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Currency Crisis

Currency Crisis. Capital Flows. Short-tem and Long-term portfolio investment Foreign Direct Investment (FDI) Both increased during the 1990’s Why? Sound macroeconomic policies Legislative changes Reduced political risk. Factors that Contributed to the Crises. Fragile banking sector

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Currency Crisis

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  1. Currency Crisis

  2. Capital Flows • Short-tem and Long-term portfolio investment • Foreign Direct Investment (FDI) • Both increased during the 1990’s • Why? • Sound macroeconomic policies • Legislative changes • Reduced political risk

  3. Factors that Contributed to the Crises • Fragile banking sector • Sluggish technology advancement • Privatization led to high degree of concentration, which is inefficient • Political intervention • Deficient regulatory system and inefficient legal system

  4. Mexican Case • Prelude • 1982 nationalization of the banking system • 1988 privatization • 1987-1994 commercial credit expanded more than 100% • Promise of high returns with the signing of NAFTA • Relatively low foreign interest rates • The optimism created an asset price boom

  5. Reality • Economic performance was below expectations • Political events • January 1994: armed uprising in Chiapas • March 1994: official presidential candidate assassinated • A little-known economist was elected President • Capital flight

  6. To defend or not to defend

  7. Facts • Mexican peso was overvalued • This overvaluation led to a current account deficit • Mexico’s interest rate premium was relatively high

  8. Government Intervention • Assured investors the instability was transitory • Tight monetary policy • Sterilized interventions in the foreign exchange rate market • Changed the composition of government debt, from CETES to TESOBONOS

  9. Initial devaluation of 15% • December Mistake: capital flight continued • Short-term public debt increased significantly • By the end of December let the peso float

  10. Resolution and Consequences • Foreign intervention: U.S. government, Canada, Europe, and IMF • Deep domestic economic crisis • Tequila effect: speculative attacks • Significant in Argentina and Brazil, not in Chile

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