How did the Mexican government?s expropriation of Mexico City real estate, following the September 1985 earthquake, affect the value of the peso and why?

41504_Pt3_Case_Studies_p417-420 3/5/02 7:27 PM Page 417 Part III Case Studies Case III.1 Rolls-Royce Limited Rolls-Royce Limited, the British aeroengine manufacturer, suffered a loss of 58 million in 1979 on worldwide sales of 848 million. The company's annual report for 1979 (page 4) blamed the loss on the dramatic revaluation of the pound sterling against the dollar, from 1 \u0002 $1.71 in early 1977 to 1 \u0002 $2.12 by the end of 1979. The most important reason for the loss was the effect of the continued weakness of the U.S. dollar against sterling. The large civil engines that Rolls-Royce produces are supplied to American air frames. Because of U.S. dominance in civil aviation, both as producer and customer, these engines are usually priced in U.S. dollars and escalated accordingly to U.S. indices. . . . A closer look at Rolls-Royce's competitive position in the global market for jet engines reveals the sources of its dollar exposure. For the previous several years Rolls-Royce's export sales had accounted for a stable 40% of total sales and had been directed at the U.S. market. This market is dominated by two U.S. competitors, Pratt and Whitney Aircraft Group (United Technologies) and General Electric's aerospace division. As the clients of its mainstay engine, the RB 211, were U.S. aircraft manufacturers (Boeing's 747SP and 747,00 and Lockheed's L1011), Rolls-Royce had little choice in the currency denomination of its export sales but to use the dollar. Indeed, Rolls-Royce won some huge engine contracts in 1978 and 1979 that were fixed in dollar terms. Rolls-Royce's operating costs, on the other hand, were almost exclusively incurred in sterling (wages, components, and debt servicing). These contracts were mostly pegged to an exchange rate of about $1.80 for the pound, and Rolls-Royce officials, in fact, expected the pound to fall further to $1.65. Hence, they didn't cover their dollar exposures. If the officials were correct, and the dollar strengthened, Rolls-Royce would enjoy windfall profits. When the dollar weakened instead, the combined effect of fixed dollar revenues and sterling costs resulted in foreign exchange losses in 1979 on its U.S. engine contracts that were estimated by the Wall Street Journal (March 11, 1980, p. 6) to be equivalent to as much as $200 million. Moreover, according to that same Wall Street Journal article, \"the more engines produced and sold under the previously negotiated contracts, the greater Rolls-Royce's losses will be.\" Questions 1. Describe the factors you would need to 2. 3. 4. 5. know to assess the economic impact on Rolls-Royce of the change in the dollar: sterling exchange rate. Does inflation affect Rolls-Royce's exposure? Given these factors, how would you calculate Rolls-Royce's economic exposure? Suppose Rolls-Royce had hedged its dollar contracts. Would it now be facing any economic exposure? How about inflation risk? What alternative financial management strategies might Rolls-Royce have followed that would have reduced or eliminated its economic exposure on the U.S. engine contracts? What nonfinancial tactics might Rolls-Royce now initiate to reduce its exposure on the remaining engines to be supplied under the contracts? On future business (e.g., diversification of export sales)? 417 41504_Pt3_Case_Studies_p417-420 3/5/02 7:27 PM Page 418 Part III Case Studies 418 6. What additional information would you sold under the previously negotiated contracts, the greater Rolls-Royce's losses will be\"? require to ascertain the validity of the statement that \"the more engines produced and Case III.2 The Mexican Peso The basic purpose of this case is to have you conduct an in-depth analysis of government macroeconomic policies on firms and banks doing business with Mexico. The vehicle being used is the Mexican peso. See Exhibit III 2.1 for statistics related to exchange rates and price indexes in the United States and Mexico for the period 1976 - 1997. Using these data, please address the following questions. 5. 6. Questions 1. What are the causes of the continuing devalua- tion of the peso since August 1976? Analyze both the immediate causes (e.g., balance-ofpayments deficits) and longer-term, more fundamental causes (e.g., inflation, the political and economic environment). Concentrate especially on the 1982 and 1994 - 1995 devaluations of the peso. 2. What role did oil price changes play in Mexico's difficulties? 3. What indicators of peso devaluation prior to 1982 and 1994 were there? 4. What were the likely effects of the peso devaluation between 1976 and January 1982 on a. Mexican companies? b. Foreign firms operating in Mexico? 7. 8. 9. 10. c. U.S. companies in border towns catering to Mexicans? Redo question 4, focusing on the effects of peso devaluation subsequent to February 1982 and prior to December 1994. In August 1982, the Mexican government devalued the peso, froze all dollar accounts in Mexican banks, and imposed currency controls. What are the government's objectives? How did these actions affect the black market value of the peso? Why? How did the Mexican government's expropriation of Mexico City real estate, following the September 1985 earthquake, affect the value of the peso and why? Consider the trust factor with respect to Mexican policies. What have been the probable effects of trust or its lack on investment in Mexico, Mexican citizens' investment choices, and the peso's value? Are dollar loans to the Mexican government and Mexican companies exposed to exchange risk? Explain. How did Mexico's economic policies contribute to its debt crisis? How have subsequent government policies affected Mexico's financial health? 41504_Pt3_Case_Studies_p417-420 3/5/02 7:27 PM Page 419 Case III.2 The Mexican Peso Exhibit III 2.1 419 The Mexican Peso's Key Statistics: 1975 - 1997 Nominal Exchange Rates (period average) Year:Quarter 75:1 75:2 75:3 75:4 76:1 76:2 76:3 76:4 77:1 77:2 77:3 77:4 78:1 78:2 78:3 78:4 79:1 79:2 79:3 79:4 80:1 80:2 80:3 80:4 81:1 81:2 81:3 81:4 82:1 82:2 82:3 82:4 83:1 83:2 83:3 83:4 84:1 84:2 84:3 84:4 85:1 85:2 85:3 85:4 86:1 Peso:Dollar 12.5 12.5 12.5 12.5 12.5 12.5 19.9 20.0 22.7 23.0 22.7 22.7 22.7 22.8 22.7 22.7 22.8 22.8 22.8 22.8 22.9 22.9 23.1 23.3 23.8 24.4 25.2 26.3 45.5 48.0 50.0 96.5 102.0 120.0 132.0 143.9 155.8 167.6 179.6 192.6 208.9 228.0 305.1 371.7 473.6 Dollar:Peso CPI Mexico CPI United States $0.08000 $0.08000 $0.08000 $0.08000 $0.08000 $0.08000 $0.05038 $0.05013 $0.04407 $0.04348 $0.04407 $0.04399 $0.04398 $0.04384 $0.04399 $0.04401 $0.04380 $0.04378 $0.04390 $0.04386 $0.04376 $0.04361 $0.04337 $0.04301 $0.04209 $0.04103 $0.03968 $0.03804 $0.02198 $0.02082 $0.02000 $0.01036 $0.00980 $0.00833 $0.00758 $0.00695 $0.00642 $0.00597 $0.00557 $0.00519 $0.00479 $0.00439 $0.00328 $0.00269 $0.00211 100.0 103.2 107.0 110.4 115.2 118.2 122.0 137.3 149.1 155.7 162.4 168.6 177.7 183.9 191.4 197.6 209.5 217.0 225.2 235.6 256.8 271.5 289.3 303.9 328.5 348.4 365.9 389.4 435.0 501.5 606.1 730.8 926.2 1,076.9 1,217.2 1,369.6 1,601.9 1,807.3 1,987.7 2,196.5 2,552.7 2,800.9 3,097.0 3,527.5 4,254.7 100.0 101.9 104.1 105.8 106.8 108.2 109.8 111.0 113.0 115.5 117.1 118.5 120.4 123.6 126.5 129.0 132.3 136.8 141.3 145.4 151.1 156.6 159.4 163.7 168.0 171.9 176.9 179.3 180.9 183.5 187.0 187.5 187.3 189.7 191.9 193.6 195.7 197.9 200.1 201.5 202.8 205.3 206.7 212.6 213.1 (Continued) 41504_Pt3_Case_Studies_p417-420 3/5/02 7:27 PM Page 420 Part III Case Studies 420 Nominal Exchange Rates (period average) Year:Quarter Peso:Dollar Dollar:Peso CPI Mexico CPI United States 86:2 86:3 86:4 87:1 87:2 87:3 87:4 88:1 88:2 88:3 88:4 89:1 89:2 89:3 89:4 90:1 90:2 90:3 90:4 91:1 91:2 91:3 91:4 92:1 92:2 92:3 92:4 93:1 93:2 93:3 93:4 94:1 94:2 94:3 94:4 95:1 95:2 95:3 95:4 96:1 96:2 96:3 96:4 97:1 97:2 97:3 97:4 575.4 752.0 923.5 1,126.0 1,353.7 1,570.8 2,209.7 2,281.0 2,281.0 2,281.0 2,281.0 2,369.0 2,460.0 2,551.0 2,641.0 2,733.0 2,817.0 2,890.6 2,945.4 2,981.0 3,018.2 3,055.8 3,071.0 3,083.5 3,122.3 3,116.3 3,115.4 3,097.6 3,121.2 3,117.8 3,105.9 3,359.8 3,391.8 3,404.0 5,325.0 6,817.5 6,309.2 6,419.5 7,642.5 7,547.9 7,610.8 7,537.4 7,850.9 7,890.5 7,958.0 7,819.9 8,136.0 $0.00174 $0.00133 $0.00108 $0.00089 $0.00074 $0.00064 $0.00045 $0.00044 $0.00044 $0.00044 $0.00044 $0.00042 $0.00041 $0.00039 $0.00038 $0.00037 $0.00035 $0.00035 $0.00034 $0.00034 $0.00033 $0.00033 $0.00033 $0.00032 $0.00032 $0.00032 $0.00032 $0.00032 $0.00032 $0.00032 $0.00032 $0.00030 $0.00029 $0.00029 $0.00019 $0.00015 $0.00016 $0.00016 $0.00013 $0.00013 $0.00013 $0.00013 $0.00013 $0.00013 $0.00013 $0.00013 $0.00012 4,957.8 5,930.4 7,164.7 8,909.4 11,120.8 13,889.6 15,228.2 29,116.0 32,453.0 33,924.0 34,968.1 36,943.5 38,435.6 39,687.9 41,501.0 45,621.2 48,104.5 50,789.0 53,783.8 57,724.0 59,806.8 61,443.3 64,270.0 67,741.4 69,576.3 70,964.8 72,750.1 75,130.5 76,519.0 77,758.8 79,048.2 80,585.5 81,825.3 83,015.4 84,552.8 92,685.7 109,447.5 117,630.0 125,713.4 137,218.5 146,789.6 153,533.9 161,071.8 172,180.2 178,031.9 182,991.0 188,793.2 212.6 214.3 215.4 217.8 220.7 223.1 225.0 229.4 232.2 235.3 237.7 240.5 244.3 246.4 248.7 253.0 255.5 260.0 264.3 266.4 267.9 270.0 272.1 274.0 276.3 278.1 280.1 282.5 284.5 285.3 288.5 290.4 292.5 295.4 296.3 299.8 302.4 303.7 305.3 307.9 311.0 313.1 314.7 315.7 316.6 317.6 318.5