PAYMENTS AND SECURITIES CLEARANCE AND SETTLEMENT SYSTEMS IN MEXICO

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1 WESTERN HEMISPHERE PAYMENTS AND SECURITIES CLEARANCE AND SETTLEMENT INITIATIVE CENTRE FOR LATIN AMERICAN MONETARY STUDIES THE WORLD BANK PAYMENTS AND SECURITIES CLEARANCE AND SETTLEMENT SYSTEMS IN MEXICO MARCH 2003

2 PAYMENTS AND SECURITIES CLEARANCE AND SETTLEMENT SYSTEMS IN MEXICO

3 PAYMENTS AND SECURITIES CLEARANCE AND SETTLEMENT SYSTEMS IN MEXICO WESTERN HEMISPHERE PAYMENTS AND SECURITIES CLEARANCE AND SETTLEMENT INITIATIVE CENTRE FOR LATIN AMERICAN MONETARY STUDIES WORLD BANK

4 First English edition, 2004 Centro de Estudios Monetarios Latinoamericanos y Banco Mundial, 2003 Publicado también en español Centro de Estudios Monetarios Latinoamericanos, 2003 Durango 54, México, D.F All rights reserved Derechos reservados conforme a la ley ISBN Printed and made in Mexico Impreso y hecho en México

5 Foreword Following a request from the Western Hemisphere Finance Ministers, the World Bank (WB) launched in January 1999 the Western Hemisphere Payments and Securities Clearance and Settlement Initiative. The World Bank in partnership with the Centre for Latin American Monetary Studies (CEMLA) leads this initiative. Its objective is to describe and assess the payments systems of the Western Hemisphere with a view to identifying possible improvement measures in their safety, efficiency and integrity. To carry out this mandate an International Advisory Council (IAC) was established in March 1999 comprised of experts in the field from several institutions. In addition to representatives from the WB and CEMLA this Council includes members from the: Bank for International Settlements, Bank of Italy, Bank of Portugal, Bank of Spain, Council of Securities Regulators of the Americas (COSRA), De Nederlandsche Bank, European Central Bank, Federal Reserve Board, Federal Reserve Bank of New York, Inter-American Development Bank, International Monetary Fund, International Organization of Securities Regulators (IOSCO), Securities Commission of Spain, Swiss National Bank and U.S. Securities Commission (SEC). To assure quality and effectiveness, the Initiative includes two important components. First, all studies are conducted with the active participation of country officials and the project builds on the existing work being undertaken in the respective countries. Second, the Initiative draws on international and national expertise on the subject, through the IAC, to provide guidance, advice and alternatives to current practices. The Initiative has undertaken a number of activities in order to respond to the Western Hemisphere Finance Ministers request. These include: the preparation of public reports containing a systematic in-depth description of each country s payments clearance and settlement systems; the delivery of recommendations reports to country authorities on a confidential basis; the organization of IAC meetings to review country studies and provide input for future work; the organization of workshops focusing on issues of particular interest; the creation of a web-page (www.ipho-whpi.org) to present the outputs of the Initiative and other information of interest in the payments systems area; and the promotion of working groups to ensure a continuation of the project activity. CEMLA has been acting as Technical Secretariat of the Initiative and is playing a major role in making the process sustainable and capable of extension to all the countries in the Hemisphere. To this end, the Initiative has helped strengthen CEMLA s in-house expertise. Additionally, practitioners in payments and securities clearance and settlement in some countries in the Region have participated in the studies under the Initiative, through CEMLA coordination, and this has contributed to the broadening of knowledge and the transfer of know-how within the Region. The endeavors of the working groups in coordination with CEMLA will maintain the infrastructure created under the Initiative and provide a permanent forum for the countries in the Region to discuss, coordinate, and add a collective impetus to the work in the area of payments and securities clearance and settlement systems. This Report Payments and Securities Clearance and Settlement Systems in Mexico is one of the public reports in the series and was prepared under the coordination of CEMLA and the World Bank. The Banco de México and the Comisión Nacional Bancaria y de Valores of México also participated actively in its preparation. Kenneth Coates Director General CEMLA David de Ferranti Vicepresident, LAC World Bank Cesare Calari Vicepresident, Financial Sector World Bank

6 Acknowledgments This Report is based on the findings of a mission that visited Mexico during March 4-22, 2001, under the auspices of the Western Hemisphere Payments and Securities Clearance and Settlement Initiative (WHI). This document was prepared under the coordination of CEMLA and the World Bank. Jose Antonio Garcia (CEMLA) was the task manager, with cooperation from Massimo Cirasino and Mario Guadamillas, both from the World Bank. The WHI mission was performed in coordination with the Financial Sector Assessment Program (FSAP) mission, the joint IMF-World Bank effort to assess vulnerabilities and development opportunities in each country s financial system. The team wants to express its appreciation to the local team comprised of officers of Banco de México, coordinated by Francisco Solís (Payment Systems Manager), and the National Banking and Securities Commission (Comisión Nacional Bancaria y de Valores, CNBV) of Mexico. Carlos Orta (CNBV) made valuable comments to the Report and contributed in collecting the information for the Statistical Appendix.

7 TABLE OF CONTENTS 1 ECONOMIC AND FINANCIAL MARKET OVERVIEW OVERVIEW OF RECENT REFORMS MACROECONOMIC BACKGROUND Real Sector External Sector Public Sector Monetary Sector FINANCIAL SECTOR CAPITAL MARKETS MAJOR TRENDS IN PAYMENT SYSTEMS MAJOR TRENDS IN SECURITIES CLEARANCE AND SETTLEMENT SYSTEMS INSTITUTIONAL ASPECTS GENERAL LEGAL FRAMEWORK Payments Securities Derivatives Specific Legal Issues Related to Clearance and Settlement Netting Zero Hour Rule Electronic Documents and Signatures Novation THE ROLE OF FINANCIAL INSTITUTIONS: PAYMENTS The Banking Sector Other Institutions that Provide Payment Services CECOBAN Payment Cards ATMs and EFTPOS Telecomm Telégrafos Remittances THE ROLE OF FINANCIAL INSTITUTIONS: SECURITIES Securities Markets Participants Exchanges Securities Clearance and Settlement Institutions MARKET STRUCTURE AND REGULATION...24 iii

8 2.5 THE ROLE OF THE CENTRAL BANK Monetary Policy and Other Functions Involvement in the Payments System THE ROLE OF THE SUPERVISORY AGENCIES OF THE FINANCIAL SYSTEM The National Banking and Securities Commission Supervision of Financial Entities Supervision Model Payment System Oversight Anti-Money Laundering Measures Deposit Insurance Agency Pensions System Regulator Financial Services Consumer Protection Agency THE ROLE OF OTHER PRIVATE AND PUBLIC SECTOR ENTITIES Ministry of Finance and Public Credit Bankers Association Brokerage Houses Association Credit Information Registries PAYMENT MEDIA USED BY NON-FINANCIAL ENTITIES CASH PAYMENT MEANS AND INSTRUMENTS OTHER THAN CASH Cheques Direct Debits/Credits Direct Credits Direct Debits Payment Cards Credit and Debit Cards ATMs Prepaid Cards Electronic Purse Electronic Funds Transfer in the SPEUA NON-CASH GOVERNMENT PAYMENTS PAYMENTS: INTERBANK EXCHANGE AND SETTLEMENT CIRCUITS CLASSIFICATION OF THE MAIN PAYMENT SYSTEMS THE REGULATORY FRAMEWORK FOR CLEARINGHOUSES RETAIL PAYMENT TRANSFER SYSTEMS Clearinghouses Cheques...41 iv

9 Direct Credits and Direct Debits Clearing and Settlement Risk Management Mechanisms LARGE VALUE PAYMENT TRANSFER SYSTEMS Extended Electronic Payments System (SPEUA) Settlement Pending Obligations in the SPEUA Risk Management Mechanisms Account Holders Service System (SIAC) Other Payment Systems that Settle in the SIAC Risk Management Mechanisms FOREIGN EXCHANGE SETTLEMENT SYSTEMS CROSS BORDER SETTLEMENT SYSTEMS MAJOR PROJECTS AND POLICIES BEING IMPLEMENTED SECURITIES: MARKET STRUCTURE AND TRADING FORMS OF SECURITIES TYPES OF SECURITIES Shares and Other Securities Representing Equities Debt Securities Short Term Debt Instruments Medium Term Debt Instruments Long Term Debt Instruments SECURITIES IDENTIFICATION CODE TRANSFER OF OWNERSHIP PLEDGE OF SECURITIES AS COLLATERAL Repos Securities Lending TREATMENT OF LOST, STOLEN OR DESTROYED SECURITIES LEGAL MATTERS CONCERNING CUSTODY Protection of the Securities in Custody in case of Bankruptcy or Insolvency of the Custodian Elimination of Physical Delivery PUBLIC OFFERING OF SECURITIES PRIMARY MARKET SECONDARY MARKET STOCK EXCHANGE TRADING Trading Hours...64 v

10 5.12 DERIVATIVES TRADING OVER THE COUNTER MARKET MARKET SIZE RECENT TRENDS GOVERNMENT AND PRIVATE SECURITIES CLEARANCE AND SETTLEMENT CIRCUITS ORGANIZATIONS AND INSTITUTIONS Mexican Stock Exchange INDEVAL SECURITIES R EGISTRATION AND CUSTODY PROCEDURES Registration in the RNV Securities Registry and Custody with INDEVAL Deposit Accounts Operations Execution Deposit Account Information Administration of the Deposited Securities Securities Transfers Registry of Seizures over Deposited Securities Securities Withdrawal GUARANTEE SCHEMES SECURITIES CLEARANCE AND SETTLEMENT PROCESS Legal Issues Concerning Securities Clearance and Settlement Settlement Alternatives Settlement Procedures SIDV, Securities Accounts and Control Accounts Operations Executed in the BMV Operations Executed in the OTC market Closing of the Settlement Cycle Flow Charts of Settlement Processes Securities Lending Procedures to Handle Failures Conventional Penalties Pending Obligations Due to Lack of Securities (at the BMV) Pending Obligations due to Exhaustion of the Operational Capacity (BMV Transactions) Operations Executed outside the BMV DERIVATIVES CLEARANCE AND SETTLEMENT Ordinary Clearance and Settlement Procedures...86 vi

11 6.5.2 Extraordinary Settlement Settlement of Contracts at Expiration Date Risk Management Mechanisms INTERNATIONAL LINKS AMONG CLEARANCE AND SETTLEMENT INSTITUTIONS SAFEGUARD AND SECURITY SYSTEMS THE ROLE OF THE CENTRAL BANK IN CLEARANCE AND SETTLEMENT SYSTEMS RESPONSIBILITIES SETTLEMENT RISK CONTROL POLICY MONETARY POLICY AND PAYMENT SYSTEMS Open Market Operations THE ROLE OF THE CENTRAL BANK IN CROSS-BORDER PAYMENTS PRICING POLICIES SUPERVISION OF SECURITIES CLEARANCE AND SETTLEMENT SYSTEMS SECURITIES REGULATORY SUPERVISORY AND STATUTORY RESPONSIBILITIES Responsibility over Stock Exchanges Responsibility over Central Securities Depositories Responsibility over Central Counterparties Obligations of Information Issuers Intermediaries Sanction Capacity of the Securities Regulator SELF-REGULATORY ORGANIZATIONS SUPERVISORY AND STATUTORY RESPONSIBILITY Stock Exchanges Central Securities Depositories APPENDIX: STATISTICAL TABLES LIST OF ABBREVIATIONS GLOSSARY TABLES IN THE TEXT TABLE 1: MACROECONOMIC INDICATORS...3 TABLE 2: ECONOMIC INDICATORS OF THE MEXICAN EXTERNAL SECTOR...4 TABLE 3: FINANCIAL RESULT OF THE MEXICAN PUBLIC SECTOR...5 TABLE 4: MEXICAN MONETARY AGGREGATES...6 vii

12 TABLE 5: COMMERCIAL BANKS FUNDING BY MAIN INSTRUMENTS...8 TABLE 6: LEGAL FRAMEWORK OF THE MEXICAN FINANCIAL SYSTEM...15 TABLE 7: CLASSIFICATION OF THE MAIN PAYMENT SYSTEMS IN MEXICO...40 TABLE 8: OPERATIONS SUMMARY OF THE CHEQUE CLEARINGHOUSE...42 TABLE 9: PRIVATE SECTOR AND LOCAL GOVERNMENT DEBT ISSUANCES IN TABLE 10: TYPES OF FUTURE CONTRACTS TRADED IN THE MEXDER...65 TABLE 11: TRADED AMOUNTS AT THE BMV...67 TABLE 12: TOTAL TRANSACTIONS PROCESSED BY INDEVAL...68 TABLE 13: BALANCE OF SECURITIES DEPOSITED IN INDEVAL...71 CHARTS IN THE TEXT CHART 1: TRANSACTIONS IN THE INTERBANK PAYMENTS SYSTEM...36 FIGURES IN THE TEXT FIGURE 1: MEXICAN FINANCIAL SYSTEM REGULATORY STRUCTURE...25 FIGURE 2: ORGANIZATION CHART OF THE NATIONAL BANKING AND SECURITIES COMMISSION...27 FIGURE 3: STRUCTURE OF ISIN CODES...55 FIGURE 4: SETTLEMENT OF TRANSACTIONS EXECUTED AT THE BMV...81 FIGURE 5: SETTLEMENT OF THE TRANSACTIONS MADE IN THE OTC MARKET...82 FIGURE 6: FLOW CHART OF A SECURITIES SALE BY A DIRECT FOREIGN D EPOSITOR OF INDEVAL...89 viii

13 1 ECONOMIC AND FINANCIAL MARKET OVERVIEW 1.1 OVERVIEW OF RECENT REFORMS The comprehensive set of reforms that Mexico has implemented since the middle of the 1980s has changed the evolution of the country s economy. The period of economic reforms from 1987 to 1993 was one of the most intense in the country s experience. Among other reforms, the external debt was renegotiated, many government enterprises were privatized, a profound fiscal and financial reform was carried out, and greater attention was paid to foreign trade as a source of economic growth. A particularly important event was the reprivatization in 1991 of the banking sector, which had been nationalized in Another significant reform was the adoption of a restrictive fiscal policy, which substantially reduced the public sector deficit from levels above 10 percent of the gross domestic product (GDP) in 1982 to close to budgetary equilibrium in the first years of the 1990s. Together with adoption of the exchange rate as the nominal anchor of the economy, the restrictive fiscal policy lowered inflation to 7 percent in 1994, down from a high of nearly 160 percent in International investors accepted the reforms, as evidenced by net inflows of foreign private capital starting in These inflows helped to finance a growing deficit in the current account, which passed from a surplus of USD 4.2 billion in 1987 to a deficit of USD 29.7 billion in The substantial increase in imports during this period was due mainly to revaluation of the real exchange rate and trade liberalization. In the first part of the 1990s and until December 1994, the exchange rate regime consisted of a lower and an upper limit within which the exchange rate could fluctuate freely. For the upper limit, there were pre-announced daily mini-devaluations (i.e., a crawling peg). One of the most relevant events of this period was the creation of the North America Free Trade Agreement (NAFTA) among Canada, Mexico, and the United States of America (USA). In 1994 a sequence of political events reversed the flow of foreign capital, leading to a substantial decline in the country s international reserves. For the purpose of containing capital outflows, the federal government began to issue Tesobonos, bonds indexed to the exchange rate. Toward the end of 1994, the amount of tesobonos outstanding was nearly USD 30 billion. Despite this effort, capital outflows continued, and by December 1994 it became impossible to sustain the existing exchange rate regime. This led to the free flotation of the exchange rate, the regime in force today. Owing to this situation, the economy entered into a financial crisis. In 1995 the Mexican economy registered a 6.2 percent drop in GDP, while inflation rose to 52 percent. Interest rates passed 1 Throughout this report, the symbol USD is used for U.S. dollars and $ for the Mexican peso. A billion is 1,000 million. 1

14 from less than 10 percent to more than 100 percent by March The banks, which, after the reprivatization, had substantially expanded the amount of credit issued to the private sector, often without adequate assessment of risk, began to experience a reduction in the payment capacity of debtors. Past-due loans rocketed, exerting severe pressure on payments in the economy. To contain the effects of the banking crisis, the government created financial aid plans for the sector through the Banking Fund for the Protection of Savings (Fondo Bancario de Protección al Ahorro, FOBAPROA). All the major banks in the country continued to operate normally, and depositors did not suffer a loss of their savings. This, of course, was possible only at enormous fiscal cost to the nation. Starting in 1996, when the main economic and financial variables were stabilized, economic growth resumed. In the period, GDP grew at an average rate above 5 percent, and starting in 2000 inflation subsided to less than 10 percent. After the crisis, the following main reforms allowed the economy to grow with more stability: The free-floating exchange rate regime was maintained, 2 which allowed shocks in the economy to be distributed among different economic variables and facilitated the necessary adjustments. In addition, this policy lessened the appeal of domestic financial markets to volatile (often speculative) foreign capital. Fiscal discipline was maintained. The central bank adopted a new monetary policy stance, which made its inflation forecasts more reliable and increased public confidence in them. The pension system was reformed, which led to the creation of individual accounts managed by specialized private sector companies. Regulation and supervision of the financial system were strengthened, and banking laws were reformed to enable foreign capital to participate more extensively in the system, resulting in an increase in its solvency. Another significant change in the domestic context was the presidential election in For the first time in more than 70 years, a candidate of a political party different from the Institutional Revolutionary Party (Partido Revolucionario Institucional, PRI) was elected president. The elections took place without incident. After nearly 15 years of economic and financial reforms, in the eyes of investors Mexico has apparently succeeded in differentiating its economy from that of the rest of Latin America. For example, in 2 Until 2000, Banco de México the central bank still intervened in the foreign exchange market through previously announced mechanisms to limit the volatility of the exchange rate. Since then, any kind of intervention has been eliminated. 2

15 contrast to the severe economic crisis recently occurring in Argentina, Mexico has experienced extreme stability MACROECONOMIC BACKGROUND Real Sector Since the end of the 1980s, economic growth has been driven by the external sector, which is highly dependent on the economic growth of the USA, Mexico s main trading partner. Between 1996 and 2000 GDP grew at a real average annual rate of 5.4 percent. In 1997 GDP grew 6.8 percent, 4.9 percent in 1998, and 3.7 percent in The instability of the world financial markets a product of crises in Southeast Asian countries, Russia, and Brazil, among others was largely responsible for this slowdown in economic growth. In 2000 the economy grew almost 7 percent, having received a big impulse from exports, which grew more than 22 percent. By the end of that year, however, the economy started slowing down in response to the first signs of slower growth in the USA. In 2001 the economic slowdown in the USA was a major cause of the 0.3 percent decrease in Mexican GDP and the 4.8 percent drop in exports. Gross capital formation declined from 21.2 percent of GDP in 1999 to 19.6 percent in 2001, as a result of revaluation of the Mexican peso and its effect on the imported component of investment. Table 1: Macroeconomic Indicators* (a) 2001 (a) GDP at current prices (thousands of millions of pesos) 3, , , ,771.9 Real GDP annual growth rate (in %) Consumption (as % of GDP) Capital gross creation (as % of GDP) F.o.b. imports (as % of GDP) F.o.b. exports (as % of GDP) Current account of the balance of payments (as % of GDP) Inflation (annual growth rate of the Consumer Price Index) Unemployment rate Memo: Nominal exchange rate (as of December) (b) Sources: Banco de México and Instituto Nacional de Estadística, Geografia e Informática (INEGI). (a) Preliminary figures. (b) Fix exchange rate (Exchange rate for the payment of obligations denominated in foreign currency payable in Mexico, determined by the Banco de México). 3 During previous crisis episodes, investors apparently did not differentiate among the countries of the region. Thus, a crisis episode in one country would generally produce extreme volatility in the financial variables of others. * The following conventions for notation are used throughout the Report: n.a. indicates data that are not available; stands for data that are not applicable; neg (this is, negligible) indicates where data are very small relative to other relevant data in the table concerned. 3

16 Job creation was boosted by the dynamic behavior of the export sector. Industries in the north of the country, particularly assembly plants known as maquiladoras, had contributed to a gradual reduction in the unemployment rate, which by 2000 stood at 2.1 percent. This trend reversed in 2001, when the decline in exports raised unemployment to 2.8 percent External Sector 4 Between 1988 and 1994, the deficit in Mexico s balance of payments current account averaged 4.4 percent of GDP, reaching 7 percent in 1994, its highest level. The portion of this deficit that was being covered by volatile sources of capital (such as foreign portfolio investment) averaged 58 percent in this period. With the 1995 crisis, the current account experienced a major adjustment, passing to a deficit of 0.6 percent of GDP. Since then, annual deficits have remained within manageable parameters, with a maximum deficit of 3.8 percent of GDP in In 2001 the current account deficit was 3.1 percent of GDP, and a similar level was estimated for Since 1995 approximately 80 percent of this deficit has been financed with foreign direct investment. In recent years foreign direct investment reached US$13 billion. In 2001, partly influenced by Citigroup s acquisition of Banamex- Accival Mexico s largest financial group it reached nearly US$25 billion. 5 International reserves, which fell abruptly in 1994, have been recovering since then, reaching the historic level of more than US$40 billion by the end of During the 1990s, the traditional vulnerability of the current account to fluctuations in international oil prices was greatly reduced, and the share of non-oil exports in total exports rose to an average of 91 percent during the period. However, foreign trade remains heavily concentrated in the USA, which receives more than 80 percent of Mexican exports. Hence, the recent slowdown of the economy of the former has had a severe impact on Mexico s export sector. Table 2: Economic Indicators of the Mexican External Sector (in USD million) (a) 2001 (a) I. Current Account -16,090-14,168-17,737-17,681 II. Capital and Financial Account 17,360 15,575 16,930 22,707 III. Errors, omissions and undetermined capital flows ,629 2,075 IV. Reserve Assets (decrease +, increase -) -2, ,822-7,325 Memo: Nominal exchange rate (as of December) (b) Sources: Banco de México and INEGI. (a) Preliminary figures. (a) Fix exchange rate. 4 The data of this section were extracted under the methodology of the Fifth Manual of the Balance of Payments of the IMF applied since The acquisition of Banamex-Accival totaled US$12.5 billion. 4

17 Mexico has executed the necessary reforms to liberalize the capital and financial account of the balance of payments within a framework of free exchange rate flotation Public Sector Even before the 1995 crisis, the public sector has been applying a balanced budget policy to avoid putting pressure on interest rates and inflation. About one-third of Mexican fiscal revenues stem from the oil sector, which in turn is highly dependent on international oil prices. This sector is controlled by the state through Petróleos Mexicanos (PEMEX), the fifth biggest oil exporter in the world. In view of this situation, and due to severe fluctuations in international oil prices, the Mexican Congress has established that, whenever the actual price of exported oil is higher than the price used for budgetary purposes, the corresponding surplus will be kept in a special fund to be used whenever the country faces the opposite situation. The efforts to reduce the fiscal deficit have borne fruit: between 1998 and 2001, the fiscal deficit did not exceed 1.5 percent of GDP in any year. The central government s deficit, which was reduced by transfers from other government sectors, was smaller than 1.8 percent of GDP and declining (see table 3). Table 3: Financial Result of the Mexican Public Sector (as % of GDP) (a) Non financial Public Sector Central Government Public Institutions Public Enterprises Source: Secretaría de Hacienda y Crédito Público (SHCP). (a) Preliminary figures. The disciplined budgetary policy also permitted a decline in the ratio of total public sector debt to GDP. From almost 37 percent in 1995, the ratio declined to a little more than 20 percent in The structure of total debt also changed as the share of internal debt grew. The costs undertaken by the government as a consequence of the 1995 banking bailout are not recognized as official public debt, and by the end of 2001 these costs represented almost 12 percent of GDP Monetary Sector Inflation has been falling since reaching a high of 52 percent in Starting in 1999, observed inflation rates have been below the official targets established by Banco de México, Mexico s central bank. For the years 1999, 2000, and 2001, observed inflation was 12.3, 9.0, and 4.4 percent, with inflation targets for these years of 13.0, 9.0, and 6.5 percent, respectively. For 2003 Mexico is seeking to match the inflation rate of its main commercial partners, which is approximately 3 percent. 5

18 From 1997 to 1999, characterized by episodes of high volatility in interest rates and in the exchange rate, the monetary policy of the central bank was highly restrictive in order to avoid money issuance, which could trigger a speculative attack. Since then, monetary policy has been characterized by the gradual abandonment of a two-step regime and the move to a regime of inflation targeting, which was formally approved in the Monetary Program for In the current paradigm, Banco de México evaluates whether the observed growth in prices is consistent with its multi-annual inflation target and signals the market of its intention to pursue a more accommodating or a more restrictive monetary policy through a mechanism known as accrued daily balances (saldos diarios acumulados) of the accounts that commercial banks hold at the central bank. This mechanism is discussed in more detail in section 7.4 of this Report. The monetary policy strategy has been supported by the free flotation of the exchange rate, which distributes the effects of external imbalances among various variables. The monetary aggregate M1 remained relatively stable at around 10 percent of GDP during the period (see table 4). For 2001, the fact that observed inflation was below the planned target of 6.5 percent together with the general slowing of the economy motivated the government to inject more liquidity into the system. The consequent change in the direction of monetary policy beginning in the second quarter of that year resulted in an increase in liquidity as measured by the various monetary aggregates. Table 4: Mexican Monetary Aggregates (in millions of pesos, at the end of each year) (a) M1 387, , , ,646 As % of GDP M2 = M1 + Internal Financial Assets owned by residents 1,656,617 2,016,394 2,337,375 2,736,549 As % of GDP M3 = M2 + Internal Financial Assets owned by foreign residents 1,683,152 2,033,275 2,365,752 2,763,792 As % of GDP M4 = M3 + Deposits in foreign agencies of Mexican Banks 1,769,041 2,106,970 2,422,133 2,812,620 As % of GDP Workers funds in the Savings for Retirement System 192, , , ,735 As % of GDP Source: Banco de México. (a) Preliminary figures. 6 The two-step regime consists of reaching final objectives through instruments and intermediate objectives. In the first step, the instruments affect the intermediate objectives, and in the second step, the intermediate objectives affect the final objectives. The inflation targeting regime establishes inflation objectives for the short and medium term. These objectives are communicated to the public in order to facilitate the alignment of private forecasts with the authority s targets. 6

19 The analysis of the velocity of the various aggregates is similar. All the aggregates showed an increase in their velocity beginning in 1998, with the exception of 2001, when monetary policy was modified. 1.3 FINANCIAL SECTOR When banks were nationalized in 1982, the monetary authorities determined the activities of this sector, and banking supervision was limited to verifying compliance with those rules. An increasing percentage of each peso in banking deposits was destined to finance the fiscal deficit. For this reason, the private sector was crowded-out and had difficulty acquiring bank loans. Restrictions were imposed on interest rates, and other quantitative and qualitative limits were imposed on credit. To address the financing needs of the private sector, a parallel banking system emerged. Brokerage houses were the main institutions to compete with the nationalized banking system. In 1990, with the creation of FOBAPROA, the ground was set for reprivatizing the banking system, a process that began in This coincided with strong net capital inflows and the abolition, by Banco de México, of the reserve requirements on new banking liabilities. These events greatly increased the liquidity of the banking system and, thus, its potential to grant loans. The nationalization had erased many market practices of banks, mainly by eliminating the responsibility for risk management, capping interest rates, and imposing qualitative and quantitative limitations on credit. Supervision was distracted from its main goal of ensuring the ongoing soundness and solvency of the system. As a result, the significant growth in banking credit from 1991 to 1994 was accompanied by extremely lax or null requirements on loans, together with very optimistic scenarios for their reimbursement. Banking was among the sectors heavily affected by the financial crisis triggered by devaluation of the Mexican peso in December In the following weeks and months, the drop in economic activity and the sharp rise in interest rates deepened the deterioration in the quality of the credit portfolio. Facing the latent insolvency of most of the country s banks, the government decided to apply several bailout programs in an attempt to avoid major repercussions in the payments system, the wider financial sector, and the real economy. In 1995 the Temporary Capitalization Program (Programa de Capitalización Temporal, PROCAPTE) was created. Its objective was to support the banking institutions so that they would comply with the minimum capital and reserve requirements. Through PROCAPTE, banks could sell part of their past-due loans, net of credit risk provisions, to FOBAPROA in exchange for FOBAPROA s high-quality securities. Moreover, bank owners committed themselves to inject new capital into their institutions through the issuance of subordinated debt, in a proportion of two pesos for every peso of securities granted by FOBAPROA. The authorities also implemented the Agreement for Immediate Support to Bank Debtors (Acuerdo de Apoyo Inmediato a los Deudores de la Banca, ADE) with the objective of containing the 7

20 deterioration of the loan portfolio. ADE had two basic features: (a) the establishment of caps on interest rates for individuals and firms, with the federal government paying the difference between these rates and prevailing market rates, and (b) the restructuring of debts in so-called investment units (unidades de inversión, UDIs). 7 Later on, some interventions became necessary for the system to remain operational. Moreover, in order to keep the banking system in the hands of the private sector, bank equity was opened to foreign capital. In this way, domestic private banking assets switched into the hands of foreign capital in a very short period of time. In 1998, 76 percent of the banking system belonged to domestic capital. In 2000, approximately half of the system was in the hands of foreign capital. By 2001, with Citigroup s acquisition of Banamex, almost 90 percent of banking system assets was owned by foreign institutions. Table 5: Commercial Banks Funding by Main Instruments (in millions of pesos) Traditional Funding 510,962 1,153,187 1,141,359 Traditional Funding in domestic currency 491,059 1,093,440 1,015,317 Checking Accounts 87, , ,940 (a) Savings Accounts 1,517 1,163 1,344 Long-Term Deposits redeemable in fixed days 7,616 5,269 5,032 Fixed Term Deposits 36, , ,012 Promissory Notes with interest payable at maturity 296, , ,130 Current Account Deposits at sight with interests 10,982 n.a. n.a. Other instruments 50,548 68,347 32,859 Funding in foreign currency (b) 19,903 59, ,042 Investment banking and repos in domestic currency 210, , ,381 (c) Source: Banco de México. (a) Includes traditional current accounts, sight current account deposits with interest and certified cheques. (b) Converted at the exchange rate of the accounting closing date. (c) Includes the balances of operations documented as trusts. Some other laws were also reformed in order to facilitate the access of national and foreign investors to other kinds of financial institutions. The most relevant changes were made to the General Law of Credit Auxiliary Organizations and Activities (Ley General de Organizaciones y Actividades Auxiliares del Crédito), the General Law of Insurance Institutions and Mutual Companies (Ley General de Instituciones Mutualistas y de Seguros), and the General Law of Guarantee Institutions (Ley General de Instituciones de Fianzas). 7 UDIs are constant-value units. In high-inflation conditions, a loan denominated in UDIs avoids the accelerated amortization of the debt principal. Hence, in the context of straight-line amortization, the periodic payments of UDI-denominated loans remain relatively constant in real terms. 8

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