The Interest Rate-Exchange Rate Link in the Mexican Float



Carlos A. Ibarra

Introduction

In an early example of what would later become a trend, Mexico
abandoned its official exchange rate band against the U.S. dollar in
December of 1994. Preserving the system had become increasingly
difficult on account of both a steady process of real currency
appreciation and the impact of major political shocks. Eventually, these
developments led authorities to devalue the band ceiling in about 20%,
but, as is well known, the policy decision backfired and a major financial
crisis ensued. Different interpretations for this seemingly perverse
market reaction exist, including the possibility that the initial
devaluation was to small to correct for the inherited real appreciation
(see Dornbusch
et al., 1995), and that the realignment acted as a focal
point for expectations of an imminent default on dollar-indexed
Tesobonos (see Ros 2001, Ibarra 1999).

The loss of international reserves intensified in the wake of
devaluation and as a result the Banco de Mexico rapidly came to a
situation in which it was no longer able to defend a target level for the
exchange rate. This fact precipitated a forced shift into a floating
regime. Initially, floatation was adopted as a strictly transitory
arrangement, under the premise that it was the only viable option in
a situation characterized by very unstable exchange rate expectations
and depleted international reserves. Contrary to the early official
statements, though, the floating regime has evolved into a rather solid
component of the country’s overall monetary framework (for a detailed
account, see Carstens and Werner 1999).

So far, the flexible exchange rate regime has survived a number
of major shocks, including the Russian debt default of 1998, the
currency crises in Asia (1997), and in Brazil (1999), wide fluctuations
in oil prices, and the country’s political transition in 2000. At the
same time, the inflation rate has fallen from a 52% peak in
December of 1995 to about 5% in 2002, while the output growth
rate remained moderately high until the recent world deceleration.
This record has certainly been a plus for the system. Demonstrating
that disinflation is possible under a fluctuating exchange rate
regime has, in particular, been a major achievement for this
developing country.

Furthermore, given the recent world economic experience, the
discouragement of major speculative attacks against the currency
may be, in practical terms, a good enough reason to keep the

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