Question

In 1994 the Mexican government abandoned their crawling peg to the US dollar. This was brought about by a complicated sequence of events, but in this question we focus only on the dynamics of the last part of the crisis. Running low on dollar reserves in December of 1994, the Mexican central bank devalued the peso. There was a spike in the risk premium investors demanded to lend to Mexico. The resulting increase in interest rates and contracting output ultimately led the government to abandon the peg.

How does a simultaneous devaluation and rise in the risk premium could lead to a scenario such as the one described above.

Answer 1

Ans. Mexico suffered currency crisis in Dec of 1994, it is also referred to as Tequila Crisis. Peso devalued from 4 peso to a dollar to 7 peso a dollar within a week. The crisis were mitigated by larger loans by the US government to ensure that Mexico crisis are not contagious. But still the Mexico GDP fell significantly The resulting increase in interest rates and contracting output ultimately led the government to abandon the peg. Key reasons for above are : Mexico went for serious economic reforms, it opened up its economy to competition, there was massive privatization and deregulation, it also adopted a pegged exchange rate (Peso to US Dollar) combined with tight monetary and fiscal policy and also there were efforts to bring the inflation down. Government decided to less regulate the private players and also decided not to print money. Also the businesses kept the prices of their goods low and labor wages were kept low. Seeing this many investors were upbeat about Mexican economy and investments started rising in the country however the Mexico economy didn't do as expected and in 90's GDP growth was only 2.8% much less then other countries in the region and as per the expectation. Also the exports were low, wages were low, productivity growth was stagnant and there was high poverty. This appreciated the currency significantly and made it difficult for the exporters to export goods. Also Mexico removed the Capital controls completely in late 1980 and in 1993 net capital inflows equaled more then 8% of the Mexico's GDP and the most of it was in the form of short term stocks and bonds. Between 1990 and 1993, $91 billion was invested in Mexico as foreign inflows There were lot of political instability during the 1994 and also financial institutions were finding it difficult to rollover the peso denominated government bonds. After the political instability many investors started viewing Peso as overvalued and the government was running out of the foreign reserves specially because the exports were not growing Government lacked the foreign reserves and cannot lower the interest rates to defend its exchange rate and it lead to currency crisis.