In this section we examine how changes in the business cycle impact exchange rates. We are trying to show relationships between specific economic circumstances and changes in the exchange rate. Thus we need to isolate each component of change, relying on the certeris paribus assumption of holding everything else equal.
Noninflationary Economic Growth
In Unit 7, we discussed the business cycle. Figure 7-8 shows aggregate demand expanding in the range of aggregate supply characterized by slack. As aggregate demand shifts from ADo to AD1, economic growth increases. In addition, aggregate supply also moves outward from ASo to AS1 due to the continuous expansion in the productive capacity of the economy. Output increases from Yo to Y1 and prices remain constant, implying that the inflation rate also does not change.
As economic growth and incomes increase, U.S. consumers increase their consumption of goods and services including imports. Assuming that foreign economic growth rates remain constant, the demand for U.S. exports remains steady. The result of an increase in imports with unchanging exports is to decrease NX (exports - imports). The fall in NX has two important macroeconomic consequences. The first is to slightly dampen the expansion in aggregate demand. Since
AD = GDP = C + I + G + NX,
a reduction in NX (actually an increase in the U.S. trade deficit) partially offsets the increase in AD resulting from higher levels of C + I + G.
The second macroeconomic consideration of increased imports is the impact on exchange rates. As we have shown in the previous section, as U.S. consumers increase their consumption of imports, the supply of dollars in foreign exchange markets rises. Figure 12-2 shows a rightward shift in the supply of dollars as U.S. consumers increase their purchases of imports. As a result, the dollar depreciates against the yen (or currencies of other countries that the U.S. increases imports from).
In the previous section, we discussed how the dollar's depreciation raises the relative prices of imports and lowers the prices of U.S. exports into foreign markets. The devaluing dollar gives a boost to NX, adding extra growth to GDP. Over time, the trade balance evens out. The initial decrease in NX caused by higher rates of U.S. domestic GDP growth is eventually followed by a dollar depreciation. This, in turn, leads to a compensating increase in NX as exports grow and consumers substitute away from relatively more expensive imports.
We now continue by assuming that the growth rate of aggregate demand eventually exceeds the long-run growth rate of aggregate supply and productive capacity. Soon our economy is knocking on inflation's door.
Inflation Increases - Current Account Effects
Figure 13-1 shows the dramatic consequences of an economy that tries to grow beyond potential output and full employment: inflation. The growth rate of aggregate demand (from AD1 to AD2) is much faster than the intrinsic rate of growth of aggregate supply (AS1 to AS2, roughly equal from 2% to 2.5% annually). As the economy expands, the slack present is absorbed and aggregate demand reaches the vertical portion of the aggregate supply curve. Suddenly prices and inflation leap from P1 to P2.
Now that we have determined that inflation in the U.S. has increased relative to inflation rates in Japan which we assume remain constant, let us turn our attention to the exchange rate. Increases in domestic inflation lead to higher prices for exported goods and a decrease in exports as foreign consumers substitute in favor of lower-priced alternatives produced within their own country or imported from elsewhere. Substitution occurs in the home market as well. As the prices of domestically produced goods increase, import prices remain constant and shoppers turn their fancy toward imports, which have fallen in price relative to inflating domestically produced goods. The net result for a country with a rise in inflation is decreased exports and increased consumption of imports. The result is a fall in NX. As you already know, as NX decreases, current account deficits eventually lead to a depreciation in the home currency.
Since we are looking at exchange rates, let us turn our attention to foreign exchange markets. As shown in Figure 13-2, the decrease in demand for U.S. exports also reduces the demand for dollars in foreign exchange markets from D$1 to D$2 as foreign consumers reduce their purchases of U.S. goods and services. In contrast, the increased consumption of imported goods raises the supply of dollars in foreign exchange markets from S$1 to S$2. The consequence is a devaluation of the dollar from P$1 to P$2.
Thus we can see the overall effect of high domestic inflation rates:
- The escalation in inflation reduces NX, resulting in a growing trade deficit.
- The resulting depreciation of the domestic currency lifts the prices of imports higher, further fueling inflation.
- The depreciation in the domestic currency, partially offsets the impact on exports, which had fallen due to inflation. Remember that eventually a depreciating currency raises the prices of imports relative to domestically produced goods and lowers the prices of exports to foreign consumers. This by itself increases NX. This leaves the economy in a muddle. The decrease in NX caused by higher domestic inflation is partially offset by the dollar's depreciation, which increases NX.
- The likely scenario is without the intervention of monetary and/or fiscal policies, economic growth will persist, fueling further increases in inflation and a depreciating currency. Economic policy makers are required to intervene. History has taught us that three things will result in the end from higher domestic inflation rates:
- an increasing trade deficit,
- a depreciating currency, and
- an eventual recession to correct the inflation.
As you can see from the above analysis, things get complicated quickly. The best remedy is to stick with the basics. First, higher inflation reduces NX. Second, a tumble in NX causes the home currency to depreciate. Finally, a currency depreciation results in a partially compensating boost to NX. Obviously, the first and last steps work in opposition (but we can expect the impact of the first to be greater than the last and NX will continue to fall as long as inflation remains excessive). The economy is likely to remain stuck in an inflationary scenario until counterinflationary economic policies are enacted to reduce economic growth and lower inflation.
The Fed Reacts - Capital Account Effects
As the domestic inflation rate in the U.S. leaps upward, the Fed, which had been cooling its heels, rises to the occasion. In the scenario created here, the Fed had not reacted to inflationary pressures and higher inflation rates were realized soon afterwards. This forces the Fed to take the necessary countercyclical action. In order to slow or reduce the growth rate of aggregate demand, the Fed will use a restrictive monetary policy to lower the inflation rate. By reducing the money supply, the Fed raises interest rates, which are already increasing to keep up with accelerating inflation. The resulting inflationary premium added to interest rates attracts foreign savings seeking higher real rates of return.
As the money of foreign savings makes its way into U.S. financial markets through the capital account, the demand for dollars increases. The demand for dollars increases as foreign savers convert their currency into dollars in the international currency markets. The dollars are then used to purchase U.S. financial assets such as Treasury Bills, Notes and Bonds. Figure 13-3 shows the demand for dollars increasing from D$2 to D$3. As a result, the dollar appreciates in value.
We know that as the dollar appreciates, relative import prices fall and the prices of exports rise, leading to a decrease in NX (decreased exports, increased imports).
Although we can go on with a number of permutations of the basic scenario, it is best to collect our thoughts at this stage and make a few important points. For each of the following, hold everything else constant.
- Increases in domestic economic growth cause an increase in imports in the current account. A fall in NX or an increase in the current account deficit will cause the dollar to depreciate.
- Increases in foreign economic growth lead to an expansion of exports in the current account. An increase in NX will cause the dollar to appreciate.
- Increases in domestic inflation will raise imports and decrease exports in the current account. A fall in NX will cause the dollar to depreciate.
- Increases in foreign inflation will raise the price of imports into the U.S. and reduce their level while making U.S. exports relatively cheaper, increasing export volume. NX grows in the current account and the dollar appreciates.
- Increases in domestic interest rates attract foreign savings through the capital account. In addition, U.S. savers keep more of their money at home as the relative rate of return on domestic assets has increased. Consequently, the dollar appreciates.
- Increases in foreign interest rates attract U.S. savings through the capital account and the supply of dollars in foreign exchange markets rises. Likewise, foreign savers keep more of their savings in the home market, and the dollar depreciates.
The following table summarizes the above list.
Economic Scenarios Affect Exchange Rates
||Change in Foreign Econ.
(from column 1)
|Net Exports (NX)||Account||$ Value|
|Interest Rates||increase||no change||capital||increase|
|Interest Rates||no change||increase||capital||decrease|
Conclusions Regarding Monetary Policy
Now let us consider the complete implications of the Fed's use of monetary policy. As with fiscal policy, we need to analyze the current account implications of changes in economic growth rates and inflation. In addition, active monetary policy leads to changes in interest rates, which impact the value of the domestic currency through the capital account.
We begin with an economic scenario where inflation and economic growth are undesirably high, and the Fed uses restrictive monetary policy to reduce both. Restrictive monetary policy entails the Fed raising interest rates. Taking each impact alone results in:
- An increase in interest rates leads to a capital account surplus and by itself would cause the dollar to appreciate.
- Lower GDP growth increases NX as imports decline. The improvement in the current account also causes the dollar to appreciate.
- A reduction in the inflation rate also increases NX as imports decline and exports rise. The gain in the current account results in an appreciation of the dollar.
Putting the three consequences of a restrictive monetary policy together shows that the dollar should appreciate in value against other floating foreign currencies.
How does the appreciation of the dollar affect the Fed's overall goal of slowing economic growth and reducing inflation? If we carry our analysis one step further and consider the consequences of the dollar appreciation, we can see that the exchange rate effect reinforces Fed policy. With the dollar's appreciation, relative prices of U.S. exports rise, while U.S. consumers and businesses buy increasing amounts of relatively cheaper imports. NX declines, which further reduces GDP growth. Furthermore, lower prices for consumer items and reduced costs of foreign inputs used in domestic production help to lower inflation rates.
Now let us reverse course and consider the exchange rate and macroeconomic implications of an expansionary monetary policy. Expansionary monetary policy means the Fed will lower interest rates. Taking each macroeconomic impact alone results in:
- Falling interest rates leads to a capital account deficit as the supply of dollars increases and demand for dollars declines. By itself, this would cause the dollar to depreciate.
- A reduction in interest rates increases domestic investment and consumption. GDP growth increases, reducing NX as imports climb. The erosion in the current account causes the dollar to depreciate as the supply of dollars increases in foreign exchange markets.
- If economic growth is accompanied by rising inflation, increased demand for relatively cheaper imports and a reduction in exports further deteriorate NX. The current account deficit is amplified, leading to a further dollar depreciation. If prices remain steady, we can leave out this last part, but our overall conclusions do not change.
Putting the three consequences of an expansionary monetary policy together shows that the dollar will depreciate in value against other floating foreign currencies. We of course assume everything else remains constant .
How does the depreciation of the dollar affect the Fed's overall goal of stimulating economic growth? By carrying our analysis one step further, the dollar's depreciation gives an added boost to Fed policy. With the dollar's depreciation, relative prices of U.S. exports fall, leading to increased export demand. Furthermore, U.S. consumers and businesses increasingly substitute in favor of relatively cheaper domestically produced goods and away from imports. NX grows, which further increases GDP growth.
Fiscal Policy Effects on the Exchange Rate
Let us consider briefly the consequences of fiscal policy. Unlike monetary policy, where economic factors work in unison to determine if the dollar's exchange rate value appreciates or depreciates, at least in theory, fiscal policy yields no clear result.
An expansionary fiscal policy, such as a tax cut or increase in government spending will result in:
- The tax cut and increase in government spending raises incomes of consumers who respond by increasing consumption. Holding foreign growth rates constant, this leads to a greater demand for imports, decreasing NX or increasing the current account deficit. As economic growth rates increase, so does the supply of dollars in international currency markets. As a result, there is downward pressure on the dollar's value (depreciation).
- At this point, there are two possibilities:
- First, the Fed sensing a buildup of inflationary pressures, takes counteractions and implements a restrictive monetary policy. As we have already discussed, the increase in interest rates puts upward pressure on the dollar.
- Or the Fed doesn't react, and eventually the expansionary policies lead to the normal spate of higher inflation rates. With rising inflation, increased demand for relatively cheaper imports and a reduction in exports further deteriorates NX. The current account deficit deficit is amplified, leading to a further dollar depreciation.
- Either way interest rates rise. In the first case, the Fed increases market interest rates. In the second, interest rates follow inflation upward, adding on an extra inflationary premium. Furthermore, if the tax cut and increased government spending lead to a greater fiscal budget deficit, the government's demand for loanable funds increases in order to finance the extra deficit spending. This adds an extra upward boost to interest rates. The net result is higher real interest rates.
Putting it all together, we see that an expansionary fiscal policy will initially put downward pressure on the dollar. However, if inflation or inflationary pressures soon build and real interest rates rise, currency markets may soon support the dollar's value. Do note that countries that allow inflation to remain at undesirably high levels will often see their currency continuously depreciate as a result of forces in the current account. It is only when interest rates become high enough to choke off economic growth and the fuel of inflation that currency values will stabilize.
In reality, life is much more complicated and anticipating currency movements is part luck and part science. Even the best currency traders can lose hundreds of millions of dollars in the course of a few days. Central banks often try to intervene to support a currency by purchasing it. While effective for a few days, the huge volume of currency trading quickly swamps any concerted effort to control a floating currency's value.
This section has addressed a basic understanding of exchange rates. By using the tools discussed here, we can batter anticipate the relationship between macroeconomic policies and long-run movements in a nation's currency.
The Current Account Deficit of the United States
In recent years, the United States has been running a persistent current account trade deficit of between $300 billion and up to $400 billion per year. If the US has a trade deficit of $350 billion, this means that the value of exports (goods and services purchased abroad) exceeds the value of imports by $350 billion. Expressed in this way, some politicians will make the argument that this is not a fair outcome. Foreigners are taking advantage of the United States since US consumers are buying more of foreign-made goods than foreign consumers are buying US-made goods and services. The solution, the argument goes is to restrict trade by placing high tariffs or even bans on imported goods. The positive result is that domestic jobs and industry will be protected. This simplified argument obviously ignores the mutual advantages of free trade presented earlier in this course and the fact that if the US restricts imports, other countries will retaliate with import restrictions of their own, hurting US exporters.
Another way to look at the US trade deficit is that US consumers purchase $350 billion more worth of goods and services than is produced domestically - foreign producers make up the difference. Presented this way, the problem (if there is any problem at all) is not that foreign consumers are purchasing too few US-made goods, but that US consumers are buying too much - generating more demand than domestic firms can meet.
For many years in the late 1990s, the US unemployment rate had fallen to about 4%, a level considered to be at full employment. Many US firms competed for scarce workers. College students would visit the beaches of Florida, Texas, California and other places to have fun and some would even party! Nevertheless, corporate recruiters would set up information booths on boardwalks to greet and encourage the students to fill out a job application. At the same time, the US economy was running a current account deficit that exceeded $360 billion. As this example shows, despite the large trade deficit, there was no scarcity of jobs in the United States.
Students of exchange rates recognize that persistent current account trade deficits should lead to the depreciation of the currency. However, at the same time the US was accumulating huge trade deficits, the US dollar appreciated against most of the world's other major (and minor) currencies. The reason for the strength of the dollar was the strong demand for dollars generated in the capital account. By the year 2000, about 80% of total global savings was saved in US financial markets (e.g. US government Treasury bonds, banks, other bonds, stock markets, real estate, etc.). Money was and has been flocking to US financial markets through the capital account, creating a tremendous demand for dollars in foreign exchange markets and the appreciation of the dollar. In net terms, the demand for the dollar due to the capital account surplus has outweighed the growing supply of dollars in the foreign exchange market resulting from the current account trade deficit, causing the dollar to appreciate.
Putting all of this together, we can conclude that the US trade deficit is a consequence of the extraordinarily strong growth that the US economy enjoyed through much of the 1990s, especially in comparison to the majority of countries in the world. The booming financial markets helped to create a strong value for the dollar in foreign exchange markets, further boosting imports and hurting the competitive position of US exporters as the prices of US exports increased along with the dollar's value.
An obvious solution to the persistent current account deficit is to trash the US economy and plunge it into a severe recession. Consumption will plunge and so will the demand for imports. Financial markets can help by falling off a cliff and foreign money will flee US financial markets as was witnessed in Mexico, Thailand, Indonesia, South Korea, Argentina and others in the 1990s and early 2000s. As a result, the dollar would depreciate wildly, boosting exports, discouraging imports but also creating immediate inflationary pressures - hardly the solution that Americans would like to see.
Past and Present
With a steady flow of oil and other exports, the Mexican economy enjoyed steady economic growth and relatively low inflation rates from the mid-1950s to the early 1970s. With the surge in oil prices that occurred during the 1970s, Mexico realized a windfall in oil export revenues. Forecasts predicted that oil prices would continue on their upward spiral, reaching $65 a barrel during the 1980s. Anticipating continued growth in oil export revenues, the Mexican government adopted generous fiscal policies to develop the economy and infrastructure.
Cartel members have an incentive to cheat to gain extra revenues, and OPEC was no exception. Initially, Iran and Iraq exceeded their quotas to help finance their war with each other, and soon other OPEC members joined in. In addition, alternative oil sources and other forms of energy became commonplace, so that by the early 1980s spot market oil prices were falling well below the official OPEC world price. Oil prices, which had peaked in the mid-$30 price per barrel range, collapsed, falling below $20 a barrel. The revenue that the Mexican government had anticipated from oil revenues was severely diminished. The reduction in revenues, coupled with rising interest rates throughout the world and the large Mexican fiscal budget deficits resulted in a debt crisis. In August 1982, the Mexican government announced that it could not meet its scheduled debt payments.
When a severe recession shook the Mexican economy in 1982, the government nationalized the country's banks and imposed severe tariffs on imported goods to protect domestic producers. This was the beginning of a period of economic contraction; real per capita GDP growth from 1981 to 1988 was -2% per year. The government was forced to cut spending on many social and economic programs including education and health care.
In response to economic stagnation, Mexican presidents have taken their economy down the road of economic liberalization during the past decade. The process was started by Miguel de la Madrid and picked up momentum with Carlos Salinas. Under current president Ernesto Zedillo, Mexican economic reforms have continued, but have been hindered by a stumbling economy.
The reform process began by reducing Mexican tariffs on imports from an average of 60% in the mid-1980s to below 20% and falling to zero for many U.S. and Canadian imports by early in the twenty-first century. To encourage trade and price stability, the peso was pegged to the dollar. The government reduced its fiscal deficit while enacting market-oriented reforms such as the privatization of resources and industry, reducing the dominance of the government sector. Fiscal restraint has helped to diminish chronic inflation, which reached 159% in 1987.
After the extremely difficult 1980s, the 1990s began with the first positive economic growth in Mexico in nearly a decade. Trade liberalization led to a jump in both exports and imports. Financial capital returned from abroad and was increasing retained by Mexican citizens saving at home. The majority of the capital inflow taking place in the 1990s was in the form of portfolio investment in the Mexican equity markets. This is a very liquid form of savings that can be moved from the economy almost overnight when conditions change. (1)
(1) In 1980 76% of capital inflows into Mexico were in the form of long-term debt, composed primarily of loans from foreign commercial banks; 26% was in the form of direct investment, while essentially no foreign money was used to purchase Mexican stocks (portfolio equity). In 1993, 64% of capital inflows into Mexico went into portfolio equity, 22% was composed of direct investment, and 14% was in the form of long-term debt.
Despite economic reforms, the Mexican economy is extremely vulnerable to internal and external shocks. For much of the 1980s, real per capita income fell. Presently, Mexico's 92 million people have a lower real per capital income than in 1980. Who can blame the Mexican people if they are becoming anxious about the success of economic reform? At the present time, Mexico provides an incubator to test modern economic theories carried out by policy makers who studied and received PhDs at prestigious U.S. universities.
By opening up its economy, Mexico has left itself vulnerable to the whims of outside forces. In this section, we will take a look at how the flight of foreign and domestic savings in the capital markets contributed significantly to the current contraction of the Mexican economy.
1995 GDP is expected to shrink by 6% in Mexico, causing the number of unemployed to double while inflation exceeds 50%. A devaluing peso, falling equity markets, and crippling interest rates (short-term interest rates have approached 90%) have combined to place the Mexican economy on the brink of a social meltdown.
We will now look at the currency crises which ended the year of 1994 in Mexico. We want to examine the interdependency of the domestic and foreign sectors of an economy. In the case of Mexico, increased dependence on whimsical, fast-moving and profit-hungry capital markets pulled the rug from under the domestic economy. We will also see what it is going to take to get Mexico back on its feet again.
Mexico, "so far from God, so close to the United States"
So goes the old aphorism about Mexico. The integration of the Mexican and the U.S. economies was a major focus of Mexican foreign policy in the early 1990s. Former Mexican president Carlos Salinas accelerated the pace of reform in the Mexican economy. As part of the program to integrate Mexico into the world economy and encourage international trade and increased rates of economic growth, Salinas risked a good deal of his political capital on the approval by the United States and Canada to include Mexico in the North American Free Trade Agreement (NAFTA).
Members of NAFTA agree to completely eliminate all barriers to trade such as tariffs within fifteen years of signing the trade accord. By accepting Mexico into NAFTA, the United States was sending the message that Mexico was ready to take its place on the world stage. In return, Salinas would deliver a maturing economy with good fiscal discipline and, to encourage international trade, a stable currency.
A volatile currency hampers international commerce as businesses must undertake the added expense of hedging against exchange rate risk in foreign exchange markets. In addition, a widely fluctuating currency (especially a depreciating one) discourages movements of foreign capital into domestic financial markets. The peso was pegged to the U.S. dollar, only allowing for a small trading range (commonly known as a "snake"), at the rate of about 3.5 pesos to the dollar (or $0.28 to the peso). A stable peso eliminated exchange rate risk in business and financial transactions, encouraging participation by U.S. investors in Mexico's consumer and financial markets. The dollar was a logical choice for Mexico, not only for geographic reasons. About 70% of all Mexican international trade is carried out with the United States.
In the early 1990s, the Mexican economic plan led to a huge inflow of foreign money through the capital account. Between 1990 and 1993, foreigners sent $91 billion into Mexico, but rather than purchasing long-run direct investments in Mexican industry, two-thirds of the money was used to buy highly liquid Mexican stocks and bonds. As a result, the majority of foreign money entering Mexico during this time period could exit almost overnight.
The high value of the peso in relation to the dollar acted as a subsidy to Mexican consumers. With a windfall purchasing power, Mexican consumers and industry went on a buying binge of imported goods, primarily from the United States. Economic policy makers worry when their country's current account trade deficit reaches 3% of GDP, since high trade deficits eventually result in a currency depreciation. Mexico's current account trade deficit rose from 6.5% of GDP in 1993 to 7.7% of GDP in 1994. The increased consumption was paid for by a reduction in domestic savings (2) rates from 22% of GDP in 1988 to 16% by 1994. By keeping the value of the peso high, and thus import prices relatively low, Mexico was sacrificing domestic production in favor of imports.
(2) Total domestic savings is the sum of public (government) plus private (consumer and business) savings.
During this period of nominal exchange rate stability, the real exchange rate of the peso had increased significantly. The nominal exchange rate measures one currency in terms of another (in this case the peso's value was pegged to the dollar). The real exchange rate is an indicator of the purchasing power of the currency. Given a fixed nominal exchange rate, a change in relative inflation rates leads to a movement in the real exchange rate. The formula for the real exchange rate is:
% change real ex. rate = % change nominal ex. rate + % change in domestic prices - % change in foreign prices
In the early 1990s, the nominal value of the peso was pegged to the dollar. At the same time relative inflation rates in Mexico were higher than in the United States (roughly 30% greater from 1991 to 1994). The effect was to increase the prices of Mexican-made goods to Mexican consumers while maintaining a steady price on imports form the United States, due to the pegged nominal exchange rate. With the real peso appreciation, Mexican consumers enjoyed an increase in purchasing power in terms of U.S. imports. With domestic incomes rising along with inflation and import prices constant, the Mexican government was subsidizing the purchase of imports from the U.S., which were falling in real terms. Consequently, Mexican consumers would substitute consumption in favor of relatively cheaper imports, increasing the current account trade deficit.
If 1994 were a fish, Mexico certainly would throw it back. The year started out promising, on January 1 when NAFTA was expanded to include Mexico in the free trade zone. But while the Mexican leaders looked to the benefits of free trade, a previously unknown guerrilla group known as the Zapatistas, led by a masked, pipe-smoking former university professor calling himself Subcomandante Marcos, seized a half dozen towns in the poor southern state of Chiapas. Subcomandante Marcos denounced NAFTA as a "death sentence" for Mexico's Indian population, including the indigenous Maya of the Chiapas region. Increased social unrest in Mexico culminated with the assassination of President Salinas' PRI successor, Luis Donaldo Colosio, a popular figure in Mexican politics.
The 1994 election went as the PRI desired and Salinas passed the presidential torch to the PRI candidate, Ernesto Zedillo. However, before the year ended, the intrinsic vulnerability of Mexico's economy was exposed as the Mexican peso/U.S. dollar exchange rate collapsed. There were several major causes of the exchange rate collapse of the peso:
- The large Mexican current account deficit. As we have seen in an earlier section of this topic, a current account deficit increases the supply of a currency in foreign exchange markets, putting downward pressure on the currency's value.
- An upward surge in U.S. interest rates resulted in an abrupt reversal of the flow of financial money that had entered Mexico through the capital account. The end of the substantial capital account surplus resulted from a tremendous flight of foreign and domestic savings from the Mexican economy searching for higher and more secure returns in the United States. (3)
- The Chiapas uprising and Colosio assassination increased anxiety about Mexico's political and social situation.
- At the beginning of 1994 Mexico had abundant foreign reserves (nearly $29 billion) that it could use to support the value of the peso. This money was available to buy pesos in the foreign exchange markets when the supply of pesos resulting from the current account deficit exceeded the demand for pesos. Buying pesos would support the peso at its pegged dollar exchange rate. With each shock to the political and economic system, financial capital increasingly fled the Mexican economy, further increasing the supply of pesos in foreign exchange markets. To compensate, the Mexican government had to buy increasing amounts of pesos in foreign exchange markets, resulting in a steady drain on its foreign reserves. By late 1994, the $29 billion had shrunk to $6 billion.(4)
(3) Until the political and economic events of 1994, Mexico could maintain the fixed peso value despite the current account deficit. In the capital account, foreign savers seeking high rates of return in Mexico's soaring equity markets and businesses with direct investments in Mexico kept the peso demand strong. The increased supply of pesos in the current account was offset by higher demand in the capital account.
(4) During this period the Mexican government issued large quantities of short-term, dollar-indexed securities known as tesobonos. Tesobonos were used to help finance government activities and were dollar-denominated to ensure buyers a rate of return that avoided exchange rate risk.
A Graphical Look at the Peso Collapse
As shown in Figure 13-4, the peso was fixed in value in relation to the dollar in the early 1990s. The graph shows the peso pegged to the dollar at a exchange rate of one peso to $0.28 (which equals 3.5 pesos to $1). Note that we show the quantity of pesos in world foreign exchange markets on the horizontal axis and the $/peso exchange rate on the vertical axis. In the beginning of 1994, it took $0.28 to buy a peso's worth of Mexican goods.
After nearly a decade of nonexistent economic growth, the Salinas-led surge in the Mexican economy occurred in the early 1990s. Economic growth averaged 3.1% annually, a respectable rate, although slow in comparison to other developing economies. Increasing rates of economic growth, coupled with the strong exchange rate of the peso (which kept U.S. imports relatively cheap and Mexican exports relatively expensive) caused a significant current account trade deficit. With over 70% of Mexico's imports coming from the United States, the supply of pesos was much greater than the corresponding demand in the current account.
As Figure 13-5 displays, the Mexican current account trade deficit of the early 1990s led to a net increase in the supply of pesos in foreign currency markets. By itself, the current account deficit puts downward pressure on the peso's value. Offsetting effects occurred in the capital market, where the demand for pesos remained strong in early 1994.
As mentioned earlier, there was a substantial demand for pesos from foreign savers looking for higher rates of return in Mexico's equity markets and an increase in direct investment by businesses in Mexico seeking access to the growing Latin American consumer markets. The capital account had a surplus due to the scorching rates of return being earned on Mexican financial assets in the early 1990s. Consider 1993, when investors who purchased Mexican stocks earned nearly a 100% rate of return, doubling their money in one year.
Figure 13-6 shows the balance of the supply and demand for pesos in foreign exchange markets in early 1994. Despite the significant supply of pesos resulting from the current account deficit, demand in the capital account remained strong. The Salinas government had little trouble maintaining a stable value of the peso in relation to the dollar.
The Mexican current account deficit was roughly balanced out by the capital account surplus. As noted, the Mexican government had a large surplus of dollars to use in foreign exchange markets to purchase pesos when the demand faltered. When there was downward pressure on the peso, the Mexican government could use its ample dollar reserves (nearly $29 billion) to buy pesos in foreign currency markets.
The United States Federal Reserve Fights Potential Inflation
After the recession of 1991 and the near catastrophe in the U.S. banking system resulting from the Savings and Loan fallout, the Federal Reserve Board engaged in expansionary monetary policies, eventually reducing U.S. interest rates. Falling interest rates helped to revitalize a comatose banking system while preventing the extinction of the U.S. savings and loan industry. A reduction in the federal budget deficit in 1993 resulted in significant reductions in long-term interest rates, stimulating consumption and investment. By 1994 the U.S. economic growth rate was soaring. Capacity Utilization and other inflationary indicators were reaching a danger zone of potentially resurgent inflation. As a result the Fed slammed on the monetary brakes, raising the U.S. Fed Funds interest rate seven times over the course of a year.
Rising U.S. interest rates increase the attractiveness of U.S. assets, such as bonds, to savers. The higher U.S. rate of return coupled with the political uncertainty present in Mexico in 1994 initially caused Mexican savers to flee Mexican markets in favor of U.S. assets. U.S. money fund managers quickly followed. True to form, money managers who controlled huge amounts of U.S. savings held in Mexican assets, overreacted and raced each other to flee the Mexican market. As the greed of 1993 turned to the panic of 1994, the value of Mexican stocks and bonds plunged.
As savers left Mexican asset markets, the demand for pesos in international currency markets dried up. In addition, by December 1994 President Zedillo's finance minister had nearly depleted the reserve of dollars used to buy pesos in order to maintain its fixed value. As shown on the graph to the left (Figure 13-7), the continued increase in the supply of pesos due to the current account trade deficit, coupled with the reduction in demand for pesos, swamped the currency markets and President Zedillo had no choice but to float the peso, allowing it to depreciate.
Consequences of the Peso Depreciation
By the fall of 1995, the peso had depreciated to roughly 8 pesos to the dollar ($0.12). Economic theory tells us several outcomes are likely when a country's currency falls as far as the peso in so short a time period. This is especially true for a country like Mexico where international trade represents an important part of GDP.
- The peso depreciation will lead to a significant increase in the prices of imported goods. This will result in a large spike in the prices of consumer goods and prices paid by businesses for materials used in the production of goods. Higher input prices raise production costs, further contributing to increases in the prices of final goods. The net effect is the potential for a significant jump in the inflation rate.
- The peso depreciation lowers the relative price of Mexican exports in world markets, especially in the United States. The Mexican current account deficit will fall as exports rise and more costly imports decrease.
- The peso depreciation leaves the Mexican government no favorable choices. The government can choose to use fiscal and monetary restraint to prevent inflation and thus cause a severe recession. Or it can continue positive economic growth in order to avoid higher unemployment rates and to mitigate social unrest, but at the cost of ever-increasing inflation rates.
The statistics confirm Mexico's situation.
- Inflation is exceeded 50% in 1995.
- As a result of the cheaper peso, Mexican exports increased by 33% during the first eight months of 1995 in comparison to a similar period during 1994. Overall, the current account deficit became a surplus by the end of 1995. The effect of the peso devaluation is especially pronounced in trade with the U.S. where Mexico engages in almost three-fourths of its international trade.
- The Mexican government chose to put on the economic brakes to prevent a further inflationary spiral. 1995 GDP growth is expected to fell by -6% as a result, and the total number of unemployed has doubled within the past year.
The long run results of NAFTA
In this part of the discussion, we will try to take an objective look at the economic effects of NAFTA on the United States and especially Mexico. The linkage between the Mexican currency crisis and NAFTA is weak at best. As discussed above, the peso collapse resulted from non-NAFTA factors such as capital flight, real exchange rate appreciation of the peso and a huge current account trade deficit.
The U.S. economy is twenty times the size of the Mexican economy. Only a small part of international trade conducted by the U.S. is with Mexico. To make NAFTA more politically palatable to its opponents in the U.S., the Clinton administration set up a program to directly assist U.S. workers who lost their jobs as a result of NAFTA. As you know from the material covered previously in this class, increased trade between the U.S. and Mexico could lead to the loss of some American jobs as consumers and firms substitute in favor of cheaper Mexican imports.
By the summer of 1996, only 117,000 Americans had signed up for the benefits offered to workers displaced by NAFTA. In comparison, 1.5 million U.S. workers lose their jobs each year from factory closures, slack demand and corporate restructuring. Contrast the jobs lost to the 2.8m new jobs created each year in the United States, and NAFTA appears to have no widespread macroeconomic effects on the U.S. labor market.
One fear associated with NAFTA, was the belief that U.S. firms would close up their local manufacturing plants and relocate into Mexico in search of cheaper labor and possibly more lax environmental laws. However, it is estimated that American direct investment in Mexico has averaged less than $3 billion a year since 1994, NAFTAs first year. That is under 0.5% of American firms total annual spending on plant and equipment. U.S. firms have not made a mass exodus for Mexico, because lower labor costs in Mexico are offset by higher labor productivity in the United States.
In his memorable November 1993 debate with then Vice Presidential candidate Al Gore, billionaire businessman Ross Perot, a protectionist presidential candidate, forecast a giant sucking sound as American jobs vanished southward as a consequence of NAFTA. Perot proved wrong. By the Fall of 1997, the U.S. unemployment rate had fallen to 4.5%, the lowest level seen in over thirty years.
Some U.S. firms have increased their direct investment in Mexico, but often to their own benefit. Over the past couple of decades, the U.S. textile industry has been in a steady decline, unable to compete with low-cost imports from Asia. As a result of NAFTA, American textile firms have undertaken joint ventures with their Mexican counterparts to produce goods at a lower cost. Without these initiatives, the U.S. textile industry would have continued its rapid erosion and loss of domestic jobs, but is now able to increasingly compete against imports from Asia.
True, since the implementation of NAFTA, Mexico has moved from a current account deficit to a surplus, but the explanation lies in the tremendous devaluation of the peso in relation to the dollar. The United States already had low tariffs on most of its goods. It therefore did not need to liberalize its markets much; and, even when it did, some favored sectors, such as agriculture, remained protected.
In addition, Mexican trade liberalization had begun in the mid-1980s. In 1985, the countrys business and political leaders, fed up after yet another economic crisis, abandoned decades of protectionism, joining GATT the following year. By 1990, Mexicos exports were 14% of its GDP , twice as much as ten years before. Although NAFTA took things further, cutting tariffs on American (and Canadian) goods from 10% to 3%, trade between Mexico and the United States was booming long before 1994.
Perhaps more significant is the improved political relations between the U.S. and Mexico that have resulted from closer economic ties. Historically, the U.S. and Mexico have not been the closest of friends despite their geographic proximity to each other. NAFTA has encouraged a more cooperative political as well as economic relationship between the two countries. For example, after the peso crashed in 1994 sending the Mexican economy into a severe recession, President Clinton rushed in, putting together a $50 billion international rescue package. The money was needed in a time of economic distress in Mexico and as Mexico's economy improved, it quickly repaid the loan in full. Without NAFTA, it is doubtful that the U.S. would have made any money available for Mexico to borrow to help their burdened economy.
It is difficult to take Mexico's perspective about NAFTA when recognizing the severe recession that followed shortly after Mexico joined the trade agreement. As noted earlier, the Mexican recession was not a direct result of NAFTA, but some of the policies implemented by the Mexican government in the early 1990s to promote Mexico's entrance into NAFTA, did contribute to the recession. By promoting trade between the U.S., Mexico and Canada, NAFTA did help boost Mexico's exports in the region, providing a silver lining during the Mexican recession. Soon after NAFTA, Mexico had a current account surplus (significantly aided by the peso's depreciation). By 1997, Mexico's recession was over and positive economic growth had resumed.
Copyright © 2002, Jay Kaplan
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