Abstract

It is increasingly asserted that recent financial crises have been driven by changes in market sentiment, the latter stemming from alterations in so-called fundamentals. There are, however, few studies aimed at identifying empirically whether this is true. Applying a Markov switching autoregressive model and using the broad money-to-international reserves ratio as the variable that captures market confidence, this chapter times the start and the end of Mexico's 1994–95 financial crisis. The estimated probabilities indicate that financial panic started since November 1993 and that it ended in May 1995. It is established that the beginning and end of the crisis is associated with a change in private agents' confidence and not to ex post events, such as the abandonment of the exchange rate or the recovery of the economy led by export growth. The results also indicate that in order to recover agents' confidence, the government had to reinforce its strategy of financial liberalisation. This placed strong limitations on the authorities' room for manoeuvre in setting macroeconomic policy.

Keywords: Markov switching autoregressive model; market confidence; financial crises; Mexico.

JEL Classification: E44, C22.

Introduction

One of the most well-worn arguments within the vast and divergent literature concerning recent financial crises is that they stem from changes in market confidence. Such confidence is held to rest on so-called economic fundamentals and domestic political conditions. As soon as the fundamentals diverge from what may be considered sound, so it is argued, the confidence of investors ebbs away causing progressive withdrawals of capital overseas.