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wary about their dealings in Mexico and many, both domestic and foreign, sold their
peso-denominated assets. When the presidential winner, Ernesto Zedillo, took office, he
agreed that the peso was overvalued and thus announced a 15% devaluation of the
peso. This was a step in the right direction but investors and economists had expected
20 to 30 percent devaluation, and instead of inspiring confidence in the new
u]v]]}vU]oo}}vu]ZZÇdid not understand the
severity of the crisis. This sent more capital out of the country and culminated in a more
then 78% loss of value for the peso. The causes for this collapse can be attributed to:
i. A policy of relying on large foreign inflows of world savings through a large
financial account surplus (current account deficit) proved to be unstable.
1. Too much of this capital was also short-term portfolio investment as
opposed to long-term direct investment. Not necessarily bad but with
an overvalued peso, investors feared that surprise devaluation could
diminish the value of their assets so they converted their pesos into
dollars and on a large scale resulted in capital flight.
ii. Another lesson learned from this crisis was how difficult it is to devaluate
was in the right step but it undermined credibility in the exchange rate system.
Since then economists have argued in favour of either a completely fixed
exchange rate system with not discretionary monetary policy, or a floating
exchange rate such as what Mexico has followed since the crisis.
a. Direct foreign investment t FDI is a measure of foreign ownership of productive assets.
Increasing this can be one measure of growing economic globalization. Generally
thought of as a long-term commitment, and thus much more stable/not capital flight
b. Portfolio investment t This the purchase of stocks, bonds, and the money market
instruments by foreigners in order to realize a capital gain. This does not result in
foreign ownership or legal control and thus is very volatile and a risk for capital flight
when exchange rates are changing.
a. Covered interest rate arbitrage is what arbitrageurs acquire money where interest rates
are low, and then lend it where they are high, pocketing the difference. This is a
powerful force in the world economy as it puts downward pressure on those with high
interest rates, and upward pressure on those with low interest rates. This is one way in
which economic conditions travel across borders. This affects the exchange rate model
in two ways:
i. Speculation that a currency will appreciate first pushes up forward rates that
govern the futures markets for currencies, and then the spot rate as traders buy
more of the currency to sell in the future.
ii. If interest rates in a country rise relative to another country, the demand for the