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

MODELING TIME-VARYING COUNTRY RISK

Selection of Economic Variables In TimeVarying Country Beta Models

Macroeconomic influences should play a major role in altering country risk, particularly in emerging economies. Thus, we argue that timevarying country betas may be explained by constructing a model that incorporates macroeconomic variables that impact country risk for Mexico. Our choice of relevant variables is influenced by past research in this area. Most relevant to our research is a paper by Gangemi et. al. (2000) who model country risk for Australia. They include measures for the exchange rate, inflation, economic activity, national debt, monetary policy, government borrowing, interest rates and commodity prices. Other work by Erb et. al. (1996) and Bekaert et. al. (1996) also rely on macroeconomic variables to explain country risk. These papers utilize macroeconomic variables which capture political risk, inflation, exchange rate volatility, GDP, size of the trade sector, indebtedness of the country, current account balance and the trade balance.

We chose the following set of macroeconomic variable for our analysis presented in table 2.

We obtained monthly macroeconomic data from the IFS database and use the monthly percentage changes in our variables computed as the log difference in our data between the current and previous month data. CPI or the index of consumer prices is our inflation measure, EXR is the Mexican peso to US dollar exchange rate and TRADE is defined as net exports. Monetary policy is captured by the remaining two variables; MBASE, reserve money, and IRES, international reserves for Mexico.

ARIMA Analysis

We use the unanticipated components or residuals from an ARIMA analysis as the relevant variables in analyzing Mexico's monthly stock returns. The reason for this is twofold. First, if markets are efficient, then changes in stock market returns should only be explained by the unanticipated components of the macroeconomic variables used. Singh (1993,1995) uses this approach when examining announcements pertaining to macroeconomic variables and their impact on the stock market, exchange rates and interest rates. Second, using the raw data for our analysis would most likely result in a high degree of multicollinearity as macroeconomic variables tend to exhibit strong correlations with each other as the result of common trends.

First, it is interesting to note that the level of systematic risk in Mexico increased substantially after the tequila crisis, due in large part to the switch from a managed exchange rate regime to a floating one.

There are 2 outliers that occur in our post sample analysis. In October 1997, the country beta for Mexico increased to 2.31. We link this outlier to the Asian crisis which directly impacted Mexico's exchange rate and hence the beta value. In this month, the exchange rate of the peso to the US dollar increased by 8%. A second outlier was identified in August 1998 where beta was 2.69. This was most likely caused by the crisis in Russia. In this month, Mexico's peso/US dollar exchange rate increased by 11%. It is apparent that significant economic events that impacted Mexico's exchange rate were a major cause for the shift in Mexico's country risk, particularly in the second half of the 1990's.