Question1 In 1994 the interest rate increases due to therecovery of Western economic. At that time, the political situation at Mexicowas unstable so lots of foreigner investors withdraw from their investments.This lets Mexico lost lots of its foreign reserve holdings and it was runningout when the new president Ernesto Zedillo took over the position.
Thus, thegovernment announced its decision to devalue the peso against the dollar by 14percent to boost exporting. In other words, the Mexico government was trying toreduce goods imported and prevent capital outflow. The following figure showsthat the account balance, net trade, and net income hit the lowest points in1994.Figure 1: The Account Balance, Net Trade, and NetIncome in 1994In addition, we can also look at exchange rate forMexico and US from 1994 to 1995.
We can know that the exchange rate wasdecrease dramatically. People were restless buying large amount of US dollardue to of Mexico’s decision for devalue.Figure 2: The Exchange Rate for Mexico and US (1994-1995) Question2 The main reason that ledto the difficulty of the balance-of-payments in Mexico is they use the inflowof foreign capital to solve the balance of payments deficit. Mexico’s neweconomic policy started in 1988, which did receive some effect.
However, due tothe large differences in inflation between Mexico and the United States, theexchange rate of the peso to the U.S. dollar has not been adjusted for a longtime, causing an overvalued currency. After participating in NAFTA, Mexicoimported much more rapidly than before, causing the trade deficit to rise. Tobalance the current account deficit, Mexico borrowed heavily.
due to thesituation has fluctuated, the government must use its foreign exchange reservesto solve the decrease of foreign investment. The sudden drop in foreignexchange reserves undermined support for domestic currencies, and thegovernment has to use currency devaluation to prevent foreign exchange lossesand finally cause the peso devaluation. Question3 In order to preventedor mitigated the balance-of-payments problem and the subsequent collapse of thepeso, there are several policy actions can be applied. Firstly, Mexicoshould have more domestic saving which belongs to long-term investments ratherthan rely more on short-term foreign capital investments. Secondly, limiting therange of the frequency fluctuations in the nominal exchange rate.
After Mexicancrisis, they used floating exchange rate, however, this lead to the serious inflation,the unstable interest rates and the foreign exchange rate. Mexico needs todevelop the future exchange market, but this lead to the additional volatilityproblems, so Mexico needs to set the highest and the lowest frequency fluctuationfor the nominal exchange rate. In addition, Mexico can improve the connectionwith the International Financial Markets especially the norms of transparency.
Transparency always helps prevent financialcrises. Besides, establishing a multinational safety net can help Mexicoprevent the peso crisis. Question41.A multinational safety net must be established to safeguard the world financialsystem from the peso-style crisis. No single country or agency can handle thepotential global crisis alone.
2.National financial transparency may help prevent financial crises. If they knowthe real economic situation in Mexico, investors would be cautious to invent.It may lead Peso gradually devalue, but would not collapse directly.3.
Mexico should do more saving instead of relying too much on foreign portfolioinvestment to finance. 4.Mexico as a developing country, it should pay attention to the structure offoreign investment. In 1993, about 80% of Mexico’s foreign investment of 30 billionU.S. dollars was in the portfolio, while only 20% was direct investment. It ledtwo problems. One is increasing domestic consumption and less saving.
The otherone is rising domestic inflation and overestimation of Peso, which hurt thedomestic trade balance.