This is a Working Paper and the author(s) would welcome IMF WORKING PAPER any comments on the present text. Citations should refer to a Working Paper of the International Monetary Fund, men- © 1996 International Monetary Fund tioning the author(s), and the date of issuance. The views expressed are those of the authors) and do not necessarily represent those of the Fund. 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 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. ©International Monetary Fund. Not for Redistribution - ii - 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 ©International Monetary Fund. Not for Redistribution - iii - 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 mone- tary 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, moti- vated in part by vulnerability in the banking system, and the (incorrect) perception that the shocks were temporary. Eventually, however, the deteri- oration 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 credibil- ity factors, and because it greatly increases the economy's vulnerability to shocks. ©International Monetary Fund. Not for Redistribution This page intentionally left blank ©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. ©International Monetary Fund. Not for Redistribution - 2 - and by issuing tesobonos. ¿/ The expansion in domestic credit compounded the already ongoing accelerated rate of lending by the state-owned develop- ment 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.