History of international monetary system
Excess amount of public and private debt Paramount inflation resulting from excess money supply to support peso which was pegged against dollar (Fixed exchange rate) Short-term capital flight resulting from the speculation that peso is overvalued.
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Mexico relied heavily on foreign capital which increased money supply. Since money apply increases the amount of funds to be allocated to real sector by banks, the interest rates went down causing more debt. In the meantime, excess money supply and debt pushed up the inflation which lead to an overvalued peso hurting Mexico trade balance (export-import). All of these developments put significant pressure on peso to devalue and finally government announced its decision to devalue against dollar. 8. Causes of Crisis: Large inflows of foreign capital Overheated economy resulting from excess amount of investment in real estate and stock markets (Investment boom) Inflationary pressures on domestic goods Decline in exports and trade balance resulting from fixed exchange rates Decline in real asset and stock prices Default on debt and banking crisis Excess foreign capital flight The incredible growth of economies in Asia brought further foreign capital which in turn was allocated to public and private investment through huge amount of debt provided by banks to domestic firms.
These firms have heavily invested in real estate markets as well as some industrial projects which in turn increased the domestic prices and put inflationary pressure on exchange rate which was fixed. Thus, exports declined because domestic goods came overpriced resulting from fixed exchange rates. The decline in exports led to an overcapacity problem, which in turn dropped the asset prices.
The drop in asset prices created problems for firms to repay the debt they obtained to buy these assets. In addition, currency speculators started selling Asian currencies estimating that those currencies would devalue. As a result of these developments, Thailand tried to defend the exchange rate by using and supplying foreign exchange reserves . However, with the fast depletion of its reserves, Thailand had to devalue its currency on July 2, 1997 and other countries followed.