BALANCE OF PAYMENTS ADJUSTMENTS
Considering intensifying volatility in foreign exchange markets derived from recent financial crises and monetary easing measures from developed countries, many emerging countries began to adopt floating exchange rate systems to protect their currencies from external adverse effects.
However, foreign exchange markets are bigger than any central banks and stability of international currency market depend on the effectiveness of policy implemented by different central banks and international organizations. The foreign exchange market involves many players, such central banks, commercial banks, and starting from the 1970s, international companies.
When the globalization and liberalization of financial markets speeded up in the 1980s, currency in flowed and outflowed among different countries involving many different players to foreign exchange market. Mexico had fixed exchange rate regime until 1976. Having analyzed the economic conditions, the government made the decision to switch to managed floating in 1976 and to free float in 1994. In early 1970, inflation was rising, and people preferred to save money abroad. As the result, significant imbalances arose between current and capital account. The fixed rate did not reflect the economic realities: actual demand and supply for currency. Under the new system, the central bank intervened into foreign exchange market only when severe fluctuations arose. However, there were two exchange rate – one for currency transactions and another for document transactions. In the period 1976 – 1994, Mexico changed exchange rate regimes several times, and in 1994, after the severe devaluation of peso finally switched to the free-floating exchange rate. Under this regime, the exchange rate is determined based on demand and supply of currency without the intervention of authorities. Before 1994, Mexico had negative balances of payments and was not unable to defend the predetermined parity.
In addition, severe peso devaluations have posted before government challenges: to reduce capital inflows, to refinance US denominated loans and maintain the solvency of banking sector. Free float properly reflects the economic realities and considers the external effects properly. Free float allows the central bank to conduct monetary policy using inflation targeting rather than concentrating on measures to preserve exchange rates from severe fluctuations.
Carstens, G.A., Werner, A.M. (1999). Mexico’s monetary policy framework under a floating exchange rate regime. Research Paper No. 9905. International Monetary …