Financial Management in the International Corporation Exchange Rates and International Parity Condit

1

11. Currency Crises
2
Mexico Peso Crisis, 1984
3
Jose Lopez Portillo (1976-1982)
Oil prices were high in 1979 after the fall of
Shah of Iran. Mexicos president proclaimed We
are rich!
4
Peso Crisis, 1984
The added spending exceeded oil revenues, so the
government mortgaged its oil to foreign bankers
to borrow more money. When even that was not
enough to pay for all the newly-launched spending
programs, the government turned up the peso
printing presses full blast. The result
roaring inflation in the period leading up to
1982. Subsequent inflation traces to an excess
supply of pesos as well, fueled by government
budget deficit financed by printing pesos.
5
Peso Crisis, 1984
Government promised its citizens more than it
demanded from them in taxes to pay for these
promised benefits, the Mexican government
borrowed money from abroad and also printed more
pesos. The latter caused the high Mexican
inflation.
6
Peso Crisis, 1984
Mexico adjusted very easily to higher standards
of living when oil prices skyrocketed and Mexican
income rose. When oil prices began to decline
in early 1981, following oil price deregulation
in the United States, the Mexican government
found it inexpedient to cut spending and lower
the nations standard of living. Instead, the
government printed even more money to make up for
the reduction in oil revenue and foreign
borrowings. At the same time, the government
attempted to maintain the current standard of
living by fixing the dollar value of peso.
7
Peso Crisis, 1984
In August 1982, the Mexican government devalued
the peso, froze all dollar accounts in Mexican
banks, and imposed currency control. What were
the governments objectives? The government was
trying to stop the outflow of hot money.
Better policies? Cutting budget deficit.
Removing barriers for foreign investment.
Allowing freer trade.
8
Peso Crisis, 1984
In 1985 the Mexican government expropriated the
Mexican city real estate following earthquake.
Property rights became more fragile in Mexico
--currency controls, expropriation of banks and
estate. November 7, 1985, Wall Street
Journal The government made sure that the best
investment you can make is in dollars At the
moment, nervous investors are trying to protect
their interests by converting pesos into
dollars.
9
Peso Crisis, 1994
Luis Donaldo Colosio, the Mexican presidential
candidate tragically assassinated on 23 March
1994 while campaigning in Tijuana, Mexico.
10
Peso Devaluation 1994
The peso devaluation in 1994 owed to a
combination of more rapid expansion in the money
supply as well as increased political risk that
led investors to dump pesos for dollars all over
the world. First, a balance-of-payment deficit
funded with increasing amount of foreign debt,
was a sure indicator of future devaluation.
Second, Mexico excessively depended on foreign
portfolio capital to finance its economic
development. In hindsight, the country should
have saved more domestically and depended more on
long-term rather than short-term capital
investment.
11
Peso Devaluation 1994
A flood of foreign money had two undesirable
effects. It led to an easy credit policy on
domestic borrowings, which caused Mexicans to
consume more and save less. Foreign capital
influx also caused a higher domestic inflation
and an overvalued peso, which hurt Mexicos trade
balances even further. Moreover, the overvalued
exchange rates, interest rates control, and
political uncertainties triggered massive capital
flight from Mexico. The result was larger balance
of payment deficit that necessitated more foreign
borrowing and higher debt service requirement.
12
Peso Devaluation 1994
In 1994, the Mexican Central Bank had announced
the crawling band policy a preannounced
maximum devaluation of 0.0004 peso/ per day.
According to this policy the slope of the
promised exchange rate line with respect to
time was 0.0004. Actual exchange rate curve shows
that sometimes exchange rate was declining by
more than promised. Such instances weakened the
credibility of the Mexican Central Bank policy.
Mexican dollar reserves were dropping sharply
during 1994 with the biggest declines during
periods when actual exchange rate curve slope was
steeper than 0.0004.
13
Peso Devaluation 1994
To prevent investors around the world from
panicking, the Mexican Central Bank stopped
announcing the reserve dollar levels from the
second half of 1994 through the beginning of
1995. The reluctance of the ongoing Mexico
administration to disclose the true state of the
Mexican economy, that is, the rapid depletion of
foreign exchange reserves and serious trade
deficit, contributed to the sudden collapse of
the peso.
14
Peso Devaluation 1994
International mutual funds are known to have
invested more than 45 billion in Mexican
securities during a three-year period prior to
the peso crisis. As peso fell, fund managers
quickly liquidated their holdings of Mexican
securities as well as other emerging markets
securities. This had a highly destabilizing,
contagious effect on the world financial system.
Faced with an impeding default by the Mexican
government and possibility of global financial
meltdown, the Clinton administration, together
with the IMF put together 53B package to bail
out Mexico. As the bailout plan was put together
and announced on January 31, the worlds
financial markets began to stabilize.
15
Peso Devaluation 1994
As concerned international investors reduced
their holdings of emerging markets securities,
the peso crisis rapidly spilled over to other
Latin American and Asian financial markets. The
Mexican peso crisis is significant in that it is
perhaps the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
16
1998 Asian Crisis, Beginning
Since early 1990s, Thai economy had attracted
massive volumes of capital inflow accommodating
economic policies stagflation of Japanese
economy recession in Europe Nominal exchange
rate stability of 24.91-25.59 baht per Stable
prices 3.3-3.9 per year Attractive interest
rates 13.25 High savings rate of 33.5 of
GDP GDP growth level of 8.08-8.94 Thai economy
attracted larges sums of foreign capital
inflow Stock market rose 175
17
1998 Asian Crisis, Beginning
Lending practice of Thai financial institutions
were not healthy real estate boom borrow from
foreigners, lent domestically Subsequent
contraction in real estate sector Competition
from ChinaDecline in semiconductor
industries Deteriorating current
account Subsequent credit crunch problem
18
1998 Asian Crisis, Timeline
http//www.pbs.org/wgbh/pages/frontline/shows/cras
h/etc/cron.html
19
Asian Crisis, 1998
Large inflows of foreign capital resulted in a
credit boom in Asia. The credit boom was often
directed in speculations in real estate and stock
markets as well as investment in marginal
industrial projects. Meanwhile, the booming
economy with the fixed or stable nominal exchange
rate inevitably brought about an appreciation of
exchange rate. This, in tern resulted in a market
slowdown in export growth in Asian countries.
20
Asian Crisis
A long-lasting recession in Japan and the yens
depreciation against the dollar hurt Japanese
neighbors, further worsening the trade balance of
the Asian developing countries. Several factors
are responsible for the onset of Asian currency
crisis a week domestic financial system, free
international capital flows, the contagion
effects of changing market sentiment, and
inconsistent economic policies.
21
Asian Crisis
As the crises unfolded, the IMF came to rescue
the three Asian countries-Indonesia, Korea, and
Thailand. As a condition for bailing out the IMF
asked to raise domestic interest rates, and to
curtail government spending. As a consequence of
the credit crunch, the Asian economies
consequently suffered a deep depression. One can
thus argue that the IMF initially prescribed a
wrong medicine for the afflicted Asian
economies. The IMF bailout plans were also
criticized on another ground moral hazard. IMF
bailouts may breed dependency in developing
countries and encourage risk taking on a part of
international investors.
22
Asian Crisis
Joseph Stiglitz writes When the IMF decides to
assist a country, it dispatches a "mission of
economists. These economists frequently lack
extensive experience in the country they are
more likely to have firsthand knowledge of its
five-star hotels than of the villages that dot
its countryside. They work hard, poring over
numbers deep into the night. But their task is
impossible. In a period of days or, at most,
weeks, they are charged with developing a
coherent program sensitive to the needs of the
country. Needless to say, a little
number-crunching rarely provides adequate
insights into the development strategy for an
entire nation. Even worse, the number-crunching
isn't always that good. The mathematical models
the IMF uses are frequently flawed or
out-of-date.
23
Asian Crisis
Joseph Stiglitz writes Critics accuse the
institution of taking a cookie-cutter approach to
economics, and they're right. Country teams have
been known to compose draft reports before
visiting. I heard stories of one unfortunate
incident when team members copied large parts of
the text for one country's report
and transferred them wholesale to another. They
might have gotten away with it, except the
"search and replace" function on the word
processor didn't work properly, leaving the
original country's name in a few places. Oops.
24
Asian Crisis
Joseph Stiglitz writes IMF experts believe they
are brighter, more educated, and less politically
motivated than the economists in the countries
they visit. In fact, the economic leaders
from those countries are pretty good--in many
cases righter or better-educated than the IMF
staff, which frequently consists of third-rank
students from first-rate universities. (Trust me
I've taught at Oxford University, MIT, Stanford
University, Yale University, and Princeton
University, and the IMF almost never succeeded in
recruiting any of the best
students.) Last summer, I gave a seminar in China
on competition policy in telecommunications. At
least three Chinese economists in the audience
asked questions as sophisticated as the best
minds in the West would have asked.
25
Asian Crisis
Paul Krugman writes When the Asian crisis
struck, however, the response that Washington
urged on the afflicted nations--and demanded as a
condition for emergency IMF loans--was very
different. True, countries were not told to
defend their exchange rates at all costs the
baht, the won, and the rupiah were allowed to
slide against the dollar. But countries were told
to raise interest rates, not cut them,
in order to persuade some foreign investors
to keep their money in place and thereby limit
the exchange-rate plunge. And they were
implicitly told to accept the resulting
recessions--recessions that have, admittedly to
everyone's surprise, turned out to be the world's
worst since the 1930s.
26
Camdessus refused to promise pie in the sky and
got pie in the face in Bangkok