Liquidity, Risk, and the Collapse of the Mexican Peso: A Dynamic CGE Interpretation

Abstract

On December 19th, 1994, Mexico's central bank announced a one-time 13% devaluation of the narrow band within which the peso had been allowed to float. Investors reacted violently, and within 48 hours the attack on reserves forced Mexico to abandon exchange rate management entirely.! The free-floating peso began a slide leaving it 33% lower relative to the dollar by the new year, and 50% lower by the middle of February. This paper argues that the Bank of Mexico's December 19th regime change revealed new information to the market, rationalizing the subsequent attack on reserves.2 Specifically, the regime change announcement contained regarding Mexico's stock of official foreign reserves. Insights borrowed from option pricing theory illustrate that such news leads investors to raise the risk premium assigned to peso-denominated loans. The general equilibrium implications of such a shock are shown to include a sharp and immediate devaluation. The shock is simulated using a multi-sector dynamic computable general equilibrium model of Mexico. Following the devaluation, the model predicts a gradual real revaluation extending over several years. In the short-run, resources shift into export and import-competing sectors (principally Mining and Manufacturing), while the current account moves into surplus and net foreign indebtedness is reduced. In the mediumto long-term, the short-run impact is reversed: non-traded goods production expands and export and import competing sectors contract, leaving Mexico with a smaller volume of outstanding debt and of international trade than would have been the case absent the shock.