- Tomás Baliño, Charles Enoch, and William Alexander
- Published Date:
- July 1995
Mexico’s financial reform and transition from direct to indirect instruments of monetary policy have occurred relatively recently and appear to be quite successful, although some significant problems remain. Reform, which began in the mid-1970s, was interrupted by the debt crisis of the 1980s but was accelerated from 1988. The most recent reforms (from 1988 to 1991) were aided by the gradual development of financial markets (especially for government debt) over the relatively long period that preceded financial liberalization and were supported by tighter financial policies.
It is often difficult to assign a date to the adoption of indirect instruments in a particular country, and this is especially true for Mexico, For most case studies in this paper, it has generally been assumed that the transition started from the date of the first treasury bill or central bank bill auction. However, in the case of Mexico, it was decided to date the beginning several years later for two reasons. First, although several important reforms in the 1970s preceded the introduction of treasury bill auctions in 1978, not many reforms took place at the end of the 1970s. Second, during the early 1980s, the direction of policies was reversed for a substantial period as Mexico grappled with the effects of the debt crisis. Thus, for purposes of this study, the beginning of the transition was dated as 1988—after which there was a relatively rapid series of financial reforms.
Motivation for Reform
The Mexican reform aimed at increasing efficiency through greater reliance on market forces, promoting the growth and deepening of financial markets, and improving the effectiveness of monetary policy. The period from 1982 to 1988 was characterized by increased financial restrictions and an expansion of the market for informal credit. Banks were nationalized at the start of the period, after which the number of banks declined from 60 to 18. From 1982 to 1988, the financial system was regulated by interest rate restrictions, domestic credit controls, high reserve requirements, and required lending to the government by banks. Most of the growth in credit over the period was channeled to the public sector, and ex ante real interest rates were highly negative. During this period, use of direct instruments encouraged attempts to micromanage monetary conditions by imposing a complex structure of interest rates and credit controls, which caused further distortions and inefficiencies.
The background for the reforms in monetary policy instruments helped to ensure their success. In the mid-1970s, there was a move from specialized banking to full-service banking. The securities market was modernized, and the market for public debt was established. In 1978, treasury bill auctions were introduced, with the view to using Certificates of the Treasury (CETES) as an indirect instrument of monetary policy. However, the volumes of CETES offered for sale in the auctions were initially quite small, and yields were fixed by the authorities. As of late 1982, participants were allowed to present their bids in terms of amounts and yields; after that, both the primary and the secondary markets for CETES began to develop rapidly. The auctions for CETES have been conducted weekly. In addition, the authorities followed a policy of gradually eliminating quantitative controls on credit.
During the 1970s and 1980s, there was a gradual development of financial markets—in particular, markets for corporate stock and for money and bonds. By the early 1990s, the Bank of Mexico (BOM) could rely on open market operations as the principal instrument of monetary policy.
Process of Reform
A series of financial reforms was introduced in 1988-91, but the groundwork had been laid much earlier. In late 1988, quantitative restrictions on banker’s acceptances were removed, and banker’s acceptances and deposits were subjected to a 30 percent liquidity ratio. In 1989, interest rates were deregulated, and restrictions on bank lending were removed. In April 1989, the high reserve requirements were replaced by a 30 percent liquidity requirement; and in September 1991, the liquidity requirements were abolished and the authorities began to use the sale of government debt to control the money supply.
After 1988, exchange rate policy was geared to reducing inflation and providing greater certainty with respect to the evolution of the peso. At the core of this policy was the effort of the authorities to anchor the peso to the dollar, first through a crawling peg system and, from November 1991, through a band—the upper limit of which allowed for gradual depreciation of the peso. Foreign exchange controls were abolished in November 1991.
In developing its market for public debt, Mexico made innovative use of adjustable-rate instruments and of instruments indexed for inflation. Interest rates on Development Bonds (BONDES) were adjusted at regular intervals. Also, in 1989, the Federal Government introduced two new indexed debt instruments: Federal Treasury Bonds (TESOBONOS), which are quoted in pesos but indexed to the exchange rate, and Federal Government Indexed Bonds (AJUSTABONOS), which have three-year and five-year maturities and are indexed to the national consumer price index. Such instruments have guaranteed savers the availability of a positive real rate of interest.
Participation in the auctions for short-term government securities, or CETES, was initially restricted to a group of licensed dealers, but is now no longer so restricted. All banks and exchange houses can participate in the auctions. Maturities of the CETES range from 28 days to 2 years. Interest rates on CETES are freely determined at auctions, although the central bank sometimes buys or sells in the market to moderate transitory swings in interest rates and in money market liquidity. Operations of the central bank include outright sales as well as repurchase and reverse repurchase agreements, which the deepening of financial markets has made possible. Credit auctions are also used to supplement these operations.
Financial reform included rapid privatization of the banking sector. On May 2, 1990, Congress began to consider legislation that would privatize the banks. Then, on September 4, 1990, the rules and regulations for the privatization process were issued. The first bank was sold in June 1991, and the last bank was sold in July 1992.
When interest rates were liberalized and legal reserve requirements and the liquidity coefficient abolished, commercial banks found that their procedures for evaluating an increased volume of loans to the private sector were insufficiently developed. This factor, combined with the slowdown in economic activity and high levels of interest rates in the 1980s, caused the proportion of overdue credits to increase.
In the face of these challenges, the authorities strengthened bank supervision. New criteria for rating credit portfolios were introduced to strengthen capitalization requirements. In March 1991, a new system for rating credit portfolios and creating reserves was introduced. Banks were required to classify the loans in their portfolios and to create reserves according to the risk classification. In addition, banks’ capitalization standards were strengthened in accordance with the Basle Concordat. Thus, the Diario Oficial of May 20, 1991, established that the capitalization requirement for 1991 was 6 percent, which was to be increased to 7 percent in 1992 and to 8 percent in 1993.
The economic effects of the financial liberalization program are difficult to separate from those of the economic stabilization program that was introduced at approximately the same time. Under the latter, fiscal policy was dramatically tightened and monetary policy was made much more stringent. The trend toward financial disintermediation, which had characterized the earlier 1980s, was reversed and financial deepening began to occur. (For instance, the ratio of broad money to GDP increased substantially.) In addition, since 1989 Mexico has experienced a major improvement in the availability of foreign savings after several years of very limited access to international capital markets.
Financial reform was accompanied by substantial private capital inflows and rapid growth of the monetary aggregates. The authorities viewed the increase in the money supply as to some extent reflecting the remonetization of the economy following the stabilization of the economy and the reduction of inflation from very high levels and reflecting distortions resulting from an increase in interest rates on interest-bearing checking accounts relative to other rates. In these circumstances, it was argued that the stance of monetary policy was better judged by the evolution of net credit of the BOM, which indicated a very restrictive monetary policy stance. Authorities made a major sterilization effort in the face of large private capital inflows.
The ultimate objective of Mexico’s monetary policy is price stability, and stabilization of the peso-dollar exchange rate serves as the intermediate target. Limits are set annually on the growth of central bank domestic credit, with the BOM informing the executive branch and Congress at the beginning of the year of the ceiling on domestic financing. Generally, interest rates are determined by supply and demand in the money market, although the BOM may attempt to smooth erratic fluctuations.
Mexico’s main instrument of monetary policy is operations in both the primary and secondary markets for government debt instruments. As described earlier, government securities are sold at weekly auctions conducted by the BOM. Participation in the auctions is mostly limited to Mexican financial intermediaries (including banks and stock houses). In the future, the BOM is expected to authorize newly licensed foreign banks to participate in the auctions.6
In addition, the BOM intervenes daily in the secondary market for government securities. The interventions are guided by estimates of liquidity conditions and take place every working day. They primarily involve operations with repurchase agreements and reverse repurchase agreements rather than direct transactions.
Because of federal surpluses, the BOM began to exhaust its holdings of government securities, hampering its ability to conduct open market operations. To meet this problem, a new mechanism or fund has been established, by which the BOM is permitted to purchase government securities directly from the government. The proceeds of these purchases are deposited in a special government account with the BOM. These deposits are remunerated at the market rate of interest for the specific government security acquired by the central bank. The funds are not readily available to the government, although they can be used to buy back the securities sold to the BOM. The BOM also has the authority to impose reserve requirements or to auction credit but generally prefers not to use these instruments.
The BOM does not operate a discount window or other short-term credit facility; however, banks are allowed to run an overdraft in their correspondent accounts for very short periods. The central bank permits a bank to “keep the books open” on an overdraft of the previous day. After that, the bank must cover the overdraft by whatever means it can. For this service, the bank is charged a fee related to the interest rate on CETES.
The banking sector continues to have problems with regard to nonperforming loans (recent data indicate a deterioration); there are still some weaknesses in the regulatory framework, and the restructuring of the banking sector is still ongoing. In the latter regard, there have been a number of mergers between domestic banks, several new bank licenses have been granted, and the market is being opened up to foreign banks (partly reflecting the provisions of the North American Free Trade Agreement). The exchange rate developments since December 1994 and the subsequent adjustment measures will probably affect the banking sector. However, it is too early to know what these effects might be.
Mexico’s experience with financial reform and the introduction of indirect monetary policy instruments suggests several preliminary conclusions. Financial reform was probably set back because of the nationalization of banks following the debt crisis of 1982. However, the gradual development of financial markets over a relatively long period helped to ensure a successful liberalization and the use of open market operations as the main tool of monetary policy. Also, efforts to improve the financial conditions of the banks through enhanced bank supervision and regulation have facilitated the transition to indirect instruments of monetary policy, as has the high level of human resource development in the financial sector generally and in the BOM particularly. The process of adopting indirect monetary policy instruments was also supported by a return to macroeconomic stabilization. While the reasons go beyond the adoption of indirect instruments of monetary policy, in this process Mexico had to face difficulties, such as destabilizing capital inflows, high interest rates, some corporate and financial sector distress, and, at least in the short run, slow economic growth.