International Financial Policy-Dollarization in Mexico

Dollarization in Mexico
Jingwen Fu Xintong Hou & Mengye Zhu

Introduction of Dollarization in Mexico
Foreign Exchange Regime of Mexico – A Historical Perspective
Pros and Cons—On-going debate on dollarization in Mexico
& other LatinAmerica countries
Dollarization in Mexico

Introduction
 What is dollarization?
 Currency Substitution:The use of a foreign currency in transactions in place of the domestic
currency
 Dollarization is the degree to which real and financial transactions are performed in dollars
relative to those realized in domestic currency
 Measure: The proportion of dollars to domestic currency circulating at any point in time.
 Full dollarization vs Partially
 Official vs unofficial (Mexico)

 Why is dollarization emerged?
 Domestic residents have strong incentives to
 diversify the composition of their currency holdings.
 Individuals and firms engaged in international exchange have
 similar transaction and portfolio incentives
 Border transactions is particularly important in the Mexican case
 Tourism
 There is a greater incentive to diversify the portfolio of liquid money
 assets under floating rates
 Depreciation pressure on Peso
 trillema
Introduction

Summary of Mexico’s exchange rate regimes since 1954
Date Regime Exchange Rates Quotes
Beginning Ends
April 19, 1954 – August 31,
1976
Fixed Rate Fixed $ 12.50 $ 12.50
September 1, 1976 – August 5,
1982
Managed floating
rate
Currency/document
transactions
$ 20.50 $ 48.79
August 6, 1982 – August
31,1982
Multiple exchange
rate
General
Preferential †
“Mexdollar' ‡
$ 75.33
$ 49.13
$ 69.50
$ 104.00
$ 49.81
$ 69 .50
September 1, 1982 – December
19, 1982
Generalized
exchange rates‟
control
Preferential
Ordinary
$ 50.00
$ 70.00
$ 70.00
$ 70.00
December 20, 1982 - August 4,
1985
Exchange's control Controlled
Special
Free
$ 95.05
$ 70.00
$ 149.25
$ 281.34
$ 281.51
$ 344.50

Summary of Mexico’s exchange rate regimes since 1954 (con)
Date Regime Exchange Rates Quotes
Beginning Ends
August 5, 1985 – November 10,
1991
Regulated Float Managedequilibrium
Free
$ 282.30 $ 3,073.00
November 11, 1991 – December
21, 1994
Exchange rate
bands with
managed
slippage
“FIX” $3,074.03 N$ 3.9970
December 22, 1994 – present Free Float “FIX” N$ 4.8875 ------
* Buy/sell average. Guide: $ = “old pesos”; N$ = “new pesos”
†The same exchange rate was used for buying or selling.
‡The peso traded at the specified exchange rate in effect only
from August 19-31, 1982.

I. Fixed rate regime (April 19, 1954 – August 31, 1976)
 For several years prior to 1954, the Mexican peso was relatively stable
against the US dollar at around 8.65 pesos per USD.
 In 1954, however, certain unfavorable conditions occurred in Mexico.
 In order to correct these imbalances, onApril 19, 1954, the peso was
devalued and fixed at 12.50 against the dollar.

II. Managed floating rate regime (September 1, 1976 – August
5, 1982)
 A fixed peso/dollar exchange rate of 12.50 was maintained until
September 1976
 In view of the imbalances in both the current account and the
capital account, on September 1, 1976, the fixed exchange rate
regime was replaced by a managed floating rate regime.
 During the managed floating rate regime there were in practice two
exchange rates: one for currency transactions and another one for
transactions with documents. Although buy/sell quotes for each
exchange rate were often different, the average buy/sell quote
usually coincided.

III. Multiple exchange rate regime (August 6, 1982 – August 31, 1982)
 At the end of 1981 and in 1982, the Mexican economy entered a phase of instability
 Thus, as of August 6, a dual exchange rate regime was introduced: a
“preferential” one and a “general” one.
 However, based on the 1982 Annual Report:
“Public reaction to the dual exchange rate system was one of surprise and
uncertainty regarding the foreign exchange market's future trend.”
 Following the announcement of the reopening of the foreign exchange market
in banks on August 19, a third peso/dollar exchange rate was introduced which
fixed the peso at 69.50 against the dollar for the settlement of foreign-currency
denominated obligations payable in Mexico. Such obligations would henceforth be
known as “mexdollars‟…”

IV. General controlled exchange rate regime
(September 1, 1982 – December 19, 1982)
 Despite the foreign exchange regulatory measures, at the end of August
some speculative movements in the foreign exchange market further
eroded Central Bank foreign reserves. Protecting international reserves
thus became the focal point of foreign exchange policy.”
 On September 1, 1982, the “general controlled exchange rate regime” was
introduced.
 Two exchange rates were also introduced: a “preferential” one and an
“ordinary” one determined by Banco de México.
 The decree published in the Official Federal Gazette on September 1,
1982 stated that “Banco de México… will determine when the preferential
exchange rate applies and when the ordinary exchange rate applies as well
as the need for any temporary or permanent special exchange rates.”

V. Controlled exchange rate regime (December 20, 1982
– August 4, 1985
 Following the presidential changeover in December 1982, on
December 13 that year the Official Federal Gazette announced a
controlled exchange rate system which would replace the
generalized exchange rate control as follows:
“Two foreign currency markets will exist side by side within the
Mexican Republic: a controlled one and a free one. “

The controlled foreign exchange market covers the following concepts:
a) Exports by private individuals or corporations …
b) Assembly plant payments…
c) Principal, interest and other concepts determined by Banco de México on foreign-
currency loans taken out by the Federal Government, Federal Government Entities
and other companies located in Mexico…
d) Imports of merchandise and demonstrable related expenses payable abroad and
determined by the Department ofTrade…
e) Expenses corresponding to the Mexican Foreign Service and quotas and
contributions corresponding to Mexico‟s participation in International Organizations;
and
f) Concepts generally determined by the Ministry of Finance and Public Credit at
Banco de México‟s suggestion, based on their importance to the domestic economy
or similarity or connection to aforegoing ones…”
Controlled Market

The free market covers foreign currency transactions not subject to the controlled
market.
Free market transactions, including the buying and selling, possession and transfer
of foreign currency, are not subject to restrictions.
Exchange rates agreed on by the contracting parties will apply to foreign currency
buy/sell transactions covered by the free market.
Free Market

VI. Regulated floating rate regime (August 5, 1985 –
November 10, 1991)
 Towards the end of 1985, it was considered that foreign exchange policy
at the time did not take account of the prevailing and expected trend in
monetary aggregates or their impact on international reserves, as the
exchange rate moved evenly in accordance with a daily slippage and not in
accordance with prevailing conditions. Therefore it was announced that:
 “…as of August 5, a regulated floating system will be introduced to replace
the even slippage in effect since December 1982. Under the new system
the controlled exchange rate will be modified on a daily basis by not
necessarily even amounts and not abruptly”

VII. Exchange rate band with managed slippage regime
(November 11, 1991 – December 21, 1994)
 In order to “provide exporters and assembly plants with a stimulus” as of
November 11, 1991, exchange rates were no longer managed and the
free and controlled exchange rates were unified.The new system
consisted of letting the exchange rate float within a band which widened
on a daily basis.The floor of the band was set at 3,051.20 pesos against
the dollar while the ceiling was adjusted upwards by 20 cents daily
(including Saturdays and Sundays) from 3,086.40 pesos. On October 21,
1992, the ceiling’s slippage was increased to 40 cents daily.

VIII. Free floating regime (December 22, 1994 – present)
 In 1994, several events occurred in Mexico which caused market instability
and resulted in a speculative attack on Banco de Mexico‟s international
reserves at the end of that year, making the exchange rate band regime
unsustainable.
 Thus, on the evening of December 19, 1994, the Foreign Exchange
Commission reached an agreement to replace the previous exchange rate
regime with a floating rate regime.
 Under the floating rate regime, which has remained in effect ever since, the
exchange rate is determined by the free market without the intervention
of the authorities.

Dollarization and Exchange Rate Regime
 Examine the trend of ratios of foreign to domestic currency demand deposits
and total deposits held in Mexican private financial institutions from 1933 to
1976

 During the first fixed exchange rate period (from November 1933 until March
1938) the demand deposit ratio fell consistently.
 In March of 1938, President Cardenas nationalized the oil industry and the
peso was allowed to float again for thirty- one months. A new process of
dollarization began with the floating of the peso.
 The dollar/peso deposit ratio reached its highest point in September 1940,
and declined substantially following the establishment of a fixed peso/dollar
exchange rate .

 A new period of floating exchange rates lasting only eleven months took
place between July 1948 and June 1949; the dollarization coefficient
increased from 7.5 to 11.5 percent during the float.
 The new parity established in 1949 (8.65 pesos to a dollar) lasted until 1954
when the peso was devalued approximately 45 percent.The exchange rate
was then maintained at 12.5 pesos to a dollar until September 1976 when
authorities decided to float the peso once more.
 The dollarization coefficients climbed once more with the 1976 devaluation
 Then while the checking deposit peso/dollar ratio declined after the third
quarter of 1977, the total deposit ratio has remained at substantially higher
levels.

 The largest jumps of the dollarization ratio (after 1937) occurred in 1940, 1952,
1954, 1957-58, and 1976. Of these dates, 1940, 1952, 1958, and 1976 correspond
to the last year of the incumbent administration. Of these dates, 1940, 1952,
1958, and 1976 correspond to the last year of the incumbent administration,
while a devaluation also occurred in 1954 and 1976.
 Conclusion: Both devaluation expectations and perceptions of possible
"economic regime" changes (or increased political risk) associated with the
renewal of the administration must play an important role in explaining the
historical record of Mexican dollarization.

Pros and Cons of Full Dollarization
 Benefit
1. In the short run is the decline of inflation rates and inflation expectations.
Full dollarization eliminates the risk of depreciation of the domestic
currency, a contributing factor to the acceleration of inflation.
2. Enhancement of economic policy credibility.The high cost of reversing full
dollarization could restore confidence in policymakers’ long-term
commitment to price stabilization and fiscal discipline.This gain in policy
credibility reinforces the reduction in inflation fears.
3. Reduction of the cost of borrowing. Use of the US dollar eliminates the
devaluation risk and should reduce interest rates.

Benefit and Cos t of Full Dollarization
Cost
 Countries are likely to be reluctant to abandon their own currencies, symbols of
their nationhood, particularly in favor of those of other nations. As a practical
matter, political resistance is nearly certain, and likely to be strong.
 From an economic point of view, the right to issue a country's currency provides its
government with seigniorage revenues, which show up as central bank profits and
are transferred to the government.They would be lost to dollarizing countries and
gained by the United States unless it agreed to share them.
 A dollarizing country would relinquish any possibility of having an autonomous
monetary and exchange rate policy, including the use of central bank credit to
provide liquidity support to its banking system in emergencies.

Panama-Full Dollarization
 Panama was the first fully dollarized economy
in Latin America.
 After the country gained independence from
Colombia in 1904, the US dollar became the
legal tender for transactions and the domestic
currency.
 Panama’s decision to adopt full dollarization
responded to political and historical reasons
rather than economic ones.

 1. Stability of output and prices
 an average stable growth rate of 4.4%, exceeding the average growth rates of
Central American countries.
 average inflation rate remained very low (1.1%) and stable (0.4% of volatility)
 2. Promotion of fiscal discipline
 Foreign debt began to decline in 1996 thanks to an external bond exchange
and a debt reduction operation.
Benefits

Cost
Increasing vulnerability to external and internal shocks
In the 1960s, political conflicts over the Canal Zone resulted in the massive
withdrawal of domestic deposits, offset by an increase in domestic lending.
The increase in international oil prices in 1973 and 1978 caused increases in
domestic prices, resulting in high inflation rates.
A major crisis came in 1987 and 1989, as a result of political tensions
between the governments of Panama and the United States. Banks
borrowed abroad and reduced their liquid assets to compensate for the loss
in domestic resources, but also reduced lending.
Real GDP decreased 15.6% in 1988 and 0.4% in1989, accompanied by large-
scale capital flight.
The effect of the financial crises in 1997-1998 was more pronounced in
Panama’s dollarized economy because of the increase in interest rates. In
2001, Panama’s GDP grew 0.3%, the lowest growth rate in the decade

Ecuador’s recent experience with full dollarization
In January 2000, President Jamil Mahuad called for full dollarization to
avoid the collapse of the banking system.
Ecuador started enjoying the expected benefits of full dollarization
even before the US dollar was officially adopted on September 9, 2000
enhanced credibility
release of frozen bank deposits
Lower inflation

Full dollarization eliminated devaluation risk, although
country risk did not decline immediately

Critics
 Ecuador is still vulnerable to external shocks due to its dependency on
revenues from oil and external financing. Full dollarization imposes an
additional cost to this vulnerability: the lack of flexibility of economic
policies to respond to real, financial and political shocks.
 An additional challenge to the dollarization process is the circulation of
counterfeit currency.
 Political consensus will be the greatest challenge for structural reform in
Ecuador.
 Full dollarization has helped Ecuador reduce inflation and enhance policy
credibility and has supported economic stability in the short run. In the
long term, however, further benefits for economic growth and
development will depend on structural and institutional reforms.

Experience from above Countries
Full dollarization can help countries achieve lower inflation, economic stability and growth.
Full dollarization enhances policy credibility and encourages foreign investment. It
promotes fiscal discipline, a competitive financial system and economic integration with
international markets.
However, countries implementing full dollarization must establish structural programs and
institutional reforms to ensure that short-term stability develops into long-term economic
growth.

Deliverables
 What products or services will your project deliver?
 Include client requirements

Success Factors
 Identify elements that are key to the success of the project, such as:
 Satisfied clients or stakeholders
 Met project objectives
 Completed within budget
 Delivered on time

Implementation
 Tasks/activities
 Procedures
 Tools/technology
 Project change control process
DYA: define your acronyms!

Resources
People
Resource 1
Resource 2
Resource 3
Resource 4
Notes
Equipment
Resource 1
Resource 2
Resource 3
Resource 4
Notes
Locations
Resource 1
Resource 2
Resource 3
Resource 4
Notes
Outside
Services
Resource 1
Resource 2
Resource 3
Resource 4
Notes
Manufacturing
Resource 1
Resource 2
Resource 3
Resource 4
Notes
Sales
Resource 1
Resource 2
Resource 3
Resource 4
Notes

Cost Analysis
$-
$200,000
$400,000
$600,000
$800,000
$1,000,000
$1,200,000
$1,400,000
Parts and
materials
Manufacturing
equipment
Salaries Maintenance Office lease Warehouse
lease
Insurance Benefits and
pensions
Vehicles Research
Annual Cost

Project Schedule and Milestones
Milestone 1
• January 10
Milestone 2
• April 10
Milestone 3
• July 10
Milestone 4
• October 10

Risk Management Plan
Risk Probability Impact Owner Mitigation Plan
Budget cuts may
reduce staff, affecting
project scope and
schedule
Medium High
Project
Manager
See appendix for a phased
implementation plan

Quality Management and Performance Measures
 Define quality management plans
 How will you monitor and control costs?
 How will you monitor and control schedule?

Appendix
 Reference supplementary materials
and resources

International Financial Policy-Dollarization in Mexico

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