Mexican Peso

http://econ161.berkeley.edu/Econ_Articles/themexicanpesocrisis.html

It is one thing to liberate an economy or a market; it is another to lift all regulations on such market. Economic liberalization should be done in an appropriate, intelligent manner. The lack of proper regulation can lead to a snowballing effect where a seemingly trivial matter can lead up to a terrible outcome. This was the case of Mexico in 1994 where birth was given to the "Tequila Effect". What were the conditions in the country that gave way to this crisis? Could the crisis have been avoided? Perhaps under a more strictly regulated economy Mexico's financial crisis could have been prevented, and if not, it could have been toned down in severity. The government's decision to liberalize the country intended well, but was poorly engineered and therefore became an uncontrollable Leviathan that took its toll on the country as a whole.

Leading up to 1994 Mexico seemed to be miraculously rising from its crippled past of inflation and instability, to become a shinning beacon for the rest of Latin America. It was the example to be followed and the cause for much excitement among the players in the financial markets. This phenomenon was known as the "Mexican miracle" and had been led by President Carlos Salinas de Gortari; a firm believer in neo-liberalization policies, and also the man who tackled inflation through a rigid fiscal and monetary policy, while strongly holding the exchange rate pegged at an average of 3.1 pesos to the dollar[1]. The new conditions of the Mexican economy were looked upon favorably by potential investment, and the stability it provided at home was very popular among the domestic population.

[1] Froot, K and Mathew McBrady, "The 1994-95 Mexican Peso Crisis", HBS Case No. 9-296-056 (Boston: Harvard Business School Publishing, 1996), 3

However the reforms did not stop there. It is questionable whether it was appropriate or not to go ahead with so many changes in the economic structure all at once. Privatization of state-owned firms, including the bank sector, took place, and plus the country opened up to investment from abroad both in the form of direct as well as portfolio investment [1]. For the first time in history, foreigners were allowed to hold Mexican government bonds and shares in private companies. Suddenly, Mexico became the recipient of massive capital inflows[2]. Between 1990 and 1993 Mexico received a total of $91 billion in overall investment; of that total 67% was in the form of short-term portfolio investment while the rest was in the form of foreign direct investment[3].

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[1] Froot, K, "The 1994-95 Mexican Peso Crisis," 2

[2] Froot, K, "The 1994-95 Mexican Peso Crisis," 8

[3] Froot, K, "The 1994-95 Mexican Peso Crisis," 2

But all was not well. A series of unexpected events, and poor foresight led to the eventual collapse of the system. Politics, it seems, was the driving force for many of the policies being implemented. Mexico was adopting a firm stance on its exchange rate to increase investor confidence and to tackle inflation, but more importantly, to look reasonably stable in order to be able to join the Organization for Economic Co-operation (OECD)[1] which fell smoothly in line with President Salinas' neo-liberal strategy. This exchange rate situation left the peso overvalued vis-Ðo-vis the dollar. The overvaluation led to a chain reaction, which culminated with the devaluation of the peso. This, in turn led to massive capital flight. To better understand the events that led to these conditions, let us start with the effects of an overvalued currency on the economy. Perhaps the first element of the sequential list is the fact that Mexican exports became expensive while imports were cheap[2]. Mexicans were finally able to import many foreign goods, which resulted in a current account deficit. Officials declared a lack of concern for the deficit stating that the high level of capital inflows more than made up for the losses made in the deficit[3]. Meanwhile, the interest rate kept increasing, putting pressure on the exchange rate to devalue. The central bank would respond by decreasing the money supply, and the government would respond by reducing government expenditure. Clearly, the government was neglecting growth in the name of inflation and its pegged exchange rate. Furthermore, the increasing interest rate made investors more attracted to buying government bonds, especially because the government was so committed to defend its exchange rate[4]. With this, the central bank's liabilities increased, while it quickly lost foreign reserves given its need to keep up with the increasing interest rate.

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[1] Sebastian Edwards, "Bad Luck or Bad Policies? An Economic Analysis of the Crisis," in Mexico 1994: Anatomy of an Emerging -Market Crash, ed. Sebastian Edwards and Moises Naim (Washington, D.C: Brooking Institution Press, 1997), 105

[2] Lustig, Nora, "Mexico the Remaking of an Economy," 2nd ed. (Washington, D.C: Brookings Institution Press, 1998) 147-151

[3] Rogelio Ramirez de la O, "The Mexican Peso Crisis & Recession of 1994-1995: Preventable Then, Avoidable in the Future?" in Mexican Peso Crisis, ed. Riordaon Roett (Boulder: Lynne Rierner Publisher Inc, 1996) 18

[4] Rogelio Ramirez de la O, "The Mexican Peso Crisis & Recession of 1994-1995: Preventable Then, Avoidable in the Future?", 12-15

Eventually fiscal policy was loosened in order to provide a slight degree of growth[1]. After all, elections were coming around and it was a good move to get people's spirits up. The peso was allowed to devalue within its pre-determined band, but investors began to get suspicious and the Mexican central bank was quick to sense the sudden lack of trust. In a final act, pursuing an increase in investor confidence, the Mexican Central Bank offered to convert all previous government bonds (cetes) into new dollar-denominated bonds (tesobonos)[2]. This move eliminated any peso related risk for the investors and passed the risk on to the central bank, which would have a tough time paying up if the