Four essays on the 1994 Mexican crisis

Most of the thesis is devoted to studying the collapse of the Mexican peso in December 1994 using empirical methods that allow shifts in regimes, as well as a small theoretical model based on the escape clause approach. Also, we present a study of the consumption boom observed in Mexico in the period 1989-1994 to highlight the importance of taking into account structural breaks in co-integration modelling. We use a series of realignment expectations, as well as linear and non-linear methods, to look for evidence that helps to characterise the Mexican crisis. Contrary to the predictions of first-generation models of currency crises, we find that the credibility of the peso did not experience any steady deterioration before its devaluation, and there was no stable relationship between realignment expectations and economic fundamentals. By using a Markov-switching regression model, we show that realignment expectations shifted over time between regimes of relatively high and low credibility, and that these shifts were more frequent during the troubled 1994. This evidence makes it problematic to endorse explanations of the collapse of the peso based on models of speculative attacks, and suggests using the approach of second-generation models of currency crises to study the Mexican experience. The theoretical model is designed to illustrate some specific features of the Mexican experience. We argue that the substitution of peso denominated assets for dollar denominated and indexed assets in investors’ portfolios helped policymakers to resist recurrent periods of confidence crisis during 1994, but it also made it more difficult to eliminate a potential self-fulfilling devaluation. In particular, the sterilisation of reserve losses during 1994 seems to be more important in the onset of the devaluation of the peso than the increase in the stock of dollar indexed bonds. We use an index of pressure in the foreign exchange market and mean-variance Markov- switching models to study the timing and causes of the shifts of the Mexican economy between states of calm and crisis. Models with time-varying transition probabilities do not yield conclusive results. Hence, we adopt a two step approach to obtain the probability of the state of crisis at each date in the sample, and then model this series as a function of economic fundamentals and political events. We find that the reduction of the debt-output ratio and positive political events maintained the economy in the state of calm up to 1994, despite a continuous real appreciation of the peso. However, the end of the declining path of the debt-output ratio and negative political shocks produced a shift towards the state of crisis for most of 1994 that finally led to the collapse of the peso. The study of the consumption boom observed in Mexico in the period 1989-1994 illustrates that structural breaks in long run relationships can be dated and evaluated if we allow regime shifts in co-integration modelling. The available data rejects a stable co-integration relationship between consumption and income. Meanwhile, using Markov- switching models, we find that there was a marked shift in the co-integration vector after the implementation of the program for stabilisation and economic reform in December 1987. The program caused the former unitary income elasticity of consumption to increase by almost 30 per cent, but later the shift was reversed when the currency and financial crisis erupted at the end of 1994