During the six years of the Salinas presidency in Mexico (1988 - 1994), GDP growth averaged 3.3% per year, a number that exceeded the growth rate of the population (2%) but fell well short of growth in other poor, developing countries. Although growth was lagging behind the pace of other emerging markets, Mexican politicians were willing to sacrifice rapid economic expansion for stability. The new, apparently more stable, Mexican economy entered 1994 with aspirations of joining the ranks of the more developed and industrialized nations of the world. The NAFTA trade arrangement and the country’s acceptance into the OECD in early 1994 were looked upon as signs that Mexico had finally arrived. However, the events of 1994 would prove that Mexico and its economy still had many problems. In his last State of the Union address on November 1, 1993, President Salinas emphasized the weight that the international factor played in many of the decisions which he made. According to Salinas, “ Mexico has changed intensely. The goals of these changes were the establishment of a new relationship between the state and society, and to place Mexico in an advantageous position in the new international reality.” The opening of the Mexican economy, or the apertura, had a profound effect on the daily lives of Mexicans. Prior to the relaxation of trade restrictions, only nationally produced consumer goods were available. In addition, import protection led to oligopoly prices for goods, which were in many cases second rate in nature. After the dismantling of ISI, a wide variety of products from around the world could be bought in stores at prices indicative of competition at the existing exchange rate. As a result, Mexican businesses began to import massive amounts of goods from around the world. Between 1988 and 1994, imports rose from $19 to $60 billion, an increase of over 300%. While many people would expect this increase to show up most in the realm of consumer products, it is noted that a large majority (71%) of Mexican imports consisted of intermediate goods. Although this number indicates increased integration between the US and Mexico, it is also a testament to policies which focused on the expansion of domestic industry.
While the increase in imports was an expected offshoot of liberalization policies, what many didn’t expect was the enormous current account deficit that developed immediately following the policy shift. As shown in the Appendix, Mexico’s current account deficit skyrocketed during the Salinas years. By 1994, the deficit was estimated at $28 billion, about 8% of GDP. In order to finance this enormous deficit, Mexico relied on voluntary movements of foreign capital into the country. Due to its growth potential, high rates of return and perceived stability, Mexico became a landing point for a great deal of foreign capital during the early 1990’s. During the Salinas Administration, the amount of foreign capital flowing into Mexico was astounding. Over the six-year period, the cumulative total of capital flowing into Mexico exceeded $ 50 billion, which at the time was equivalent to one fifth of all such inflows to developing economies. One third of these capital inflows were direct foreign investment with the remainder entering as a result of foreign portfolio choices. The net result of this capital inflow was an increase in the level of foreign reserves from about $6 billion in 1989 to about $30 billion in 1993. When Mexico initiated economic reform, the key element of its monetary policy was the use of the exchange rate as an anchor. By maintaining a stable nominal exchange rate, the government could effectively tie domestic prices to international prices.
During the early stages of Pacto reform, the exchange rate was fixed to the dollar and was later held to a widely known daily depreciation. Although the peso was allowed to float somewhat, the levels that it was allowed to move within were small throughout the early 1990’s. The benefits of keeping the exchange rate closely tied to the dollar was that it kept volatility low and allowed foreign investors a simple means by which to check Mexico’s monetary policy. In practice, if investment conditions weakened in Mexico either through lower relative growth prospects or higher inflation, dollars would leave Mexico and flow into places such as the US. This would result in upward pressure on the exchange rate, as people who previously held pesos would now buy dollars. In order to keep the exchange rate within the allowable band, the Mexican government would be forced to tighten monetary policy and increase interest rates. Since higher relative interest rates attract investors, dollars would flow back into the country and cause the exchange rate to fall. As a result of the nominal exchange rate targeting employed by the Mexican government, anyone who watched the movement of foreign reserves could predict what would happen to monetary policy.
From 1987 to the end of 1993, Mexico’s monetary policy was consistent with low inflation and exchange rate targets. In fact, it was so successful that inflation fell from a high of 160% in 1987 to around 7% in 1994. By December 20, 1994, just three weeks after new President Ernesto Zedillo Ponce de Leone took power, the peso was devalued, foreign investment was leaving and the nation’s economy was on the brink of disaster. Although Mexico’s large current account deficit was looked upon as a possible problem, many observers believed that as long as there were sufficient capital flows from abroad there was no need to panic or take action. What these people failed to realize was that a majority of the capital flowing into Mexico was in a form where it could just as easily flow out.
As was the case in most Latin American countries in 1994, most of the capital inflow to Mexico was in the form of portfolio investment. However, the difference between Mexico and other Latin American nations was the structure of the portfolio investments that foreigners were making. During 1994, external holdings of short-term public sector debt rose rapidly. These instruments were typified by relatively short maturities that were also readily transferable. One example of such an investment was the tesobono. These bills, though formerly designated in the local currency with high peso yields, contained an exchange rate guarantee that made them particularly attractive to foreign investors. By the end of 1994, 85% of the $20 billion of foreign holdings in Treasury bills were in tesobonos. In addition, foreigners were also very large holders of cetes, a short-term government security whose value was not linked to the US dollar. Whereas the tesobono was subject only to credit risk, return on the cete was associated with both exchange and credit risk. As a result of the country’s debt management policies, the total amount of short-term external debt, with maturity within the year, exceeded $67 billion as 1994 drew to a close.
While the amount of short-term debt was increasing, the amount of foreign reserves in the country was dwindling rapidly. Throughout 1994, Mexico was plagued by instability and civil unrest. Although Mexico had once again begun to grow economically, many of the poorer areas of the country had not taken part in the revitalization. Poverty in rural areas of the country was close to three times higher than that in urban areas and was concentrated in areas with large indigenous populations. In 1990, 32% of the population lived in the eight poorest states of the country, according to average per capita GDP numbers. However, theses areas were home to some 65% of the indigenous population. Although the government began to rectify the situation during the early 1990’s through revenue sharing plans and improved social welfare programs, the problem was far from rectified by 1994.
On January 1, rebels in Chiapas began a violent uprising in protest of rampant poverty, which prevailed in the region. Although the government increased its resources to the areas, the peasant population had grown tired of what it viewed as a lack of effective action on the part of national policy makers. Of all the Mexican states, Chiapas was in the worst shape with an estimated 36% of households living in extreme poverty. While poverty in Chiapas had existed for a long time, the situation worsened when the Mexican government signed the NAFTA agreement. As a result of the unraveling of the existing international arrangement, the price of coffee dropped and, with no safety nets in place, the people of Chiapas slipped deeper into poverty. While this would be a massive shock to stability in itself, Mexico was also subjected to other internal problems. The assassinations of presidential candidate Luis Donaldo Colosio and of Institutional Revolutionary Party leader Jose Francisco Ruiz were further indications that the nation was in a state of domestic turmoil
As stated earlier, some two-thirds of foreign capital inflow into Mexico was in the form of portfolio investment. One of the main reasons for investments of this type is that it gives investors the opportunity to get money out quickly when there are unforeseen shocks to the system. The instability exhibited by the assassinations and the violence in Chiapas prompted a large number of investors to reevaluate the attractiveness of the Mexican market. In addition to the higher risk associated with the country, relative return rates had fallen as a result of rising interest rates around the world. The consequence of this was a marked depletion in Mexico’s level of foreign reserves. Mexico had engaged in an exchange rate targeting policy, which necessitated the use of foreign reserves as a means of countering the effects of capital outflows. Due to the large outflow of capital during the year, the government was forced to utilize its foreign reserves to keep the peso at the desired exchange rate. Between February and December, gross foreign exchange reserves fell from $30 billion to $6 billion. By December 20, 1994, it was clear to policy makers that they could no longer target the nominal exchange rate.
In hopes of alleviating the strain on foreign reserves, the government decided to engage in a 15% devaluation of the peso. While this move was intended to stabilize peso financial markets, it had the opposite effect. Before the devaluation, the exchange rate was 3.46 new pesos to the dollar. Markets and international authorities came to the conclusion that Mexico would find it impossible to meet its short-term debt obligations without a coordinated package of support and tighter policies. After a failed attempt to use its minimal foreign reserves to maintain the peso at its devalued exchange rate of 4 new pesos to the dollar, the Mexican government was forced to allow the peso to float freely. As a result, the peso’s external value plummeted even further. By January 6th, the exchange rate had fallen to 5.795 pesos to the dollar. In addition to the crumbling peso, the domestic stock market fell as a result of the devaluation.
At the time of the crisis, foreigners held $50.4 billion in Mexican stocks, about 26% of the market. Their rapid exodus from the market resulted in an enormous decline in Mexican stock prices in the hopes of attracting new investors. However, even with lower prices, investors were still frightened by the perceived risks involved. By its own policy errors leading up to and following the Crisis, Mexico has made itself into a symbol from which lessons can be learned. In the eyes of many international observers, the problems that Mexico faced in 1994 were not the consequence of a failed economic framework, but an offshoot of errors made over a short period of time. The existence of massive foreign currency requirements in the short term and the lack of obvious sources of finance have been widely recognized as the major cause of the crisis. Through instruments such as the cete and the tesobono, Mexico had been able to finance its rising current account deficit, but as a result, the nation was exposing itself to a wide array of shocks.
During 1994, Mexico was hit by a number of shocks; most notably rising US interest rates and internal political unrest. The end result was a loss of investor confidence and subsequent outflow of capital from the country. While the debt management lessons to be learned from the Crisis are important, they merely provide the observer with the first layer of complexity. While Mexico’s debt management policy was far from sound, another serious problem within the country was the lack of information regarding important financial statistics. One of the main reasons for the jump in global capital flows in recent years has been the marked improvement in information technology. Due to the economic significance of private capital flows, which can sometimes be volatile, it is crucial that markets receive timely and accurate information about the economy. While information technology certainly has improved, many decisions are still based upon inaccurate, out-of-date information. In a system where information is made available frequently, markets can adjust their expectations continually, resulting in price and availability corrections that take place more smoothly. When information is provided infrequently and is subject to multiple revisions, assessments of the economic situation cannot be made on a regular basis. The result is that when accurate data is finally made available to the market, there is more of a tendency for large shifts to occur.
While there was a severe lag between actual reserve depletion and investor’s awareness of what was happening, asymmetric information was a plague that mainly affected foreign investors. At first, it would seem as though panicky foreigners were the cause of Mexico’s economic debacle in late 1994. However, studies by the IMF revealed that domestic investors were the first to pull their money out of the market. In the three weeks leading up to the initial devaluation, foreign investors sold only $326 million in government debt, while actually purchasing Mexican equity. However, Mexican reserves fell $2.8 billion over the same time. While the trade deficit accounted for some portion of the fall in reserves, a majority of the depletion was the result of nervous domestic investors. Due to their better acquaintance with the fragility of the Mexican economy, domestic investors were able to get out before the problems started. Foreigners, who lacked the knowledge of indigenous investors, did not begin large scale selling of Mexican equity until February 1995. Such dramatic differences in information between foreign and domestic sectors makes risk gauging extremely difficult and can cause major problems for investors. In addition to more transparent markets, the Crisis led to the belief that more effective surveillance and early-warning systems were needed as prevention tools.
Prior to the devaluation of the currency, there were no effective systems in place, either foreign or domestic; to monitor what exactly was happening inside the nation. Mexican officials had fallen into their old habit of focusing inward, ignoring possible external shocks to their economy. There have been demonstrable changes in the conduct of the surveillance process by individual nations and international agencies. These changes have focused their attention on increasing coverage of capital account issues, identifying possible pressure points and probing important financial systems. As a result of the trend towards increased surveillance, more structural problems are identified and corrected prior to their mushrooming into crisis situations. According to IMF policy, one of the organization’s main objectives is to, “Spot which countries are most likely to be heading for crisis, in time for them to implement corrective policies.” While all of the aforementioned lessons have had important implications in the world of international finance, I think that the most fundamental take-away from the Peso Crisis is that domestic problems and inefficiencies cannot be hidden through the utilization of foreign sector funds.
Since 1929, Mexico has been subject to the unbroken rule of the Institutional Revolutionary Party (PRI). Although Mexico has elections and puts on the facade of democracy, the reality of the situation is that the PRI determines who wins and who loses. While reform movements in recent years have attempted to usher in more democracy through the creation of reform groups and crackdowns on corruption, the PRI has never lost its tight control over the populace. In fact, many have speculated that political and social reforms have only been enacted as a means of appeasing the suspicious US government. While the effects of capital outflow would have probably been the same regardless of who ran the country, I think that the corrupt and authoritarian rule of the PRI was an environmental factor that facilitated the crisis. In addition to suspected corruption, narcotics trafficking and murder, the PRI was probably guilty of an even greater sin; listening to the public. As Mexicans acquired a taste for imports, the government received pressure to speed up the nation’s rapid trade and capital liberalization. Although Mexican savings had decreased as a result of increased consumption, the PRI policy makers decided to do what the public had asked. In order to finance increased imports, the government was forced to issue short-term debt in the form of tesobonos and cetes. As you can see, the PRI and its methods of rule played a key role in the unfolding of the Crisis in Mexico.
If policy makers hadn’t feared a public outcry against them, they could have stopped the Crisis before it even began. The Mexican Peso Crisis was certainly an important moment in world economic history. Although it was an example of what not to do, the Crisis pointed out a number of inefficiencies in international finance. Even though the PRI and President Salinas did a great disservice to the Mexican people, their incompetence has proven to be an invaluable resource for policy makers. It is essential that all of the parties involved with financial markets remember what happened in Mexico. This may just help to save their economy ……
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