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Financial crises, the IMF, and Mexico Financial crises, the IMF, and Mexico

Financial crises, the IMF, and Mexico - PowerPoint Presentation

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Financial crises, the IMF, and Mexico - PPT Presentation

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: 683395

current government rates account government current account rates imf currency dollars countries loans repaid mexico deficit interest higher spending

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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