Reforming the International Monetary and Financial System

Comments: Mexico as a Benchmark Case

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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Ito’s paper starts with the premise that the IMF’s programs for Asia have been a failure, without setting a benchmark for what a successful IMF program is. I would like to propose such a benchmark, the 1995 Mexican program that, to many analysts, was successful in confronting what has been called the first crisis of the twenty-first century. Table 1 summarizes the main macroeconomic aggregates in Mexico and Asia during the IMF programs.

Table 1.Selected Countries: Main Macroeconomic Indicators(In percent)
GDP GrowthInflationCurrent Account
Source: J.P. Morgan.

Forecast of May 1999.

Source: J.P. Morgan.

Forecast of May 1999.

Comparing the results in Asia with those in Mexico, we see that although in both regions a significant recession took place, the change in the rate of GDP growth was smaller in Mexico’s case. The reason for this becomes clear when we look at the forced correction in the current account deficit. The Mexican program is the only one in which the economy was not forced to generate a current account surplus. Compared with the huge current account surplus that Korea had in 1998, it is clear why the Mexican economy could resume growth as fast as it did. On another criterion, as both Table 1 and Table 2 indicate, we have to accept that the programs in Korea and Thailand were extremely successful in avoiding an inflationary crisis.

Table 2.Selected Countries: Exchange Rate Pass-Through(In percent)
199719981997-98 Average
Asia average54.55.83.315.928.99.7
199519961995-96 Average

Methodologically, assessing the market’s response after the announcement of an IMF program is not a good measure on which to judge, as Ito does, the success of the program, given the short time horizon he adopts—only one month after the announcement. To show this we performed the same exercise as Ito’s for the Mexican case, where the IMF program was announced on January 26, 1995, and the agreement with the U.S. government was signed on February 21, 1995. As shown in Table 3, four weeks after the second announcement the exchange rate had depreciated by 20 percent and the stripped spread increased by almost 50 percent. Figure 1 illustrates that it was not until April and May that the exchange rate and the stripped spread recovered.

Table 3.Mexico’s Program Announcement(February 21, 1995 = 100)
DateFunding RateExchange RateStripped Spread
Jan. 2436.997.672.8
Jan. 3143.892.080.5
Feb. 756.292.885.4
Feb. 21100.0100.0100.0
Feb. 2864.6102.0111.3
Mar. 7100.0100.0100.0
Mar. 1476.8101.7108.0
Mar. 2180.8119.6146.9

Figure 1.Funding Rate, Exchange Rate, and Stripped Spread, 1995

1994–95 Mexico Crisis

While the Mexican and Asian crises shared several common features, the Mexican economy experienced a less prolonged recession and the contagion to other emerging economies was contained. Therefore, it is instructive to look at those particular factors that were responsible for the quick economic turnaround and for avoiding contagion to other markets.

The origins of the Mexican and Asian crises lie in the following:

  • overvalued real exchange rates and large current account deficits financed to an important extent by short-term capital inflows,
  • large public or private sector short-term debt,
  • financial liberalization coupled with excessive short-term inflows that led to a rapid expansion of credit in the context of a weak financial system, and
  • abundant liquidity in international financial markets that drove investors to search for higher yields in emerging markets.

Let me expand on why contagion was largely avoided during the Mexican crisis.

Early Diagnosis

The Mexican crisis started on December 19, 1994. It was immediately clear to us that the economy was experiencing a dual crisis. The Mexican crisis combined elements of a typical current account and overvaluation speculative crisis with a financial market panic, in which the short maturity of the country’s external liabilities exposed it to a self-fulfilling refinancing crisis.

The Mexican crisis of 1994–95 was the first clear-cut example of a dual crisis in which the large current account deficit, together with significant amortizations of dollar-denominated government debt, proved to be a lethal combination for the economy. This explanation for emerging markets’ financial crises parallels the theories explaining bank runs in which depositors suddenly demand withdrawals of their funds when they fear that other depositors will withdraw their money, thereby driving the bank into illiquidity and eventual collapse.

Determination to Act

President Zedillo understood the severity of this dual crisis and that there was no alternative but to act decisively and rapidly to establish an orderly macroeconomic adjustment in response to the sudden capital outflows, to refinance short-term public debt by approximately US$30 billion, and to maintain the solvency of the banking sector. It was our conviction that by acting in this manner the cost of the adjustment would be minimized.

Four weeks after the onset of the crisis, Mexico had an IMF program in place, and a financial assistance package from the United States was being negotiated. The negotiations were finished by February 21 and the whole program was announced in early March 1995.

Addressing the Banking Sector Problem

The fragilities accumulated by the domestic financial system, the overindebtedness of firms and households, and the damaging effects of the crisis all seriously threatened the life of the financial system. To preserve the integrity of the sector, the authorities implemented a series of programs with the following objectives: (1) prevent a systemic run on the banking system; (2) avoid moral hazard and minimize distortions; and (3) absorb the cost of the banking sector restructuring as a fiscal item and avoid expansion of credit by the central bank.

With these objectives, the central bank opened credit lines denominated in foreign currency at a penalty rate so that commercial banks could fulfill their obligations. A program was established to promote the capitalization of the banking system, and legal reforms were undertaken to allow greater foreign participation in the banking system.

By the second half of 1995 the economy was growing at positive rates again, after falling by 11.8 percent during the first semester and by 6.2 percent for the whole year. In the three years from 1996 to 1998, the economy grew at 5.2, 7.0, and 4.7 percent, respectively; and inflation came down from 52 percent in 1995 to 18.6 percent in 1998. Moreover, the government regained access to international capital markets soon after the announcement of the program, and in January 1997 we were able to fully repay our loans from the U.S. Treasury, three years ahead of schedule.

We knew that because markets overreact, policy had to overreact as well if confidence was to be restored. And in the Mexican case, the international assistance package was sufficient to guarantee that all of the maturing liabilities could be honored. The quick reaction of the Mexican authorities together with a healthy U.S. economy were crucial elements in explaining the quick recovery of the economy and in minimizing contagion to other economies.

In contrast, the Asian countries shared important trade and financial links that intensified contagion, and the crisis took place at a time when Japan was undergoing an economic recession and its financial system, which has significant ties in the region, was in an extremely delicate situation.

Criticism of IMF Policies

The three main parts of the IMF-supported Asian programs that have been criticized are tight monetary policy, tight fiscal policy, and the appropriateness of structural reform.

In my opinion the first two policies are indispensable to reestablishing the credibility of the authorities. In the middle of a confidence crisis, if the interest rate response is delayed, confidence continues to erode, inflation expectations pick up, and the currency depreciation continues. Therefore, in the midst of a currency crisis, there might not be a level for the currency where all market participants feel that the exchange rate has overshot its long-term equilibrium so that it is a good time to invest in that currency. For this reason, critics who argue that once the exchange rate was floated there was no reason to pursue a tight monetary policy are wrong. Once the exchange rate is floating, monetary policy has to become the nominal anchor of the system. To accomplish this in the middle of a confidence crisis, it is imperative that the country follow a tight monetary policy.

A fiscal adjustment is similarly needed for three reasons: (1) to cover the flow cost of the financial restructuring; (2) to share the needed adjustment in absorption with the private sector; and (3) to signal that any additional cost to the budget or to the banking sector restructuring process, generated by the increase in interest rates, can be handled by fiscal means, and that it will not generate inflationary pressures in the future.

Finally, regarding the appropriateness of the structural measures aimed at reforming the financial sector, I think they should be taken immediately, but it is necessary to guarantee fully the deposits in the banking system to avoid a systemic run.

Advice for Preventing Crises

On exchange rate systems, I disagree with the author with respect to the possibility of finding a middle ground between a fully flexible regime and a currency board or monetary union. In the Mexican experience, the adoption of a flexible exchange rate regime has contributed to reducing speculative pressures in financial markets. The flexible exchange rate has served multiple purposes. First, it has provided the economy with an additional adjustment variable to absorb financial shocks and to take some of the pressure away from interest rates. Second, a flexible exchange rate facilitates the adjustment of the real exchange rate to its equilibrium level whenever an exogenous shock warrants a new equilibrium exchange rate, without affecting the credibility of the monetary authority. And third, the significant losses that can be incured in the short run because of the movements in the exchange rate discourage short-term capital inflows.

Regarding the development of an early warning system I agree with the author about the difficulties in forecasting crises.

Again, I fully agree with theoretical arguments in favor of a gradual financial liberalization. However, sometimes the political process leads to a window of opportunity that might not be open in the future. Under such circumstances, the choice is between abrupt financial liberalization and no liberalization at all.

The author ends by proposing the implementation of regional monetary funds that could be used as mutual insurance for providing liquidity support and funds for financial stabilizations. Ito advocates the creation of these institutions on three grounds: (1) to provide close surveillance and monitoring; (2) to supplement an IMF support package; and (3) to promote close ties in trade and investment in the region, which would facilitate better regional solutions.

It is erroneous to think that countries with similar problems and a lack of market credibility could perform the functions of surveillance and monitoring without the assistance of an outside authority. It seems hard to believe that programs sanctioned by a regional monetary fund could become a signal of good behavior and reestablish credibility in the country’s policies.

Regional monetary funds will tend to exacerbate contagion, given that the drawing of funds by one country will tend to reduce the availability of funds for the other members, thereby inducing runs on them.

Last of all, Ito’s paper concludes by saying that the IMF programs did not address the core of the problem in these countries. The author, however, does not mention what that core actually is.

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