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WP/96/80 INTERNATIONAL MONETARY FUND

Monetary and Exchange Affairs and Western Hemisphere Departments

"Déjà Vu All Over Again?" The Mexican Crisis and the Stabilization of Uruguay in the 1970s

Prepared by Mario I. Blejer and Graciana del Castillo I/

July 1996

Abstract

Comparing the 1978-82 Uruguayan stabilization with the 1990-94 Mexican experience reveals that exchange rate based stabilization tends to increase the economy's vulnerability to unexpected shocks. An exchange rate rule, with full capital mobility, can only succeed if compatible financial policies are strictly adhered to--even when severe negative shocks take place--and if reliance on persistent capital inflows is not essential. This requires monetary restraint, even under serious recessionary conditions, and tight fiscal policies to moderate interest rates. The epilogues of both experiences demonstrate that abandoning the exchange rate rule in the wake of a shock, even if inevitable, makes future stabilization more difficult.

JEL Classification Numbers:

F41, F31, F32

i/ The authors are grateful to Guillermo A. Calvo, Juan Carlos Di Tata, José Gil Diaz, Jorge P. Guzman, Alfredo M. Leone, Robert A. Mundell, Paulo Neuhaus, Carmen Reinhart, Brian Stuart, Istvan Szekely, Andrew J. Tweedie, Alejandro Végh, and Ewart Williams for many useful comments, and to Lisabeth A. Moore for excellent research assistance.

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Contents Page

Summary iii

I. Introduction 1

II. A Striking Commonality of Factors 4

III. Some Important Differences 9

IV. Some Concluding Remarks 11

Figures

1. Annual Inflation Rate 2a 2. Real Exchange Rate 6a 3. Trade Balance 6b 4. Interest Rates and Inflation 6c 5. Real Interest Rates 6d 6. Gross International Reserves 6e 7. Stock of Foreign Public Debt 6f 8. Foreign Savings 6g 9. Total Domestic Savings 6h 10. Real Private Consumption 8a 11. Real Domestic Credit 8b 12. Real Wages 10a

Annex Table 14

References 15

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Summary

Soon after the initial phase of the late 1980s Mexican stabilization, the exchange rate became a central component of the anti-inflation strategy in order to reduce inflation to single-digit rates. After four years of seeming success, in December 1994 there was a generalized loss of confidence and a run on the Mexican currency. Following political disruptions and U.S. interest rates increases, international reserves fell significantly, putting increased pressure on the nominal anchor. Rather than accepting the monetary contraction dictated by these developments, the authorities resorted to large credit expansion. This compounded the ongoing accelerated lending by public development banks and a slight fiscal deterioration. As reserves continued falling, the exchange rate rule was abandoned, the currency depreciated sharply, and Mexico plunged into stagflation.

This case recalls some Latin American experiences from the early 1980s. The paper analyzes the striking similarities, in policies and in the length of the cycles, between the current Mexican episode and the 1978-82 Uruguayan experience. Although the problem was significantly larger in Uruguay and in the period just before the crisis the exchange rate rule was not fully credible, in both countries consumption soared, domestic savings plunged, and the current account deteriorated sharply. As unexpected shocks hit and international reserves fell sharply, the authorities expanded domestic credit rapidly in an attempt to contain increases in interest rates, motivated in part by vulnerability in the banking system, and the (incorrect) perception that the shocks were temporary. Eventually, however, the deterioration in the external sector led to the abandonment of the exchange rate regime.

Comparing these experiences reveals that while exchange rate based stabilization can indeed succeed, it poses serious challenges because of the potential overvaluation of the currency arising from inertial and credibility factors, and because it greatly increases the economy's vulnerability to shocks.

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©International Monetary Fund. Not for Redistribution I. Introduction

Following a number of failed attempts to restore sustainable growth while preserving price stability, everything seemed to indicate, until December 20, 1994, that Mexico's stabilization-cum-reform attempt launched in the late 1980s was, at last, a resounding success. In December 1987 Mexico had embarked on what has been called "the remaking of the Mexican economy" [Lustig, 1992]. This consisted of major fiscal and monetary adjustments to be accompanied by profound structural reforms centered on a radical reshaping of the role of the State in the economy and a fundamental change in the nature of the country's economic relations with the rest of the world.

After succeeding in reducing inflation from more than 130 percent at the end of 1987 to the 20-30 percent range, the Mexican macroeconomic strategy for the 1990s was based on traditional budgetary and monetary discipline, including a series of social pacts between government, business and labor agreeing on a path for incomes, key prices, and the exchange rate. In addition, soon after the initiation of the adjustment, the exchange rate became a central anti-inflationary instrument. I/ The use of the exchange rate as a nominal anchor was an essential component of the stabilization package but, together with the reduction of trade and investment restric- tions, the full liberalization of the capital account, liberalization of the financial sector and the reprivatization of banks, and the conclusion of the North American Free Trade Association (NAFTA) and other trade pacts, it was also seen as a useful tool for the reactivation of growth by reducing uncertainty and attracting portfolio investment.

After years of pursuing this strategy, which many regarded as highly successful, the serious--and to many, unexpected--December 1994 run left Mexico reeling. As a consequence of the rise in U.S. interest rates at the start of 1994, and a number of serious domestic political disruptions that shocked the country over the course of the year, international reserves experienced a significant drop due to the reversal of capital flows and the exchange rate came under increasing pressure. Rather than accept the monetary contraction dictated by the fall in reserves, and in an attempt to contain increases in interest rates, the monetary authorities sterilized capital outflows by resorting to a significant expansion in domestic credit,

I/ The exchange rate was fixed until January 1989 and, afterwards, a crawling peg with narrow bands was adopted until November 1991, when an adjustable band allowing for a maximum preannounced rate of devaluation was introduced.

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and by issuing tesobonos. ¿/ The expansion in domestic credit compounded the already ongoing accelerated rate of lending by the state-owned development banks (a type of extrabudgetary public spending) and the pressure exerted by some deterioration in the 1994 Mexican conventional fiscal balance. ¿/ All this resulted in an excess supply of money, particularly given the increase in velocity over the year arising from political and economic uncertainty, and, finally, in the abandonment of the nominal anchor. The peso was devalued on December 20, in the expectation that it would correct the existing perceived overvaluation of the real exchange rate and avert the recessionary pressure of tight credit policy. However, the pressure on the peso continued and, on December 22, the currency was allowed to float; its value collapsed, the stock market tumbled, and Mexico plunged anew into stagflation which has proved difficult to revert. In spite of a generous international rescue package, Mexico's economy is still experiencing serious problems.

Many analysts and market participants reacted initially with surprise, and even incredulity, to the Mexican debacle. But, as time passes, a feel- ing of "déjà vu all over again" 3/ seems to be now emerging. One need only recall the stabilization experiences of the Southern Cone of Latin America in the early 1980s, characterized by many of the same policy responses to large shocks, which created analogous problems and were treated with similarly unpalatable medicine. Two interesting recent studies have compared the Mexican story of the 1990s with the events that surrounded the Chilean stabilization in the 1970s, 4/ and The Economist has traced the origins of such crises to the 1820s, when British investors financed the new countries of the continent as they gained independence from Spain and Portugal. 5_/ In this paper we try to sharpen these comparisons by

I/ The Ministry of Finance and Public Credit and the Bank of Mexico encouraged the substitution of tesobonos--a government paper that offered investors an option to cover their exchange risk exposure in exchange for a lower rate of interest--for government bonds that were not indexed to the dollar (cetes. bondes. and ajustabonos). In 1994, the circulation of tesobonos reached US$26.4 billion allowing for a reduction of Mex$78 billion in the stock of non-indexed domestic debt. As pointed out by the Bank of Mexico, "investors's preference for tesobonos was reflecting a higher expected yield on this instrument--adjusted for exchange risk--than that on peso-denominated paper [Banco de México (1995b), pp. 42-43]. 2/ The overall fiscal balance deteriorated from a surplus of 0.7 percent of GDP in 1993 to a deficit of 0.3 percent in 1994. Also, the primary and the operational balances deteriorated markedly after the second half of 1992. See Massen and Agénor (1996), pp. 3-4 and Figure I. ¿/ To borrow an expression attributed to Yogi Berra, the New York Yankees' legendary baseball catcher and sage. 4/ See Edwards (1995) and Gil Diaz (1995). See also Velasco and Cabezas (1995) for a comparison between Mexico and the most recent Chilean experience with capital inflows. 5_/ The Economist (1995).

©International Monetary Fund. Not for Redistribution Figure 1 : Annual Inflation Rate (In percent) - 2 a

Source: See Annex Table.

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analyzing the striking similarities between the recent Mexican episode and the stabilization experience of Uruguay in 1978-82. Despite the obvious differences between Uruguay and Mexico in terms of size and economic charac- teristics, as well as the nature of the shocks they faced, the Uruguayan episode emerges as a harbinger (both in terms of the trends and the lengths of the cycles) of what was likely to happen much later in Mexico. Our purpose is therefore to argue that, based on earlier experiences with both the management of the exchange rate as an anti-inflationary instrument in the presence of full capital mobility and the reliance on a substantial amount of foreign savings to finance external imbalances, it could have been predicted that the abandonment of monetary and fiscal discipline in the wake of large exogenous shocks would lead to a financial crisis, and that painful adjustment would indeed be necessary to overcome the stagflation, higher indebtedness, and loss of confidence likely to result from such a policy mix.

To illustrate these points, the paper reviews and compares the stylized facts of the Uruguayan experience during the 1978-82 period with those of Mexico in 1990-94. In addition to identifying the commonality of factors, it also reviews some of the most pronounced differences between these two cases. From the observation of the parallels, it is not difficult to conclude that both consistency and credibility are crucial, and that the latter depends on the former. Exchange rate based stabilization, imple- mented in a context of full capital mobility, can only succeed if the authorities adhere strictly--even under severe domestic or external shocks-- to monetary and budgetary policies compatible with the adopted exchange rate rule and if the reliance on persistent and ever-increasing private foreign inflows is not essential to finance substantial current account deficits.

Some have claimed that the second, i.e., the critical reliance on capital inflows, is not a necessary condition in the new reality of free, integrated, and global capital markets. It may be so, provided that the credibility in the Government's commitment to an anti-inflationary policy stays intact. For this, however, the will and endurance of the authorities should remain unswerving, even if inertia has appreciated the currency in real terms, or if major internal or external shocks have caused a large fall in international reserves. It would certainly be arduous and politically onerous for the monetary authorities to resist devaluation pressures or to desist from overexpanding domestic credit to avoid recessionary effects when international reserves fall, but any such reaction to overvaluation or to unexpected shocks would result in a loss of credibility, a reversal of savings flows, and the eventual abandonment of the model. This was the case in the Southern Cone and in Mexico as well. This should not, however, be taken as a blanket indictment of exchange rate based stabilization strategies but, rather, as a warning of the perils that they entail.

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II. A Striking Commonality of Factors

The analysis of the patterns of economic policies followed by Uruguay in 1978-82 and by Mexico in 1990-94 shows a striking number of commonali- ties. \J After prolonged periods of inflation and slow growth, both countries adopted comprehensive stabilization programs. Although initially the battle against inflation was largely based on conventional orthodox compo- nents, including major fiscal deficit reduction and contractions in the supply of credit, these programs proved unable to fully eliminate inertia, to stabilize expectations, and to bring down inflation to single-digit levels. They were, therefore, later expanded to rely more heavily on the use of the exchange rate as a nominal anchor. The specific policy adopted was one of preannouncing the future path of the exchange rate (a tablita type of regime with a declining rate of devaluation). 2/ In both countries stabilization took place in the framework of major liberalization and structural reforms designed to improve the allocation of resources through increased reliance on market forces and through the integration of the domestic economy into the world economy--both regarding the current and the capital accounts.

The policy packages--with their centerpiece, the preannouncement of the exchange rate path--were indeed successful in their immediate objective of bringing down inflation to levels significantly lower than those prevailing before their inception (see Figure 1), although still higher than those implied by the announced exchange rate schedule. Therefore, because the actual devaluation was, in both cases, lower than the actual inflation out- come, both the Uruguayan and the Mexican peso became increasingly overvalued (as conventionally defined) vis-à-vis the U.S. dollar. 3/ This is shown

\/ For the sake of brevity, and since many studies of the individual countries' policies exist, we do not provide here a detailed account of the developments. For comprehensive examinations of the countries' economic policies during the periods discussed here, see del Castillo (1986, 1992) and Talvi (1995) for Uruguay; and Calvo and Mendoza (1995), Sachs, Tornell, and Velazco (1995), Kamin and Rogers (1995), and Masson and Agénor (1996) for Mexico. 2/ As mentioned above, in Mexico this regime was modified in November 1991 with the adoption of an exchange rate band, with the band ceiling subject to a daily preannounced depreciation at a fixed amount and a fixed band floor. 3/ This result could reflect a myriad of factors well analyzed in the literature. It could arise from the unexpected stubbornness of inertial effects (that could, in turn, reflect, inter alia, a persistent lack of credibility or widespread backward-looking indexation), from intentional overvaluation to bring down inflation quickly, from unanticipated productivity gains in the nontraded sector, from noncompetitive structures in the import/export sectors, or from the monetary expansion arising from unanticipated large surpluses in the current or in the capital account of the balance of payments.

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in Figure 2. \J Clearly, over the first three years, the real exchange rate in each country had appreciated by more than 20 percent and, purely on the basis of this measure, international competitiveness in both countries had seriously deteriorated. 2/ This appreciation of the real exchange rate was concurrent with a large deterioration in the trade balance, which reached significant proportions in both countries (Figure 3) and in the current account, as discussed below.

Given the growing external imbalances, and the widespread perception of increasing exchange rate overvaluation, the view that the announced exchange rate policy could not be sustained became pervasive among many economic agents. ¿/ Expectations of a sudden devaluation, and a consequent revival of inflation, persisted over the course of the program in both countries, albeit with varying degrees of intensity. Such exchange rate uncertainty impeded, therefore, a fall in nominal interest rates commensu- rate with the drastic fall in inflation. 4/ Figure 4 shows the behavior of nominal interest rates and inflation in Mexico and Uruguay, and Figure 5 compares the trajectory of the real rate in both countries. Although expectational inertia seems to have been stronger in Uruguay, the emerging pattern is, again, very similar: after an initial fall in both nominal and real interest rates, the nominal rates fail to follow the declining trend in inflation, resulting, after the first year of the periods analyzed here, in an ever-increasing level of (ex post) real rates. If these variables are an indicator of the degree of credibility of the announced exchange rate policy (or of the stabilization package as a whole), it is evident that the erosion of credibility started, in both countries, not later than the second year

I/ Given the large differences in magnitude in the two economies, for purposes of the figures, nominal data has been normalized to an index of 100 at the beginning of the respective periods (see Annex Table for data and sources). 2/ This is, indeed, a deficient measure of competitiveness in the context of large structural changes and of increasing integration of the countries considered into the international goods and capital markets. Moreover, overvaluation could induce significant imports of technologically advanced capital equipment with the concomitant increase in productivity. 3./ Some analysts have argued that the December 1994 crisis in Mexico took investors by surprise. However, even if some investors underestimated the devaluation risk [Masson and Agénor (1996)], official data show that flows of portfolio investment which had turned negative in April 1994 right after Colossio's assassination, had been negative again from September to December of that year [Banco de México, (1995a)]. 4/ For a discussion of exchange rate risk and interest rates in Uruguay see Blejer and Gil Diaz (1986) and del Castillo (1992).

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under analysis. It is also evident that the loss of confidence was much larger in Uruguay. I/

High nominal rates of interest in the context of low and stable inflation and consistent economic reforms attracted large capital inflows. 2/ In Uruguay, net capital inflows increased from US$105 million in 1978 to US$1.1 billion in 1982. In Mexico, net flows reverted from outflows amounting to about US$6 billion in 1989 to inflows of US$26 billion in 1993. These inflows did not only allow for a large current account deficit, but also facilitated the building up of international reserves and the reduction in the stock of public foreign debt. The current account deficit averaged 7.3 percent in Mexico in 1992-94 and 4.8 percent in Uruguay in 1978-81. Gross international reserves of the Central Bank of Uruguay increased from US$745 million in 1978 to US$960 million in 1981 and those of the Bank of Mexico rose from US$10.1 billion in 1990 to US$25.3 billion in 1993 (Figure 6). Foreign public debt of the nonfinancial public sector in Uruguay fell from 11.4 percent of GDP in 1978 to 4.8 percent in 1981. In Mexico, the comparable ratios fell from 21.0 percent in 1990 to 11.3 percent in 1993 (Figure 7). 3/

These similarities in the external accounts of Uruguay and Mexico during the implementation of their programs, which can also be appreciated by observing the significant transfer of foreign savings over the period (Figure 8), extend as well to the utilization of foreign resources. Unlike the experience of the East-Asian countries that also faced large current account deficits, foreign savings in both Uruguay and Mexico seem to have replaced domestic savings, which fell by more than 2 percent of GDP over the first two years of the respective periods and remained at their new lower levels until the abandonment of the programs (Figure 9). This contraction in domestic savings was the counterpart of the notable boom in real private

I/ High and rising real interest rates are not necessarily an indication of inflation and exchange rate uncertainty, but may also reflect increased credit risk that usually accompanies the initial stages of rapid stabilization. 2/ External factors may also have had some impact since both episodes occurred during periods in which capital flows into Latin America had increased markedly. 3_/ The fall reflects to some extent the appreciation of the currency. Mexico's data were adjusted to include tesobonos held by nonresidents, which, although included in domestic debt because of their currency denom- ination, were in fact dollar indexed and hence more comparable to other foreign liabilities.

©International Monetary Fund. Not for Redistribution Figure 2: Real Exchange Rate (Index) - 6 a

Index: 1978=1990=100 Source: See Annex Table. Note: An increase indicates a real depreciation.

©International Monetary Fund. Not for Redistribution Figure 3: Trade Balance (Mexico: billions US$s; Uruguay: 100 million US$s) - 6 b

Source: See Annex Table,

©International Monetary Fund. Not for Redistribution - 6c - Figure 4: Interest Rates and Inflation (Annual % rate)

4a: Mexico

4b: Uruguay

Source: See Annex Table.

©International Monetary Fund. Not for Redistribution Figure 5: Real Interest Rates (Annual % rate) - 6 d

Source: See Annex Table.

©International Monetary Fund. Not for Redistribution Figure 6: Gross International Reserves (Index) - 6 e

Index: 1978=1990=100 Source: See Annex Table.

©International Monetary Fund. Not for Redistribution Figure 7: Stock of Foreign Public Debt (as % of GDP) - 6 f

Source: See Annex Table. Note: Data refers to the non-financial public sector and in the case of Mexico it also includes Tesobonos held by non-residents.

©International Monetary Fund. Not for Redistribution Figure 8: Foreign Savings (as % of GDP) - 6 8

Source: See Annex Table.

©International Monetary Fund. Not for Redistribution Figure 9: Total Domestic Savings (as % of GDP) - 6 h

Source: See Annex Table.

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consumption that grew by about 20 percent both in Uruguay (1978-81) and in Mexico (1989-94) (Figure 10). I/

The remarkable resemblance in the path followed by the key macroeconomic variables in the two countries is not restricted to the successful face of the stabilization programs, but extends to the developments that led to the crises. In both countries, exogenous shocks, of internal or external origin, caused an initial breakdown of confidence and a sharp reversal of capital inflows. 2/ This led to a serious deterioration in the international reserve position which, in turn, tended to increase the uncertainty about the ability and the determination of the Government to maintain an exchange rate policy that looked increasingly unsustainable in light of the policy response to the destabilizing shocks. In Uruguay, gross international reserves plunged from US$960 million at the end of 1981 to US$560 million at the end of the following year. In Mexico, reserves fell from US$25.3 billion at the end of 1994 to US$6.4 billion a year later (see Figure 6).

What is remarkable in this account is the similarity of the reaction of the authorities to the unexpected shocks. In both cases, in order to avoid the contractionary cost bound to arise from a serious compression of liquidity, the monetary authorities offset the fall of international

\J As has been argued by Calvo in a number of contributions, this increase in consumption, despite the higher and rising price of credit, could reflect the perception of economic agents that liberalization was temporary and that the stabilization strategy was unsustainable. The boom in real consumption could therefore be another indication of the increasing lack of credibility of the policy package (see, for example, Calvo and Mendoza [1994]). Also, if people expect the inflation rate to be higher than the planned devaluation for a certain period of time, the ex ante real interest rate on foreign borrowing becomes negative. This could also explain the boom in consumption, as could wealth effect and the relaxation of liquidity constraints following financial liberalization. 2/ As discussed in more detail below, contrary to Mexico, the main shock in Uruguay was external, relating to the change in policy mix and disinflation policy in the United States and the subsequent high real rates of interest in capital markets and world recession, although political and economic instability in the region also had a negative impact.

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reserves by significantly increasing the rate of growth of domestic credit. I/

In real terms, domestic credit expansion increased in Uruguay from an average of 18.0 percent a year in 1979-81 to 94.0 percent in 1982. 2/ The increase for Mexico was from 6.6 percent a year in 1992-93 to 51.3 percent in 1994. Figure 11 depicts this singular parallel in the behavior of the credit aggregates in both countries. It is clear, in our view, that this significant acceleration of domestic credit creation was perceived as largely inconsistent with the maintained exchange rate rule, and was, perhaps, the single most important factor behind the collapse of internal and external confidence and the eventual disintegration of the stabilization package.

The dramatic expansion of domestic credit seems to have been regarded merely as a compensating operation carried out in order to insulate the aggregate money supply from the exogenously caused decline in international reserves. This, in turn, was most probably motivated by the monetary authorities' attempt to avert a further increase in domestic interest rates and to lower the probability of widespread defaults and bankruptcies of private enterprises, particularly in the presence of an increasingly weak banking sector. 3_/ As pointed out by Heath [1995], in the case of Mexico, "... the credit expansion in 1994 was an effort to pump up ailing banks."

The rest of the stories are, of course, well known. The combination of expanding liquidity in the face of a falling demand for domestically

¿/ It should be emphasized that both financial systems were already under considerable strain as a result of risky lending policies (in the case of Mexico followed by the recently reprivatized banks). Some analysts have argued that exchange rate stabilization may promote excessive risk-taking by financial institutions in environments lacking appropriate banking super- vision and regulation. Perhaps more importantly, the increase in real domestic interest rates causes a reduction in the value of collateral held by the banks. For a detailed analysis of the causes and consequences of the banking crisis in Uruguay see Pérez-Campanero and Leone (1991). 2/ The increase in domestic credit in Uruguay did not only reflect the effort to sterilize the fall in international reserves but also the need to monetize a large fiscal deficit starting in mid-1981. After having a small deficit of 1 percent of GDP in 1978, fiscal balance was obtained in 1979 and there was a small surplus in 1980. Although the deficit was 1.5 percent in 1981, the fiscal situation deteriorated sharply in the second half of the year and the deficit soared to 9 percent of GDP in 1982 [del Castillo (1976)]. ¿/ Such response probably resulted from the authorities' perception (which turned out to be incorrect) that the shocks were temporary. The Mexican response to a previous large fall in reserves in early November 1993 resulting from uncertainty about the future of NAFTA was similar but the shock proved transitory and large capital inflows ensued in early 1994.

©International Monetary Fund. Not for Redistribution Figure 10: Real Private Consumption (Index) - 8 a

Index: 1978=1990=100 Source: See Annex Table.

©International Monetary Fund. Not for Redistribution Figure 11 : Real Domestic Credit (Annual % change) - 8 b

Source: See Annex Table.

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denominated assets resulted in a continuously growing excess supply of money that, eventually, led the respective governments to abandon the exchange rate regime. It is interesting to point out that the decision to do so was particularly untimely in both cases. In Uruguay, the devaluation was extremely untimely because it took place in the midst of the grave 1982 recession in the region, at a time when it was very unlikely to result in a significant improvement in the balance of payments. In Mexico, the devaluation took place after the private sector portfolio had shifted in favor of the doliar-indexed tesobonos. which accounted for over 50 percent of total government securities at end-November 1994.

In both cases the medicine may well have been as damaging as the dis- ease . The devaluations caused such loss of confidence ¿/ that external financing was needed, in very significant amounts, to ameliorate the weak financial situation in the short run. 2/ This, of course, caused large increases in foreign indebtedness which, in the case of Uruguay, was to have a negative impact for years to come. In Uruguay, foreign debt of the nonfinancial public sector increased from 4.8 percent of GDP in 1981 to 14.4 percent in 1982 and to 18.3 percent in 1983. In Mexico, the respective figures were 11.3 percent in 1993, 17.5 percent in 1994, and 26.0 percent in 1995 (see Figure 7). ¿/ Economic activity also suffered seriously from the crisis: in both countries output declined sharply, 4/ with plummeting real wages and widespread unemployment, and major rescue packages for their banking systems had to be put in place. History, therefore, repeated itself also regarding the real cost of adjusting to a set of inconsistent macroeconomic policies.

III. Some Important Differences

Even though the graphic parallelism is remarkable, the question still arises: why compare such strikingly different countries? We argue that, in spite of the obvious differences, had the Mexican statistical information been more transparent to economic agents and the Southern Cone experience better remembered, they could have provided a warning that the type of monetary/exchange rate policy mix that Mexico was implementing was likely to lead to a financial crisis. To say this, however, is not to deny the major differences in the structure and performance of both economies under analysis that must be taken into consideration to avoid unwarranted generaliza- tions .

I/ See Masson and Agénor (1996). 2/ Note, however, that in both cases, the large increase in the stock of foreign debt of the nonfinancial public sector had started the year before the crisis. ¿/ Part of this increase is accounted for by the depreciation in the domestic currency. 4/ Real GDP fell by 10.2 percent in Uruguay and by 7.0 percent in Mexico.

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Growth performance was strikingly different in the reform period leading to the financial crisis. While in Uruguay real growth averaged 4.7 percent a year (4.1 percent in per capita terms), Mexico's real growth in 1990-94 averaged only 2.8 percent (1 percent in per capita terms). !/ The Mexican performance is particularly puzzling in light of the enormous capital inflows, amounting to US$91 billion, that took place in 1990-93 (about one fifth of all net inflows to developing countries).

The behavior of investment has historically been different in the two countries. While Mexico invested 21 percent of its GNP annually in 1955-89, Uruguay only invested about 13 percent. Although the lower Uruguayan investment rate reflects to some extent the more modest demands imposed by the very slow population expansion, a significant increase in the rate of investment took place in Uruguay after economic liberalization, starting in 1974, with investments averaging close to 16 percent in 1978-80. This did not happen in Mexico, where the ratio of investment to GDP fell every year from 1992 onwards.

Although, as we pointed out above, real wages fell drastically in the two countries after the devaluation, the situation in the period before the crisis was somewhat different (Figure 12). In Mexico, real minimum wages, which had fallen by half in 1982-89, fell by a further 10 percent in 1990-93 in spite of the consumption boom. With the reactivation of the economy in 1994, real minimum wages practically stopped falling (showing only a 0.2 percent decrease). In Uruguay, real wages fell by 28 percent in 1973-78. Real wages continued to fall in 1979 (by 8.5 percent as a result of the jump in inflation caused by the second oil shock) , but by 1981 they had practically regained their 1978 value. The recuperation in real wages took place concomitantly with a very large fall in the rate of unemployment (from 10.6 percent in the first half of 1978 to 5.8 percent in the same period of 1981).

Another significant difference relates to the type of capital inflows experienced by each country. While portfolio capital--relatively volatile in nature--represented 60 percent of all inflows into Mexico in

\J This should be contrasted with the overall post-war performance. While, in the period 1950-70, Mexico expanded in real terms at over 2 percent a year, in 1955-73 Uruguay grew at only 0.5 percent a year. In per capita terms, however, since the population of Uruguay grew at only 0.8 percent during this period and that of Mexico at 3 percent, real per capita GDP declined annually by 0.3 percent in Uruguay and by 1 percent in Mexico.

©International Monetary Fund. Not for Redistribution Figure 12: Real Wages (Index)

I M ? I

Index: 1978=1990=100 Source: See Annex Table,

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1990-93, i/ Uruguay attracted mostly Argentine capital directed to the nontradeable sector (construction and real estate). 2/

A most important difference is related to the types of shocks affecting the two economies over the period analyzed. The nature of the most serious shocks suffered by Uruguay was external, largely related to the change in the policy mix and to the turn toward disinflationary policies in the United States, with the subsequent world recession arising from the rise in interest rates in international capital markets, which became highly positive in real terms in 1981-82. Two other external factors that contributed to the crisis were the drastic reduction in international bank credit to Latin America following the 1982 debt crisis, and the appreciation of the U.S. dollar (to which the peso was pegged from October 1978 to November 1982). These factors had a serious adverse effect on Uruguay's external accounts. In addition, political and economic instability in the region, particularly the collapse of the Argentine tablita in mid-1981, the weakness of the Brazilian economy in 1981 as well as the confiscation of dollar assets in Mexico in August 1982, also intensified recessionary pressures and contributed to large capital flight. In the recent Mexican case, on the other hand, it is fair to say that the main shock was domestic, relating to the instability created by a series of political assassinations and the unrest in the Chiapas region during an election year. However, the significant rise in U.S. interest rates at the beginning of 1994 also played an important role. At the same time, the Mexican shock was perceived as temporary, more so than the Uruguayan one.

Because of these differences in the nature of the shocks and because of the changes in the international environment, the adjustment to the crisis was also different, with corrections to the trade balance being achieved mainly through a contraction in imports in the case of Uruguay and mostly through an expansion of exports in the case of Mexico. Adjustment in Mexico should be facilitated by her special relationship with the United States reflected not only in NAFTA, which has obviously helped exports, but also in the generous rescue package that has allowed Mexico to deal with its deli- cate financial situation.

IV. Some Concluding Remarks

The experiences of the Southern Cone of Latin America in the 1970s, and particularly that of Uruguay, have provided earlier evidence of the problems that arise from the use of exchange rate policy to stabilize an economy

I/ Although the foreign direct investment share represented only 30 percent of capital inflows in 1990-93, it increased to 70 percent in 1994 [Banco de México (1995a)]. 2/ Availability of data in the case of Uruguay does not allow for a comparable breakdown of capital inflows between portfolio and foreign direct investment.

which enjoys full capital mobility. The dangers arise because, although exchange rate stability has, indeed, proved to be a critical instrument in achieving disinflation in the short run, as a long-term anti-inflationary weapon it poses serious challenges to policymakers. The first challenge results from the potential overvaluation of the currency arising from inertial and credibility factors. The second danger is rooted in an increase in vulnerability arising from the ever-present likelihood of exogenous shocks and the need to accept the often unpalatable recession imposed by a large fall in international reserves.

In Mexico, as in Uruguay a dozen years earlier, the motivation behind the exchange rate based experiment was the frustration with previous orthodox and heterodox strategies that had failed to reactivate the economy while maintaining inflation at manageable levels and keeping a reasonable amount of international reserves. By preannouncing the future path of the exchange rate at levels compatible with fiscal discipline and with the expansion of domestic credit at rates below domestic monetary demand, a convergence of inflation to world levels and an accumulation of international reserves could, indeed, have been expected.

But in Mexico, as in Uruguay before, economic agents did not fully believe that the experiment with the management of the exchange rate would be sustainable. The current account deteriorated sharply, consumption soared, and domestic savings plunged. Although this pattern of behavior could have been eventually overcome, the impact of large negative shocks (always unpredictable, by definition) sharpens the government dilemma and increases its vulnerability, particularly if it is not fully committed to accepting the constraint that a fall in international reserves imposes on domestic financial policies. A policy of utilizing the exchange rate policy as an anti-inflationary instrument can only succeed if the authorities stick--even under severe shocks and intense opposition from business and trade unions--to a fiscal policy compatible with the exchange rate policy and refrain from overexpanding domestic credit in order to avoid recessionary effects. In Mexico, as in Uruguay, the authorities succumbed to the temptation to sterilize the fall in reserves.

The experience of Mexico and Uruguay indicates that credibility in exchange rate based stabilization is likely to be low from the beginning because of the side effects mentioned above and because the public under- stands the dangers that it entails. It therefore often leads to high nominal and real rates of interest, which have a detrimental effect on the private sector in general and on the banking system in particular. If the anti-inflationary intentions of the monetary authorities were credible, or if there were institutional arrangements to ensure that deviations are

unlikely (such as a currency board or other such institutional arrange- ment) , I/ nominal interest rates would eventually come down. However, if the Government lacks a firm commitment to financial policies compatible with exchange rate stability, economies with fixed exchange rates, high nominal interest rates, large current account deficits, and full capital mobility would become highly vulnerable to external and/or internal shocks.

Just as the anchor of a ship is most important when the tide is running high, the maintenance of the exchange rate, the nominal anchor in the stabilization program, becomes critical in the presence of instability resulting from severe negative shocks. In the presence of such shocks, the right approach for a government that has committed itself to an exchange rate based program is to ensure that monetary and fiscal policies do not get out of line with the announced exchange rate policy. Furthermore, if credibility were low, as is often the case in such situations, fiscal policy may need to be exceptionally tight to help keep interest rates manageable and limit the recessionary impact of the shocks. Obviously, if what led to a financial crisis were overexpansionary monetary and fiscal policies, it is crucial that these be brought back in line. Abandonment of the exchange rate anchor during the financial crisis is not likely to solve the crisis except in the short run through large increases in foreign borrowing that will, at the same time, exacerbate the confidence crisis.

The experiences of Uruguay and Mexico show that the expected rewards of this type of exchange rate based stabilization can be high but that the potential costs are also high. They also provide evidence that most of the gains from the experiment in terms of stability and growth are lost once the exchange rate policy is discontinued. Worse still, the credibility cost of such failures makes future stabilization more difficult, entails a further loss of flexibility, and requires even stronger initial measures.

\J In Argentina, for example, the Convertibility Law of 1991 prevented the Central Bank from expanding domestic credit in light of the fall in reserves resulting from the Mexican crisis. As noted by Calvo, however, it did not completely preclude an expansion of liquidity since commercial banks were allowed to increase credit as a result of a fall in reserve requirements.

1990 1991 1992 1993 1994 1995

Inflation rate (percent change) 26.70 22.70 15.50 9.80 7.01 35.00 Real exchange rate (index) 100.00 90.00 84.00 78.00 81.00 108.00 Trade balance (billions of US$) -0.89 -7.30 -15.90 -13.50 -18.46 7.09 Nominal interest rate (percent change) 37.07 22.56 18.78 18.56 17.24 52.00 Real interest rate (percent change) 10.37 -0.14 3.28 8.76 10.24 17.00 Gross international reserves (index) 100.00 177.23 192.08 250.50 63.37 183.17 Stock of foreign public debt (percent of GDP) 21.00 17.40 13.50 11.30 17.45 26.00 Foreign savings (percent of GDP) 3.10 5.30 7.50 6.50 7.80 0.30 National savings (percent of GDP) 15.70 14.30 14.00 14.20 13.80 17.20 Real private consumption (index) 100.00 105.20 109.80 109.80 112.80 106.60 Real domestic credit (percent change) -4.16 8.88 5.30 5.68 51.33 -14.97 Real minimum wage (index) 100.00 95.74 91.70 90.17 89.95 74.54

Source: IMF, International Financial Statistics, various issues, updated with Fund staff estimates. - 1 4

Uruguay: Selected Items, 1978-83

1978 1979 1980 1981 1982 1983

Inflation rate (percent change) 44.49 66.76 63.40 34.00 19.03 49.22 Real exchange rate (index) 100.00 87.00 76.00 75.00 75.00 133.00 Trade balance (US$100 million) -0.24 -3.78 -6.10 -3.62 2.18 4.17 Nominal interest rate (percent change) 71.20 68.10 66.60 60.40 58.50 93.60 Real interest rate (percent change) 27.00 1.00 3.00 26.00 39.00 44.00 Gross international reserves (index) 100.00 112.45 123.81 128.70 75.36 97.85 Stock of foreign public debt (percent of GDP) 11.36 8.23 4.64 4.82 14.41 18.26 Foreign savings (percent of GDF) 2.46 4.48 6.24 3.74 3.14 -1.83 National savings (percent of GDF) 13.55 12.83 11.11 11.41 11.28 12.86 Real private consumption (index) 100.00 108.00 116.00 116.80 103.00 97.90 Real domestic credit (percent change) 5.50 19.60 20.70 14.10 93.60 -37.30 ANHE X TABL E Average real wage (index) 100.00 91.48 92.04 98.63 98.07 77.81

Source: del Castillo (1986), except data for the real exchange rate, from Talvi (1995).

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