In 1994 the Mexican government abandoned their crawling peg to the US dollar. This was brought...

In 1994 the Mexican government abandoned their crawling peg to the US dollar. This was brought about by a complicated sequence of events, but in this question we focus only on the dynamics of the last part of the crisis. Running low on dollar reserves in December of 1994, the Mexican central bank devalued the peso. There was a spike in the risk premium investors demanded to lend to Mexico. The resulting increase in interest rates and contracting output ultimately led the government to abandon the peg.

How does a simultaneous devaluation and rise in the risk premium could lead to a scenario such as the one described above.

Expert Solution

The iMexican ipeso icrisis iwas ia icurrency icrisis ithat iwas ihappened idue ito ithe iMexican igovernment's isudden idevaluation iof ithe ipeso iagainst ithe iU.S. idollar iin iDecember i1994. i iThis icrisis iwas itriggered iby ia icombination iof ipoorly icarried iout ireforms, ia icurrency ipeg, icurrent iaccount ideficits, ipolicy irate ihikes iin ithe iUS iand isocial iunrest, iand ifinally iled ito iboth ia icurrency iand ibanking icrisis. iThe iMexican icrisis iare ithat ithe idevaluation iof ithe ipeso iwas ia isurprise ito iparticipants iin ifinancial imarkets, iand ithat iMexican iauthorities, iby iintervening iheavily iin ithe imoney imarket, idid inot ilet iinterest irates irise ito ifight ithe ispeculative iattack ion ithe ipeso. iTherefore, iin i1994 iassassination iof iLuis iDonaldo iColosio, ithe icandidate ifavored ito iwin iMexico's ipresidential ielection iin iAugust i1994. iA ifew imonths iafter ithis ievent, ithe iinterest irate idifferential ibetween ipeso-denominated iand idollar-denominated igovernment ibonds ipartially ireversed iits iincrease. iSimultaneously, ithe igovernment iimplemented ia isignificant ichange iin ithe icomposition iof iits idomestic idebt. iThe ichange iin ithe iratio iof idollar-denominated ibonds i(Tesobonos) ito ipeso-denominated ibonds i(Cetes) iin iprivate ihands ithat iled ito ichange iin ithe icurrency icomposition iof igovernment idebt ihas ibeen iprincipal icaused iof ithe ifinancial icrisis ithat ilead ito idevaluation iin ipeso. iThe icentral ibank idevalued ithe ipeso iand iforeign iinvestor's ifear iled ito ian ieven ihigher irisk ipremium. iTo idiscourage ithe iresulting icapital iflight, ithe ibank iraised iinterest irates, ibut ihigher icosts iof iborrowing imerely ihurt ieconomic igrowth. iUnable ito isell inew iissues iof ipublic idebt ior iefficiently ipurchase idollars iwith idevalued ipesos, iMexico ifaced ia idefault. iLater, ithe ibank iallowed ithe ipeso ito ifloat ifreely, iafter iwhich iit icontinued ito idepreciate.

The iinterest irate idifferential ibetween iMexican igovernment ibonds iin idomestic icurrency i(Cetes) iand ithe iUS iTreasury iBill irate ican ibe idecomposed iinto ipolitical irisk, iexpected idevaluation iand iexchange irate irisk ipremium. iTo imeasure ithe ipolitical irisk ipremium ifor iMexico, ithe idifference ibetween ithe idollar-denominated ibond iand ithe iUS iinterest irate ican ibe iconsidered iand ito icalculate ithe iexpected idepreciation iplus ithe icurrency irisk ipremium ithe idifference ibetween ithe ipeso-denominated iinterest irate iand ithe idollar- idenominate ibond iinterest irate ican ibe iused. iThe iColosio iassassination, ithere iwas ia isubstantial iincrease iin ithe iCete-Tesobono iinterest irate idifferential, iwhereas ithe ipolitical irisk ipremium iis ionly islightly iaffected. iHowever, ithe icurrency irisk ipremium iis inegligible ior iconstant, ithis iimplies ithat ithere iwas ia isignificant irecovery iof iconfidence iafter iJuly i1994. Apart from, iif ia irisk ipremium iwhich idepends ion ithe icurrency icomposition iof idomestic idebt iis ipresent, ithe iinterest idifferential iis inot ia ireliable ipredictor iof ithe iexpectations iof ia idevaluation. i

Rahul Sunny answered 2 years ago

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