Foreign Exchange Dynamics, Debt and the ‘Peso Problem’

Abstract

Located next to the largest economy of the world, Mexico – the second largest Latin American nation – has been experiencing a process of painful adjustments for over a decade and half. Its financial woe owing to its gargantuan foreign debt, intractable rates of inflation and plummeting value of the peso has brought about real and fundamental economic disequilibrium, and the economy hardly seems to be pulled back toward an order by any centripetal forces or by any governmental policy menu. The Government has been trying seriously to correct or, at least to contain, the continuous downslide of the economy, but nothing appears to be working well. It is quite ironic that when the peso is greatly depreciating in the market, it is often getting overvalued in reality by the combined effects of the Fisher Open Principle and the Purchasing Power Parity.¹ This sort of turn or twist causing the paradox of appreciation in the midst of depreciation probably further sustains the plunging condition of the Mexican currency. Some analysts argue that since the foreign exchange market is not always efficient, even a low probability of an event may cause a large change in the exchange rates, and this is what is happening with the peso. This is the so-called 'peso problem'. It is, unlike 'speculating bubbles', as amplified by Blanchard (1979), Tirole (1982) and Blanchard and Watson (1982), an exchange rate dynamics of disequilibrium in which expectation of expansionary policy menu induces an actual erosion in current exchange rate and thus forces current inflationary pressures ahead of any expansion.