Unit 10: Study the financial crisis of 1994 in Mexico.

Describe
how the crisis manifested itself and discuss its causes.

INTRODUCTION

 Mexico is a federal constitutional republic in north America and has a

federation comprising of 31 states and a federal district
 It is the fifth largest country in the America by total area and 14 th largest
independent nation in the world.
 Mexico has an estimated population of 110 million people
 The economy of Mexico is the 11th largest in the world
 Mexico has a free market mixed economy and is firmly established as an
upper middle country and its domestic currency is the peso

MACROECONOMIC HISTORY OF MEXICO

 From the mid 1950’s to the early 1970’s mexico was a financially stable
country with high growth and relatively low inflation
 The sharp increases in oil prices in 1973-4 generated significant additional
export revenues for the Mexican government from the state owned oil
industry
 By the early 1980’s the Mexican economy was vulnerable to changing
conditions and perceptions in international capital markets
 Such changes were soon incoming with rising interest rates and falling oil
prices. This prompted to a capital market revaluation of mexico
 This revaluation quickly turned into a run from mexico and lead to a
significant economic crisis
 In august 1982 the Mexican government announced that it could not meet its
scheduled debt payments leading to the 1982 debt crisis
 Throughout the rest of the 1980’s the Mexican economy struggled under its
crushing debt burden
 Per capita GDP growth from 1982 to 1988 was -2% per year
 By late 1982, incoming president Miguel de la Madrid, had to reduce public
spending drastically, stimulate exports and foster economic growth to
balance the national accounts
 However recovery was extremely slow to materialized
 The economy was stagnated throughout the 1980’s as a result of continuing
negative terms of trade, high domestic interest rates and scarce credit
 Mexico GDP grew at an average of just 0.1% per year between 1983 and
1988, while inflation was on an average of 100%
 Public consumption grew at an average annual-rate of less than 2% and
private consumption not at all
 Total investment fell at an average annual rate of 4% and public investment
at an 11% pace
 After the crisis of 1982, lenders were unwilling to return to Mexico and in
order to keep the current account balance; the government resorted to
currency devaluations which in turn sparked unprecedented inflation which
reached a historic high in 1987 at 159.7 %.
 In 1986 Mexico became a member of the general agreement on tariffs and
trade(GATT)
 In 1989 the new incoming president Carlos Salinas De Gortari planned to
achieve growth by boosting the investment share of GDP and by
encouraging private investment through denationalization of state enterprises
and deregulation of the economy
 In 1990 Salinas took his next step toward higher capital inflows by lowering
domestic borrowing costs, reprivatising the banking system and broaching
the idea of a free trade agreement with the US
 The growth rate of real GDP rose impressively during the early years of
Salinas presidency but began to slow during the early 1990’s
 In 1992 Mexico joined the NAFTA(north American free trade agreement)
and this came into effect in early 1994
 The NAFTA further opened Mexico to foreign investment and bolstered
foreign investor confidence in Mexico
 This is mainly because investors perceived that with NAFTA, Mexico’s
long-term prospects for stable economic development were likely to
improve.
Mexico’s 1994 peso crisis

 Before 1994 Mexico’s lax monetary and fiscal policies appeared to be

having its intended effects
 Inflation has been reduced, government spending was down and foreign
capital investment was large
 Moreover, most of the foreign capital flowing to the Mexico’s private sector
rather than to the Mexican government to finance budget deficits
 By late 1994 Mexico was experiencing a very large current account deficit
both in absolute terms and in relation to the size of its economy
 There was a growing concern among the investors in Mexico about the
likelihood of a currency devaluation
 In response to this, the government issued large amount of short term dollar
indexed notes called “tesobonos”
 By beginning of December 1994, Mexico had become particularly
vulnerable to a financial crisis because its foreign exchange reserve had
fallen to $12.5 billion while it had tesobono obligations of $30 billion
maturing in 1995
 It became increasingly clear for the government to adjusted the monetary,
fiscal and exchange rate policies
 On December 20, Mexican authorities sought to relieve pressure on the
exchange rate by announcing a widening of the peso/dollar exchange rate
band
 The widening of the band effectively devalued the peso by 15%
 However the government did not announce any new measures to accompany
this devaluation
 This mistake led to a further loss of $4billion in foreign reserve and
contributed to the loss of confidence in the Mexico government
 Accordingly, the peso devaluation led to a rise in import prices, which
produced an annual inflation rate of around 50 percent, and a sharp rise in
nominal interest rates.
 This created significant financial exposure for the financial and non-
financial institutions, which had already accumulated huge amounts of
dollar-denominated short-term debt.
  The sharp rise in interest payments adversely affected their cash flows and
reduced the value of their assets, leading to the Mexican banking crisis of
1995.
 To minimize their exposure, banks and other financial institutions stopped
lending, leading to a full-fledged financial crisis.

The most important factors contributing to the peso devaluation are as

follows:

 paucity of reliable data and poor dissemination of financial information;

 Mexico’s inability to cope with challenges of its membership into the North
American Free Trade Agreement (NAFTA);
 its inefficient and segmented capital market and banking;
 the nation’s unwarranted and prolonged maintenance of an over-valued fixed
exchange rate regime;
 its dependence on volatile free-flowing portfolio capital;
 its external borrowings, particularly reliance on volatile short-term debt; and
 a host of politically destabilizing factors

Factors contributing to the peso crisis

1-Paucity of reliable data and poor dissemination of financial information

 it is one of the main structural weaknesses facing the Mexican economy

 There has been little and infrequent release of accurate and transparent
financial data and economic indicators by Mexican Central Bank (Bank de
Mexico) and other government agencies.
 Furthermore, most Mexican companies have been conducting non-
transparent accounting practices that are inconsistent with the international
accounting standards.
  This practice has allowed firms to manipulate financial data either to hide
profits and avoid the full burden of tax liability, or to hide corporate losses.
 Lack of adequate resources to train and supervise staff in preparation and
performance of independent audits of financial statements of public and
private sector, has created the asymmetric information problems of adverse
selection and moral hazard.
 Over the years this has arrested development of a sound financial system,
and has made Mexico’s financial markets vulnerable to external shocks.

2-The impact of NAFTA

 Mexico’s hasty membership in NAFTA was inadvisable.

 Prior to joining NAFTA, Mexico was engulfed in political turmoil and
social unrest.
 Despite movements toward liberalization of its economy, and some
privatization efforts, its economy was fundamentally closed with a
high degree of state ownership, inferior infrastructure and a weak
capital market and banking.
 Moreover, the Mexican economy was afflicted with chronic fiscal and
monetary problems, and a huge external debt, and trade account
deficit.
 Mexico’s financial problems were greatly compounded by its
premature membership in NAFTA in 1994 for the following reasons:

 NAFTA did not provide Mexican policy makers adequate time to assess the
implications and ramifications of functioning in a free market.

 According to Sachs (1996), the financial crises in Argentina, Mexico,

and Venezuela demonstrate that undercapitalized banking sectors may
exacerbate macroeconomic instabilities by engaging in large-scale
foreign borrowing at the time of capital-market liberalization.
 The weak and inefficient banking system in Mexico significantly
contributed to the destabilizing of the financial sector, since financial
deregulation took place before adequate measures were put in place.
  The result was excessive build-up of bank credits driven by moral
hazard.

 NAFTA did not effectively address issues concerning macroeconomic

coordination and monetary cooperation amongst the trading partners or
provide an adequate safety net while Mexico was undergoing rapid
deregulation and liberalization of its economy.

 There was a lack of coordination of economic policies among NAFTA

partners.
 Most notably, the impact of the US monetary policy, and its
ramification for Mexico’s small and debt-ridden, archaic economy
were little understood, and mostly ignored

 Trade liberalization under NAFTA imposed cost-price squeeze pressures on

many firms.

 The increased international competition held down prices in the

tradable goods sector while simultaneously increasing the prices of
non-tradable products.
 This condition created a double jeopardy on profits to firms engaged
in tradable goods, since most of their inputs used were non-tradable.

 Mexico’s joining NAFTA, and ensuing trade liberalization and deregulation

of capital market and banking stimulated large capital flows in the form of
portfolio investment.

 Banks and the capital account transactions were liberalized before

adequate regulation and supervision measures were in place.
 The result was an excessive accumulation of external credit and an
unprecedented lending boom driven mostly by moral hazard.
 The availability of foreign capital promoted excessive borrowing by
both the public and private sectors.
  As Mexican economic fundamentals deteriorated and the peso
became overvalued, foreign portfolio funds reversed direction
leading to the peso devaluation.

3-The impact of Mexico’s capital market and banking

 The major task of a nation capital market and banking system is to optimally
allocate funds into various productive investment opportunities.
 Hence, developing a strong and efficient capital market and banking system
is indispensable before any financial deregulation and liberalization of
financial system takes place.
 In Mexico, as in many emerging markets, structural and institutional
rigidities have hampered the development of the capital market and modem
banking.
 Despite recent improvements, the Mexican capital market suffers from
inadequate market regulation, security registration, high transaction costs,
and poor disclosure practices.
 These limitations have made the nation’s small capital market inefficient,
fragmented, and illiquid.
 This has restricted domestic savings, capital formation and economic
growth.
 Also, the inability of weak, inefficient Mexican banks to fund long-term
projects made the public and the private sector totally dependent on external
financing.
 Traditionally, Mexican banks have operated in a highly intrusive and non-
competitive environment.
 Mexico introduced multipurpose banking in the mid-1970s, where banks
could perform the functions of depository institution, savings bank,
mortgage bank, and finance company.
 Mexican banks were poorly managed and inadequately capitalized. President
Lopez Portillo nationalized the banking system in 1982.
 But ineffectiveness of the banking system led to Mexican government
selling its banks, during 1991-1992, to a few wealthy Mexican nationals for
somewhere between two to four times their book value.
 But, the newly privatized banks also failed to invest in training personnel
and new equipment. The banking sector disclosure standards were
substantially lower than those of their NAFTA counterparts.
 In short, they lacked the necessary managerial skill, accountability and
transparency, which are imperative for good business practice in a global
economy.
 Mexico’s 1994 peso crisis and ensuing 1995 banking crisis clearly
demonstrated that its capital market and banking did not possess the required
capacity to handle the nation’s growing investment demand nor flexibility to
absorb the shock emanating from volatile liquid portfolio funds.
 With the deregulation and liberalization of financial systems, there was a
huge inflow of international capital, particularly volatile liquid portfolio
funds, which created a huge rise in risky lending and investment activities
by banks.
 To attract customers, banks engaged in risky loans and offered above market
interest rates.
 For example, from 1988 through 1994, bank credit to the private sector rose
from 14 percent of GDP in 1988 to 55 percent.
 Most of these loans were for non-productive consumer credit, or for
speculative activities.
 Meanwhile, banks overloaded their balance sheet with external debts that
rose from $9 billion in 1989 to $23 billion in 1993.
 Hence, by late 1994, one-third of the loans extended by the Mexican banks
were in foreign currencies and 25 percent of these loans were to businesses
and individuals that had no income in foreign currencies.
 In Mexico, the very conservative estimate in percentage of loans that were
non-performing increased to over 10 percent before the financial crisis.
 Also the under-capitalized banks that were recently liberalized operated
under highly distorted moral hazard incentives to borrow excessively abroad
and to lend excessively to domestic firms.
 If the investments turn out to be profitable, bank owners make money.
 If the lending fails and firms default, bank owners have nothing to lose
because their own equity in the banks is very small, and the government
promises to bail them out.
 As a result, the nation’s banks developed huge financial leverage and
became highly exposed to external shocks.
 The speculative attack on the Mexican peso led to the currency devaluation
and the consequent deterioration in banks’ loan portfolio.
4-The impact of foreign portfolio capital
 Mexico’s low domestic savings rate (less than 16 percent of GDP in 1995)
along with its small and ineffective capital market and weak banking has
made the country too dependent on foreign capital flows to finance
economic growth.
 This dependence on foreign capital has become a structurally destabilizing
influence on the nation’s economy, particularly when most foreign capital
inflows were in the form of volatile liquid portfolio investments in bonds or
equities investments.
 The nation’s dependence on international liquid capital instead of immobile
foreign direct investment (FDI) became alarmingly high.
 Portfolio investment being liquid and mobile could easily reverse direction,
once investors’ confidence was undermined.
 Whereas FDI is associated with a transfer of technology, which in turn leads
to productivity increases.
 In addition, well-conceived direct foreign investment plans brought about by
creating linkages to the rest of the economy become an engine for stability
and growth.
 Moreover, by creating positive externalities, they improve the nation’s
structural efficiency.
 In 1993, the portfolio capital in Latin America peaked to $62 billion
compared with $21 billion in direct investment.
 The imbalance was particularly marked in Mexico, with portfolio inflows of
$28 billion and direct investment of only $7 billion.
 This is because Mexican laws encouraged portfolio investment while
restricting foreign ownership of Mexican business and the government
controlled the banking sector.
  Without having adequate safeguard measures in place to prevent capital
movements, the Mexican peso became much more vulnerable to capital
flight and hence external shocks.

5-The impact of the pegged exchange rate regime

 Before the devaluation of the Mexican peso, the peso was pegged to the US
dollar and traded within a narrow band (0.0004 pesos per dollar per day).
 The bands allowed Mexico’s central bank to manage monetary policies
independent of US Federal Reserve banks, to the extent that the resulting
movements in the exchange rates did not violate the boundaries set by
trading bands.
 There were two important policy considerations:

1. (1) The Mexican government successfully used the pegged rate to end
high inflation in the late 1980s, and it utilized the pegged exchange-rate
regime as a substitute for monetary policy to control inflation.
2. (2) Monetary policy was used as a political tool in an attempt to
stimulate the economy before the August presidential elections.

 Prior to the peso devaluation, Mexico’s money supply was allowed to grow
at about 20 percent during the first half of 1994.
 Although the Mexican government’s use of fixed exchange rate policy was
successful in lowering the inflation rate to 7 percent, the real exchange rate
rose.
 This was because the Mexican inflation rate was still more than twice the US
rate and the creeping devaluation of 0.0004 of the nominal peso per dollar
per day was insufficient to prevent the currency from being overvalued.
 The overvalued peso led to a huge deficit in the nation’s current account; the
resulting capital outflows lowered the nation’s foreign exchange reserve,
which was utilized to support the peso.
 Meanwhile, the rise in expected inflation after the currency crises led to a
sharp rise in nominal interest rates, which led to huge increases in interest
payments by firms.
  The outcome was a weakening of firms’ cash flow position and a further
weakening of their balance sheets, which then increased adverse selection
and moral hazard problems in the credit market.
 Mexico’s adoption of a pegged-exchange rate regime was not wrong but its
prolonged commitment to a fixed exchange rate regime, even when it was
apparent that it became overvalued, was the mistake.
 Under a pegged exchange-rate regime, when a successful speculative attack
occurs, the decline in the value of the domestic currency is usually much
larger, more rapid and more unanticipated than when depreciation occurs
under a floating exchange-rate regime.
 For instance, during the Mexican crisis of 1994-1995, the value of the peso
fell by half in only a few months.
 According to Sachs (1996), there are limited circumstances in which a
permanent pegged rate is appropriate. The first is for very small open
economies with a high degree of wage-price flexibility, such as Hong Kong.
The second case is a true monetary union, where the nations adopt an
irrevocable peg under a single currency, with a single issuer.

6-The impact of external borrowings

 Many emerging nations such as the USA in the nineteenth century and South
Korea in the twentieth century have relied heavily on external financing to
finance their economic development.
 As long as a country’s growth rate in gross domestic product (GDP) exceeds
the real interest rates it is paying on its debt, the borrowing nation’s income
generated by high growth rate should rise sufficiently to create savings to
service its debt.
 Historically, Mexico has repeatedly relied on huge external borrowings and
much of it in volatile short-term debts for non-productive reasons.
 The nation has suffered greatly from the consequences.
 Assumption of a large external debt resulted in the creation of huge
financial leverage, which made the peso more vulnerable to external shocks.
  Servicing these massive foreign debts, meanwhile, has meant liquidity
problems, a lowering of the standard of living, and restricting funds needed
for capital formation and economic growth.
 In 1994, Mexico ran up an imprudently large foreign debt, which reached
$160 billion. Foreigners provided 70 percent of peso-denominated bonds
(Cedes) and about 80 percent of outstanding dollar-denominated bonds.
 Interest payments to service these debts created an immense burden to both
the public and private sectors.
 Mexico’s ratio of short-term foreign debt relative to reserves exceeded 1.5.
This high degree of illiquidity suggests a high degree of vulnerability to a
financial crisis.
 Liberalization of financial markets and deregulation of capital account
enabled large Mexican financial and non-financial institutions with access to
cheap foreign capital to leverage their balance sheet with billions in dollar-
denominated loans.
 They became subject transaction and economic exposures.

7-The impact of political risk factors

 Political stability is a necessary prerequisite to financial stability in an

emerging nation.
 This is because events such as social unrest, armed rebellions, and
assassinations seriously impair the creditability of a country’s currency as a
medium of exchange and store of value.
 They undermine investors’ confidence in the viability of their investment
decisions.
 The impact of the political risk factor on Mexico’s in December peso
devaluation is clearly demonstrated by the loss of foreign exchange reserves
and the ensuing devaluation.
 With each significant political upheaval in 1994 in Mexico there was a loss
of foreign exchange reserves.
 For instance, the assassination of the presidential candidate Luis Donaldo
Colosio made the nation future look less certain to investors.
  when Colosio was assassinated, the Salinas administration reacted by
devaluating the peso to 3.4 pesos to a US dollar from 3.1 pesos to a US
dollar. It also used some of its foreign exchange reserves to purchase pesos.
 In Chiapas, because of grain imports, an armed rebellion erupted on New
Year’s Day 1994, causing the peso to drop by 10 percent.

Post-peso crisis developments

 The $50 billion bailout package arranged by the International Monetary

Fund and the US Treasury in 1995 required the Mexican government to
undertake major structural and institutional reforms to upgrade the nation’s
financial system.
 Since the peso crisis, the Mexican government has constituted a more
transparent regulatory framework.
 It has eliminated restrictions on capital inflows, limits on commercial
borrowing from abroad, investment in securities and money market
activities.
 Mexican investors are allowed to participate freely in foreign markets, and
controls on capital outflows have also have been abolished.
 Archaic bankruptcy laws have been reformed. Mexico has established
deposit insurance to protect small depositors.
Since the peso devaluation, Mexico has adopted a floating exchange rate
regime.
 In order to reduce volatility under the floating exchange rate system,
Exchange Stabilization Fund of US$18 billion has been established from
contributions of monetary authorities of other major countries and from
private commercial banks under the North American Financial agreement

CONCLUSION

 Mexico’s 1994 peso crisis has underlined the weaknesses in the nation’s
financial institutions, financial markets and economic policies.
 Mexico’s rapid deregulation and liberalization of its capital market and
banking, which was accelerated under NAFTA, has proved disastrous.
 Given Mexico’s structural deficiencies and institutional rigidities, prior to
the peso devaluation, the ensuing crisis was bound to happen.
 However, the recent structural and institutional reforms with better
dissemination of reliable and transparent information have stabilized the
economy and attracted FDI.

 According to Mexico’s Ministry of Finance, from 1984 to 1993 FDI averaged US$3.1
billion a year, while between 1994 and 1998 FDI averaged US$10.6 billion a year. The
nation’s GDP grew by 4.8 percent in real terms during 1998. Moreover, it is expected that
in 1999 and 2000, the Mexican economy will grow 3 percent and 5 percent respectively.
Monetary policy has been focused on the reduction of inflation; accumulated inflation
during the first eight months of 1999 was 8.5 percent, the lowest figure for that period
since 1994. This result is consistent with the government’s inflation target of 13 percent
for 1999. Inflation is expected to fall to 10 percent by the year 2000 (Ministry of Finance,
2000)