<!-- Start of picture text --> Policy Resea;¢ch<br>Country Operations<br><!-- End of picture text --> <!-- Start of picture text --> WPS 833<br><!-- End of picture text --> This paper is a product of Country Department II, Country Operations Division 1, Latin<sup>America and the</sup> Caribbean Regional Office. Copies are available free from the World Bank, 1818<sup>H Street NW,</sup> Washington DC 20433. Please contact Lily Franchini, room 18-165, extension 38835 (23 pages).<sup>January</sup> 1992.

Before 1988, "orthodox" policies (fiscal discipline and tight money) failed to bring inflation down and induce a sustained economic recovery. The Mexican stabilization plan announced in December 1987 (the Pact) shows that the right combination of orthodox and "heterodox" policies (for example, income policies) can meet, and has met, both objectives.

increases with the amount of government liabilities that could, in a given period, be exchanged for foreign reserves. For example, if the average maturity of domestic debt is low, as it was in Mexico at the beginning of the stabilization plan, this probability is high -and thus also shows up in high interest premia between peso-denominated and dollar-denominated debt.

Oks shows that although many orthodox - adjustments especially of fiscal policy and domestic debt management -- were begun before the Pact, considerable further adjusting was needed before it could succeed. To make the stabilization credible required significantly tighter fiscal policy and a lengthening of the maturities of domestic debt between 1988 and 1990.

The Pact succeeded in stabilizing prices without a recession, but a few loose ends remain:

* The sharp decline in private savings which '-'s not been fully offset by higher public saving, causes many to question the sustainability of the recent economic recovery. In particular, it makes Mexico more vulnerable to volatile private capital flows.

A key factor behind high real interest rates during the recent Mexican stabilization plan was the initially low credibiliy of the fixed - and - later the preannounced exchange rate. While it is difficult to assess what establishes credibility, we can hypothesize about the factor3 that may hamper it. Crucial among them is the consistency of the macroeconomic policy framework, where fiscal policy plays a key role. Domestic debt management also matters as the probability of a successful run on the peso

* The continued real appreciation of the peso risks bringing a slowdown or recession over the medium term.

In the shon term, Mexico may not have other options than further tightening its fiscal and monetary policies. Over the medium term, however, a real peso depreciation appears necessary so that extra output from new investment can be absorbed.

The Policy Research Working Paper Series disseminates the findings of work under<sup>way in the Bank. Anobjective of the seriesl</sup> is to get these findings out quickly, even if presentations are less thar, fully polished.<sup>The fndings, interpretations, and</sup> conclusions in these papers do not necess'rily represent official Bank policy.

Produced by the Policy Research Dissemination Center