Mexico's tequila crisis--hangover or hair of the dog? Country risk and exchange rate regimes

Multinational Business Review, Fall 2002 by Goldberg, Cathy S, Veitch, John M

This paper examines the importance of economic factors in a time-varying beta model of country risk. We examine measures of Mexico's inflation, exchange rate, trade and monetary policy in the model but find that exchange rates are the only economic variable that matters for variations in beta. We investigate the role that changes in exchange rate regimes, fixed to floating, play in affecting the time variation of beta for Mexico. Our results show that a switch from a managed to a flexible exchange rate regime leads to a rise in the level and volatility of Mexico's country beta over time.

INTRODUCTION

The World Capital Asset Pricing Model (CAPM) is a standard approach for estimating the risk of a country's financial markets with respect to a world market index. A large body of literature has established the importance of a country's economic and political variables in explaining cross-sectional variations in beta measures across countries. This literature begins with Harvey (1991) who investigates global CAPM regressions and continues through Ferson and Harvey (1999) who investigate multi-factor model regressions across 18 countries.

Another strand of this literature recognizes that a country's beta with respect to the world index is likely to change for countries that liberalize their previously closed financial markets to foreign investors. It is likely that the beta exhibits a structural break for a liberalizing country, with beta changing to reflect the higher correlations of local financial markets returns to movements in the world index after liberalization. Much empirical work has been done on exploring the effects of liberalization on country risk as measured by its beta, and dating liberalization incidents based on shifts in estimated betas. Bekaert and Campbell (1995) estimate timevarying degrees of integration across a variety of liberalizing countries. More recently, Goldberg and Delgado (2001) date liberalization episodes using panels of stock returns for each country. If country betas change systematically across liberalization episodes, as all the literature suggests, it seems reasonable to believe that a single country's beta may fluctuate with changes in that country's other important economic variables. Gangemi, Brooks, and Faff (2000) explore the notion that economic risk factors may change a country's beta over time, even if the country's degree of integration into world markets remains essentially unchanged. They focus on whether increasing government debt burdens are responsible for shifts in country risk for Australia. Their results are somewhat surprising; the only risk factor that seems important for changing Australia's beta with respect to the world index are surprises associated with changes in Australia's exchange rate.

Our paper investigates the importance of economic factors in a time-varying beta model of country risk for Mexico, a developing economy with financial markets that have been integrated with world markets for at least the past decade. We find that exchange rate surprises are the main determinants of how Mexico's beta varies over the period 1990 2000. We also find that the type of exchange rate regime, managed rates versus floating rates, affects the influence of exchange rate surprises on Mexico's country risk. Mexico's beta trends lower over the managed rate period, 1990 1994, but shifts up and becomes more volatile in the floating rate period, 1995 - 1999.

We provide an overview of Mexico experiences with financial market liberalization, exchange rate regimes, and correlation structure with world and US capital markets. We also provide a discussion of the expected effects of changes in exchange rate regimes on country risk. The next section introduces the data to be used and the paper's estimation strategy for time-varying country risk. We then present our results on time-varying beta estimates for Mexico and summarize the consequences for exchange rate regimes and country risk. Finally, we conclude the paper and make suggestions for future research.

EXCHANGE RATE REGIMES AND COUNTRY RISK: MEXICO'S EXCHANGE RATE EXPERIENCE

In 1981 the Mexican Country Fund was issued on the NYSE. Prior to this time the market was effectively closed to foreign investors. In May 1989, the Mexican stock market was made fully investable with the exception of a few key areas. The official IFC liberalization date for Mexico occurs during 1989. Bekaert and Harvey (1995) find their measure of the degree of integration for Mexico's financial markets peaks between mid-1988 and the end of 1989. In contrast, Goldberg and Delgado(2000), using return series on a panel of individual Mexican stocks, identify June 1987 as the breakpoint for liberalization of the Mexican stock market.

Our interest is not in when the liberalization of Mexico's financial markets occurred per se, but rather on how a newly integrated country's covariance risk with the world market index is affected by a change in its exchange rate regime. We chose January 1990 through September 1999 as our sample period - a period in which Mexico had moved towards integrated financial markets but which also includes a major change in Mexico's exchange rate regime.