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COMMENT: Pan Yotopoulos, Food Research Institute (415) 723-3129; e-mail

Mexican peso crisis illustrates distortion in some currency markets

STANFORD -- The most important factor in the collapse of Mexico's peso last Dec. 20 may have been overlooked, according to a conclusion that is easily drawn from a new book by a Stanford economist.

The peso collapse was precipitated not by foreign bankers and mutual funds withdrawing their short-term loans, or by the sudden decline in Mexico's current account, but by wealthy and middle-class Mexicans converting their pesos to dollars, says Pan Yotopoulos, an economist and professor at Stanford's Food Research Institute.

Yotopoulos built this scenario more than a year ago in his book Exchange Rate Parity for Trade and Development: Theory, Tests and Case Studies, just published by Cambridge University Press. Information supporting his claim became available this summer from the International Monetary Fund, but has been largely overlooked by journalists and the "Washington consensus" of policymakers who advise developing countries to let the value of their currencies float on the "free" market, he said.

Yotopoulos argues that currency substitution is a problem not unique to Mexico: Free currency markets have inherent distortions that lead less developed countries with so-called "soft" currencies to systematically misallocate resources, which, in turn, hurts their economic growth.

Developing countries cannot rely on free currency markets to "get the price right" in the same way that developed countries such as the United States can, Yotopoulos said, and therefore effective government intervention is necessary.

He bases his conclusions on an analysis of data from 70 countries for the years 1970, 1975, 1980 and 1985. He used commodity price data that the United Nations and the World Bank collect to compare the real income of countries. But Yotopoulos instead compared the prices, in a nation's own currency, of the products it traded with the products it produced for domestic use. He found that the nations that had high prices for their tradables relative to their nontradables had low rates of growth in their gross domestic product. In his analysis, high prices of tradables correspond to high exchange rates - too many pesos to the dollar - which, in turn, can be related to free currency markets.

His argument goes this way:

In "soft" currency countries, people, when given the choice, would rather hold dollars as a hedge against devaluation. Entrepreneurs find it more attractive to produce tradable products because that is the way they can acquire American dollars. Nontradables trade in the local currency, such as pesos, which will be converted to fewer dollars after devaluation. This increases the risk for entrepreneurs who produce nontradables.

The dilemma doesn't exist for a producer located in a developed country because both tradables and nontradables trade in hard currency, Yotopoulos said. In soft currency countries, the expectation of devaluation of the currency becomes a self-fulfilling prophecy.

The problem, he said, is one of an "incomplete market" for foreign exchange in less developed countries. An incomplete market is one in which supply equal to demand does not produce the optimal outcome. For example, in a credit market, because of asymmetric information between banker and borrower, the banker who allocates his credit to whoever is willing to pay the highest interest rate is likely to default for having attracted the highest risk loans. In such markets, rationing becomes desirable.

The currency market for developing countries is also an incomplete market caused not by asymmetric information but by "asymmetric reputation" between hard and soft currencies, he says.

Yotopoulos says his idea probably hasn't been advanced before because it was so difficult to measure how much tradable and nontradable prices are off from their "real value." His analysis of commodity data, he said, "resoundingly confirms that less developed countries are likely to have undervalued real exchange rates"; that is, relatively high prices for tradable goods in the domestic currency.

Yotopoulos' conclusions support government intervention, which may be viewed by some free marketers as heresy in the aftermath of the collapse of socialism. To them, he responds that "intervention is not central planning. It is a perfectly respectable economic tool if it is done when the market calls for it. This is the message from the study of incomplete markets.

"The issue for developing countries, and some developed as well, is not whether to intervene or not in the exchange market. It is rather how to do it gracefully and effectively. If intervention is botched, free markets and free exchange rates are the superior default alternative."

Graceful, effective intervention requires a government bureaucracy that knows how to intervene and does so with integrity. To demonstrate, he compares Japan and Taiwan, successful interventionists, to the Philippines and Uruguay, which were failures at development.

The Japanese government kept the yen overvalued and below a free market level from 1955 to 1975, he said. "It meant that imports became cheap and exports expensive. Under these circumstances, Japan could have been flooded by cheap consumer imports for the middle class and luxuries for the wealthy," he said. "That did not happen because the government steered foreign exchange to imports of raw materials and intermediate products such as oil and machinery. Then they targeted those 'cheap' imports to the export sectors. In the Brazils of the world, a high valued currency usually implies huge imports of luxury items and consumption goods that don't help build the economy."

Yotopoulos concedes that graceful, effective intervention is not easy. Protectionist polices create profits that accrue to whoever is influential enough to receive the appropriate government licenses. In a well known 1974 paper, Anne Krueger, another Stanford economist, argued that in many developing countries, resources squandered in pursuit of these profits are a large net cost to the economy. The key to intervention, Yotopoulos believes, is to "make sure the excess profits are not captured by a country's elite but are plowed back into the development process."

The issue, he said, is not just to have national leaders who are skilled at intervention but also to have mid-level bureaucrats with integrity. "If Mexico, for example, controlled its exchange rate at five pesos to the dollar and the bureaucrats responsible for allocation of foreign exchange sold them for 10 pesos to the dollar [pocketing the difference], you haven't achieved anything," he said. "The moral hazard reappears and every little bureaucrat is making his own policy."

If, on the other hand, nothing is done, he said, the peso will continue to slide or Mexico will have to keep selling dollars to prop it up. He would suggest, he said, that Mexico "go part way" toward restricting Mexicans' access to dollars by increasing the transaction costs. Currently, various small shops in Mexico freely convert peso to dollars without any limit on the total. By restricting competition and shifting exchange transactions exclusively to the banks, the spread between buying and selling dollars will increase and that will discourage Mexicans from hedging against another devaluation by holding dollars.

A related "market-friendly" suggestion, he said, has been proposed by Michael Camdessus, the managing director of the International Monetary Fund. He would create a new international lending facility to help countries that face unexpected foreign exchange emergencies. It would sell bonds denominated in an index of currencies that citizens may find an attractive alternative to the non-interest-earning dollars stuffed under their mattresses.

"As long as the exchange rate of a country were 'fairly valued,'" Yotopoulos said, the international facility would support the country against unjustified market speculation" and make the defense of the exchange rate "virtually costless."



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