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Bank Crises in Mexico

Trond Gabrielsen

The Mexican "Tequila Crisis" of 1994 is the story of a deadly combination: an overvalued fixed exchange rate, a non-independent Central Bank, weak financial regulation, short-term dollar-denominated debt, and political assassinations. Together, these factors led to the devaluation of the peso on December 20, 1994. This case study will investigate the causes and effects of the crisis in the Mexican banking sector in particular.

How did the crisis come to pass? As foreign reserves, which were supporting the peso, declined throughout 1994, investors started to fear that the Mexican government could not afford to maintain the peg against the US dollar. Following the December 20 devaluation, the peso fell by 50 percent in one week. Massive runs on the banks weakened the peso even further - with severe consequences for the country's business infrastructure, as well as its population. In 1995, Mexico's GDP shrank by 7 percent.

The roots of the crisis, however, significantly predate the events of 1994.
The years following the debt crisis of 1982 were characterized by high inflation and a contraction of the economy by an annual average rate of 2 percent. Thus, towards the end of the 1980s, the Mexican government became increasingly aware of the need to adopt liberal reforms in an attempt to end the recession. In 1987, a wide-ranging economic stabilization plan that gradually introduced market-oriented institutions came into effect. In an attempt to curb inflation, the government imposed strict fiscal and monetary policy and pegged the peso to the dollar. The banks, which had been nationalized after the debt crisis of 1982, were again open for privatization, leading to a wave of mergers and acquisitions in the years to follow.

In the beginning, Mexico was successful in curbing its inflation, and in fact gained worldwide acclaim for its monetary policy. It was widely held that the country would go through an economic paradigm shift in signing NAFTA and promising to evolve into a "convergence" story - one from which both domestic and foreign investors hoped to benefit. As a result, the Mexican economy started to pick up again, and grew at an annual average rate of 3.1 percent between 1989 and 1994. Both exports and imports soared, and the country also experienced an upswing in foreign direct investment (FDI). During this period of growth, restrictions on capital inflows were lenient, leading to a very large current account deficit increasingly financed by short-term debt.

At the same time, interest rates in the US were low, encouraging extensive foreign borrowing both by banks and by the government. In an attempt to enlarge its market share, Mexican banks took loans in US dollars and expanded their credit lines. As a result, domestic banks' debt to international banks increased from $8 billion in 1991 to $15.5 billion in 1994. However, neither the banks' staff nor the regulatory system were well-equipped to assess the increased credit or market risk. Furthermore, weak bank supervision also contributed to an increase in non-performing loans (NPLs). From 1991 to 1994, the stock of outstanding international bonds rose from $1 billion to $3.8 billion - making Mexico extremely vulnerable to fluctuations in exchange rates and speculative attacks on the currency.

Mexico's credit expansion was not sustainable. From 1988 to 1994, private savings declined, creating a steadily growing current account deficit. As a result, the country required ever-increasing inflows of capital to finance the deficit, which reached 7.9 percent of GDP in 1994. Extensive borrowing and inflows also led to a 30 percent rise in prices against US prices from 1991 to 1993. It became increasingly clear to foreign investors that the peso was overvalued, forcing the Central Bank to spend massive foreign reserves to maintain the peg to the US dollar.

The Banking Sector
Further examination of the "Tequila Crisis" of 1994, with an eye to the role of the banking sector in particular, indicates that a number of different factors contributed to the devaluation. They include weak banking supervision, failed privatization of banks, moral hazard, public debt, fixed exchange rate, foreign interest rates, a non-independent Central Bank, and political crisis.

Weak banking supervision
The weak supervision of the Mexican banking sector at the end of the 1980s and the beginning of the 1990s forms one major reason for the banking crisis. For a start, poor borrowing screening led to excessive credit volumes. Banks' capital adequacy requirements were also relaxed as part of the financial liberalization program of 1987. When the crisis hit, many of the loans turned non-performing. Following devaluation, a full 8 percent of total loans fell into this category. This phenomenon led to liquidity problems for some banks, and to insolvency for others.

Failed privatization
At the end of the 1980s, the Mexican government opened for privatization of banks. However, the particular manner in which the banks were privatized is also considered to be one of the leading causes of the banking crisis. Most of the banks remained in government hands for half of the expansion period (late 1980s-early 1990s). The nationalization of the banking system following the debt crisis in 1982 led to a loss of international human capital and expertise for Mexico's banks. As a result, the state-owned banks were not in very good shape when they were taken over by private owners at the end of that decade. Former vice governor of the Bank of Mexico, Francisco Gil-Diaz-- now Minister of Finance -- states in an academic paper in 1998 that some of the private investors who took over the banks had no previous experience in banking and took on high risks in expanding credit lines. 1

Moral hazard 
Moral hazard is another important factor in the Mexican banking crisis. Due to the government's unlimited backing of banks' liabilities until its reserves ran dry, bank managers could carelessly take on greater risks. The fact that they believed the government would eventually bail them out created a business climate that lacked accountability. The Fobaproa scandal in particular may be viewed as a case of moral hazard. Fobaproa was set up by the Mexican government to rescue the major banks and companies and thereby avoid a total collapse of the economy following the devaluation of 1994. A large percentage of the banks and companies that were rescued by the Fobaproa scheme had a history of irregularities and mismanagement. Others, however, had been encouraged by the government to borrow in dollars to finance their operations. The government has also been criticized for using tax money to finance the rescue operation. Today, Ipab has replaced Fobaproa, and the government has overhauled its regulations of the financial system.

Public debt
During the early 1990s, the problem of "hot money" financing began to materialize. From December 1990 on, foreigners were allowed to purchase domestic short-term foreign currency-denominated government bonds. This increased the already high public debt further and made the country even more vulnerable to fluctuations in foreign exchange rates. However, the problem was not that the debt was high compared to GDP (the debt-to-GDP ratio was only 34.7% in 1994, as opposed to 78.4% in 1980), but rather that the public debt was being financed with short-term dollar-denominated bonds (Tesobonos) rather than longer term peso-denominated bonds (CETES). Due to this debt composition, Mexico became highly vulnerable to fluctuations in exchange rates. In Mexico's case, that meant that a devaluation of the peso would increase the amount of dollar-denominated debt by the same percentage as the devaluation itself. Foreign investors, fearing that this would happen, started pulling out of short-term dollar-denominated bonds, making it impossible for the government to meet its debt obligations. 

In this regard, the Mexican financial crisis is very similar to the Russian financial crisis. Both countries decided on a fixed exchange rate regime, which effectively blocked the Central Bank from printing money and left the government with only one means of financing fiscal gaps, namely, foreign borrowing. As foreign inflows, which were needed to maintain the fixed exchange rate regime, became harder to attract, interest rates soared and bond maturities fell. Eventually, this became unsustainable: investors realized that such rates were inconsistent with growth and could eventually cause a banking crisis, which in turn could lead to the complete cessation and massive reversal of flows, which would force the Central Bank to devalue the currency.

Exchange rates
The stabilization program of 1987 introduced a fixed exchange rate by pegging the peso to the US dollar. This meant that the Central Bank had to defend a given band of the peso to dollar. When the peso became overvalued, the Central Bank had to spend an ever greater percentage of its foreign reserves in order to defend the peg.

Foreign interest rates
The expansion in foreign borrowing meant that Mexican banks became highly vulnerable to fluctuations in foreign exchange rates and interest rates, notably in the United States. When the US Federal Reserve Bank increased interest rates again after the recession in the late 80's - early 90's, Mexico's banks and government were badly hit.

Role of the Central Bank
Some would argue that the Central Bank's lack of independence made it vulnerable to political pressures. Due to the upcoming elections in 1994, the Central Bank was pressed not to tighten its monetary policy, as this could lead to higher interest rates and anger among voters. What's more, due to the government's fear of an economic slowdown in an election year, the Central Bank was coerced into not raising interest rates to prevent capital flight. However, market interest rates went up, even if policy rates did not. The independence of the Central Bank was more of an issue in that the decision to float the currency was delayed. Had the peso been devalued earlier -- as technocrats wanted -- some experts argue that the pain of the crisis would have been mitigated.

Political crisis
The uprising in the Chiapas province and the assassinations of the presidential candidate for the ruling party in March 1994 created a political uncertainty that spilled over onto the financial markets. This political turmoil was followed by a second political assassination in November 1994 and the inauguration of a new president in December, which intensified the rumors of devaluation.

Policy responses 
When the crisis hit, the most urgent need was to refinance the short-term dollar-denominated debt owned by Mexican banks. The government negotiated a financial rescue package with international institutions like the International Monetary Foundation, the US Treasury, the World Bank and the Bank for International Settlements, an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability. 

Due to the overvaluation of the peso, the Central Bank tried to restore macroeconomic stability by letting the peso float. Monetary policy was aimed at controlling inflation, and interest rates were allowed to be determined by market forces. 

On the eve of the crisis, banks and debtors faced the most serious challenge of the devaluation, because they held debt denominated in dollars. As a result, ensuring that the exchange rate did not overshoot became a policy priority. This required that strict reserve requirements be imposed and that the Central Bank limit the expansion of net domestic credit. Furthermore, a dollar liquidity facility was put in place by the Central Bank to meet the run on dollar-denominated liabilities. 

During 1995, half of the banks' capital ratios to assets fell below the minimum requirement of 8 percent. Therefore, the government required under-capitalized banks to issue subordinated debt, which was convertible into common shares. The government also provided incentives for banks to remain sound by offering to acquire a fraction of their loan portfolios of bad loans through the already mentioned Fobaproa.

Looking ahead
The overhaul of the Mexican banking sector is still taking place. Citigroup's recent acquisition of Banamex is the latest step away from the nationalization that took place in 1982. According to a World Bank report, the cost of the Mexican banking crisis reached 22 percent of GDP and will have to be repaid over the next 25 years. 2

The IMF sees major improvements in the Mexican banking system since the 1994-95 crisis, and has especially welcomed the approval by Congress of the new secured lending and bankruptcy laws. However, IMF still wants to see a more rapid increase in bank capital and a faster phasing in on the new bank capital requirements. 3

In the reform efforts, transparency and disclosure of financial information are also viewed as key factors to ensure a stable banking sector.

 

Footnotes

1. Francisco Gil-Diaz, "The Origin of Mexico's 1994 Financial Crisis", Cato Journal, Vol. 17, No.3, 1998. 
2. "Crisis Management Mexico, 1994-1995", The World Bank, June 2001. 
3.  IMF, Completes Final Mexico Review, Press Brief, Sept. 2000.

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