Author(s): Jeffrey Sachs, Aaron Tornell, Andrés Velasco, Francesco Giavazzi and István Székely

Source: Economic Policy , Apr., 1996, Vol. 11, No. 22 (Apr., 1996), pp. 13-63

Published by: Oxford University Press on behalf of the Centre for Economic Policy Research, Center for Economic Studies, CESifo Group, and the Maison des Sciences de l’Homme

Stable URL: http://www.jstor.com/stable/1344521

Summary

In the first quarter of 1995, Mexico found itself in the grip of an intense financial panic. Foreign investors fled the country despite very high interest rates, an undervalued currency and financial indicators that pointed to long-term solvency. The fundamental conditions of the Mexican economy cannot account for the extent of the crisis. The crisis was not the result of irresponsible fiscal behaviour. The crisis was due to unexpected shocks that occurred in 1994, the inadequate policy response to those shocks, the increased vulnerability to panic, and finally panic itself In the aftermath of the March assassination, the exchange rate experienced a nominal devaluation of around 10% and interest rates increased by 7 percentage points. However, capital outflows continued.

The policy response was to maintain the exchange rate rule and to prevent further increases in interest rates. Interest rates were held down by expanding domestic credit and by converting short-term peso- denominated government liabilities (Cetes) falling due into dollar- denominated bonds (Tesobonos). A fall in international reserves and an increase in short-term dollar-denominated debt resulted. The govern- ment simply ended up illiquid, and therefore financially vulnerable. Illiquidity exposed Mexico to a self-fulfilling pa

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