Three Stages of Mexico´s Monetary and Fiscal History: Growth with Low Inflation, Fiscal Expansion and Reforms

Alejandro Hernandez-Delgado, Felipe Meza, and Ignacio Trigueros-Legarreta (ITAM)

April 2014Discussant: Gerardo della Paolera

(Universidad de San Andrés)

Three Stages of Mexico´s Monetary and Fiscal History: Growth with Low Inflation, Fiscal Expansion, and Reforms

• Analysis of the monetary and fiscal history of Mexico (circa 1978-2009) through the lenses of Sargent (1992), Kareken and Wallace(1981), Nicolini ( 2010) .

• The authors follow the economics of budget constraints which includes debt denominated in foreign currency and debt indexed to inflation.

• This is expressed as in Kehoe, Nicolini, Sargent (2013) as:

The Economics of Budget Constraints

• Rearranging the «canonical» budget constraint, KNS(2013) obtain equation (1a):

• The debt triplets are to be explained by the inflation tax, the return on nominal bonds, the return on the indexed bonds, the return on the dollar denominated debt and the primary deficit including transfers.

The Economics of Budget Constraints

defining:

• The authors gather data for the 1978-2009 period to decompose the changes in public debt into (a) the inflation tax; the return on the government debt and the primary deficit.

Definitions and Data

• Government: PublicSector + IFDC +IFIBC

• Data: InitialProblems to assesstheDebt Stock: mix of registration at par and marketvalues. ProxiedforNationalDebt

• OnlyPublic Sector, usedmarketvalue of debtissuedbynationalgovernment net of debts at Central Bank

Computing the Foreign Debt Ratio

• No statistics on the market value of foreign debt: the 1988 debt stock estimated at 64 billion USD composed by the bank debt at market values plus non-bank debt at face value.

• Then to calculate the yearly stocks use of the flows related to assets and liabilities from the Capital account.

Difficulties to get indexed Debt

• In the paper, only a consolidated figure for the Total Nominal debt could be obtained. The ratio θr is implicitly included in the National Debt Ratio θN.

Fig. 1: Evolution of Nominal, Foreign Debt Ratios, and Deficit

Fig. 2(a): Change in Nominal Debt Ratio and Deficit (fraction of GDP)

Fig. 2(b): Change in Foreign Debt Ratio and Deficit (as fraction of GDP)

Fig. 2(c): Change in Monetary Base to GDP and Inflation Tax Revenue (as fractions of GDP)

Fig. 2(d): Change in Foreign Debt Ratio and Total Net Interest Payments (as fractions of GDP)

Results

• In Figure 1 (and 6), primary deficits until 1982/3. After 1986 fall in the foreign debt ratio but increase in the nominal debt ratio.

• In 2(a) through 2(d), the graphs show if the deficit, total interest payments and the inflation tax revenues drive changes in both ratios.

• In 2(b) the ratio of foreign debt seem to respond strongly to changes in primary deficit; in 2(d) total net interest payments is closely related to the increase in the Foreign Debt ratio.

Fig. 6: Primary Deficit as a Fraction of GDP

Accounting for total net interest payments

• After calculating the sequences of the debt ratios, the authors compute net interest on the debt:

and

• They need to proxy the gross interest rate R and r*: for R the proxy is the yield on the CETE, the interest payments is calculated as a residual from the total.

• In Figure 4, the interest rate payments on foreign debt is the main source of fluctuations in total interest payments.

Fig. 4: Total Net Payments on Nominal Debt; On Foreign Debt and Total Net Interest Payments

Fig. 3: Growth Factor of Price Level and Gross Nominal Yield on Domestic Debt

Analysis of cumulative changes in debt and their driving components

Analysis of cumulative changes in debt and their driving components

• Introduce:a) A sequence of primary (deficits) surpluses;b) A sequence of interest payments;c) The negative of cumulative changes in the money base

(reduces borrowing);d) The negative in cumulative changes in the inflation tax.

• Results: In 5(a) interest rate payments are the main driving force to increase the level of indebtedness. In 5(b), the surpluses after 1983 the main force to reduce the ratios.

Fig. 5(a): Cumulative Change of Nominal, Foreign and Total Debt Ratios

Fig. 5(b): Cumulative change of Debt Ratios, Cumulative Primary Deficit, and Negative of Cumulative Inflation Tax Revenue

Fiscal Expansion of 1970s and the Debt Crisis of 1982

• Dynamics lead by sizeable primary deficits (Fig 6); jump in 1981.

• Banco de Mexico dominated by the government (fiscal dominance).

• Progressive increase in the level of indebtedness until 1982 (Fig 9), when debt constrained , inflationary scenario.

• The stylized facts are explained by the SW model: deficits need not be inflationary as long as you can finance them by issuing debt (foreign?), once debt intolerance is present, the Unpleasant “Fiscal” Arithmetics push you to an inflationary scenario.

• The “repressed” inflation is a short-run equilibrium when running continuous primary deficits.

Fig. 6: Primary Deficit as a Fraction of GDP

Fig. 9: Total Debt as a fraction of GDP

Fig. 7: Inflation Tax Revenue as a Fraction of GDP

Fig. 8: Inflation Rate measured with the GDP Deflator (%)

Economic Reforms in the 1990s and the 1994 Crisis

• In 1990’s Independence of the Banco de Mexico, goal is to maintain the purchasing power of the peso: limits advances to the Government (Change in Macroeconomic Regime?)

• However, huge internal political shock in March 1994, Colosio killed. Political Uncertainty; start issues of Tesobonos; sizeable capital outflows by Nov/Dec 1994.

• Change in the exchange rate regime.• Sudden Stop? Substituting for short term borrowing ( with

maturities shortening) and the ratio dollar indexed debt to international reserves increasing) but even then in early 1995 Mexico could not roll-over the short term debt.

• How the facts fit with the model?

Economic Reforms in the 1990s and the 1994 Crisis

• Some stylized facts:1. Debt ratios not at its maximum, however stock of tesobonos

net of international reserves equivalent to 30billion USD.2. Interest rates skyrocketed because the expectations of

further devaluations increased and because of tight monetary policy which maybe the agents believed was to become unsustainable (role of the external bail-out to redress those expectations?) due to a potentially explosive burden of the short-term debt. (here there is a SW flavor only that maybe bailout meant degrees of freedom to maintain monetary independence)

3. These dynamics in spite of a contractionary monetary policy and a pro-cyclical fiscal policy. Smax was not attained because of bail-out?

Fig. 10: International Reserves and Government Bonds (in millions)

Fig. 11: Average monthly annualized nominal interest rate paid by 28 days CETES (%)

A Historical Example of Deficit Dominance: Debt, Fiscal Deficits and Inflation (Argentina 1885-1893)

Fig. 9: Total Debt as a fraction of GDP

Primary Deficit Pre-Baring Crisis

1885 1886 1887 1888 1889 1890 1891 1892

-20

-15

-10

-5

0

5

10

15

20

25

Primary deficit (in millions)

Fig. 6: Primary Deficit as a Fraction of GDP

Price Level and Exchange Rate 84-1914

Fig. 8: Inflation Rate measured with the GDP Deflator (%)

Sustained Primary Deficits: From Debt Finance to Fiscal Dominance

“The monetary and fiscal inconsistency became apparent by the end of theyear 1889. The government, already under a debt-ceiling constraint and withits specie reserves almost depleted, had no choice but to switch from debtfinance to money creation to cover an ongoing budget deficit. For the 1889-91 period, the accumulated inflation rate (163.7 percent) and the accumulateddepreciation rate (152.7 percent) are closely correlated with the accumulatedcounterfactual inflation rate (154.9 percent)”.

Sustained Primary Deficits: From Debt Finance to Fiscal Dominance

“Before the curtain fell in 1891, the drama concluded with an economic policythat had finally exhausted all the available genuine means of finance and heavilyrelied on the inflation tax to finance the budget. The inflation tax and currencysubstitution interacted in unfortunate ways that exacerbated the fiscal problem.If there is a high sensitivity of velocity to inflation (a greater propensity forcurrency substitution) then this will imply a higher inflation rate for the samelevel of deficit, all else equal. Moreover, currency substitution will lower thebase for the inflation tax, requiring an even higher inflation rate to sustain thesame fiscal gap.» l6