wealthy market for goods produced in Mexico. In February 1994, interest movements in the United States and exchange rates around the world caused big losses for a number of banks and other investors. Portfolio managers began to reevaluate their investments and seek ways to reduce their exposure to risk. Political events also forced investors to review their financial position in Mexico. First, as the NAFTA began effectuation on January 1, 1994, livelihood farmers in Mexico’s poorest state of Chiapas revolted against the federal government.

Second, in March, the presidential candidate was killed while campaigning for the post. Leading the signing and implementation of NAFTA encouraged the view that Mexico is a safe, stable and modern country, while these events shocked investors. President Ernesto Zedillo admitted that he was overvalued in December 1994 and announced  15 percent devaluation. Transactions this measure may have been explicated as a cautious and responsible move to address an overvalued currency problem. Unluckily, the actions of President Zedillo elicited that his administration did not understand the severity of the crisis. As a result, the devaluation announcement of Zedillo’s 15 percent value sent money and financial markets to even greater convulsion. More investors fled from the country, the credibility of Mexican exchange rate policies entered into a serious questioning. Damaged and both foreign and domestic capital continued to leave the country. In March 1995, pesos fell more than seven per dollar; this value was a loss of more than 50 percent of its value compared to the beginning of December 1994. Zedillo addressed the crisis in the short term, with financial support from NAFA partners and the IMF. The reprieve came in late January 1995 in the form of a loan and line of credit. In the weeks when peso-type property owners began to relax in a currency exchanger information for their terms, the money markets calmed and the rate of capital flight slowed. The peso rehabiliteted some of its depreciation and was traded at six per dollar in late April 1995. Medium and long-term problems, saving  measures were implemented, which reduced government spending, increased taxes and reduced consumption. The major current account deficit at the end of 1994 increased the fragility of Mexico’s financial system against the capital flight and was responsible for the discharge of dollar reserves. For this reason, spending derogation policies were an appropriate step to address the crisis, as tax increases and cuts in government spending would help impairmant the current account deficit. The loan was limited due to high increases in interest rates and new limits on bank loans.    

These measures reduced consumption and increased savings, provided a larger pool of domestic funds for investment and reduced the country’s dependence on foreign capital inflows. After all, the drop in depletion and government spending brought stability; Mexico’s GDP decreased by 6.2 percent in 1995 and many people lost their jobs. Most of the foreign capital is invested in short-term portfolios rather than long-term direct investments. This distribution is not naturally insecure, but when the peso is overvalued, both foreign and domestic investors are afraid that a surprise devaluation will destroy the value of their assets, and they have begun to turn a large number of pesos into dollars. 15 percent devaluation of Mexico was a step in the right direction, but rather undermined market fears, it undermined the trustworthiness of the exchange rate system.

Domestic Issues in Crisis Avoidance

Some crises can not be prevented. However, there are steps countries can take to minimize the likelihood of a crisis and the damage they do when they happen. In addition to the need to maintain reliable and sustainable fiscal and monetary policies, governments should participate in active observation and collocation of the financial system and provide timely information on key economic variables such as the international reserves of the central bank. Envisioning effective policies in these areas is slightly simple, but there is a wide range of expert opinions in other areas and consensus is difficult to understand. Of the economy. Credit dries, investment disappears, consumption drops and the economy become dull. For this reason , even if governments have to spend income to energise the sector, there is a huge encouraging to mobilize the financial sector. This creates a contradiction for policymakers because if you fail, the information you save often causes people to take more risks, including bankers.

Moral Hazard and Financial Sector Regulation

 Economically, this is a moral hazard problem. Moral hazards arise when there is an encouraging to hide basic information or act in a way that creates personal benefits at the cost of a common purpose. Banks and other institutions are encouraged to make risky investments that provide higher returns if they know they will be bailed, ın the financial sector . If there is a general policy to protect the financial system from crumple, moral hazard problem is inescapable. There is a general agreement that a key to abatement moral hazard in financial institutions is to increase capital requirements in order to raise the current capital level during the crisis. Includes items such as capital, equity, undistributed profits, bank reserves and several other financial items. Taken together, it is the investment of bank owners. Various international agreements have been signed, including Basel III, signed in 2010, aggregately regulating bank capital levels known as the Basel Agreements. Since the latest of the Basel Agreements (Basel III) was signed in 2010, it has not been tested with a new crisis, and there is disagreement over its real effectiveness in preventing another major financial crisis. Another way in which a creeping peg exchange rate system increases a country’s fragility to crisis is that it is sometimes politically difficult to exit from the system if it becomes overvalued. When a government announces a change in the system, it runs the risk of losing its credibility. Both domestic and foreign economic agents incorporate the existing system, and a extempore large devaluation leads to economic losses and a loss of confidence in the country’s policymakers. The end of Mexico’s creeping peg in 1994 is a good example.

Exchange Rate Policy

Many countries adopted a crew exchange rate in the 1970s and 1980s as part of the inflation and anti-inflation strategy. Included in fixing the exchange rate to a major world currency such as the dollar or euro, or to currencies that contain the country’s major trading partners. The pegs generally aim to balance the real exchange rate better than trading partners in a country with high inflation.

If domestic inflation is higher than external inflation, nominal devaluation keeps the real exchange rate constant. Definition of the real rate as  Rr = Rn (P*/P) then  if the change in P (domestic prices) is greater than the change in P * (external prices), the nominal rate Rn must increase to keep the real rate constant. The maintenance of the anchor requires the monetary authority to use discipline in the creation of new money, and in this sense it is anti-inflationary. At the same time, countries often try to strengthen the anti-inflation trend of the crawling hook at a slower pace than the difference between home and foreign inflation. This creates a real forecast in the exchange rate and is planned to act as a brake on domestic inflation, as foreign goods are becoming cheaper in real terms, limiting the price increases that domestic producers can apply.

Capital Controls Generally ,economists think that the free movement of capital is a covetable goal, because it allows investors to send their financial capital to the highest return, which raises world welfare by putting financial capital in its most valuable use. However , capital mobility allows countries to invest more than possible only with their own internal savings, which again increases world welfare when there are valuable investment projects and inadequate savings to realize them. Frequently, capital flow limitations are applied by limiting transactions that are part of the financial account of the balance of payments. Capital movements are usually allowed as they are essential for trade to support transactions in the current account. As a result, one of the main ways firms can overcome capital account limitations is to overpay bill import.  Alternatively, they can undo exports so that the notifications received are smaller than the real payments, and the difference can be deposited abroad without reporting to the authorities. For these reason , as a general rule, inflow limitations appear to be more feasible than effluence limitations. However, restrictions on capital inflows cannot be stopped when a crisis begins. After all, there is an progressing discussion about the benefit of limiting capital outflows when a crisis begins. Many crises argue that a provisional limitation in capital outflows can help stop a crisis by artificially extenuating foreign currency demand, as the country includes a speculative attack on the country’s currency. Abstractly, this will increase the value of the domestic currency and eliminate the expectations for a large decrease in its value.

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