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

The early part of our sample is Mexico's managed exchange rate period; a period in which Mexico begins with a dual exchange rate system, abandoned in 1991, through a pegged rate, to a crawling peg, and finally to a widening band regime which collapsed in the "Tequila Crisis" of December 1994. The Tequila crisis marked a decisive defeat for Mexico's attempts at managed exchange rate regimes. Post crisis, Mexico moves to a floating rate regime for the peso with limited interventions by the central bank into the foreign exchange markets.

Exchange Rate Regimes and Country Risk

When financial markets are completely integrated, assets with identical risk should earn identical returns across, as well as within, markets. In our model, risk refers to the country's exposure to a common world factor, the Morgan Stanley World Index (MSWI). Changes in the degree of capital market integration for a country should cause shifts in the betas of its market index or its individual stocks with respect to the world index. Identifying such shifts has formed the basis for dating liberalization episodes in a variety of ways.

Changes in a country's exchange rate regime should have similar effects on a country's beta measures. Managed exchange rate regimes seek to limit the volatility of a country's exchange rate using international reserves and/or capital controls. As a result the US dollar denominated returns for a country will reflect mostly movements in local currency denominated returns. These returns are likely to be heavily dependent on local economic conditions. As a result, the country's US dollar returns are likely to move differently from those of the world index, making the country a diversification play so long as the managed rate regime survives. We expect that the country's beta in a global CAPM regression will be low but highly sensitive to changes in the exchange rate, particularly large changes that may indicate fragility in the managed regime.

A collapse in a managed exchange rate regime to floating regime means US dollar returns will reflect both local currency returns, and economic conditions, and unanticipated exchange rate changes. As a result, we expect a country's US dollar return to move more closely with returns on the world index. Flexible exchange rates represent another stage in the integration of a country's capital markets into world markets. Under a flexible regime, the country's exchange rate should respond to capital flows, resulting from return differentials, with more rapid and sizable adjustments. As a result we expect changes in the correlation structure between the country's returns in local currency and US dollars. It is expected that a country's US dollar returns will be more volatile and more highly correlated with returns on the world index than under a managed regime. We expect the result of a switch from managed to flexible exchange rates to be a rise in the country's beta and an increase in the variability of its beta over time. Table 1 demonstrates that during our managed exchange rate period, Mexico's local currency returns exhibit essentially the same variability as its US dollar return. In contrast, during the later floating exchange rate period, Mexico's US dollar returns are almost twice as variable as its local currency returns. As expected, the correlation between the US dollar and local currency returns is also lower in the floating exchange rate period at 0.9610 versus 0.9924 in the earlier fixed rate period. Finally, the correlations of Mexico's returns, both US dollar and in pesos, to the returns on the Morgan Stanley World Index (MSWI) and the S&P 500 increase in the floating rate period, suggesting that Mexico's beta changed systematically across exchange rate regimes.