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The Crisis of the Mexican Peso

Nick Rosen

In 1994, as Mexico hemorrhaged billions of dollars and watched the value of its currency plunge, the new global market's potential for brutality was revealed. The crisis showed that in even the most favored emerging market countries, the tide of investment could turn suddenly, and capital inflows could quickly change into outflows. The so-called “Tequila crisis” would also confront the world with the terrifying prospect of economic contagion, and, after a financial rescue of unprecedented cost, the event would spark a vigorous debate - one that continues today - about how the great powers should deal with outbreaks of financial instability in the emerging markets.

Like other crises that would follow, Mexico's financial tragedy interrupted a period of swelling capitalist euphoria. In the early 1990s, Mexico was hailed as a champion of free-market reform. Then-President Carlos Salinas de Gortari, a Harvard-trained economist, turned his country away from the traditional statist, inward-looking policies of other Latin American nations towards an outward-oriented, neoliberal economic path. In an effort to enhance Mexico's competitive profile, Salinas undertook a relentless campaign to privatize state industries and deregulate the private sector. He reduced foreign capital restrictions and took other steps to attract investors, including painful cuts in public spending; the fiscal deficit was cut from 16 percent of GDP in 1987 to almost zero in 1994.

To control inflation, the value of the peso was tethered to a “band” which kept the currency from straying farther than a tightly bound ratio to the dollar. When the value of the peso strayed below the band, the Mexican central bank would use its hard currency reserves to buy up pesos and return the value to its predetermined range.

And in an effort to engage in the burgeoning market of international commerce, Mexico cut its import tariffs and sought out new markets for its exports. In 1992, Mexico signed the North American Free Trade Agreement (NAFTA), a far-reaching trade pact designed to strengthen economic ties with its prosperous Northern neighbor, the United States, and hopefully lift Mexico into the pantheon of great economic powers.

Mexico had rendered itself up to the global markets, and foreign investors responded with exuberance. Between 1991 and 1993, more than $75 billion in foreign capital was funneled into Mexico, making it the world's second-largest recipient of foreign investment after China. While this did not translate into extraordinary growth - GDP increased at a rate of approximately 3.3% during these years - analysts continued to extol the country's great prospects for profit-making. The global environment was ripe at that time; financiers around the world were flush with cash, and this high level of liquidity, combined with low interest rates in the U.S. and elsewhere, was practically pushing money into the emerging markets in search of investment opportunities. Commercial banks and multilateral development banks, impressed with Mexico's apparent commitment to market discipline, had ratcheted up their lending.

However, fast and furious capital inflows were not an unconditional good for Mexico. The capital flowing into Mexico was largely “portfolio capital” - stocks and bonds rather than direct investment - and could thus depart as quickly as it arrived. The expansion of credit fed a frenzy of consumption; Mexico was merely spending, not investing its new money, and the government did not invest much in important areas like education and infrastructure. At the level of international trade, the country continued to buy more than it could sell, thus pushing the Mexican current account dangerously out of balance. All the short-term foreign investment would mask this disequilibrium for only so long.

Most precarious of all, however, was the Mexican banking system. Mexico's already weak state-owned banks had been haphazardly privatized in the late 1980s. Bank managers were inexperienced, borrower screening was poor, and regulatory oversight was lacking. As a result, non-performing loans piled up. Attracted by low interest rates in the U.S. and liberal loans from local development lenders, Mexican banks had themselves borrowed heavily, and now found themselves dangerously over-leveraged - domestic banks' debt to foreigners nearly doubled between 1991 and 1994.

1994 was an election year in Mexico, which always seemed to spell trouble. Since the 1970s every transition between six-year presidential terms was marked by a rash of financial uncertainty and turmoil - an event which came to be known as the “curse of the sexenio.” The country's raw, clientist brand of politics dictated that spending would always go up before an election, as the then-ruling party PRI attempted to stimulate the economy and curry favor with voters. And 1994 would be no different: The government deficit ballooned to 4.4% of GDP, the highest level since the 1980s. Monetary policy was also geared to short-term election interests. The central bank, which was officially independent but actually under PRI influence, boosted the money supply and brought interest rates down. Later, when Mexico was losing capital to high interest rates abroad, this “monetary populism” would have harsh consequences.

While few foreign investors acknowledged it, Mexico's weak banking system, poor savings rate, mounting trade deficit, and over-reliance on short-term capital all combined to make the country highly vulnerable to shock. Sailing on the capricious winds of the capital markets, all that was necessary to topple the Mexican economy was the “trigger” of an unforeseen calamity.

On March 23, 1994, three and a half months before the election, the front-running candidate Luis Donaldo Colosio was murdered at a campaign rally. Portfolio investors, spooked by the political tremor, immediately began to rush their money out. Local Mexican investors, who were more aware of their country's lurking economic problems, led the expatriation stampede.

To relieve pressure on the peso, President Salinas allowed the peso to devalue slightly - from 3.1 to the dollar to 3.5 - while vowing to keep the currency band. There were serious indications at the time that more serious measures were needed to reconcile the bloated value of the peso with Mexico's economic realities. However, Salinas was constrained from abandoning the currency band and a deeper devaluation. His party faced a serious challenge in the upcoming election, and reducing the value of Mexicans' income against the dollar would not help the PRI at the polls. Secondly, foreign investors, who faced significant currency-exchange losses in the event of devaluation, strongly “advised” against it, implying that they would punish Mexico dearly for such a move.

Salinas' minor adjustment to the peso relieved pressure a little while, but it quickly began to build again. The Colosio murder (which was eventually linked to the brother of President Salinas) was followed by more political assassinations and a rash of kidnappings. There was also intensified struggle in the southern state of Chiapas, where a group of disenfranchised Indians from Southern Mexico - the Zapatistas - had taken up arms against the Mexican state as they protesed the callous neglect of the government's neoliberal program.

This coincidence of events threw Mexican political stability into question at a time when investors were finally beginning to recognize its deteriorating current account and fiscal deficits. As Mexican banks struggled to meet their obligations under derivatives contracts, the peso came under renewed pressure, straining at the top of its band.

But what hurt the Mexican currency even more than the myriad political disruptions at home were dynamics that had nothing to do with Mexico: Monetary tightening by the Federal Reserve had caused a steady rise in U.S. interest rates, making bond investments more attractive there. Thus the relative pay-off venturing south of the border was severely dampened, causing many investors to conclude that Mexico was no longer worth the risk.

In an effort to soothe the abraded nerves of investors, Mexico had begun to swap peso denominated debt for “tesebonos,” short-term government bonds indexed to the dollar. This was good for investors, who were protected by tesebonos from any exchange rate risk. But it was Mexico that now shouldered the risk - it meant that when the devaluation finally occurred, Mexico's debt burden would expand dramatically. By the end of 1994, tesebonos accounted for over half of all government debt.

By this time, the Mexican central bank had spent vast amounts of its reserves, but it seemed that nothing could save the peso. On December 20, 1994, President Ernesto Zedillo (who had replaced the late Colosio as Salinas' hand-picked successor for the ruling party PRI candidacy) expanded the currency band's range, effectively devaluing the peso by 15%. When this did not work, he was forced to finally abandon the government's long-standing commitment to the currency band, and allow the embattled Mexican currency to float against the dollar. The peso's fall would be even longer than expected, as currency speculators attacked, and many investors came to realize that Mexico would be ultimately unable to cover its dollar liabilities. Within days, the peso's value to the dollar would plunge to 7.5. Foreign reserves were further drained; after months of speculative attacks, the central bank eventually shelled out 24 billion dollars, about 80% of its international reserves, trying to defend the peso.

Following the devaluation, the global capital marketplace that had once opened its arms to Mexico was suddenly closed off. The dreaded possibility of debt default and a run on the Mexican banks became very real; without international assistance, the Mexican economy seemed doomed to oblivion. In the U.S., which was now confronted with a financial crash on its Southern border, a political battle erupted over what to do. The Clinton Administration proposed a historic bailout, justified by the considerable threat that a Mexican disaster would pose to the health of the U.S. economy. His opponents in Congress, however, were resistant to the idea of spending taxpayer money to patch up the Mexicans' mistakes. In the end, the Clinton Administration devised a way to furnish the money without the need for Congressional approval. The total package amounted to $51 billion - $20 billion from the U.S. Treasury, and the rest from the IMF and other international donors. The credits were collateralized with Mexican oil receipts, and were contingent on stiff economic adjustment measures.

But no economic medicine would have been strong enough to take away Mexico's pain. During the first year of the crisis, private investment was down 30%. Inflation rose to 51%. Consumption fell by 10%, and wages lost roughly one-third of their value. Real incomes in many parts of Mexico still have not recovered from devastation wrought by the Tequila Crisis. It has been estimated that the crisis cost Mexico nearly one-fourth of its GDP, an expense the country will be paying off for decades to come.

GDP fell by 7% in real terms during 1995, but then quickly began to rise again. A boom in Mexican exports, fostered by a devalued peso, a strong U.S. economy and the NAFTA integration, quickly replenished Mexico's accounts.

The effects of the Tequila Crisis would reverberate far beyond the sphere of Mexico's economic relevance, as financial markets from Thailand to Sweden were attacked as a result. Countries like Argentina, which, like Mexico, had a weak banking system and a large current account deficit, were hit particularly hard.

The emerging markets were indelibly changed after the Mexico crisis. Awakened to the volatility of the global game, many countries began to scan their own economies for weak spots and the “Washington consensus” ideals of fiscal responsibility, monetary stability and competitiveness continued to be ideals that every emerging country was to strive for.

The Mexican crisis was a turning point for the powerful architects of the global economy. Policymakers in Washington realized that rigorous surveillance was crucial to avoiding the next Tequila crisis before it happened although in fact the Mexican lesson did not prevent similar outbreaks in East Asia and Russia a few years later.

Mexico was a special case, of course. Situated so intimately with the U.S., it clearly received the kind of special treatment that would not be offered to countries of lesser importance. This was demonstrated several years later when Argentina, whose economy is far more isolated than Mexico's, was allowed to fall without a bailout.

The Mexican crisis seemed to create more discord than agreement on preventative economic policy. Some argued that Mexico's fixed exchange rate should have been maintained and defended with tighter fiscal and monetary policy. Others blamed the debacle on the decision not to devalue earlier and impose capital controls to avoid a liquidity crisis. There was general agreement that the Mexican government's mixed messages regarding its exchange rate intentions served to heighten market uncertainty and intensify the downside.

The politics of NAFTA was partly to blame. Mexico's unsustainable policies went unquestioned by the Clinton Administration, which was busy selling the great economic prospects of its new trade partner to the American public. Mexico, on the other hand, had concluded that devaluation would be devastating to their chances of passing the trade deal through the U.S. Congress, which was already concerned about losing a competitive edge to Mexico. As a report by the Council on Foreign Relations later concluded, “The NAFTA debate did not encourage transparency.”

Mexico's massive financial rescue continues to be a focal point of an ongoing debate about the appropriate reaction to future emergencies. For instance, not everyone is convinced that the bail-out was a decisive factor in Mexico's recovery; a 2000 study by World Bank economists Joseph Stiglitz and Guillermo Perry gives much of the credit to a boost in investment arising from Mexico's engagement in NAFTA. Other critics blamed the strategy for setting a bad precedent and fuelling moral hazard; they argue that bond investors - who were among the biggest beneficiaries of the bail-out - can continue making risky bets in fragile economies, and governments can proceed with irresponsible policies, because they believe the U.S. and the IMF would step in and save them if things turned bad. But as volatile financial flows race and shift across the globe, the dangers of not responding to crisis may be incalculable.

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