Lecture 17 Housekeeping Papers due today Professor Bozovic will be lecturing Oct 28 Professor Graham returns Oct 30 Flexible currencies can avoid crises One tempting solution to a current account deficit is to ID: 358442
Download Presentation The PPT/PDF document "Financial crises, the IMF, and Mexico" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
Slide1
Financial crises, the IMF, and MexicoLecture 17Slide2
HousekeepingPapers due todayProfessor Bozovic will be lecturing Oct 28Professor Graham returns Oct 30Slide3
Flexible currencies can avoid crisesOne tempting solution to a current account deficit is to:Change the exchange rateCreate inflation (print money) to deflate the value of your currency
A devalued currency makes your exports cheaper
Other countries buy more of your goods
Imports into your country become more expensive
Your citizens buy less from abroadSlide4
Current account deficits with fixed exchange ratesSome countries have pegged currencies, so they are unwilling or unable to depreciate. The costs of leaving the fixed currency may be too high to consider as a policy option.
Euro-zone countries don’t have individual control over the Euro, so they also can’t depreciate in response to
deficits
Greece is willing to pay a very high price to stay in the Euro
Mexico in
1994 kept the peso fixed to the dollar
Wanted to encourage trade with U.S. under newly signed North American Free Trade Agreement (NAFTA)
Wanted to keep up appearance of stability to win a critical electionSlide5
Costly fixes to current account deficitunder a fixed currencyX-M = (S-I) + (T-G)Exports – Imports =
(Savings – Investment) + (Taxes – Government consumption)
To fix a current account deficit, they can either
Boost savings (less spending)
Reduce investment (less capital per worker, lower productivity)
Raise taxes (disincentive to work, reduces private spending)
Reduce government spending
All of these things reduce GDP growth!Slide6
Check-in on current accountWhich of the following reduce a current account deficit? Remember: Exports - Imports = (Savings - Investment) + (Taxes - Government Consumption)Increasing government spending
Increasing investment
Increasing household savings
A&B
B&CSlide7
Borrowing abroad:The temporary fixIf you have a current account deficit:You can borrow money from abroad to cover
it, or
Sell off assets to foreigners
This
only works for so long. As the debt grows, will or can the borrowing country repay?Slide8
Mexico’s borrowing- 1994Fixed and overvalued exchange rateThis only works as long as the central bank has the foreign currency reserves to keep buyingMexico’s dollar borrowing
Mexico borrowed dollars
using bonds
that had to be repaid in dollars
Used those dollars to buy
pesos, keeping value of peso high
7
% current account deficitSlide9
Over-borrowing and debt crisesStep 1: Ominous signsQuestions arise about a country’s willingness or ability to make payments on its growing debtStep 2: Investors grow cautiousCautious investors pull out or raise interest to cover the higher risk
Step 3: Higher rates make it harder
Current account balance gets worse under higher interest payments, debt rises even faster
Step 4: Downward spiral
More investors lose faith and pull out, interest rates rise higher, current account deeper in deficit, cycle repeats and gets worse each timeSlide10
Peso’s weakness was hidden(?)Investors continued to loan Mexico dollars, as long as they were repaid in dollarsInterest rates would have been higher if they had borrowed dollars to be repaid in pesosWhat does this mean? Was Mexico fooling Wall Street?Slide11
Default risk vs. inflation riskLenders were happy to buy Mexican debt, to be repaid in dollars. They were confident that they would be repaid, no matter what.Why? They knew the U.S. wouldn’t let Mexico’s economy collapse. That is what the IMF is for.But fears that the peso would drop in value made them less willing to give loans that would be repaid in pesos.Slide12
Tequila crisis buildup 1994Political RiskArmed rebellion in Chiapas, assassination of ruling party presidential candidateBad political choices
One-party government facing a real election threat, high government spending to win election
Unwilling to offer higher interest rates on peso-backed loans
Foreign reserves depleted by maintaining overvalued exchange rate and making loan payments in dollarsSlide13
Checking understandingHow do debt crises start?As lenders get scared, interest rates fall, giving countries incentive to borrow moreAs lenders get scared, interest rates rise, making existing debt even harder to pay back
Undervalued currencies lead to too many exportsSlide14
Types of crises are related and interchangeableDebt crisisInterest rates increase sharply, government default imminent
Currency
crisis (aka balance of payments crisis)
Government is low on reserves, currency loses
value
As long as a government can borrow internationally, it can use the borrowed money to stabilize currency
As long as a government can print money, it can pay off its
debtsSlide15
What the IMF does in a crisisIMF is the “lender of last resort”When a government can’t borrow, the IMF steps in with a subsidized loanIMF doesn’t take collateralIt imposes “conditions” on loans
Conditions: designed to fix the problems that created the crisis in the first place
Austerity: raise taxes, cut government spending, tight monetary policy
Sell off state assetsSlide16
IMF: the big picturePart of the Bretton Woods systemGoal = keep currencies stable, prevent economic collapses, and promote trade.Three functions:Surveillance: Collecting data, giving governments advice
Technical Assistance: Guidance and training to poor countries to help them manage their economies
Lending: Loans to countries facing balance of payments crises or otherwise w/o access to other credit
Smooth out shocks, avoid defaults
“Concessional” loans available for poor countriesSlide17
IMF gets Mexico out of crisisUS govt and IMF step in with $50 billion in loans in 1995Conditions:New monetary and fiscal policy
controls, since the overvalued currency caused the problem
Mexico already had liberalized economy so no major structural conditions such
as austerity or privatization
Major
recession but quick economic recovery
Considered an IMF success story
Mexico repaid the crisis loans ahead of schedule
Since then, almost two decades of relatively stable inflation and exchange rates