Case: The Mexican Peso
Case: The Mexican Peso
On August 31,1976, the Mexican peso was cut loose from its exchange rate of 12.5 pesos to the dollar, which was established in 1955. From 1955 to 1976 the exchange rate had been maintained artificially through a variety of mechanisms. Import controls and market intervention were used extensively to allow the peso to appear stabler than it was, thereby frustrating firms operating in Mexico. Many companies established manufacturing operations in Mexico only to find that the government eventually would phase out their ability to import needed raw materials and components.
During the 1970s pressure began to build for a change in the value of the currency. Tourism, a major source of foreign exchange, began to taper off because of rising prices resulting directly from general inflation in the economy. (See Map 7.2.)
Mexico began importing more than it was exporting, which resulted in an outflow of pesos to buy the excess imports. Exporters to Mexico did not want to hold onto pesos, preferring instead to convert them into dollars. To give so many
dollars in order to buy back the pesos would have depleted Mexico's holdings of dollar reserves severely if Mexican authorities used these existing reserves to make the conversion. Instead Mexico chose to maintain its level of reserves by increased short-term external borrowing of dollars, which would eventually result in principal and interest payments that could rob Mexico of what little foreign exchange it could gather.
Because of these and other pressures, officials agreed to devalue the peso on August 31, 1976, to 20.5 pesos to the dollar in the hope that this devaluation would absorb some of the excess supply of pesos in the market and allow the economy to stabilize. Even though devaluation was the initial solution to the problem, the government also considered establishing more elaborate foreign-exchange controls so that spot transactions could be allocated according to governmental priorities. Finally, Mexico decided on devaluation rather than the establishment of an elaborate bureaucracy to administer the foreign-exchange controls.
Unfortunately, the solution to the problem was short-lived. From 1976 to mid-1981 the peso held its postdevaluation level, but inflation and other forces that had created the problems leading up to the 1976 devaluation reemerged.
Imports again exceeded exports, tourism fell steadily, foreign credit became tight and expensive, and world oil prices and demand softened considerably. The Central Bank of Mexico steadfastly maintained that a relatively modest devaluation of 15-20 percent would correct the imbalances in the economy, and officials appeared to be in no hurry to make any changes.
Meanwhile, the situation worsened. In the absence of capital controls, wealthy Mexicans spent their money abroad on consumer durables and investments that would shelter them against another possible devaluation. With the government continuing to exude confidence up to the last hour, a devaluation of over 40 percent was announced on February 17, 1982, bringing the new rate to 38.50 pesos to the dollar. At the
same time the government announced that it hoped to keep the exchange rate to a level of 38-43 pesos during the rest of the year. In an interesting move, a subsequent devaluation was announced on February 26, 1982, to 47.25 pesos, rendering obsolete the prediction of slightly a week earlier.
The two devaluations were not successful. In August 1982, after another devaluation, the government decided to establish two exchange rates: a preferential rate and a free-market rate. The official rate was only 49 pesos, unfortunately, and the free-market rate shot up to 105 pesos.
In September 1982 the government nationalized all private banks and instituted currency controls. In addition to these rules, the govern
ment established a fixed priority list for determining who would get foreign exchange.
A preferential rate of 50 pesos was established for imports of basic foods and capital goods needed to produce food, intermediate products and capital goods needed to keep industry functioning, and capital goods for industrial expansion.
Importers faced obstacles in getting foreign exchange, even when they were high enough on the priority list to be eligible for foreign exchange. However, the controls did recognize the contribution of exports to the generation of foreign exchange. For materials imported and incorporated in export products the preferential rate could be used even if such materials were not on the preferential list if the exported product generated more foreign exchange than the cost of the import.
During the 1980s, the peso continued to weaken. Fueled by inflation that averaged a low of 59.2 percent in 1984 and a high of 159.2 percent in 1987, the peso fell to a year-end rate of 143.9 pesos per dollar in 1983 and 2281 pesos per dollar in 1988.
During 1988 there were two exchange markets in Mexico: the controlled market and the free market. Transactions in the controlled market included (1) merchandise export receipts (with some exceptions); (2) payments by in-bond industries for wages, salaries, leasings or rents, and the purchase of Mexican goods and services, other than fixed assets; (3) royalties for the use of foreign technologies and patents; (4) payments of principal, interest, and related expenses resulting from financial and suppliers' credits by the public and private sectors; (5) payments for imports with some exceptions; (6) expenses in relation to the Mexican foreign service and contributions regarding Mexico's membership in international organizations; and (7) other transactions specifically authorized by the Secretariat of Finance and Public Credit.
Those who wished to convert pesos in the controlled market could use a retail exchange
rate that was determined between the participant and the banks, or at the "equilibrium exchange rate," which was determined for the controlled market each day at a fixing session at the Bank of Mexico in which the major banks exchanged bids for purchases and sales of foreign exchange. For example, on December 30, 1988, the equilibrium exchange rate in the controlled market for the U.S. dollar was Mex $2281 per U.S. $1, and the buying and selling rates in the same market were Mex $2241 and Mex $2273 per U.S. $1, respectively. On the same date in the free market, the buying and selling rates for the dollar were Mex $2270 and Mex $2330, respectively. In the free market, there were no limitations to the access to, ownership, or transfer of foreign exchange.
The Bank of Mexico provided an instrument for forward cover of foreign exchange for the repayment of certain foreign-debt obligations. Since 1987, the Bank of Mexico also began to operate a short-term foreign-exchange risk coverage market through which commercial and financial operations are covered against exchange fluctuations. The scheme applies only to the U.S. dollar, and the coverage is based on the equilibrium exchange rate prevailing on the date of the contract.
In 1988 there were also a variety of import controls and controls on access to foreign exchange. In the controlled market, importers could acquire foreign exchange for the full value of merchandise already imported and for which payment had not yet been made. Full advance payment for all imports was also allowed, if the value of the goods did not exceed U.S. $10,000 or if the payment was made through a letter of credit. For purchases in excess of U.S. $10,000, only 20 percent advance payment was allowed.
In July 1988 Carlos Salinas de Gortari was elected President in Mexico, and he took office on December 1. At that time, he speeded up the process of economic liberalization by liberalizing trade and foreign investment and by embarking on an ambitious privatization program. It soon
became obvious that the centerpiece of his economic program was the control of inflation. Consumer price increases fell to 19.7 percent by 1989 year-end, and they were expected to rebound to nearly 30 percent by 1990 year-end. However, Salinas continued to work to control inflation, and many experts predicted inflation below 20 percent by the end of 1991 and possibly single digits thereafter. As a commitment to those policies, the government extended the Pact for Stabilization and Economic Growth (PECE) through the end of 1991.
The Pact relies on continued price controls and a decline in the rate of daily peso slippage. In order to reduce inflation induced by higher-priced imports, the government decided to formally devalue the peso by P0.8 per day. However, that slippage was reduced to P0.4 per day at the end of 1990. The feeling in Mexico was that the peso was overvalued and that exports were becoming increasingly difficult. However, strong oil revenues and the repatriation of capital into Mexico were helping to keep the peso in line. This inflow of capital nearly eliminated the difference between the official and free-market exchange rates by the end of 1990.
The controlled exchange rate was expected to reach about Mex $2951 by the end of 1990, and many experts were predicting major changes in the exchange rate in 1991. Given that 64.2 percent of Mexico's exports are to and 68.2 percent of its imports are from the United States, it made sense for the Mexican government to tie its currency to the U.S. dollar. The key to a parity with the dollar is the elimination of inflation. A total freeze in the peso/dollar exchange rate was expected to be announced during the third quarter of 1991, together with a new currency unit (a New Peso) worth 1000 old pesos and a maxi-devaluation of about 24 percent that would produce a fixed new parity of four new pesos per dollar. If inflation could be controlled, that would allow the new exchange rate to remain at four new pesos to the dollar for the foreseeable future and the elimination of a controlled/free-market differential.
On August 31,1976, the Mexican peso was cut loose from its exchange rate of 12.5 pesos to the dollar, which was established in 1955. From 1955 to 1976 the exchange rate had been maintained artificially through a variety of mechanisms. Import controls and market intervention were used extensively to allow the peso to appear stabler than it was, thereby frustrating firms operating in Mexico. Many companies established manufacturing operations in Mexico only to find that the government eventually would phase out their ability to import needed raw materials and components.
During the 1970s pressure began to build for a change in the value of the currency. Tourism, a major source of foreign exchange, began to taper off because of rising prices resulting directly from general inflation in the economy. (See Map 7.2.)
Mexico began importing more than it was exporting, which resulted in an outflow of pesos to buy the excess imports. Exporters to Mexico did not want to hold onto pesos, preferring instead to convert them into dollars. To give so many
dollars in order to buy back the pesos would have depleted Mexico's holdings of dollar reserves severely if Mexican authorities used these existing reserves to make the conversion. Instead Mexico chose to maintain its level of reserves by increased short-term external borrowing of dollars, which would eventually result in principal and interest payments that could rob Mexico of what little foreign exchange it could gather.
Because of these and other pressures, officials agreed to devalue the peso on August 31, 1976, to 20.5 pesos to the dollar in the hope that this devaluation would absorb some of the excess supply of pesos in the market and allow the economy to stabilize. Even though devaluation was the initial solution to the problem, the government also considered establishing more elaborate foreign-exchange controls so that spot transactions could be allocated according to governmental priorities. Finally, Mexico decided on devaluation rather than the establishment of an elaborate bureaucracy to administer the foreign-exchange controls.
Unfortunately, the solution to the problem was short-lived. From 1976 to mid-1981 the peso held its postdevaluation level, but inflation and other forces that had created the problems leading up to the 1976 devaluation reemerged.
Imports again exceeded exports, tourism fell steadily, foreign credit became tight and expensive, and world oil prices and demand softened considerably. The Central Bank of Mexico steadfastly maintained that a relatively modest devaluation of 15-20 percent would correct the imbalances in the economy, and officials appeared to be in no hurry to make any changes.
Meanwhile, the situation worsened. In the absence of capital controls, wealthy Mexicans spent their money abroad on consumer durables and investments that would shelter them against another possible devaluation. With the government continuing to exude confidence up to the last hour, a devaluation of over 40 percent was announced on February 17, 1982, bringing the new rate to 38.50 pesos to the dollar. At the
same time the government announced that it hoped to keep the exchange rate to a level of 38-43 pesos during the rest of the year. In an interesting move, a subsequent devaluation was announced on February 26, 1982, to 47.25 pesos, rendering obsolete the prediction of slightly a week earlier.
The two devaluations were not successful. In August 1982, after another devaluation, the government decided to establish two exchange rates: a preferential rate and a free-market rate. The official rate was only 49 pesos, unfortunately, and the free-market rate shot up to 105 pesos.
In September 1982 the government nationalized all private banks and instituted currency controls. In addition to these rules, the govern
ment established a fixed priority list for determining who would get foreign exchange.
A preferential rate of 50 pesos was established for imports of basic foods and capital goods needed to produce food, intermediate products and capital goods needed to keep industry functioning, and capital goods for industrial expansion.
Importers faced obstacles in getting foreign exchange, even when they were high enough on the priority list to be eligible for foreign exchange. However, the controls did recognize the contribution of exports to the generation of foreign exchange. For materials imported and incorporated in export products the preferential rate could be used even if such materials were not on the preferential list if the exported product generated more foreign exchange than the cost of the import.
During the 1980s, the peso continued to weaken. Fueled by inflation that averaged a low of 59.2 percent in 1984 and a high of 159.2 percent in 1987, the peso fell to a year-end rate of 143.9 pesos per dollar in 1983 and 2281 pesos per dollar in 1988.
During 1988 there were two exchange markets in Mexico: the controlled market and the free market. Transactions in the controlled market included (1) merchandise export receipts (with some exceptions); (2) payments by in-bond industries for wages, salaries, leasings or rents, and the purchase of Mexican goods and services, other than fixed assets; (3) royalties for the use of foreign technologies and patents; (4) payments of principal, interest, and related expenses resulting from financial and suppliers' credits by the public and private sectors; (5) payments for imports with some exceptions; (6) expenses in relation to the Mexican foreign service and contributions regarding Mexico's membership in international organizations; and (7) other transactions specifically authorized by the Secretariat of Finance and Public Credit.
Those who wished to convert pesos in the controlled market could use a retail exchange
rate that was determined between the participant and the banks, or at the "equilibrium exchange rate," which was determined for the controlled market each day at a fixing session at the Bank of Mexico in which the major banks exchanged bids for purchases and sales of foreign exchange. For example, on December 30, 1988, the equilibrium exchange rate in the controlled market for the U.S. dollar was Mex $2281 per U.S. $1, and the buying and selling rates in the same market were Mex $2241 and Mex $2273 per U.S. $1, respectively. On the same date in the free market, the buying and selling rates for the dollar were Mex $2270 and Mex $2330, respectively. In the free market, there were no limitations to the access to, ownership, or transfer of foreign exchange.
The Bank of Mexico provided an instrument for forward cover of foreign exchange for the repayment of certain foreign-debt obligations. Since 1987, the Bank of Mexico also began to operate a short-term foreign-exchange risk coverage market through which commercial and financial operations are covered against exchange fluctuations. The scheme applies only to the U.S. dollar, and the coverage is based on the equilibrium exchange rate prevailing on the date of the contract.
In 1988 there were also a variety of import controls and controls on access to foreign exchange. In the controlled market, importers could acquire foreign exchange for the full value of merchandise already imported and for which payment had not yet been made. Full advance payment for all imports was also allowed, if the value of the goods did not exceed U.S. $10,000 or if the payment was made through a letter of credit. For purchases in excess of U.S. $10,000, only 20 percent advance payment was allowed.
In July 1988 Carlos Salinas de Gortari was elected President in Mexico, and he took office on December 1. At that time, he speeded up the process of economic liberalization by liberalizing trade and foreign investment and by embarking on an ambitious privatization program. It soon
became obvious that the centerpiece of his economic program was the control of inflation. Consumer price increases fell to 19.7 percent by 1989 year-end, and they were expected to rebound to nearly 30 percent by 1990 year-end. However, Salinas continued to work to control inflation, and many experts predicted inflation below 20 percent by the end of 1991 and possibly single digits thereafter. As a commitment to those policies, the government extended the Pact for Stabilization and Economic Growth (PECE) through the end of 1991.
The Pact relies on continued price controls and a decline in the rate of daily peso slippage. In order to reduce inflation induced by higher-priced imports, the government decided to formally devalue the peso by P0.8 per day. However, that slippage was reduced to P0.4 per day at the end of 1990. The feeling in Mexico was that the peso was overvalued and that exports were becoming increasingly difficult. However, strong oil revenues and the repatriation of capital into Mexico were helping to keep the peso in line. This inflow of capital nearly eliminated the difference between the official and free-market exchange rates by the end of 1990.
The controlled exchange rate was expected to reach about Mex $2951 by the end of 1990, and many experts were predicting major changes in the exchange rate in 1991. Given that 64.2 percent of Mexico's exports are to and 68.2 percent of its imports are from the United States, it made sense for the Mexican government to tie its currency to the U.S. dollar. The key to a parity with the dollar is the elimination of inflation. A total freeze in the peso/dollar exchange rate was expected to be announced during the third quarter of 1991, together with a new currency unit (a New Peso) worth 1000 old pesos and a maxi-devaluation of about 24 percent that would produce a fixed new parity of four new pesos per dollar. If inflation could be controlled, that would allow the new exchange rate to remain at four new pesos to the dollar for the foreseeable future and the elimination of a controlled/free-market differential.
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